17 May 2020
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Hotel Lawyer: Increasing Distressed Hotel Loans and Troubled Hotel Assets
Originally published in November 2008 on HotelLawBlog.com, then updated in 2010 for our Lenders Handbook for Troubled Hotels, we have updated this article through May 2020 to assist industry friends in dealing with distressed loans provoked by the COVID-19 crisis.
How can a “special purpose entity” borrower ever file bankruptcy
if independent directors must approve the filing?
Jim Butler, Bob Kaplan, and Nick De Lancie
Since the mid-1990s, lenders on hotels and resorts have generally required their borrowers to transfer the asset being financed into a “single purpose” LLC or other “bankruptcy remote” entity sometimes respectively referred to as an “SPE” and “BRE.” The main feature of an SPE is that it owns only the single asset being mortgaged, is unlikely to become insolvent due to its own activities, and is generally protected from the effects of the insolvency of its affiliates. The main feature of a BRE is that filing bankruptcy is only a remote possibility because of various inherent or contractual legal requirements built into the very entity.
What is a bankruptcy remote entity? Why use one?
A BRE is an entity (usually an SPE) that has a structural layer of protection in its organic documents that makes it more difficult for the entity to seek bankruptcy protection. A number of approaches have been developed to create this “bankruptcy remote” structural layer.
Today, a BRE’s structural protection for the lender typically provides in its organic documents that in order to commence a bankruptcy case, approval must first be obtained from one or more independent directors or the equivalent, depending on the entity. Such a person must be independent of the borrower and is appointed by the lender, or approved by the lender. For simplicity, we will call such persons “independent directors.”
The lender expects that the independent director simply will not approve the entity’s commencement of any bankruptcy case. Thus, without a bankruptcy, the lender would be able to foreclose on the hotel or real estate without the delay and cost of bankruptcy.
Clashing fundamental principles – state corporate governance vs federal bankruptcy relief
At root, each BRE approach or strategy is based on the long-established, fundamental principle that, even though bankruptcy is a federal law matter, the entities in question are created under and governed by state law. Some believe that such corporations, limited liability companies, limited partnerships or other types of “corporate” entities can only be governed by the law of the state in which the corporate entity was organized. Therefore, the organic documents of the entity (adopted pursuant to that state’s law), govern who has the authority to decide that the entity will commence a bankruptcy case.
But this long-established principle of state law controlling corporate governance runs headlong into another long-established, fundamental principle of bankruptcy. The Bankruptcy Code (section 109(a)) expressly authorizes any “person” to file a bankruptcy petition. A person includes any corporation, limited liability company, and general or limited partnership. Waivers or attempts to contractually surrender this right are void as against public policy and, thus, unenforceable.
Various BRE approaches and strategies
As the BRE concept was first being developed, some lenders required as a condition of financing—or subsequent forbearance—that they themselves, or an affiliate, be appointed as an independent director. Generally, all directors (or at least a supermajority including the independent directors) had to approve any bankruptcy filing, even if the independent director was not otherwise involved in corporate governance. As time went on, “professional” independent directors offered their services in order to distance lenders further from the approval process.
Another approach involved the lender or affiliate taking a real economic equity interest in the entity. Organic corporate documents then provided that bankruptcy could not be filed without the unanimous vote of all the entity’s economic interests, or at least a sufficiently high vote to effectively give the lender’s interest a “blocking” vote to prevent any bankruptcy filing.
Not all lenders, however, wanted to take real economic equity interests (as opposed to financing interests) in their borrowers, but liked the equity “blocking” approach, so they required a “golden share.” This interest had no real economic equity value, but was still required to provide equity approval of a bankruptcy filing. Sometimes the independent director approach was combined with the true equity or “golden share” approach.
Over the past several decades, bankruptcy cases have tested various BRE structures. Typically, the borrower entities filed bankruptcy without the approval of the independent director, lender’s equity or golden share. Then creditors filed motions to dismiss the bankruptcy on grounds that the filing was not properly authorized.
Courts have wrestled with the clash of competing interests between the fundamental sanctity of state law controlling entity formation and corporate governance vs. the fundamental federal law public policy offering bankruptcy protection which cannot be waived or contracted away. Some of these approaches have proved problematic. Others have fared better.
Below is a brief summary of how some of these BRE strategies have fared.
