Courts disagree over whether provisions in a borrower's organizational documents designed to prevent the borrower from filing for bankruptcy are enforceable as a matter of federal public policy or applicable state law. There have been a handful of court rulings addressing this issue in recent years, with mixed outcomes. The U.S. Bankruptcy Court for the District of New Jersey weighed in on this controversial issue in In re 3P Hightstown, LLC, 631 B.R. 205 (Bankr. D.N.J. 2021). The court dismissed a chapter 11 case filed by a Delaware limited liability company ("LLC") because the LLC agreement precluded a bankruptcy filing without the consent of a holder of preferred membership interests whose capital contributions had not been repaid. According to the court, the bankruptcy blocking provision was not void as a matter of public policy because, under both Delaware law and the express terms of the LLC agreement, the holder of the preferred membership interests, which held a noncontrolling position, had no fiduciary duties.
Bankruptcy Risk Management by Lenders
Astute lenders are always looking for ways to minimize risk exposure, protect remedies, and maximize recoveries in connection with a loan, especially with respect to borrowers that have the potential to become financially distressed. Some of these efforts have been directed toward minimizing the likelihood of a borrower's bankruptcy filing by making the borrower "bankruptcy remote," such as by implementing a "blocking director" organizational structure or issuing "golden shares" that, as the term is used in a bankruptcy context, give the holder the right to preempt a bankruptcy filing. Depending on the jurisdiction involved and the particular circumstances, including the terms of the relevant documents, these mechanisms may or may not be enforceable.
As a rule, corporate formalities and applicable state law must be satisfied in commencing a bankruptcy case. See In re NNN 123 N. Wacker, LLC, 510 B.R. 854 (Bankr. N.D. Ill. 2014) (citing Price v. Gurney, 324 U.S. 100 (1945)); In re Comscape Telecommunications, Inc., 423 B.R. 816 (Bankr. S.D. Ohio 2010); In re Gen-Air Plumbing & Remodeling, Inc., 208 B.R. 426 (Bankr. N.D. Ill. 1997). As a result, while contractual provisions that prohibit a bankruptcy filing may be unenforceable as a matter of public policy, other measures designed to preclude a debtor from filing for bankruptcy may be available.
Lenders, investors, and other parties seeking to prevent or limit the possibility of a bankruptcy filing have attempted to sidestep the public policy invalidating contractual waivers of a debtor's right to file for bankruptcy protection by eroding or eliminating the debtor's authority to file for bankruptcy under its governing organizational documents. See, e.g., In re DB Capital Holdings, LLC, 2010 WL 4925811 (B.A.P. 10th Cir. Dec. 6, 2010); NNN 123 N. Wacker, 510 B.R. at 862; In re Houston Regional Sports Network, LP, 505 B.R. 468 (Bankr. S.D. Tex. 2014); In re Quad-C Funding LLC, 496 B.R. 135 (Bankr. S.D.N.Y. 2013); In re FKF Madison Park Group Owner, LLC, 2011 WL 350306 (Bankr. D. Del. Jan. 31, 2011); In re Global Ship Sys. LLC, 391 B.R. 193 (Bankr. S.D. Ga. 2007); In re Kingston Square Associates, 214 B.R. 713 (Bankr. S.D.N.Y. 1997).
These types of provisions have not always been enforced, particularly where the organizational documents include an outright prohibition of any bankruptcy filing. See In re Lexington Hospitality Group, 577 B.R. 676 (Bankr. E.D. Ky. 2017) (where an LLC debtor's operating agreement provided for a lender representative to be a 50% member of the debtor until the loan was repaid and included various restrictions on the debtor's ability to file for bankruptcy while the loan was outstanding, the bankruptcy filing restrictions acted as an absolute bar to a bankruptcy filing, which is void as against public policy); In re Bay Club Partners-472, LLC, 2014 WL 1796688 (Bankr. D. Or. May 6, 2014) (refusing to enforce a restrictive covenant in a debtor LLC's operating agreement prohibiting a bankruptcy filing and stating that the covenant "is no less the maneuver of an 'astute creditor' to preclude [the LLC] from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy").
Many of these efforts have been directed toward "bankruptcy remote" special purpose entities (sometimes referred to as special purpose vehicles) ("SPEs"). An SPE is an entity created in connection with a financing or securitization transaction structured to ring-fence the SPE's assets from creditors other than secured creditors or investors (e.g., trust certificate holders) that provide financing or capital to the SPE.
For example, in In re Gen. Growth Props., Inc., 409 B.R. 43 (Bankr...
