Blocking Directors 101: Fiduciary Duties Apply

May 11, 2016Alerts Financial Restructuring & Bankruptcy Alert

Lenders beware: An Illinois bankruptcy court recently ruled that a lender went too far in its efforts to stop a debtor from filing for bankruptcy. The court invalidated the lender’s “blocking director” provision for explicitly excusing the lender from considering any interests other than its own. See In re Lake Mich. Beach Pottawattamie Resort LLC, 2016 WL 1359697 (Bankr. N.D. Ill. April 5, 2016).

The LLC debtor owned and operated a vacation resort. After the debtor defaulted on its secured loan, it entered into a forbearance agreement that required the debtor to amend its operating agreement to establish the lender as an additional “special” member with the right to disapprove of any “material action,” including the filing for bankruptcy relief.

The amended operating agreement also provided that the special member was “entitled to consider only such interests and factors as it desires, including its own interests,” and “to the fullest extent permitted by applicable law, ha[d] no duty or obligation to give any consideration to any interests of or factors affecting the Company or the Members.”

Soon after the forbearance agreement was signed, the debtor defaulted again and the lender filed for foreclosure. The debtor filed a bankruptcy petition on the eve of foreclosure, authorized by the four non-special members. The lender’s special member did not consent.

As of the petition date, the property was worth in excess of $6 million and the secured loan was roughly half of that.

The lender moved to dismiss the petition as unauthorized. The debtor responded that the special member provision was void as against public policy because it amounted to a prohibition against the exercise of the debtor’s right to bankruptcy relief.

The court explained that the appointment of the special member followed “the well-established commercial practice of using ‘blocking directors.’ A blocking director is the lynchpin that holds together a bankruptcy remote special purpose entity, formed to ring fence assets from creditors other than a secured creditor who is unwilling to lend otherwise and for whom the structure is made… One specific director, chosen by the secured creditor, may withhold its vote and thus block, hence the name, a voluntary bankruptcy petition.”

However, 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 they were chosen by.”

Here, the court said, the lender’s “playbook was, unfortunately, missing this page.”

Because the special member provision explicitly stated that the lender had “no duty or obligation to give any consideration to any interests of or factors affecting the Company or the Members,” the Court held it void as a matter of both state law (imposing fiduciary duties on members to consider the LLC’s best interests) and bankruptcy law (making contractual prohibitions against filing for bankruptcy unenforceable).

The court dismissed the savings clause (“to the fullest extent permitted by applicable law”) by observing that while it might cure the invalidity of the provision, it was only “by rendering it meaningless.”

In this case, the lender learned the lesson of moderation the hard way: By trying to control the debtor according to its interests alone, the lender ended up losing control altogether.

For more information about this alert or if you have any questions or concerns, please contact Audrey Noll at 310.693.4414 or [email protected] or any member of Fox Rothschild’s Financial Restructuring & Bankruptcy Practice Group.