Agreement not to commence bankruptcy case
A manger-managed limited liability company’s operating agreement had a provision agreed to by all members that the LLC could not commence bankruptcy case where the no-bankruptcy provision was not “coerced” by a lender as a loan condition. The manager caused the LLC to file a bankruptcy case over the objection of one member. The objecting member’s motion to dismiss the case for lack of authority to file was granted by the bankruptcy court. The court held that the LLC’s members were free to contract between themselves not to have the LLC commence a bankruptcy case, so the provision was not void as against federal bankruptcy public policy. The Tenth Circuit bankruptcy appellate panel affirmed the bankruptcy court. In re DB Capital Holdings, LLC, 463 B.R. 142 (B.A.P. 10th Cir. 2010, unpublished opinion).
A manager-managed limited liability company’s operating agreement had the same type of provision as in DB Capital Holdings agreed to by all members, but the provision was required by a lender as a condition of a loan to the LLC and operative only as long as the loan was outstanding. The manager, supported by all but one member, caused the LLC to file a bankruptcy case. The lender’s motion to dismiss the case for lack of authority to file, in which the objecting member joined, was denied by the bankruptcy court. The court held that even though there was no express LLC agreement with the lender (such as in the loan agreement) not to file a bankruptcy case (which agreement, the court noted, would clearly have been void), the provision the lender required to be in the LLC’s operating agreement was “cleverly insidious” and the fact that it was the members’ agreement between themselves instead of the LLC’s agreement directly with the lender was “distinction without a meaningful difference”, so the provision was still void as against federal bankruptcy public policy. The court noted the direct connection in the no-bankruptcy provision between the loan being outstanding and the bankruptcy filing prohibition and also the strong policy in the Ninth Circuit against bankruptcy filing waivers. In re Bay Club Partners–472, LLC, 2014 WL 1796688 (Bankr. D.Or. 2014),
Lender or affiliate as a holder of true equity interest
As a condition required by an investor for making a substantial equity investment in a corporation for 100% of newly-issued convertible preferred stock, the corporation’s charter was amended to require a vote of a majority of each class of the corporation’s equity for the corporation to commence a bankruptcy case. The investor’s parent, the arranger of the equity investment, was owed an investment fee by the corporation for arranging the investment. The corporation commenced a bankruptcy case without the vote of the investor that held the convertible preferred stock. The investor’s and the creditor-arranger parent’s motion to dismiss the case for lack of authority to file was granted by the bankruptcy court. The bankruptcy court held that even if the investor and the creditor-arranger parent were treated as one, the debtor’s charter’s required vote of each class of equity to authorize commending a bankruptcy case was not a “ruse” to protect the creditor-arranger parent, and the investor was a “bona fide” substantial equity holder that did not have—since it was not a majority equity holder—fiduciary duties to the corporation (unlike officers and directors would have). In re Franchise Services of North America, Inc., 891 F.3d 198 (5th Cir. 2018) [this was the first circuit court to rule on this issue]. Key quote: “There is no compelling federal law rationale for depriving a bona fide equity holder of its voting rights just because it is also a creditor of the corporation.”
Lender or affiliate as a holder of “golden share”
As conditions required by a lender in a forbearance agreement for a loan to a limited liability company, (i) the lender was granted a “special” membership interest in the LLC with no economic value (a “golden share”) and expressly had no fiduciary duties; and (ii) the LLC’s operating agreement was amended to add provisions, agreed to by all members, that required the approval of the “special” member (the lender) for the LLC to commence a bankruptcy case (previously, the approval of only a majority of the members was required to do so) and relieved the “special” member of traditional fiduciary duties to the LLC. The LLC commenced a bankruptcy case without the “special” member’s approval. The lender’s motion to dismiss the case for lack of authority to file was denied by the bankruptcy court. The court observed that if the “special” member had had traditional fiduciary duties to the LLC, the required bankruptcy approval structure might have been permissible, but this lender “golden share” member expressly had no fiduciary duties. Hence, the court held that the new provision was void as against federal bankruptcy public policy because it gave the lender the ability to prohibit debtor’s bankruptcy. In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill 2016).
