And Another Lender Blocking Provision Bites the Dust, Texas Bankruptcy Court Rules

The Bottom Line

One feature commonly seen in commercial lending transactions is a waiver of the borrower’s authority to file for bankruptcy without the consent of the lender. While such “blocking” provisions are generally upheld where the equity interest holders are the parties with such rights, they are generally unenforceable as a matter of public policy when such protection is given to a creditor with no meaningful ownership interest in the corporate debtor.

In a recent decision issued in In re Roberson Cartridge Co., LLC, Case No. 22-20192 (RLJ), 2023 Bankr. LEXIS 588 (Bankr. N.D. Tex. March 7, 2023), the Bankruptcy Court for the Northern District of Texas denied a secured creditor’s motion to dismiss the corporate debtor’s Chapter 7 case on the grounds that the petition was filed without the requisite corporate authority. In doing so, the court held void as against public policy a blocking provision in the company’s governing documents, which purported to give the creditor — which held convertible debt of the debtor — the exclusive right to consent to the debtor’s bankruptcy filing. The court noted that a pledge of equity by the debtor-LLC’s member did not divest the LLC’s manager from corporate authority to file for bankruptcy. Nor was the consent right enforceable with respect to convertible debt where, prior to the bankruptcy filing, the creditor had not exercised its right to convert the debt to equity (and therefore was only a creditor on the petition date). This ruling of a bankruptcy court in the Fifth Circuit joins the growing body of case law from other circuits that holds such bankruptcy-restrictive contractual provisions void as a matter of public policy.    

What Happened?

Roberson Cartridge Co. LLC (the "Debtor" or the "Company"), a Texas limited liability company, was in the business of manufacturing ammunition cartridges. The same individual was the sole member, manager and president of the Debtor (the "Principal"). 

Prior to the bankruptcy filing, the Debtor received a convertible loan from Matador Brass Partners LLC (the "Lender"), which provided for a credit line of up to $10 million. Pursuant to the loan agreement, the Lender at its option could elect to convert the outstanding principal amount to a certain amount of the Class B units of the Debtor’s equity. As security for the loan, the Principal pledged his membership interests in the Debtor pursuant to a pledge agreement, which further provided that the Principal’s voting rights would immediately cease and vest in the Lender upon the occurrence of an event of default.

As required by the loan agreement, the Debtor executed an “Amended Company Agreement” (the Texas equivalent of an operating agreement for a New York LLC), which provided that until the Lender exercised its option to convert the outstanding debt to Class B Units, the Lender “shall not be a Member of the Company” but shall have the right to enforce the provisions applicable to the Lender, as a third-party beneficiary. The Amended Company Agreement further contained a blocking provision, whereby the Debtor was required to obtain the Lender’s written consent prior to taking “any action that results in a liquidation or dissolution of the Company,” such as filing a bankruptcy petition. The Company later defaulted on the loan. 

On Oct. 18, 2022, the Principal, in his capacity as the Company’s manager and without the Lender’s consent, entered a resolution authorizing the Company to file for bankruptcy. That same day, the Company filed a voluntary Chapter 7 petition.

On Nov. 3, the Lender filed a motion seeking (i) conversion of the case to Subchapter V of Chapter 11, or (ii) alternatively, dismissal of the case as an unauthorized bankruptcy filing or a bad faith filing. Both the Debtor and the Chapter 7 trustee filed opposition to the motion. Following a three-day trial, the bankruptcy court issued its decision, denying the motion in its entirety.  

Opinion

The court first addressed the portion of the Lender’s motion to dismiss the Chapter 7 case. The Lender’s unauthorized filing argument was two-fold: (1) Under the pledge agreement, the Principal’s member voting rights ceased immediately upon the default, thereby rendering ineffective the board’s resolution authorizing the Chapter 7 petition; and (2) under the Amended Company Agreement, the Company was required, but failed, to obtain the Lender’s prior consent to the bankruptcy filing. 

It is black letter law that a corporate entity can only act through its authorized agents and that any unauthorized action, including filing a bankruptcy petition, must be dismissed as void ab initio. The scope of an agent’s corporate authority is determined by state law. Thus, the court’s analysis involved examining the provisions of the Texas Business Organizations Code (TBOC) applicable LLCs and the terms of the Amended Company Agreement.

Voting Rights (Authorization to File)

As to the voting rights argument, the controlling issue was whether the Principal, as sole manager, had authority to execute a board resolution authorizing the Company to file a bankruptcy petition. Put another way, the determination of the Lender’s argument turned on whether the Principal was acting as “member” or “manager” in connection with authorizing the Company’s bankruptcy filing.

Section 101.108 of the TBOC expressly provides that an assignee — solely by virtue of an assignment of a membership interest in an LLC — is not entitled to participate in the management and affairs, or to become or otherwise exercise the rights of a member, of the company. Rather, an assignee may only step into the shoes of a member upon approval of all members of the LLC. See TBOC § 101.109. Under the Amended Company Agreement, “no Member, in its capacity as Member, shall have the power to act for or on behalf of, or to bind, the Company,” and, here, the voting rights of the members were limited to electing managers and to voting on certain matters brought to a vote by the Company’s managers.  

Under Section 101.251 of the TBOC, an LLC’s governing authority lies with its managers if the company agreement provides that the company is managed by one or more managers. The Debtor’s Amended Company Agreement similarly delineated that the board of managers manages, operates and controls the business and affairs of the Company, and has authority to act on behalf of the Company pursuant to a board resolution. 

