US Special Purpose Vehicles’ Independent Directors and the Need for Fiduciary Duties

Essentially all securitization structures utilize a bankruptcy remote entity, a/k/a special purpose entity (“SPE”), to reduce the lenders’ or investors’ exposure to a bankruptcy of the sponsor. A standard feature of SPEs is the appointment of an independent person (director, member, manager) to the body managing the SPEs. That independent person’s consent is required for “major decisions,” one of which is the filing of, or consenting to a bankruptcy of the SPE (hence the court’s reference to them as “blocking directors”). When properly structured, courts enforce these provisions and dismiss bankruptcy cases filed without the vote of such independent person.¹ But that is not always the case as is shown by In re Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (N.D. Ill. 2016) (“Lake Michigan”). 

Background 

The Lake Michigan case did not involve an SPE. The debtor owned a vacation resort encumbered by a secured loan made by its secured lender, BCL-Bridge Funding LLC (the “Lender”). Pre-petition, the debtor defaulted on the loan and entered into a forbearance agreement with the Lender. As part of the forbearance agreement, the debtor amended its LLC agreement by adding the Lender as special member of the Debtor with the right to approve or disapprove any “Material Action.” Material Action included a bankruptcy filing. 

As is common for SPEs used in securitizations, the Lender, as a special member, had no interest in the Debtor’s profits or losses, no right to distributions and was not required to make capital contributions. Its role was limited to approval of Material Actions. 

Unlike standard SPE structures, however, the amended LLC agreement provided that “when exercising its rights under the [LLC agreement], [the Lender] is not obligated to consider any interests or desires other than its own and has ‘no duty or obligation to give any consideration to any interest of or factors affecting the company or its Members.’” 

Following entry into the forbearance agreement, the debtor failed to meet its obligations to the Lender, the Lender commenced a foreclosure action and the debtor filed a bankruptcy petition without obtaining the consent of the Lender, its Special Member. The Lender moved to dismiss the bankruptcy case, based, among other things, on the lack of corporate authority for the filing. 

Decision 

The bankruptcy court refused to dismiss the petition due to the alleged lack of corporate authority, finding the requirement for Special Member’s approval unenforceable under the circumstances of the case. 

The court began its analysis by noting that “blocking directors” are common in SPEs and securitization structures and that their purpose, according to the court, is to block a voluntary bankruptcy filing. The reason for the adoption of these provisions, the court noted, is that “a simpler, absolute prohibition against filing for bankruptcy will likely be deemed void as against public policy.”² Yet, the court recognized that state law corporate formalities must be satisfied in commencing a bankruptcy case. The problem arises when the putative debtor’s organizational documents conflict with the unenforceability of provisions designed to prohibit a bankruptcy filing. 

Standard SPEs’ organizational documents, however, avoid this conflict by providing that “the blocking director must always adhere to his or her fiduciary duties to the debtor in fulfilling the role.”³ Therefore, at least theoretically, the independent director may vote for a bankruptcy filing when his or her fiduciary duties so require.⁴ “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.”⁵ 

Since this essential feature was missing from the debtor’s LLC agreement’s provisions concerning the Lender as a Special Member, the court found them to be unenforceable, and as a result, held that the bankruptcy filing was duly authorized. 

Conclusion 

Lenders and investors in securitizations and other transactions utilizing SPE techniques should carefully consider how aggressive they should be in negotiating for the “best” protections they can get. As Lake Michigan shows, sometimes getting all that you requested, means you got nothing at all. 

Footnotes 

_{1) See e.g., Pasta Bar by Scotto II, LLC, Case No. 15-12766 (Bankr. S.D.N.Y. Nov. 19, 2015).
2) Lake Michigan, 547 B.R. at 911.
3) Id., at 912.
4) Id. (“[A]t least theoretically, there will be situations where the blocking director will vote in favor of a bankruptcy filing, even if in so doing, he or she acts contrary to the purpose of the secured creditor for whom he or she serves.”)
5) Id., at 913.}