Remote Control Not So Remote: Bankruptcy Remote Entities and Fiduciary Duties
Special purpose entities ("SPE" or "SPE's") are frequently utilized in financial transactions for any number of reasons including: tax issues, protection of assets, liability insulation (including environmental concerns), and for the benefit of creditors involved in the transaction. SPE's involve the creation of a corporate entity usually taking the form of a limited liability company, corporation, or limited partnership designed solely to serve a special need between the parties in a transaction. They provide a layer of insulation between one or more of the parties owning the SPE and the outside world. One subset of SPE's is the "bankruptcy remote entity" ("BRE" or "BRE's"). A BRE is most often created a the behest of a creditor/lender, and is used to protect that creditor's collateral from other creditors or in an attempt to prevent a voluntary filing for bankruptcy protection. Typically, the creditor or someone friendly to the creditor is appointed as a director or member of the BRE with voting power as to the BRE's major corporate affairs, commonly known as a "Special Member." The creditor will also insist upon special powers for the Special Member including the requirement that any bankruptcy filing must be approved by all directors or members. By inserting this requirement, the creditor can, ideally, block a bankruptcy filing by voting against it. While conceptually this is a nuclear weapon against a bankruptcy, the question turns to whether this is practically possible.In April 2016, the United States Bankruptcy Court for the Northern District of Illinois addressed this issue in In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016). The debtor was a Michigan limited liability company created to hold and manage income producing property, namely a resort on Lake Michigan. The debtor borrowed approximately $2,700,000.00 from secured creditor and pledged all business assets as collateral. Debtor defaulted on its obligations in July 2015. As a result of the default, the parties entered into a ninety (90) day forbearance agreement that required, among other things, the debtor to amend its operating agreement to make the secured creditor a "Special Member" of the debtor with the absolute right to approve or disapprove of any "material action" to be taken by debtor. Specifically, the applicable provision of the operating amendment stated that secured creditor had the exclusive right to approve or disapprove any action to "institute proceedings to have the Company adjudicated bankrupt or insolvent, or consent to the institution of bankruptcy or insolvency proceedings against the Company or file a petition seeking, or consent to, reorganization or relief with respect to the Company under any applicable federal or state law relating to bankruptcy..." Id. at 904.In October 2015, the debtor breached the terms of the forbearance agreement, and the secured creditor set a foreclosure sale on the real estate for December 17, 2015. The debtor filed for relief under Chapter 11 of the United States Bankruptcy Code on December 16, 2015, with approval of all its members except the secured creditor. Subsequently, the secured creditor moved to dismiss the bankruptcy filing for cause under 11 U.S.C. Section 1112(b) and because the filing was unauthorized since it violated the operating agreement's amendment requiring approval of the "Special Member". The debtor responded by stating that the operating agreement amendment was ineffectual because it was void as against public policy since it amounts to a total prohibition against the debtor's ability to file for bankruptcy protection, and because the amendment is invalid under Michigan corporate law.The court first undertook a very thorough analysis of the request for dismissal under Section 1112(b) finding that the case did not warrant dismissal "for cause." Next, the court turned its attention to the dismissal request asserting that the actual filing was unauthorized because it was not unanimously approved by all the Debtor's members as required under the operating agreement's third amendment. The court first reviewed Michigan corporate law to determine if the provisions contained in the third amendment are void. The court determined that the third amendment is not void because Michigan corporate law permits parties to override Michigan's corporate law default provisions mandating a majority of voting interests to prevail. The court held that the default provisions are the baseline for determining how a corporate entity will approve or disapprove corporate actions but the parties are free, under Michigan law, to alter these requirements making them more or less stringent. Therefore, the requirement that unanimity of all members contained in the third amendment is not, in and of itself, void.The court then shifted its focus from whether such provisions are generally prohibited under law to the actual language of the third amendment, essentially holding that one must look "beneath the surface" to determine if the third amendment is actually valid in its application. The question can be framed as "does the unanimity requirement of the voting members for bankruptcy filings fail for violation of law?" Herein lies the heart of the matter and the new wrinkle presented by the court for SPE's. In evaluating this question, the court ultimately relied on Michigan state law's requirement that directors/members exercise their independent duty of fiduciary responsibility in determining whether to vote in favor or against a particular action. Simply because a "Special Member" exists, whose purpose is designed to protect the creditor, the fiduciary responsibility is not abrogated and the "Special Member" has the duty to independently exercise the required fiduciary duty to determine whether, as is the case here, the corporate action may benefit the SPE and damage the creditor. Given the financial distress of the SPE, the court determined that the provision violated the fiduciary duty imposed by corporate law, and thus was void. In point of fact, the court went on to say that voting against filing for bankruptcy protection clearly failed to independently consider the benefits to the debtor as no reasonable person in the shoes of the "Special Member" could reasonably conclude that such a filing was unwarranted.In light of the foregoing, two main issues arise. First, does the finding of an independent fiduciary duty gut the anticipated purposes of SPE's and BRE's? The answer is somewhat unclear. From a total prohibition standpoint, it does gut the efforts of a creditor to fully bankruptcy-proof a transaction and accompanying collateral. Notwithstanding that, SPE's and BRE's still provide a great deal of protection to creditors from other dangers such as third-party attacks against collateral, tax issues, and environmental concerns, as well as other concerns. In essence, creditors should be wary of attempts to completely negate the ability of SPE's or BRE's from bankruptcy, and should consult state corporate law to determine the extent and reach of "Special Members".Second, the case raises the question of whether there is potential liability to the "Special Member" and/or creditor for violation of the fiduciary duty imposed upon the "Special Member" by corporate law. Of concern to creditors is whether they can be held liable for a breach of fiduciary duty (and the resulting decrease in value of the debtor's assets) when the creditors' "Special Member" votes not independently, but in the interests of the creditor. By potentially creating liability, creditors are exposed to potential litigation for efforts heretofore designed to protect themselves. In essence the "hunter" may become the "hunted." As a result, care should be exercised in creating the powers and duties of the "Special Member," giving particular attention to the corporate and fiduciary duties imposed by law upon all members/directors.One thing is abundantly clear: SPE's and BRE's are not as safe as they once were. The remote may not be totally broken, but it is definitely lacking some functionality for creditors.For more information regarding this article, please contact Ronn Steen. He can be reached at (615) 465-6000 or by email at firstname.lastname@example.org.