Tying it all together, the membership voting rights did not factor into the corporate authority equation. Even if the Principal’s voting rights as a member were immediately divested upon the Company’s default, the Principal — as sole manager of the Company — was also acting as the Debtor’s manager when causing the entry of the board’s resolution that authorized the Chapter 7 petition filing. The manager’s authority remained unaffected. Having dispensed with this unauthorizing filing argument, the court turned to the second grounds for dismissal.

Blocking Provision

Essentially, the Lender’s second argument was that, pursuant to the terms of the Amended Company Agreement, obtaining the Lender’s approval was a prerequisite to a legally authorized bankruptcy filing. And since the Company failed to obtain such prior consent, the Chapter 7 petition was a nullity. The issue therefore was whether the blocking provision in favor of the Lender was valid and enforceable. The court held it was not, finding it void as against public policy.

Citing to Collier on Bankruptcy, the court noted that blocking provisions are enforceable depending upon who has them. “If it is creditors, they are generally unenforceable. If it is equity interest holders, they are generally enforceable.” The court observed that the Fifth Circuit has not directly addressed the issue of pre-petition waivers of the right to file for bankruptcy. Citing to In re Franchise Services of North America, Inc., 891 F.3d 198 (5th Cir. 2018), the court observed that federal law does not prevent a bona fide shareholder from exercising its right to vote against a bankruptcy petition just because it is also an unsecured creditor. (In that case, the shareholder’s $15 million equity investment outweighed its $3 million debt.) Here, the court found that, unlike in Franchise Services of North America, “the Court is presented with a case where the creditor holds a convertible loan, not yet converted into a membership interest[.]” Looking outside of Fifth Circuit precedent, the court found a consensus in case law from other circuits: Blocking provisions where a creditor, without an ownership interest in the debtor, retains the ability to block the filing of a bankruptcy petition are void and unenforceable under public policy principles.   

Against this legal backdrop, the court turned to the case at hand. While the loan agreement provided the Lender with an option to convert all or some of the debt to membership interests in the Company, the Lender never exercised such option. Thus, the Lender “entered into a relationship with [the Company] and remains a creditor,” without any ownership interest in the Debtor. In the absence of any precedent supporting the Lender’s position, the court joined other courts in holding that the blocking provision was void as against public policy. The court therefore rejected the remaining unauthorized filing argument, concluding instead that the petition was filed with proper authority pursuant to the Amended Company Agreement and applicable Texas law. 

Bad Faith Filing

The court quickly dispensed with the third and final asserted ground for dismissal — that the Chapter 7 petition was filed in bad faith. The enumerated bases for dismissal under Section 707(a) of the Bankruptcy Code did not apply. Notably, the court found that a reorganization under Chapter 11 was not viable in light of the Company’s “mounting losses” and absence of liquidity, financing and capital, among other signs of financial distress. With this final ruling, the Lender’s motion to dismiss was denied.

Conversion to Subchapter 11

Regarding the Lender’s request that the case be converted from Chapter 7 to Subchapter V of Chapter 11, the court found no legal authority in the Bankruptcy Code or Bankruptcy Rules for granting such relief absent the Debtor’s affirmative election or consent. Thus, the court likewise denied this remaining relief sought, thereby dismissing the Lender’s motion in its entirety. 

Why This Case Is Interesting

Courts have long held that various attempts to circumvent the protections of the Bankruptcy Code are void as a matter of public policy — for example, pre-bankruptcy waivers of the automatic stay. Another unenforceable provision can be a consent right given to a lender as collateral protection versus a lender who is also an equity interest holder with a bona fide equity investment. Grounds for dismissal absent consent can fall along a spectrum between protecting an equity holder consent right and the creditor’s consent right. On one end of the spectrum, the court identified a Delaware bankruptcy case, In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016), in which the Delaware Bankruptcy Court had gone so far as to conclude that such a blocking provision was void as against public policy where the creditor held a merely nominal ownership interest in the debtor. On the other end, the court, citing Franchise Services of North America, observed precedent for a blocking provision in favor of a bona fide shareholder, where the shareholder’s $15 million equity investment far exceeded the $3 million in debt also held by the shareholder. Here, having a convertible debt interest where the lender did not, in fact, convert the debt to equity did not support upholding the bankruptcy consent right as the underlying relationship remained debtor-creditor.         

Regarding the voting rights portion of the unauthorized filing analysis, this case provides an example of how state law-governed issues vary across different jurisdictions and may yield different results. There is an important distinction between the laws governing LLCs in Texas and those in most other states, including New York. In the latter jurisdictions, the default is that LLCs are managed by the members of the company, unless the formation documents expressly provide otherwise (i.e., for a manager-managed LLC). See, e.g., N.Y. Ltd. Liab. Co. Law § 401. By contrast, Texas law requires the organizational documents (whether in the certificate of formation or the company agreement) to specify whether the LLC is manager-managed or member-managed. See Tex. Bus. Orgs. Code §§ 101.251–.252. Had the Debtor been a New York LLC with the articles of organization (i.e., formation documents) silent as to its governing authority, a court could conclude that the Company is member-managed. And in such instance, any decision on authority to file could require a more involved analysis in examining the issue of whether, and to what extent, the immediate extinguishment of the Principal’s member voting rights under the pledge agreement would have impacted the board’s authority to execute the resolution when acting as a member.