Rated and other debt issuances are often structured with borrowers that are special purpose entities, whose governance provisions are designed to inhibit bankruptcy filings. A recent District of Delaware bankruptcy court case, while not directly on point, throws into question the premises underlying the efficacy of such provisions.
Intervention Energy Holdings, LLC and Intervention Energy, LLC, each a Delaware limited liability company, were formed for the purpose of oil and natural gas exploration and production, operating almost entirely in North Dakota. To fund drilling and well-development costs, each Intervention entity entered into a Note Purchase Agreement with EIG Energy Fund XV-A and related entities, pursuant to which EIG purchased $200 million in senior notes, in the aggregate, issued by the Intervention entities and secured by liens on substantially all their assets.
After a time, the Intervention entities defaulted under the Note Purchase Agreement by breaching certain financial covenants contained in the Note Purchase Agreement, and EIG entered into amendments to the Note Purchase Agreement with the Intervention entities which, among other things, waived the defaults thereunder. In December 2015, the Intervention entities entered into the fifth such amendment, titled Amendment No. 5, Forbearance Agreement and Contingent Waiver.
Under the Forbearance Agreement, EIG waived all defaults under the Note Purchase Agreement if the Intervention entities raised $30 million in equity to repay a portion of the existing senior notes by June 1, 2016. As a condition to the Forbearance Agreement, EIG required Intervention Energy Holdings to amend its limited liability company operating agreement to issue one common unit to EIG and to require the unanimous consent of all common unit holders to authorize a bankruptcy filing of Holdings (the “Blocking Member Requirement”). The consideration for the newly issued common unit effectively consisted of the forbearance, waiver and amendments EIG provided under the Forbearance Agreement.
In May 2016, the Intervention entities filed a voluntary bankruptcy petition in the United States Bankruptcy Court for the District of Delaware ( In re Intervention Energy Holdings, LLC et al. , 2016 WL 3185576 (Bankr. D. Del. June 3, 2016)). EIG filed a motion to dismiss Holdings’ bankruptcy petition, asserting among other things that Intervention Energy Holdings was not authorized to file the voluntary petition because it had not obtained the consent from EIG required under the Blocking Member Requirement. In a June 2016 decision, the court denied EIG’s motion to dismiss, holding among other things that the Blocking Member Requirement, “the sole purpose and effect of which is to place into the hands of a single, minority equity holder the ultimate authority to eviscerate the right to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor — not equity holder — and which owes no duty to anyone but itself in connection with an LLC’s decision to seek federal bankruptcy relief is tantamount to an absolute waiver of that right, and even if arguably permitted by state law, is void as contrary to federal public policy.”
The requirement that a limited liability company obtain special consent for any voluntary bankruptcy filing is not new to limited liability operating agreements. Limited liability companies that are formed as special purpose entities (SPEs) typically build into their structure a blocking director or manager, the purpose of which is to reduce the likelihood of a voluntary bankruptcy filing by the SPE. The blocking director or manager is an important feature of SPEs generally, as the SPE structure is used for the purpose of isolating the assets of the SPE from the creditors of its parent company and minimizing the risk of a voluntary or involuntary bankruptcy filing related to the SPE.
Even when a financing does not involve any rated debt, financing providers often look to the criteria used by rating agencies in determining whether a borrower is bankruptcy remote when structuring loans to SPEs. Rating agencies have looked to the following four factors in determining whether there exists a meaningful risk that a company would be subject to a voluntary bankruptcy filing: (a) the presence of at least one independent director who is a nationally recognized corporate services provider; (b) the requirement of cause in dismissing any independent director; (c) the requirement of the independent director’s consent in any voluntary bankruptcy filing; and (d) the absence of any fiduciary duties requiring the independent director to consider the interests of the SPE’s shareholders when voting on whether to file for voluntary bankruptcy. 1
Following the decision in the Intervention case, the application of these criteria, and the bankruptcy remote nature of structures that were based on these criteria, have been called into question. A distinction that the ratings criteria highlights but was not before the court in the Intervention case was whether giving the consent right to an independent director or manager, rather than the lender itself, would be enough for the Blocking Member Requirement to survive a challenge under federal public policy. While that remains an open question, the decision in the Intervention case suggests that bankruptcy courts in Delaware may view this distinction with suspicion, given the working assumption by parties (and the market generally, as reflected in the rating criteria) that giving the right to an independent director or manager virtually eliminates as a practical matter the risk of a voluntary bankruptcy filing.
Based on the particular facts of the Intervention case — a borrower in financial distress with increasingly fewer workout options (and, as a result, declining bargaining leverage) and facing a real, short-term risk of bankruptcy — it is perhaps no surprise that a court would view the imposition of the Blocking Member Requirement as overreaching and as an absolute waiver by Intervention Energy Holdings of its right to seek federal bankruptcy relief. It remains to be seen whether different circumstances — for example, the inclusion of a Blocking Member Requirement or its practical equivalent using an independent manager or director at a time when the parties have more equal bargaining leverage and where the prospect of financial distress is more remote — would be viewed by a court as justifying a different conclusion than that reached in the Intervention case. Until courts give additional guidance in this respect, lenders and other counterparties to an SPE should consider the risk that impediments to a bankruptcy filing will be invalidated.