In order to file for bankruptcy, a corporate entity must be legally authorized to do so. Whether the bankruptcy petition has been duly authorized is governed by state law and often depends on the entity’s governance documents. If a petition has not been properly authorized, creditors may seek its dismissal.

Lenders, either in structured finance transactions or otherwise, routinely seek to limit their bankruptcy exposure by requiring that the borrower’s corporate governance documents include “bankruptcy remote” provisions which, inter alia, make filing for bankruptcy more difficult. This can be done as a precondition to lending or subsequently in a default situation such as a forbearance. The question, however, is whether such restrictions are enforceable in light of the public policy in favor of allowing a fresh start through bankruptcy. In In re Lexington Hospitality Group, LLC, Case No. 17-51568-grs (Bankr. E.D. Ky. Sept. 15, 2007), the bankruptcy court held that creditor-imposed restrictions in a limited liability company’s operating agreement that prohibited the company from filing bankruptcy without the creditor’s consent were unenforceable as a matter of federal public policy. The court also criticized the appointment of an independent manager who was given sole responsibility to pre-authorize any bankruptcy filing because the manager was not truly independent and the operating agreement purported to abrogate the manager’s fiduciary duties.

Background

The debtor operated in the hotel and hospitality industry, and was organized as a limited liability company under Kentucky law. Initially, the debtor was wholly-owned by Janee Hotel Corporation (“Janee”). Under the debtor’s operating agreement, Janee was also named as the company manager.

The debtor’s ownership and corporate governance structure changed after the debtor acquired a hotel in Lexington, Kentucky. PCG Credit Partners, LLC (“PCG”) financed the acquisition by loaning the debtor US$6.15 million in exchange for a promissory note secured by the hotel. As additional consideration, an entity controlled by PCG—referred to as “5532 Athens”—was provided a 30% membership interest in the debtor “until such point that [the debtor] has repaid the Loan Amount, Exit Fee…and Equity for funds.”

The debtor’s operating agreement was also amended to limit the debtor’s ability to file bankruptcy. First, a provision was inserted into the amended operating agreement that prevented the debtor from filing bankruptcy unless an “Independent Manager authorizes such action.” The independent manager, in turn, was instructed to consider not only the debtor’s interests, but also the interests of creditors and the economic interests of 5532 Athens. The amended operating agreement purported to eliminate any fiduciary duty or liability that the independent manager might have to other members or managers.

Second, even if the independent manager were to authorize the debtor’s bankruptcy filing, a vote of not less than 75% of the members was required to ratify the decision. Importantly, the amended operating agreement provided that 5532 Athens’ 30% membership interest could not be diluted until the promissory note was repaid. In this way, 5532 Athens was afforded an absolute veto right over any decision whether to authorize a bankruptcy filing.

Almost a year-and-a-half after the hotel acquisition, the debtor defaulted on the promissory note. The debtor and PCG entered into a forbearance agreement under which 5532 Athens was given an additional 20% membership interest in the debtor—for a total of 50%. Roughly five months later, the debtor defaulted under the forbearance agreement. Subsequently, PCG sued the debtor in state court and sought the appointment of a receiver.

Shortly thereafter, the debtor filed for chapter 11. The filing itself was authorized by Janee in its capacity as company manager. Only a few days into the proceedings, PCG filed a motion to dismiss the bankruptcy on the basis that the debtor failed to comply with the restrictions contained in its amended operating agreement. The debtor replied that the bankruptcy restrictions were unenforceable because they were against public policy.

Decision

The bankruptcy court agreed with the debtor and denied PCG’s motion to dismiss. The court held that, while state law generally governs whether an entity is authorized to file bankruptcy, the enforceability of bargained-for limitations on the debtor’s right to file bankruptcy is a question of federal public policy. The court then cited to decisions from the Delaware and Northern District of Illinois bankruptcy courts for the proposition that “contractual provisions in operating agreements that essentially prohibit a company’s ability to file bankruptcy without a creditor’s consent are void” on public policy grounds. The restrictions at issue were unenforceable in this case because they “create[d] an absolute waiver of [the debtor’s] right to file bankruptcy” since they “enabl[ed] an entity controlled by PCG to carry the deciding vote….”

A conflicting provision of the amended operating agreement that required advance written consent directly from PCG to authorize a bankruptcy filing was found unenforceable on public policy grounds as well.

The court also questioned the independent manager’s role. In particular, the court reasoned that, while “[a] requirement that an independent person consent to bankruptcy relief…is not necessarily a concept that offends federal public policy,” the debtor’s amended operating agreement was drafted such that the manager was not truly disinterested and was instead beholden to creditor interests. The court was particularly troubled that the amended operating agreement purported to abrogate the independent manager’s fiduciary duties to the company, reasoning that “[a]n independent decision maker cannot exist simply to vote ‘no’ to a bankruptcy filing, but should also have normal fiduciary duties.” With the bankruptcy restrictions excised from the agreement, the court held that the debtor’s chapter 11 petition had been duly authorized under Kentucky law.

Implications

Lexington Hospitality Group follows a trend of bankruptcy court decisions scrutinizing attempts by lenders and securitization transactions parties to limit a borrower’s ability to file bankruptcy. In all likelihood, these decisions will impact negotiating dynamics between lenders and borrowers, particularly in pre-bankruptcy distressed situations in which the lender’s ability to limit the borrower’s right to file bankruptcy is important. Another situation in which these issues will be paramount is in structured financed transactions wherein so-called “bankruptcy remote” vehicles are often used. While the court was careful to broadcast that bestowing a truly independent manager having appropriate fiduciary duties with sole authority to authorize or prevent a bankruptcy filing would likely withstand scrutiny (a mechanism that is often used in structuring bankruptcy remote vehicles), parties should be mindful of the court’s guidance in structuring such vehicles.

Read the decision »