Does the bankruptcy filing of a limited liability company without the approval of its “Special Member,” the secured lender serving as “blocking director,” render that filing infirm as unauthorized and subject to dismissal? Not necessarily, held the United States Bankruptcy Court for the Northern District of Illinois in a decision concluding that the secured lender’s blocking director playbook in that case was missing an essential page — the debtor’s amended operating agreement allowed the blocking director to consider only its interests, without consideration to any interest affecting the debtor. This absence of member fiduciary obligations was contrary to the law of the debtor’s state of formation (Michigan) and rendered the “blocking director” provision of the operating agreement void as a matter of both state and bankruptcy law. In Part One of this two-part series, we delve into the bankruptcy court’s analysis of the allegedly unauthorized filing, and in Part Two, we tackle why the court disagreed with the secured lender’s argument that the debtor’s filing was in bad faith.
What is a “blocking director”? Blocking directors are typically appointed by secured creditors in structures called “bankruptcy-remote special purpose vehicles or entities” (sometimes referred to as “SPVs” or “SPEs”), which are intended to insulate the particular assets in those entities from a bankruptcy filing. True to its name, a blocking director has the ability to block a bankruptcy filing because the entity’s organizational documents do not authorize a filing absent unanimous director consent.
In In re Lake Michigan Beach Pottawattamie Resort LLC, the “blocking director” provision appointing the secured lender as a member was included in an amendment to the debtor’s operating agreement after the debtor, a Michigan LLC, had defaulted on its debt. The provision granted the “Special Member” the right to approve or disapprove certain actions by the debtor, including the filing of a bankruptcy petition. In addition to executing the amendment, the secured lender and debtor executed a forbearance agreement under which the secured lender promised to forbear from exercising any remedies until a date certain. Ultimately, the debtor failed to pay by the deadline, the secured lender initiated a non-judicial foreclosure sale, and the debtor subsequently filed a petition for chapter 11 relief.
Moving to dismiss the case, the secured lender argued, among other things, that the filing was unauthorized because the “Special Member” did not approve it (notably, the remaining majority members had done so). In response, the debtor argued that the “blocking director” provision was “void as against public policy because it amount[ed] to a prohibition of the Debtor’s right to exercise its right to bankruptcy relief and, alternatively, [was] not valid under Michigan law.” After parsing through case law and the debtor’s amended operating agreement, the bankruptcy court denied the secured creditor’s motion to dismiss.
Citing to supporting case law from a number of jurisdictions, including Delaware and the Southern District of New York, the bankruptcy court explained that “blocking director” provisions cannot be used as an end-run around blanket prohibitions against bankruptcy filings in organizational documents, which are likely void against public policy. A blocking director provision is an end-run around such prohibition where, as here, the operating agreement rendered the “Special Member” immune from any member fiduciary duties by explicitly allowing the secured lender to consider only its own interests, without any regard to the debtor’s interests. The court held that a blocking director “must always adhere to his or her general fiduciary duties to the debtor in fulfilling the role.” Because that did not happen in this case, the provision was void.
In addition to being a violation of bankruptcy law, the court found that the provision violated Michigan law. The bankruptcy court observed that the “blocking director” provision in the amended operating agreement was in direct contravention of a section of the Michigan Limited Liability Company Act that required each LLC member to, among other things, discharge its duties “in a manner [it] reasonably believes to be in the best interests of the limited liability company.” Although the court acknowledged the existence of a savings clause, which allowed the member to “consider only such interests and factors as it desires . . . to the fullest extent permitted by applicable law,” the savings clause could cure the provision “only by rendering it meaningless.” Consequently, the bankruptcy court held that the “blocking director” provision was void under Michigan corporate governance law.
After finding that the blocking director provision was void under both bankruptcy and state law, the court concluded that the filing was authorized, as the remaining members voted in favor of the filing.
In drafting “blocking director” provisions, Lake Michigan stresses that consideration should be given not only to the law of the entity’s state of formation (Delaware, for example, permits LLC members to restrict or eliminate fiduciary duties, subject to the implied covenant of good faith and fair dealing), but to bankruptcy law as well (which requires leaving intact a blocking director’s fiduciary duties to the entity). Thus, drafters of “blocking director” provisions should mark the page in the Lake Michigan blocking director “essential playbook” — leave out the blocking director’s fiduciary duties to the debtor, and your move to dismiss the bankruptcy case will likely be blocked.