Authority to File Bankruptcy: When Is a Veto Void as Against Public Policy?

Squire Court Partners L.P. v. Credit Enhanced Partners LP Series J (In re Squire Court Partners L.P.), 574 B.R. 701 (E.D. Ark. 2017)

A general partner filed a bankruptcy petition on behalf of a limited partnership without consent of the limited partners. The limited partners objected and moved to dismiss. The bankruptcy court granted the motion on the grounds that the general partner did not have authority to file, and various parties appealed to the district court.

The debtor was a limited partnership formed to develop an apartment complex using low-income housing tax credits. One limited partner committed to make capital contributions of ~$1.4 million. It had a 99.98% interest in the partnership, a second limited partner had a .01% interest, and the general partner had a .01% interest.

In connection with the project an affiliate of the general partner executed a typical “Development Deficit Guarantee Agreement” which obligated it to cover designated costs, such as (1) acquisition and development costs (including a $3.4 million mortgage) in excess of revenue and (2) expenses in excess of collections necessary to maintain break-even operations. The appellants claimed that the project was expected to reach break-even operations within the first year or so but was not achieved. As a result, the guarantor claimed that it contributed more than $2.4 million under the guarantee.

When the debtor defaulted on the mortgage, the mortgagee accelerated the mortgage. The guarantor refused to pay the accelerated amount, so the limited partners filed suit to enforce the guarantee. In the meantime, the general partner filed a Chapter 11 petition on behalf of the limited partnership.

Under the partnership agreement, the general partner “was given exclusive authority to manage and control [the debtor’s] business, assets, and affairs.” However, the agreement also required unanimous consent of the partners before the general partner could file a bankruptcy petition on behalf of the partnership. The general partner sought the consent of the limited partners before filing, but they declined.

The limited partners moved to dismiss the bankruptcy case, arguing in part that the general partner lacked authority to file since they did not consent and that the petition was filed in bad faith. They also moved for sanctions against the general partner.

The primary response of the appellants was that the partnership agreement provision requiring unanimous consent was void as a matter of public policy. They argued that only a fiduciary should be able to decide whether to file bankruptcy. In this case the unanimous consent requirement constituted a veto held by self-interested parties with no obligation to put the partnership interests ahead of their own.

The appellants also contended that the limited partners were unable to act in the best interests of the partnership because there was a conflict in interest due to their capital contribution commitment and their decision to sue to enforce the guarantee rather than filing bankruptcy. “The combination of conflicting interests and a lack of fiduciary duties, [the appellants] say, frustrates the partnership’s constitutional right to seek bankruptcy relief.”

The district court noted that the authority to file a bankruptcy petition derives from state law. In this case that meant a combination of the state partnership statute and the limited partnership agreement: Under state law, the partnership agreement governed the relations of the partners in the partnership. The agreement required unanimous consent, and not all partners consented. Consequently, unless the consent requirement could be invalidated as against public policy, the petition was filed without authorization.

The court considered three cases cited by the appellants in support of their position. In the first case, after default the debtor gave a creditor “special member” status if it agreed to forbear. In particular, the creditor as special member had the right to approve certain actions, including filing bankruptcy. The creditor had no interest in the profits or losses, no right to distributions, no tax consequences, and no obligations to make capital contributions. It only had the authority to block the debtor from filing a bankruptcy petition.

Similarly, in a second case after default the debtor agreed to make the creditor a “common member” in exchange for waiving defaults. The debtor had issued 22,000,001 common units, and the creditor held one common unit. In the third case, in connection with making a loan the creditor requested that the debtor’s operating agreement include restrictive covenants, including a prohibition on filing bankruptcy until the loan was paid in full.

The court agreed that in each of these cases the contractual provisions amounted to a prepetition waiver that limited the debtor’s right to seek bankruptcy relief as a condition of supplying credit. This violated federal public policy.

However, the court noted that none of the cases stood for the more general proposition that a nonfiduciary cannot have a controlling role in deciding to file bankruptcy. Discussions about a “blocking director structure” were made in the context of an outside party attempting to control internal corporate matters. However, in this case the limited partners were owners, not creditors of the debtor.

The court also rejected the argument that case law discussing corporate directors meant that a bankruptcy decision should be made by fiduciaries. Instead, the court found that decisions holding that directors rather than shareholders had authority to file bankruptcy on behalf of a corporation stemmed from the delegation of authority to the board of directors, not the fact that they have fiduciary duties.

Here there was a broad delegation of authority to the general partner. However, that was qualified by a retention of the right to decide whether to file bankruptcy based on the unanimous consent of the partners. The parties negotiated giving each partner the power to veto a bankruptcy petition.

Thus, the general partner did not have authority to file a bankruptcy petition on behalf of the partnership since it did not have unanimous partner consent. In ruling on several additional arguments, the court noted that authority to file was a jurisdictional issue. Once a court finds that authority is lacking the case must be dismissed. Accordingly, the district court affirmed the bankruptcy court.

It is common to argue that an agreement that gives somebody the power to block a bankruptcy filing is void as against public policy. However, in most cases this involves giving an outside party the right to control the decision. It is not surprising that this argument failed when the veto power was a matter of internal governance procedure.

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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