Relating to Real Estate

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Bankruptcy Filing Upheld Despite Lender's Failure to Consent As "Special Member" of the Debtor

On April 5, 2016, the U.S. Bankruptcy Court for the Northern District of Illinois upheld a Chapter 11 filing by a limited liability company even though the LLC’s operating agreement required the consent of the “Special Member” to the filing, and the Special Member did not consent. In re Lake Michigan Beach Pottawattamie Resort LLC, No. 15-bk-42427, 2016 WL 1359697 (Bankr. N.D. Ill., April 5, 2016).

In connection with the execution of a forbearance agreement on August 21, 2015, the LLC executed an amendment to its operating agreement which appointed its lender as a “Special Member” of the LLC with the right to approve or disapprove any “Material Action” including a filing for bankruptcy. The amendment also provided that the Special Member would owe “no duty or obligation to give any consideration to any interest of or factors affecting the Company or the Members.” After the LLC defaulted under the forbearance agreement, the lender scheduled a foreclosure sale. Before the sale occurred, the LLC filed under Chapter 11 in order to stay the foreclosure. All of the LLC’s members consented to the filing except for the lender, as the Special Member. The lender moved to dismiss the filing on the basis that it was not authorized by the LLC’s operating agreement.

The bankruptcy court denied the lender’s motion. The court acknowledged in its opinion “that there is a well-established commercial practice” of using “blocking directors” in connection with a loan made to bankruptcy remote special purpose entities; that is, entities that are created to own only a single property and to be very unlikely to file for bankruptcy protection. The court stated that bankruptcy law and policy are not offended by such practice where the “blocking director” retains a fiduciary duty to make decisions that are in the interest of the entity, as opposed to the lender alone. The court distinguished the LLC’s situation in the instant case from the established commercial practice on the basis that under the LLC’s amended operating agreement the Special Member was relieved of its fiduciary duty to the LLC. The court concluded that the elimination of the Special Member’s fiduciary duty to the LLC, combined with its right to block a bankruptcy filing, was contrary to public policy under Michigan and bankruptcy law. As a result, the court ruled that the blocking member provision in the LLC agreement was void and that the bankruptcy filing was authorized.

The Lake Michigan court’s decision was made in response to a lender’s overreaching and should be limited to its facts. The court indicated that by-law or operating agreements that appoint a “blocking director” or member are generally enforceable so long as the director or member is not relieved of its fiduciary duty to act in the interest of the entity. Under the Lake Michigan decision, lenders that go beyond this line may fail in their effort to prevent a bankruptcy filing.

For questions, please contact Larry Coppel (410) 576-4238.