Private equity sponsors should be aware of two recent court decisions. One involves fiduciary duties under state law that may be owing to a limited liability company borrower by its managers, in the context of receivables financing facilities or other asset-based lending transactions involving the use of special-purpose vehicles. The other involves certain implications of governing-law choices under acquisition financing and related agreements.
Pottawattamie: Maybe Not So Special (Purpose) After All
A private equity firm whose portfolio companies utilize receivables financing facilities, or other asset-based loan structures in order to reduce overall financing costs and increase debt-service capacity, are likely familiar with the formation of special-purpose vehicles (SPV’s). An SPV can house assets to be financed, and commonly agrees to limit its activities to owning those assets, so that the assets may be financed without the added credit risk and costs associated with operating activities and with owning and operating unrelated assets. SPVs are also commonly designed to minimize the possibility of a bankruptcy filing. Making the SPV “bankruptcy-remote” reduces financing costs further by limiting the delay and costs to creditors arising from a potential bankruptcy filing. Reduced financing costs are obviously attractive, but there are certain pitfalls that should be avoided in order for the parties’ expectations to be realized.
A recent case involves the issue of giving a secured lender to an SPV excessive control over its ability to file for bankruptcy, with the court finding that the contractual provisions at issue were void as a matter of both state law and federal bankruptcy law. In re Lake Michigan Beach Pottawattamie Resort LLC1 involved an operating agreement of a limited liability company (LLC) borrower that owned a vacation resort and which contained the provision in dispute.
The LLC borrower was organized in Michigan, where its resort was located. The resort was the key asset being financed under a secured loan. After the borrower’s default, and in the course of negotiating various forbearance agreements with the lender to postpone the exercise of secured creditor remedies, the borrower agreed to amend its operating agreement in order to give it certain SPV characteristics, including designating the secured lender as a “special member” whose vote would be required (along with that of all the other members) to authorize the borrower to file for bankruptcy.
Under the borrower’s amended operating agreement, the special member, in determining whether to authorize a bankruptcy filing, was required to consider “only such interests and factors as it desires, including its own interests, and shall to the fullest extent permitted by applicable law, have no duty or obligation to give any consideration to any interests of or factors affecting the Company or the Members.”2
Shortly after its operating agreement was amended, the borrower defaulted again and the lender began a non-judicial foreclosure on the resort by scheduling a public auction for it. In order to prevent the foreclosure auction from going forward, the remaining members of the borrower (not including the special member) voted to file for bankruptcy protection, which would trigger the automatic stay under U.S. bankruptcy law and prohibit the auction from taking place. This result was achieved, and the lender then filed a motion in the bankruptcy court to dismiss the bankruptcy case altogether, arguing that the bankruptcy filing was invalid because (among other grounds) the consent of the special member was required but not obtained, and thus the filing was unauthorized under the borrower’s constitutive documents.
The court rejected the lender’s motion, invoking both federal bankruptcy law and Michigan limited liability company law. The court reasoned that the special-member provisions in the company’s amended operating agreement were tantamount to an absolute prohibition on bankruptcy filing. One might consider whether the court’s reasoning in this regard may have been flawed to the extent it seemingly did not consider that, given evolving and oftentimes complex capital structures, a creditor in particular instances (e.g., when it views itself as holding the “fulcrum security”) may favor a bankruptcy filing, and thus even a veto right over such a filing would not be tantamount to an absolute prohibition on such a filing. However, under the court’s reasoning, the provisions were void as a matter of public policy under federal bankruptcy law due to the implicit absolute prohibition on filing.
Additionally the court noted that, under Michigan law, managers of an LLC must consider the interests of the entity in discharging their functions. The court pointed to the relevant Michigan statute:
A manager shall discharge the duties of manager in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner the manager reasonably believes to be in the best interests of the limited liability company.3
Contrary to Michigan’s statutory requirements, the special-member provisions of the amended operating agreement removed such fiduciary duties owing to the LLC borrower. The court therefore held that such provisions were invalid under Michigan law as well. Although the court acknowledged that the amended operating agreement purported to eliminate the special member’s fiduciary duties “to the fullest extent permitted by applicable law,” it found this “savings clause” to be meaningless in the context in question, and thus incapable of validating the provision at issue, in view of the inability under Michigan’s LLC law to disclaim the fiduciary duty to consider the interests of the entity.
Different Result with a Delaware LLC?
The SPV at issue in Pottawattamie was a Michigan LLC. The question arises as to whether the court’s decision would have been different had the LLC borrower been formed in Delaware, a more common jurisdiction of formation.
Delaware’s limited liability company law diverges from Michigan’s, providing greater flexibility and allowing an LLC to do away with manager fiduciary duties in its operating agreement. Compare the above Michigan statutory provision with the corresponding Delaware one:
To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.4
The Delaware statute reflects a policy that parties to limited liability company arrangements, who tend to be sophisticated and able to protect their own interests, should be afforded maximum freedom of contract, including the power to contract away fiduciary duties that otherwise may exist in a corporate context or in an LLC context in another jurisdiction.
