November/December 2016

Blocking Rights in LLC Operating Agreements: Do These Provisions Help Lenders?

Traditionally, secured lenders have utilized blocking rights to prevent a limited liability company from filing for bankruptcy before the lenders have recovered the debt. Nancy Peterman explains that two recent court decisions have made it more difficult for lenders to use blocking rights without taking the rights of other stakeholders into account.



Nancy A. Peterman, Shareholder, Greenberg Trauig

Nancy A. Peterman, Shareholder, Greenberg Trauig

When structuring a loan, a lender has to consider the possibility that some day the loan may be in default and the lender may need to recover the amounts due. A lender typically has certain standard rights and remedies, including deposit account control rights, the right to foreclose and credit bid and the right to the exercise pledge rights to change the board composition.

With a limited liability company (LLC), a lender can build additional rights into the operating agreement. For example, the lender may have the right to appoint a member to the board of managers who will have to consent to certain “major decisions.” Or the lender itself may have consent rights over these “major decisions.” Two recent bankruptcy court decisions have questioned these types of blocking rights in favor of lenders.

General Overview of Blocking Rights — What Are They?

For LLCs, the operating agreement is the document that governs the corporation. In an operating agreement, a major investor may be given blocking rights on major decisions, including whether to file a bankruptcy case, sell the company, engage in a restructuring, dissolve the LLC or enter into a new financing. These blocking rights may be given to the member or to that member’s board appointees if there is a board of managers. Without the consent of the blocking member or the blocking member’s board appointees, the LLC will not have the necessary consents to approve major decisions and cannot proceed. As part of a loan transaction, including forbearance agreements, these types of blocking rights are sometimes given to the company’s secured lender.

In an operating agreement, a member’s fiduciary duties may be contracted away if permissible under applicable state law. Therefore, if a member has blocking rights over major decisions, that member may be able to exercise those blocking rights without taking into account the interests of the corporate entity, other creditors or other members. This fiduciary duty issue was the focal point of two recent bankruptcy cases questioning the propriety of blocking rights in favor of secured lenders.

Limitations on Blocking Rights for Major Decisions

In two 2016 cases addressing the issue of whether a member can block a bankruptcy filing by an LLC, the member holding the blocking rights was also the debtor’s secured lender. In both cases, the courts found these blocking rights void as against public policy.

In the case In re Lake Michigan Beach Pottawattamie Resort LLC,1 the debtor, a Michigan LLC, entered into a forbearance agreement with its lender a few months prior to the bankruptcy filing. As part of that agreement, the debtor agreed to modify its operating agreement to establish the secured lender as a special member with the right to approve any material action by the debtor, including any bankruptcy filing.2 The secured lender, in its capacity as special member, had “no interest in the profits or losses of the debtor, no right to distributions or tax consequences and [was] not required to make capital contributions to the debtor.”3 In addition, the operating agreement indicated that the secured lender, in its capacity as special member, was not obligated to consider any interests other than its own. The secured lender sought to dismiss the debtor’s bankruptcy filing given that the secured lender’s consent, in its capacity as the special member, was not obtained.

The bankruptcy court found the blocking right void under state law and federal public policy. Under the Michigan Limited Liability Company Act, the members of an LLC have a duty to consider the interests of the entity and not just their own interests. Under bankruptcy law, the blocking director or member must always adhere to his or her general fiduciary duties to the debtor in fulfilling the role.

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 appointed the director.

In this case, the secured lender’s playbook was, unfortunately, missing this page.

In the case In re Intervention Energy Holdings, LLC, the bankruptcy court found a similar provision relating to a Delaware LLC as void under federal public policy.4 Approximately five months prior to the bankruptcy filing, the debtor entered into a forbearance agreement with its secured lender and agreed to amend its operating agreement to admit the lender as a member holding one common unit. The lender, as unit holder, had to approve any bankruptcy filing. When the debtors filed for bankruptcy without this necessary approval, the secured lender sought to dismiss the bankruptcy case.

The bankruptcy court held that a provision in an LLC governance document, obtained by contract, with the sole purpose and effect of giving a single, minority equity holder the ultimate authority to eliminate the entity’s right to seek federal bankruptcy relief — when the entity’s primary relationship with the debtor is as a creditor, not an equity holder, which has no duty to anyone but itself in connection with an LLC’s decision to seek federal bankruptcy relief — is tantamount to an absolute waiver of that right. Even if permitted by state law, the right is contrary to federal public policy and, therefore, void.

These cases may represent a trend. Courts may more closely scrutinize provisions granting blocking rights on major decisions to a lender or its designee. To read these cases narrowly, you have to focus on the facts. Both debtors in these cases agreed to amend their operating agreements as part of a forbearance agreement only a few months prior to the bankruptcy filing to create the blocking member. The blocking member was allowed to consider only its interests (or the interest of the lender) in exercising the blocking rights while ignoring the interests of the corporate entity, other creditors or other members. The blocking member was trying to prevent a bankruptcy filing that would otherwise be permissible — a fundamental right that any bankruptcy court would likely question.

Should Blocking Rights Be Pursued?

Lenders want every protection available to ensure their debt position and recovery is protected in the event of default. For lenders considering the use of a blocking member or blocking director for major decisions to bolster these rights and remedies upon default, these cases can provide a few valuable lessons.

First, the ability of the blocking member or director to exercise fiduciary duties is key. If the blocking member or director has to exercise fiduciary duties to the entities, all creditors and all members, those rights would likely be enforceable. The blocking member or director may not take the position that the lender had hoped, but the court would likely uphold the rights exercised by that member or director.

Second, if the lender holds these blocking rights, it is advisable to transfer the rights to another person, or structure these provisions to allow the appointment of a board designee or special member, so an independent party exercises the blocking rights in the event of a default instead of the lender. Lenders that fail to do this might face questions raised about their good faith or potential claims for exerting too much control over the company.

Ultimately, lenders must use these blocking rights cautiously. They cannot overreach. But the rights can ensure a fair process in which those making decisions on behalf of the debtor to approve bankruptcy filings, sale transactions or other major decisions are acting in a manner consistent with the fiduciary duties owed to all constituents, including the lender.

Footnotes

  1. 547 B.R. 899 (Bankr. N. D. Ill. 2016)
  2. Id. at 903-04.
  3. Id. at 904
  4. 553 B.R. 258 (Bankr. D. Del. 2016),