Lenders and rating agencies often require "bankruptcy remote" structures on a borrower to isolate the cash flow of a project or a stream of income or receivables. This is done by creating a special purpose entity whose organizational documents restrict the entity's business operations to a single purpose. These structures require separateness from affiliates in operations, recordkeeping and dealings with third parties. They also require the admission of "special members" or "independent directors" who must affirmatively vote in favor of "material actions" such as the sale of assets or the commencement of a bankruptcy case. Judge Timothy Barnes of the United States Bankruptcy Court for the Northern District of Illinois ruled that public policy overrode the veto given to the lender that was appointed in a workout to be a "special member" of the debtor, a Michigan LLC.
As part of a forbearance agreement following default, the lender in Lake Michigan Beach required an amendment to the debtor's LLC agreement to appoint the lender as a “special member” with no ownership interest, but with a veto power over the filing of bankruptcy proceedings, among other material actions. After another default, the lender began a foreclosure that was stayed when the debtor filed a Chapter 11 proceeding -- without obtaining the approval of the lender.
The bankruptcy court rejected the lender’s contention that the bankruptcy filing was unauthorized due to the lack of consent of the lender (in its capacity as special member). It weighed the conflict between state governance laws and the appointment of a special member, which it recognized to be a “lynchpin” of special purpose, bankruptcy remote entities. “For public policy reasons, a debtor may not contract away the right to a discharge in bankruptcy”. Similarly, the court noted that a so-called “blocking manager” cannot be appointed “solely for the purpose of voting ‘no’ to a bankruptcy filing because of the desires of the secured creditor” because fiduciary duties apply. Rather, enforceable bankruptcy remote structures must allow the blocking member or director to adhere to his or her “normal 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.” The court also invalidated an exculpation provision inserted in the operating agreement that absolved the lender (as special member) from any fiduciary duty to the debtor or its members as contrary to public policy. This blanket exculpation conflicted with Michigan LLC law imposing a duty of loyalty and care of an ordinarily prudent person. So great was the conflict, that the exculpation was not saved because it only operated “to the fullest extent permitted by applicable law”. Michigan law did not allow the lender solely to consider its own best interest if it were to vote as a special member, so its veto power over the debtor’s bankruptcy was invalid.
In light of Lake Michigan Beach and the authorities cited, lenders should exercise care in crafting bankruptcy remote structures. First, bankruptcy courts often are hostile forums for the interpretation and weighing of statutorily imposed fiduciary duty and the debtor’s contractual impairment of its bankruptcy rights. Bankruptcy “remoteness” does not guaranty the entity is bankruptcy “proof” because of the risk that a bankruptcy court will scrutinize the parties’ loan documents, organizational documents and conduct thereunder.
Second, the lender must carefully consider whether the state of organization (and, hence, the governing law) of a bankruptcy remote entity is acceptable. The Illinois LLC Act, like the Michigan LLC statute cited above, affirmatively imposes duties of due care and loyalty on LLC managers and members in member-managed LLCs. Delaware LLCs often are chosen because the Delaware LLC Act flexibly allows exculpation from all fiduciary duties except the duty of loyalty. However, the veto of a lender as an LLC member might not pass muster in Delaware LLC either because of the potentially conflicting loyalties of the member.
Third, putting the lender or its employees in control as a “special member” or manager role may increase lender liability risk with little reward. Judge Barnes in Lake Michigan Beach ruled that public policy can trump contractual exculpation from statutory fiduciary duties and void a special member’s veto due to inherent conflict of interest. A safer approach to bankruptcy remoteness could be the appointment of an “independent” manager, often supplied by a service company to perform that role for a fee. Such a manager probably would not rush to file a bankruptcy merely to protect the equity interests of the debtor, but theoretically could, in the exercise of his or her fiduciary duties, approve a bankruptcy filing if it were in the best interests of the entity and all creditors. Although it was not raised in Lake Michigan Beach, lenders always should exercise caution if they acquire a substantial voting equity interest in a debtor, because they can be deemed to be an “insider” and thus exposed to lender liability claims for breach of fiduciary duty, liability for mistakes in governance, and even enhanced liability for preferences and fraudulent transfers.
Fourth, merely appointing a blocking director or manager is not sufficient for bankruptcy remoteness. Best practices require, among other things, specification of the substantive qualifications and nonaffiliation of independent members and manager and require advance notice of selection, removal or replacement of such persons. They also require that the entity only have a single business purpose and prescribe many affirmative and negative “separateness” practices designed to avoid creditor confusion or commingling of the assets, liabilities, and financial affairs of the debtor with affiliates.
Fifth, decisions like Lake Michigan Beach suggest that lenders should consider backing up the bankruptcy remote structures with springing recourse to guarantors for the full debt if the bankruptcy remote requirements are violated or a voluntary or collusive bankruptcy is filed, or to recover the lender’s loss due to the violation of the separateness provisions or misapplication of cash collateral. Such “bad boy” guaranties are enforceable, but must be carefully drafted to avoid entangling the guarantor and borrower to such a degree that the bankruptcy remoteness of the borrower is compromised.
If you have questions regarding bankruptcy remote structures after Lake Michigan Beach, please contact Mark Fisher, 312.258.5710,email@example.com, or any other member of the firm’s Restructuring, Bankruptcy and Creditors’ Rights Practice Group.
 In re General Growth Props, Inc. 409 B.R. 43, 49 (Bankr. S.D.N.Y. 2009)(and authorities cited); S.J. Rothman, Lessons from General Growth Properties: The Future of the Special Purpose Entity, 17 Fordham J. Corp. & Fin. L. 227 (2012).
 In re Lake Michigan Beach Pottawattamie Resort LLC, 2016 WL 1359697 (Bankr. N.D.Ill. April 5, 2016). The court also denied the lender’s motion to dismiss the bankruptcy as a bad faith filing under section 1112 (b) of the Bankruptcy Code because the lender failed to meet its burden of showing bad faith.
 Lake Michigan Beach, supra, at *9; Kingman v. Levinson, 831 F.2d 1292, 1296 (7th Cir. 1987); cf. In re Shady Grove Tech Ctr. Assoc. Ltd. P’ship, 216 B.R. 386, 390 (Bankr. D.Md. 1998), opinion supplemented, 227 B.R. 422 (Bankr. D.Md. 1998) (enforces debtor’s waiver of right to object to lift stay motion in workout agreement); In re Tru Block Concrete Prods., Inc., 27 B.R. 486, 492 (Bankr. S.D. Cal. 1983)(advance waiver of bankruptcy protection void as against public policy).
 Lake Michigan Beach, supra, at *18; General Growth, supra, 409 B.R. at 65 (special manager); In re Kingston Square Assoc., 214 B.R. 713, 735-36 (Bankr. S.D.N.Y. 1997)(blocking director); see NNN 123 N. Wacker, 510 B.R. 854, 858 (Bankr. N.D. Ill. 2014)(enforces unanimous member consent requirement).
 Lake Michigan Beach at *11.
 Mich. Comp. Laws Ann. § 450.4404 (manager’s duties).
 805 ILCS 180/15-3.
 6 Del. Code Ann. § 18-1101(d) & (e).