Bankruptcy Filing Veto: Better Follow the Playbook

In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016)

A mortgage lender moved to dismiss a chapter 11 bankruptcy case filed on the eve of foreclosure without the lender’s consent (in its role as a special member of the debtor) on the grounds that the case was filed in bad faith and the filing was not authorized.

The debtor owned a vacation resort that included condominium units and a cabin that were seasonally rented and undeveloped land. It granted a mortgage and assignment of rents to the lender to secure a ~$1.3 million loan and a $500,000 line of credit. Within 6 months the debtor defaulted. The parties agreed to a forbearance that included the debtor’s stipulation that it owed ~$2.6 million and its agreement to certain conditions.

In particular, the debtor (which was a limited liability company) agreed to amend its operating agreement to add the lender as a “Special Member.” The Special Member did not have any economic rights or obligations, but was given the right to approve or disapprove of any “Material Action.” The definition of Material Action included several actions such as merging, selling substantially all of the company’s assets, instituting litigation and liquidation, but primarily focused on instituting or consenting to any sort of bankruptcy or insolvency proceeding.

When deciding whether to consent or not, the Special Member “is not obligated to consider any interests or desires other than its own and has ‘no duty or obligation to give any consideration to any interest of or factors affecting the Company or the Members.'” Thus, the lender was given a right to block the debtor from filing a bankruptcy petition based solely on its own self-interest.

After the debtor defaulted at the end of the forbearance period, the lender commenced a non-judicial foreclosure. Shortly before the foreclosure sale the debtor filed bankruptcy to prevent the sale from occurring.

The lender argued that the case should be dismissed for “cause” because it was filed in bad faith. The court acknowledged that the lack of good faith can provide a basis dismissing a bankruptcy case. The court’s evaluate this issue on a case to case basis, and typically begin by reviewing a long list of factors.

In this case the lender identified about a half-dozen factors that it contended were applicable. The court rejected the lender’s characterization of facts that it alleged supported several of the factors and noted that other factors without more did not justify dismissal. In particular:

  • “It is well settled, of course, that the filing of a bankruptcy petition on the eve of a foreclosure or eviction does not, by itself, establish a bad faith filing.”
  • “[T]he fact that this is a single asset real estate case does not render it a bad faith filing.”

In evaluating this issue, it appears that a key consideration in the court’s determination that the case was not filed in bad faith was the fact that the debtor had equity in the property so that it had a legitimate interest to protect by filing bankruptcy.

With respect to whether the filing was unauthorized because the lender acting as a special member of the debtor did not consent, the court considered both state governance and federal bankruptcy law. The debtor argued that the lender consent provision (1) was void as against public policy because it in effect prohibited the debtor from exercising its right to bankruptcy relief, or (2) alternatively was not valid under state law.

As background the court explained that the practice of using “blocking directors” was intended to “ring fence assets from creditors other than a secured creditor who is unwilling to lend otherwise and for whom the structure is made.” (Note that the court used the term “director” interchangeably with “member” or “manager” of an LLC.) The court posed the question of why anyone would go to such an effort. It answered its own question by noting that a simpler, absolute prohibition against filing would probably be deemed void as against public policy.

Prior to the Third Amendment the debtor’s operating agreement required approval of actions by a majority in interest based on “Sharing Ratios,” which were determined based on capital contributions. Absent the Third Amendment, the petition would have been properly authorized. However, the Third Amendment superseded any conflicting or inconsistent provisions in the operating agreement, and as a threshold matter the state LLC statute permitted modification of the default requirement for approval by a majority of interests.

Turning to the question of whether the Third Amendment approval requirement passed muster as a permissible procedure:

The essential playbook for a successful blocking director structure is this: the director must be subject to normal director fiduciary duties and therefore in some circumstances vote in favor of a bankruptcy filing, even if it is not in the best interests of the creditor that they were chosen by.

[The lender’s] playbook was, unfortunately, missing this page.

Consequently, the court denied the lender’s motion to dismiss.

There were several places in the opinion where the court commented on formatting in the lender’s brief – noting items in italics and/or bold. The court provided the following elaboration in a footnote:

While court filings share little in common with email and other forms of modern, textual communication, in each medium parties are encouraged to exercise decorum and not to overuse emphasis. Just as all capital letters are deemed to be shouting in the latter, so goes bold plus italics in the former. The parties are cautioned against the overuse of textual modification for emphasis.

The court’s irritation probably did not make any substantive difference in this case, but it is easy to imagine circumstances where a court’s negative reaction to overuse of exclamation points or other forms of emphasis could be just enough to tip the balance in a close case.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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