As required by a lender in a forbearance agreement for a loan to a limited liability company, (i) the lender purchased a de minimus value membership interest (one out of 22 million for $1—again, a “golden share”); and (ii) the LLC’s operating agreement was amended to add provisions, agreed to by all members, that required approval of all members for the LLC to commence a bankruptcy case and eliminated fiduciary duties for the “golden share” membership interest holder. The LLC commenced a bankruptcy case without the lender-member’s approval. The lender’s motion to dismiss the case for lack of authority to file was denied by the bankruptcy court. The bankruptcy court held that the new provision was void as against federal bankruptcy public policy because it was the functional equivalent of an agreement not to commence a bankruptcy case. Even though state law permitted LLCs to eliminate fiduciary duties of their members, the court held this was a matter of federal law. The court noted that “[t]oday’s resourceful attorneys have continued [the] tradition” of trying to find ways to circumvent the federal bankruptcy public policy bar against waivers of the right to commence bankruptcy. In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016). Key quote:
“A provision in a limited liability company governance document obtained by contract, 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 of that entity 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.”
As conditions required by a lender for a loan to a limited liability company, all of which were to be in effect only until the loan and an associated “equity kicker” had been paid, (i) an affiliate of the lender was granted a 30% membership interest “equity kicker”; and (ii) the LLC operating agreement was amended to add provisions, agreed by all members, that required (A) the LLC to have an independent manager selected by the lender (with no fiduciary duties and no management involvement other than regarding a prospective bankruptcy case); and (B) approval of (1) the independent manager (who had to consider the interests of creditors in deciding); (2) 75% of membership interests; and (3) the lender for the LLC to commence a bankruptcy case.
The LLC commenced a bankruptcy case without the approval of the independent manager, the lender-affiliate member, or the lender. The lender’s motion to dismiss the case for lack of authority to file was denied by the bankruptcy court. The court held that taken together, the required provisions were void as against federal bankruptcy public policy because they gave the lender the ability to prohibit the LLC’s bankruptcy. The court observed that a truly independent manager with fiduciary duties to the LLC would have been permissible, but this manager was not truly independent and the whole structure was a “pretense” effort to “disguise” the lender’s power to prohibit the LLC’s bankruptcy. In re Lexington Hospitality Group, LLC, 577 B.R. 676 (Bankr. E.D. Ky. 2017).
Truly independent director
A large real estate investment trust had, among other things, multiple, indirect, project-level limited liability company or corporate subsidiaries as part of very complex capital and asset holding structure. As conditions required by various individual lenders for loans to various of the project-level subsidiaries, each borrower subsidiary was required to have two independent directors, which were supplied by “professional” independent director services, both of whom were required to approve the commencement of any bankruptcy case by the subsidiary. Prior to the REIT and its multiple subsidiaries commencing bankruptcy cases, multiple project-level subsidiaries replaced the existing “professional” independent directors with other independent directors who had direct experience in commercial real estate and restructuring, and these new directors approved the commencement of each respective subsidiary’s bankruptcy case.
Multiple lenders’ motions to dismiss various subsidiaries’ cases for lack of authority to file were denied by the bankruptcy court. The court held that replacement of the original independent directors by the various subsidiaries’ members or shareholders was authorized by the subsidiaries’ organic documents, the new independent directors satisfied the organic documents’ requirements for the position, the replacements were not “bad faith” on the debtors’ parts, and the new independent directors functioned as they were supposed to function with their fiduciary duties—considering the interests of their company and its shareholders or members—even if that was not what the lenders wanted. In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y 2009). Key quote (one of the lender’s officers testified about the purpose of independent directors, and court responded thereto):
[Lender Officer] “Well, my understanding of the bankruptcy as it pertains to these borrowers is that there was an independent board member who was meant to, at least from the lender’s point of view, meant to prevent a bankruptcy filing to make them a bankruptcy-remote, and that such filings were not anticipated to happen.”
[Court] “[I]f Movants believed that an ‘independent’ manager can serve on a board solely for the purpose of voting ‘no’ to a bankruptcy filing because of the desires of a secured creditor, they were mistaken. As the Delaware cases stress, directors and managers owe their duties to the corporation and, ordinarily, to the shareholders.”
Bankruptcy and appellate courts will strongly protect the federal bankruptcy public policy against waivers of the right to commence a bankruptcy case in whatever “clever” forms “resourceful attorneys” try to implement them. True, significant equity holders, even if creditors also, acting in their equity interests, may block bankruptcy cases of the entities in which they hold their interests if the organic documents permit that blockage. But blocking provisions required by lenders as a condition of loans, or forbearances with respect to loans, accomplished by subterfuges such as “golden shares” or evaporating equity interests will be seen for what they are: effective waivers of the right to commence a bankruptcy case and, hence, void as against federal bankruptcy public policy.
