September 26, 2017
As discussed in our August 8, 2016 client alert, lenders and borrowers continue to experiment with creative structures to prevent a bankruptcy filing. As discussed below, recent decisions clarify previous case law, develop the prevailing rules and highlight outstanding open issues.
In two recent cases, In re Lexington Hospitality Group, LLC and Squire Court Partners LP v. Centerline Credit Enhanced Partners LP (In re Squire Court Partners LP), bankruptcy courts continue to look past parties’ structures and have invalidated restrictions where the intent is to allow a lender to prevent or control its borrower’s ability to seek bankruptcy protection. These decisions, from Kentucky and Arkansas respectively, provide further guidance to lenders seeking to protect against the risks of bankruptcy.
In Lexington Hospitality, decided September 15, 2017, the court denied a secured lender’s motion to dismiss a borrower’s bankruptcy petition, holding that certain bankruptcy-filing restrictions in the borrower’s operating agreement, which was amended in connection with a loan and subsequent forbearance agreement, were void as contrary to public policy.
Under Lexington Hospitality’s original operating agreement, the company manager was authorized to manage the borrower’s business and affairs, with no express provisions authorizing the borrower’s manager to commence a bankruptcy on behalf of the borrower.
In connection with an acquisition loan secured by hotel assets, Lexington Hospitality agreed to: (1) amend its operating agreement to require the authorization of an independent manager and a 75% vote of the members before a bankruptcy filing could be authorized by the borrower, (2) grant the secured lender veto power over the borrower’s bankruptcy authorization regardless of obtaining the consent of the independent manager and 75% of the members, and (3) transfer 30% of its membership interests to an entity controlled by the lender. When Lexington Hospitality initially defaulted on the loan and entered into a forbearance agreement with the secured lender, Lexington Hospitality agreed to amended its operating agreement to transfer an additional 20% of its membership interests to entities controlled by the secured lender.
Despite these significant limitations on its ability to commence a bankruptcy proceeding, Lexington Hospitality filed for bankruptcy without the secured lender’s consent. On that basis, the secured lender sought to dismiss the bankruptcy case, arguing that Lexington Hospitality did not obtain the appropriate corporate consents. Upon review, the court found that the borrower’s ability to ever file for bankruptcy protection was frustrated by the reduction in the company manager’s membership interests—making it impossible for the members to achieve a 75% majority without the lender’s affirmative vote—and by the lender’s veto power. As a result, the court held that the bankruptcy restrictions benefitting Lexington Hospitality’s secured lender were void as contrary to public policy and denied the secured lender’s motion to dismiss.
Earlier this year, in Squire Court, the court affirmed the bankruptcy court’s dismissal of a general partner’s bankruptcy petition, holding that the limited partners were permitted to retain for themselves the decision whether to file a bankruptcy petition, even if that decision required the unanimous consent of all of the partners in the partnership.
Here, the Squire Court partnership consisted of two limited partners and one general partner. The amended partnership agreement gave the general partner the exclusive authority to manage and control the partnership, but required unanimous consent of both the general partner and the two limited partners before the partnership could file for bankruptcy protection.
The general partner filed a voluntary petition to commence a bankruptcy for the partnership without receiving unanimous consent. The general partner defended the bankruptcy filing, arguing that the provision in the partnership agreement requiring the unanimous consent of the general and limited partners to commence a bankruptcy case was void as contrary to public policy because only a fiduciary may decide whether an entity could receive relief by filing bankruptcy.
Upon review, the court found no cases had been presented to indicate that a bona fide equity owner must hold a fiduciary position before it can make a decision on whether to file for bankruptcy. Instead, as the court noted, relevant case law focuses on whether the persons or entities managing a partnership had been delegated the authority to file for bankruptcy by the other partners. Here, the limited partners did not delegate authority to file for bankruptcy to the general partner; rather, the limited partners retained the authority to make the decision for themselves. Accordingly, the court affirmed the bankruptcy court’s dismissal of the general partner’s bankruptcy petition.
In our previous client alert, we discussed the Delaware bankruptcy court’s holding in In re Intervention Energy Holdings, LLC. In that case, the court held that it is void as against public policy for a creditor to require a borrower to issue a creditor "golden share" and amend its operating agreement to require unanimous consent to file for bankruptcy, with the purpose that the creditor could control—and withhold consent from—potential filings. We observed that, despite the holding in Intervention Energy, it remained uncertain whether a lender’s required consent to file bankruptcy may be valid if the transaction was structured so that a lender was also an equity investor in borrower with "more than immaterial actual equity investment."
