Bankruptcy Court Chips Away at Bankruptcy Remoteness of Special Purpose Vehicles

April 18, 2016

A Chicago bankruptcy court declined to dismiss the Chapter 11 case of a “bankruptcy remote” limited liability company even though the debtor failed to obtain the unanimous consent of its members as required by its operating agreement. See In re Lake Mich. Beach Pottawattamie Resort, LLC, Case No. 15bk42427, 2016 Bankr. LEXIS 1107 (Bankr. N.D. Ill. April 5, 2016).

The debtor was a Michigan limited liability company that owned and rented vacation property in Michigan. The debtor defaulted on a loan secured by the debtor’s real estate and other assets owned by related parties. When the lender was on the verge of completing its foreclosure on the debtor’s real estate, the debtor filed a Chapter 11 in Chicago. The lender moved to dismiss the case because, among other things, the filing was not authorized by all members, and an amendment to the LLC operating agreement provided for unanimous consent of members, including a “special” member appointed by the lender.

The court first approached the issue by focusing on corporate directors, stating that corporations, like individuals, should be constrained by public policy consideration from contracting away their bankruptcy rights. However, the court indicated that “an improperly authorized corporate bankruptcy filing is infirm.” The court also found that while corporate control documents may limit authority to seek bankruptcy protection, such documents “should not include an absolute prohibition against bankruptcy filing,” because a corporate director must adhere to his or her fiduciary duties to the debtor.

The court extended that analysis to limited liability company members. It found that, under Michigan law, the bank’s special member could not exercise a blocking position unless that member took into consideration the debtor’s interests. Absent that duty, which was eliminated for only the special member by an amendment to the operating agreement, the debtor’s “playbook was … missing a page,” and thus the “blocking” provision was unenforceable.

This decision demonstrates the reluctance of many bankruptcy courts to permit a lender, who disclaims any fiduciary duty to the debtor, to limit the debtor’s access to bankruptcy protection. Consequently, lenders and their counsel may want to re-evaluate the extent to which special purpose vehicles are “bankruptcy remote” or a blocking member or director can be insulated from attack for exercising a blocking position. Counsel for lenders may also want to review their “playbook” to determine if it achieves the appropriate balance of interests.