Under Delaware’s LLC law, the elimination of the fiduciary duties of the special member should have survived judicial scrutiny, due to the flexibility afforded under Delaware law noted above. But the Pottawattamie court’s ruling likely would remain unchanged on account of the federal bankruptcy law basis of the court’s decision, which was an independent ground. Under the terms of the LLC borrower’s amended operating agreement, there was still what the Pottawattamie court held was a de facto prohibition against its filing for bankruptcy, sufficient under federal law to void the provision. In fact, the Pottawattamie court cited precedent from a bankruptcy court sitting in Delaware to bring home the point: “Bankruptcy courts are loathe to enforce any waiver of rights granted under the Bankruptcy Code because such a waiver ‘violates public policy in that it purports to bind the debtor-in-possession to a course of action without regard to the impact on the bankruptcy estate, other parties with a legitimate interest in the process or the debtor-in-possession’s fiduciary duty to the estate.’”5
A bankruptcy court in Delaware earlier this month in fact followed this approach in denying a secured lender’s motion to dismiss a chapter 11 case filed by a Delaware LLC,6 on grounds of its failure to have obtained the lender’s consent (as member of the LLC) to the filing as required by the LLC’s amended operating agreement. The court declined to rule on the Delaware state law issue raised (i.e., that the bankruptcy case was not validly authorized in accordance with the operating agreement), finding the federal public policy sufficient for its ruling: “A provision in a limited liability governance document obtained by contract, 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 of that entity 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.”7
Thus, even if the operating agreement provision in such a situation is valid under Delaware state law, it remains problematic under federal bankruptcy law.
Imposing instead on an SPV’s special member a fiduciary duty owing to “the limited liability company as a whole, including all of its creditors,” or otherwise making clear that the special member cannot simply ignore the entity’s interests but needs to consider them in making relevant decisions, should enhance the prospects that lenders’ expectations will be achieved in this regard and that a special member’s “No” vote to a proposed bankruptcy filing may be respected by a court. Imposing such a fiduciary duty in favor of the entity will obviously also comport with the SPV’s and sponsor’s interests generally.
Boilerplate under the Microscope
Many financing agreements provide that they are governed by New York law, and acquisition financing agreements are no exception. The parties will expect that, in the event of legal action under the agreement, the selected state’s law will apply.
For a legal action to be maintained, it must be commenced within the allotted timeframe under the applicable statute of limitation, effectively the deadline for bringing a lawsuit. Under a New York law governed loan agreement, if one knew that New York’s limitations period for contract claims is six years from the time the claim accrued, then one would expect this New York deadline to apply to any such claim under the agreement, regardless of where the claim was brought, right?
Not so fast.
The Delaware Superior Court, in Pivotal Payments Direct Corp. v. Planet Payment, Inc.,8 has answered the above question in the negative, as a matter of Delaware law. The case illustrates how, under a contract governed by New York law, the statute of limitation of another state (Delaware in this case) can apply to bar a claim for breach of contract. Under New York’s six-year statute of limitation there would have been no issue regarding the timeliness of the action, but under Delaware’s shorter three-year statutory period the claim could be time-barred and precluded from going forward.
Parties should be mindful of these issues so their expectations will be met in the event of litigation.
Pivotal Payments involved a breach of contract claim under a multi-currency processing agreement governed by New York law. The agreement provided for exclusive jurisdiction in federal and state courts in Delaware, which would be required to apply New York law to the substantive issues of the case. The plaintiff brought the claim in question five years after the alleged breach, asserting that New York’s six-year statute of limitation governs, under the contract’s New York governing law provision.
The court disagreed, and held that Delaware’s shorter three-year limitations period applies. The court held that a contract’s governing-law provision does not incorporate that state’s statute of limitation unless expressly so specified within the governing-law provision itself. The Delaware court thus treated the statute of limitation like a procedural rule, which ordinarily follows the law of the forum state, even when a different state’s law governs the substance of the dispute.
There are additional implications of the Pivotal Payments holding as well.
Consider, for example, a secured lender that brings an action in Illinois against a portfolio company borrower formed in Illinois, more than six years after the borrower’s payment default under a New York law governed loan agreement. Assume that the lender’s bringing the action in Illinois facilitates the exercise of certain remedies against collateral located in Illinois. New York’s applicable limitations period is six years, and Illinois’ is ten years.
Under the Pivotal Payments analysis, the lender would argue that Illinois’ ten-year limitations period should apply and that the action is thus timely. The portfolio company borrower would contend that New York’s shorter limitations period should apply to bar the action, given that New York law governs the contract. The borrower might contend, in addition, that the lender is merely “forum shopping” to get the benefit of Illinois’ longer limitations period, and that the court should bar the action to prevent such abuse.9
In this example a court might well reject the borrower’s contention that the lender was merely forum-shopping to get the benefit of Illinois’ longer limitations period, and thus side with the lender on that issue, since Illinois’ longer limitations period was not the only factor informing the lender’s choice of the Illinois forum. Bringing the action there would also facilitate the exercise of remedies against certain collateral located in Illinois pledged by the Illinois borrower. Ruling in favor of the lender also would be consistent with the holding in Pivotal Payments.
Private equity sponsors and their portfolio companies should be aware of the implications of their governing law choices under their acquisition financing and related agreements.