The outcome in Lexington Hospitality—finding invalid an arrangement where an entity controlled by the creditor was transferred 30%, and then an additional 20% of the borrower’s membership interests—partially addresses this question. In Lexington Hospitality, a party that was a lender at the outset of the relationship, remained a lender for these purposes notwithstanding having been transferred a substantial equity stake in the borrower. It did not appear to matter that the lender had a meaningful actual equity investment, rather than simply one golden share.
The ruling in Squire Court adds weight to the line of cases that hold that members or equity holders of a business entity may agree among themselves the appropriate threshold for authorizing a bankruptcy filing. The caveat to this rule, as articulated in Lexington Hospitality and Intervention Energy, is that a lender cannot insert itself into this decision-making process by creating a veto right to authorize a bankruptcy filing, even if the lender holds a meaningful equity stake in the borrower. These rulings are consistent with the ruling by the Tenth Circuit BAP in DB Capital Holdings v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC),  where the court affirmed the dismissal of a bankruptcy petition filed by the manager of an LLC where the operating agreement indicated the manager did not have authority to file the bankruptcy without consent of both of the members. The logic of the DB Capital opinion appears to have increased its reach in the recent opinions discussed above.
We note several issues have not been resolved that may provide opportunities for lenders seeking to protect against the risks of a borrower bankruptcy. First, while Lexington Hospitality indicates that granting more than an immaterial amount of equity interest to a lender does not in and of itself allow the required-consent right to survive, the lender in that case also had an absolute veto right regardless of member consent. If the lender had a meaningful equity stake that did not result in a veto, the result could be different.
Second, the reverse situation—where an equity holder freely entering an agreement not to file bankruptcy subsequently becomes a creditor—has not been addressed specifically in case law. As is often the case, equity holders seek to support a failing company and may become both equity holders and lenders as a situation deteriorates. It is not clear whether such a change in status will invalidate an otherwise valid authority-to-file restriction.
Third, and finally, it is unclear under the current line of cases what level of independence an independent manager must have from a secured lender for a court to rule that the independent manager is really an alter ego of the lender and, therefore, requiring the vote of an independent manager to commence a bankruptcy is, in essence, giving the lender a veto right over the filing. Lenders and investors should continue monitoring new cases in this area as they consider how to mitigate risks associated with borrower bankruptcies.
 Bouslog, Matthew G., Little, Robert B. & Rosenthal, Michael A., Delaware Court Invalidates Lender’s Attempt to Prevent Bankruptcy Through Issuance of "Golden Share," Gibson Dunn Client Alert (August 8, 2016).
 No. 4:16CV00935JLH, 2017 WL 2901334 (E.D. Ark. July 7, 2017). The District Court’s order was appealed to the Eight Circuit Court of Appeals on August 3, 2017, but as of the date of this publication the appellants have filed a notice of settlement which may result in dismissal of the appeal. See docket for Appellate Case 17-2700 (8th Cir.).
 Id. at 3. Still, it should be noted that because the debtor in DB Capital failed to bring forth any evidence on whether the amendment to the operating agreement was coerced by a creditor, the court was not able to rule on the impact of creditor coercion in such an agreement among the members. Id.
The following Gibson Dunn lawyers assisted in preparing this client update: Samuel A. Newman, Matthew K. Kelsey, Daniel B. Denny, and Brittany N. Schmeltz.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following authors:
Samuel A. Newman – Los Angeles (+1 213-229-7644, firstname.lastname@example.org)
Daniel B. Denny – Los Angeles (+1 213-229-7646, email@example.com)
Matthew K. Kelsey – New York (+1 212-351-2615, firstname.lastname@example.org)
Please also feel free to contact the following practice group leaders:
Business Restructuring and Reorganization Group:
Michael A. Rosenthal – New York (+1 212-351-3969, email@example.com)
Jeffrey C. Krause – Los Angeles (+1 213-229-7995, firstname.lastname@example.org)
Robert A. Klyman – Los Angeles (+1 213-229-7562, email@example.com)
David M. Feldman – New York (+1 212-351-2366, firstname.lastname@example.org)
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