Stop SignA recent decision from the Bankruptcy Court for the District of Delaware further puts into doubt so-called bankruptcy blocking tactics. And the opinion from In re Intervention Energy Holdings, LLC, No. 16-11247, 2016 Bankr. LEXIS 2241 (Bankr. D. Del. June 3, 2016), is especially notable because it relies on federal public policy, rather than state law, in concluding that a provision in a limited liability company governance document was void because it “eviscerated[d] the right of that entity to seek federal bankruptcy relief.” While the Intervention Energy court’s reasoning was limited to its particular facts, and although the court explicitly declined to determine the scope of limited liability company members’ freedom to contract under applicable state law provisions, the opinion raises an additional uncertainty regarding the use of contractual blocking tactics.

In Intervention Energy, Delaware limited liability companies Intervention Holdings and its subsidiary Intervention Energy filed voluntary petitions in contravention of provisions in Intervention Holdings’ limited liability company agreement. These provisions were required under the forbearance agreement between Intervention Holdings and its secured lender. The forbearance agreement waived all defaults by both debtors, but required Intervention Holdings to admit the secured lender as a member of Intervention Holdings. In addition, the forbearance agreement required Intervention Holdings to amend its limited liability company agreement to require unanimous consent by its members in order to file a bankruptcy petition.  Essentially, the amendment to the forbearance agreement granted the lender the ability to veto a bankruptcy petition.

When Intervention Holdings and Intervention Energy filed for bankruptcy protection, the lender filed a motion to dismiss their cases, claiming that the debtors did not have authority to file the petitions because the lender had not consented to the filings. The lender sought to distinguish earlier decisions involving the efficacy of special director structures. The lender argued that because a limited liability company can abrogate its fiduciary duties to the extent permitted by Delaware law, a limited liability company can also contract away its right to seek bankruptcy protection. In response, the debtors argued that the lender, as the blocking member, retained the duty to vote in the best interest of the potential debtors in order to comport with federal bankruptcy policy.

The court declined “to accept the parties’ invitation to decide what may well be a question of first impression of state law,” and instead considered federal public policy. The Intervention Energy court reviewed the extensive case history dealing with efforts to contractually limit or prohibit a party’s ability to seek bankruptcy relief. Courts have repeatedly struck down such contract provisions as unenforceable. The Court then considered the forbearance agreement and the resulting change in the debtor’s governance documents, concluding that “to contract away the right to seek bankruptcy relief is precisely what both parties here have attempted to accomplish.” Despite the “unmistakable” intent of the parties, the court found the amendment to Intervention Holdings’ limited liability company agreement to be void as contrary to federal public policy.

The court pointed to several aspects of the amendment that made it contrary to federal public policy. First, the amendment gave the authority to eviscerate the debtors’ ability to seek bankruptcy protection to a minority equity holder. Furthermore, this minority equity holder was primarily a creditor of the debtors, rather than an equity holder, meaning that it owed no fiduciary duty to anyone but itself. As a result, the amendment to the limited liability company agreement “is tantamount to an absolute waiver of that right [to seek federal bankruptcy relief], and, even if arguably permitted by state law, is void as contrary to federal public policy.”

Earlier cases, such as In re Gen. Growth Properties, 409 B.R. 43 (Bankr. S.D.N.Y. 2009) and In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016), analyzed state law fiduciary duties of directors in nullifying purported blocking tactics. Intervention Energy shifts the focus from state law to federal law, asserting that there is an important federal public policy consideration which also must be protected. When this federal public policy is compromised by what effectively serves as an absolute waiver of the right to seek federal bankruptcy relief, regardless of state law and even when the debtor has consented, blocking tactics and their contractual provisions may be declared void.

It remains to be seen how state law interests in governance of corporations and other entities will be balanced against the federal public policy interest in allowing distressed entities to avail themselves of relief under the Bankruptcy Code. The court in Intervention Holdings acknowledged cases that had enforced super-majority or other special voting arrangements. And clever draftsmen will no doubt continue their efforts to avoid or limit the risk that a bankruptcy filing presents to creditor enforcement efforts.