In an effort to minimize the risk of loss in connection with a loan default, lenders often employ creative means to make it difficult, if not impossible, for a borrower to file bankruptcy. Lenders are generally aware that the right to seek bankruptcy protection is a fundamental constitutional right, given the inclusion of Congressional power to establish uniform laws on bankruptcy set forth in Article 8 of the U.S. Constitution. As a result, bankruptcy courts have regularly denied motions to dismiss bankruptcy cases predicated upon a violation of a loan agreement covenant prohibiting the filing of a bankruptcy case.
Some lenders require the formation of a bankruptcy-remote entity, by mandating that a borrower form a new special purpose entity (SPE) to use as the vehicle to obtain a loan, which is then subject to stringent loan covenants designed to minimize the risk that other obligations might be incurred which would drive the SPE into bankruptcy. Other lenders require their borrowers to modify their organizational documents to add one or more independent directors whose consent is required before certain organic changes, such as the commencement of a bankruptcy case, can be implemented.
Most lenders are aware that a direct prohibition in a loan agreement on the filing of a bankruptcy petition is unenforceable. A recent case from the U.S. Bankruptcy Court from the District of Oregon,In re Bay Club Partners-472, LLC , highlights a creative approach undertaken by one lender to attempt to overcome this limitation. Instead of having the prohibition against commencing a bankruptcy case included in the loan agreement, the lender required the borrower to amend its operating agreement to prohibit the commencement of an insolvency proceeding until the loan to the lender was paid in full.
After the borrower filed bankruptcy, the lender filed a motion to dismiss the bankruptcy case. The lender argued that the borrower’s operating agreement prohibited the borrower from filing for bankruptcy protection. After concluding that the creditor had standing to file and prosecute the motion to dismiss, the bankruptcy court concluded that the pre-petition waiver of bankruptcy protection was contrary to public policy and was unenforceable.
The court called the lender’s tactic in requiring the borrower to amend its operating agreement and insert the prohibition against filing bankruptcy “more cleverly insidious” than merely inserting a similar provision in a loan agreement. It was clear to the court that the prohibition against filing bankruptcy contained in the borrower’s operating agreement was “a distinction without a meaningful difference” from the insertion of such a provision in a loan agreement, and in either event was unenforceable as a matter of public policy.
This is far from a settled area of the law. In an earlier case, In re DB Capital Holdings, LLC , the Bankruptcy Appellate Panel for the Tenth Circuit Court of Appeals upheld on appeal an order from the bankruptcy court granting a motion to dismiss the bankruptcy case of a debtor whose operating agreement prohibited the LLC’s members and management from filing a bankruptcy petition. The Tenth Circuit B.A.P. determined that in the absence of evidence of coercion by a creditor that led the members of the LLC to adopt this bankruptcy prohibition provision in the LLC’s operating agreement, the order granting the motion to dismiss was appropriate.
The Tenth Circuit’s analysis suggests that the scenario which best supports a lender’s goal of lending to a bankruptcy-remote entity is to extend a loan to a borrower which has a bankruptcy prohibition provision in its organizational documents before ever seeking a loan. Consistent with the holding of Bay Club Partners, if the bankruptcy prohibition is inserted in the borrower’s organizational documents at the insistence of the lender, it appears likely that a court will find the prohibition is unenforceable as a violation of public policy.