Similarly, truly independent directors—independent both from the entity and its lender—who are required by lenders to approve the commencement of a bankruptcy case but are permitted to abide by their fiduciary duties to the entities they serve and their shareholders or members in considering whether to do so, do not, by themselves, constitute waivers of the right to commence a bankruptcy case. But if, in fact, the “independent” director is not truly independent of the lender, and is required to be present solely to vote “no”, however that is accomplished, that structure, too, will be seen for what it is: an effective waiver of the right to commence a bankruptcy case and, hence, void as against federal bankruptcy public policy as well.
If there is a way to maximize the value of your hotel, we will find it. If there is not, we will tell you. Our goal is always to find alternatives to increase hotel asset value. We usually succeed.
Troubled hotel, retail and retail chain loans –
forbearances, loan modifications, recapitalizations, receiverships, workouts, turnarounds, restructurings, and bankruptcies.
Our distressed assets team. We’ve been recognized internationally for the business and legal advice we provide to creditors dealing with distressed hotel, retail, retail chain and complex real estate assets. See our distressed loan credentials for more information.
Who we help. We assist banks, special servicers, and other financial institutions with all aspects of distressed projects, including forbearances, loan modifications, recapitalizations, receiverships, workouts, turnarounds, restructurings, and bankruptcies.
Wide-ranging experience. The size of the troubled loans we have worked on ranges from a few million dollars to billion-dollar properties and portfolios; as of April 21, 2020, we have been engaged on new distressed hotel and retail loans for two major lender/special servicers in excess of $1.2 billion.
For information, contact one of the senior members of the team, below.
From our Global Hospitality Group® library of free resources, here are a few updated and classic articles on workouts and bankruptcies:
This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We’ve done more than $87 billion of hotel transactions and more than 100 hotel mixed-used deals in the last 5 years alone. Who’s your hotel lawyer?
This is Jim Butler, author of www.HotelLawBlog.com and founding partner of JMBM and JMBM’s Global Hospitality Group®. We provide business and legal advice to hotel owners, developers, independent operators and investors. This advice covers critical hotel issues such as hotel purchase, sale, development, financing, franchise, management, ADA, and IP matters. We also have compelling experience in hotel litigation, union avoidance and union negotiations, and cybersecurity & data privacy.
JMBM’s Global Hospitality Group® has been involved in more than $87 billion of hotel transactions and more than 3,900 hotel properties located around the globe. Contact me at +1-310-201-3526 or email@example.com to discuss how we can help.
Nicolas De Lancie is a partner in JMBM’s Bankruptcy Group. His practice of 40 years has concentrated on commercial credit and commercial real estate finance transactions, and on creditors’ rights and bankruptcy matters.
Nick has significant experience in commercial and real estate finance and related areas, including loan structuring and documentation; loan syndications and participations; CMBS special servicing and other asset securitization matters (Regulation RR); hotel financings; mutual funds liquidity facilities; ESOP loans; power generation project financing; probate estate and trust matters; merchant bank credit card matters; loan sales and other secondary market transactions; forward purchase agreements, interest rate, and other derivative transactions; troubled commercial credit, commercial real estate loan, public finance, and distressed debt investment transactions; collection litigation; bankruptcy cases, and relief from stay, cash collateral, post-petition lending, plan confirmation, and appeals; and lender liability defense. For more information, please contact Nicolas De Lancie at 415.984.9675 or at NDE@jmbm.com.
Robert Kaplan is a partner in JMBM’s Bankruptcy Group which is recognized by U.S. News & World Report / Best Law Firms® with a Metropolitan First-Tier Ranking (San Francisco) for Bankruptcy Litigation and Bankruptcy and Creditor Rights/Insolvency and Reorganization Law.
Bob represents lenders, special servicers, hard money lenders, community banks, national banking associations, distressed debt investors, and equity investors, positioning them for the best possible outcome by acting expeditiously to preserve value and increase cash flow. His industry experience and his knowledge of the current capital markets — where distressed assets often include complex deal structures and securitized loans — allows him to bring creative and effective strategies to the table. When aggressive litigation is the best strategy, he is a vigorous and effective advocate for his clients. For more information, please contact Robert Kaplan at 415.984.9673 or at RBK@jmbm.com.