Rated and other debt issuances are often structured with
borrowers that are special purpose entities, whose governance
provisions are designed to inhibit bankruptcy filings. A recent
District of Delaware bankruptcy court case, while not directly on
point, throws into question the premises underlying the efficacy of
such provisions.
Intervention Energy Holdings, LLC and Intervention Energy, LLC,
each a Delaware limited liability company, were formed for the
purpose of oil and natural gas exploration and production,
operating almost entirely in North Dakota. To fund drilling and
well-development costs, each Intervention entity entered into a
Note Purchase Agreement with EIG Energy Fund XV-A and related
entities, pursuant to which EIG purchased $200 million in senior
notes, in the aggregate, issued by the Intervention entities and
secured by liens on substantially all their assets.
After a time, the Intervention entities defaulted under the Note
Purchase Agreement by breaching certain financial covenants
contained in the Note Purchase Agreement, and EIG entered into
amendments to the Note Purchase Agreement with the Intervention
entities which, among other things, waived the defaults thereunder.
In December 2015, the Intervention entities entered into the fifth
such amendment, titled Amendment No. 5, Forbearance Agreement and
Contingent Waiver.
Under the Forbearance Agreement, EIG waived all defaults under the
Note Purchase Agreement if the Intervention entities raised $30
million in equity to repay a portion of the existing senior notes
by June 1, 2016. As a condition to the Forbearance Agreement, EIG
required Intervention Energy Holdings to amend its limited
liability company operating agreement to issue one common unit to
EIG and to require the unanimous consent of all common unit holders
to authorize a bankruptcy filing of Holdings (the "Blocking
Member Requirement"). The consideration for the newly issued
common unit effectively consisted of the forbearance, waiver and
amendments EIG provided under the Forbearance Agreement.
In May 2016, the Intervention entities filed a voluntary
bankruptcy petition in the United States Bankruptcy Court for the
District of Delaware ( In re Intervention Energy Holdings, LLC
et al. , 2016 WL 3185576 (Bankr. D. Del. June 3, 2016)). EIG
filed a motion to dismiss Holdings' bankruptcy petition,
asserting among other things that Intervention Energy Holdings was
not authorized to file the voluntary petition because it had not
obtained the consent from EIG required under the Blocking Member
Requirement. In a June 2016 decision, the court denied EIG's
motion to dismiss, holding among other things that the Blocking
Member Requirement, "the sole purpose and effect of which is
to place into the hands of a single, minority equity holder the
ultimate authority to eviscerate the right to seek federal
bankruptcy relief, and the nature and substance of whose primary
relationship with the debtor is that of creditor — not equity
holder — and which owes 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, and even
if arguably permitted by state law, is void as contrary to federal
public policy."
The requirement that a limited liability company obtain special
consent for any voluntary bankruptcy filing is not new to limited
liability operating agreements. Limited liability companies that
are formed as special purpose entities (SPEs) typically build into
their structure a blocking director or manager, the purpose of
which is to reduce the likelihood of a voluntary bankruptcy filing
by the SPE. The blocking director or manager is an important
feature of SPEs generally, as the SPE structure is used for the
purpose of isolating the assets of the SPE from the creditors of
its parent company and minimizing the risk of a voluntary or
involuntary bankruptcy filing related to the SPE.
Even when a financing does not involve any rated debt, financing
providers often look to the criteria used by rating agencies in
determining whether a borrower is bankruptcy remote when
structuring loans to SPEs. Rating agencies have looked to the
following four factors in determining whether there exists a
meaningful risk that a company would be subject to a voluntary
bankruptcy filing: (a) the presence of at least one independent
director who is a nationally recognized corporate services
provider; (b) the requirement of cause in dismissing any
independent director; (c) the requirement of the independent
director's consent in any voluntary bankruptcy filing; and (d)
the absence of any fiduciary duties requiring the independent
director to consider the interests of the SPE's shareholders
when voting on whether to file for voluntary bankruptcy.
1
Following the decision in the Intervention case, the application
of these criteria, and the bankruptcy remote nature of structures
that were based on these criteria, have been called into question.
A distinction that the ratings criteria highlights but was not
before the court in the Intervention case was whether giving the
consent right to an independent director or manager, rather than
the lender itself, would be enough for the Blocking Member
Requirement to survive a challenge under federal public policy.
While that remains an open question, the decision in the
Intervention case suggests that bankruptcy courts in Delaware may
view this distinction with suspicion, given the working assumption
by parties (and the market generally, as reflected in the rating
criteria) that giving the right to an independent director or
manager virtually eliminates as a practical matter the risk of a
voluntary bankruptcy filing.
Based on the particular facts of the Intervention case
— a borrower in financial distress with increasingly fewer
workout options (and, as a result, declining bargaining leverage)
and facing a real, short-term risk of bankruptcy — it is
perhaps no surprise that a court would view the imposition of the
Blocking Member Requirement as overreaching and as an absolute
waiver by Intervention Energy Holdings of its right to seek federal
bankruptcy relief. It remains to be seen whether different
circumstances — for example, the inclusion of a Blocking
Member Requirement or its practical equivalent using an independent
manager or director at a time when the parties have more equal
bargaining leverage and where the prospect of financial distress is
more remote — would be viewed by a court as justifying a
different conclusion than that reached in the Intervention
case. Until courts give additional guidance in this respect,
lenders and other counterparties to an SPE should consider the risk
that impediments to a bankruptcy filing will be invalidated.
Footnote
1 The fourth factor of the above analysis is implicated in a recent decision out of Illinois (In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. April. 5, 2016). The debtor in Lake Michigan was a Michigan limited liability company and, as such, the analysis centered on Michigan law, which provides that the independent director must "discharge the duties of [the independent director] in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner the [independent director] reasonably believes to be in the best interests of the limited liability company." Because the operating agreement provisions in Lake Michigan specifically provided that the lender member would have no duty or obligation to give consideration to the interests of the debtor, the court held that the consent requirement was void as a matter of both state corporate governance law and federal bankruptcy law. Although Delaware law expressly allows for the broad waiver of fiduciary duties (subject to the implied covenant of good faith and fair dealing), the court in the Intervention case viewed the absence of a duty to the debtor as an important reason the Blocking Member Requirement ran afoul of federal public policy.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
