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Bankruptcy Court Issues Decision about Restrictions on Bankruptcy Blocking
Courts can not come to a consensus about whether statements found in a borrower’s documents established to prohibit the borrower from filing for bankruptcy are enforceable as the result of either federal public policy or state law.
Various court rulings have tackled this issue over the last few years. A New Jersey District Bankruptcy court recently addressed this issue in the Hightstown case. The case saw the dismissal by the court of a chapter 11 reorganization plan pursued by a limited liability company (LLC) registered in Delaware due to the LLC agreement, which prohibited a bankruptcy filing unless a receipt of consent was received from an entity who held preferred membership interest but had not received repayment of capital contributions.
The court found that the clause prohibiting filing for bankruptcy was permissible because, under Delaware law as well as the corresponding LLC agreement’s terms, the entity that held preferred membership interests lacked fiduciary obligations.
How the Hightstown Case Arose
Several years ago, 3P Equity Capital, an associate of the LLC, 3P Hightstown, borrowed $420,00 from the company, Progress Direct.
A minority interest was utilized to secure the loan that 3PEC held. 3PEC then assigned its membership interest to the party that was owed money. The debtor then raised half a million dollars from the 4J investor group in exchange for preferential membership interests. Furthermore, the debtor was loaned $125,000 by 4J Group subject to subordination.
Next, Hightstown Enterprises LLC in June 2020 paid over half a million dollars to the 4J Group in exchange for a loan and preferential membership interests. During the fall of 2020, Progress sold the loan to the LLC.
The agreement made between debtors and their associated members featured a clause that restricted the debtor’s management from taking certain actions, which included bankruptcy filing. Additionally, the LLC included a provision limiting liability.
At the beginning of the year, the debtor initiated a bankruptcy petition in a New Jersey court because the joint venture’s real estate assets were located in that state. The LLC made a motion for dismissal of the case and argued the entity that owed money did not possess the power to begin bankruptcy under the terms of the agreement between the two entities.
The party that owed money then argued that the LLC held no standing to pursue the case’s dismissal because 4J’s loan assignment and membership interests failed to follow the requirements involving notice procedures found in the agreement between the parties. The debtor additionally claimed that publicly left the LLC’s agreement clause that limited its options to pursue bankruptcy invalid.
The Court’s Ruling in Hightstown
The Bankruptcy judge in the Hightstown case first ruled that the LLC’s efforts to obtain a dismissal were not relevant. The judge’s decision was based on the finding that under the Bankruptcy Code’s section 1112(b), the court held the power to dismiss chapter 11 cases.
The Judge then found that the LLC’s agreement language prevented pursuing bankruptcy because not all capital was given back to the relevant interest holders. Despite the assignments, the court found that consent on behalf of the LLC or a predecessor of the LLC was necessary for a bankruptcy filing but the debtor received neither.
The Judge subsequently rejected the debtor’s claims involving the public policy. The judge found that other cases where the court ruled that restrictions on filing for bankruptcy were not capable of being enforced could be distinguished from this one. The Judge also noted that previous court concerns that led to striking out contractual provisions did not exist in Hightstown.
Noting the lack of any existing Third Circuit precedence, the Judge examined several existing bankruptcy cases including Franchise Services, Intervention Energy, and Lexington Hospitality. The judge found that the Franchise Services case was similar because it involved a filing for dismissal initiated by a party that was both a holder of equity and a creditor. The judge found that similar to the Fifth Circuit, the provision restricting bankruptcy filing found in the LLC agreement avoided becoming null because the LLC was both an equity holder and creditor.
The Judge decided the case could be distinguished from the Lexington Hospitality and Intervention energy cases because the parties that lent money in these cases permitted financing on being provided with a share that granted the ability to prevent filings for bankruptcy. In Hightstown, the judge noted, no evidence existed that the limited liability’s contribution surpasses the size of what was loaned. Instead, the judge found that this was simply a disguised tactic to make sure that the loan was repaid.
The Judge also held that the Pace court attempted to weigh the right to pursue bankruptcy versus
the right to enter into contracts and enforce contracts created between creditors and other stakeholders. The Judge noted that Pace is distinguishable from Hightstown because the set of facts in each case was vastly different. The Judge also clarified that the party who owed money in Pace had to pursue bankruptcy to both maintain value and safeguard creditors as well as employees. The court then found the case in bankruptcy would likely resolve to most stakeholders’ benefit.
The court in Pace found that the block provision was null due to public policy. The Judge noted that this block was based on the discovery that most of the shareholders had an obligation to creditors and shareholders because the business existed in the “insolvency” zone. The judge found that the Pace court held that the block provision permitted minority shareholders to violate their obligations and interfere with a debtor’s right to pursue bankruptcy.
The Judge refused to apply this Pace strategy for several reasons. The judge first found that the party who was owed money was an investor who was part of a venture between companies. This venture had no workers, creditors, or stakeholders that were poised to gain from bankruptcy.
Additionally, the judge had significant reservation about the LLC’s operation because state law in Delaware provides that only an LLC’s managing members have such a duty, Delaware’s LLC Act allows members to enter into contracts involving these duties, and the liability limitation clause found in the agreement operated as such. Consequently, the judge found that no fiduciary breach existed to make the provision in question a public policy violation.
The Impact of the Court’s Ruling
Court rulings over the last decade have not led to a resolution in the ongoing disagreement about whether blocking provisions are enforceable as well as golden shares or other clauses created to improve access to protections afforded by bankruptcy.
Cases like Franchise Services, Hightstown, and Pace suggest that these provisions’ validity depends on if the entity who possesses the right to block filing for bankruptcy also has the fiduciary obligation due to contract or law in which courts have vocalized growing concerns about public policy. These as well as other influential decisions emphasize the value of understanding what approach was utilized by courts in bankruptcy cases.
Contact an Experienced Bankruptcy Attorney
Chapter 11 bankruptcy is full of challenges, but an experienced attorney can help you navigate this process and obtain the results you deserve. Contact Attorney Melanie Tavare today to schedule a free case evaluation.
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