Texas Court Voids Lender’s Bankruptcy Consent Requirement

Lenders often attempt to limit what a borrower can do outside the ordinary course of business by negotiating contractual protections. Some of these provisions are designed to make the borrowers bankruptcy remote by, for example, requiring the borrower's Board to include an independent director whose consent is required for a bankruptcy filing. Others, as was the case we discuss here, go further by including contractual rights that limit a borrower's ability to file for bankruptcy without the lender's consent. The enforceability of these so-called "blocking provisions" has long been debated. See OnPoint: Bankruptcy Blocking Rights - The Saga Continues, available here. A recent decision by a Texas bankruptcy court joins the view that a creditor cannot enforce a "blocking provision" without holding a legitimate equity interest in the debtor. See In re Roberson Cartridge (Roberson), No. 22-20192 (Bankr. N.D.Tex. Mar. 7, 2023), available here.

Background

A small and newly formed ammunition manufacturer, Roberson Cartridge Co., LLC (the "Debtor"), filed for bankruptcy in the Northern District of Texas. Facing liquidity troubles and year-over-year operating losses, the Debtor sought an orderly liquidation under chapter 7 of the Bankruptcy Code. The bankruptcy petition was approved by Jeff Roberson, who was the sole member, manager, and officer of the Debtor.
According to the Debtor's schedules, the Debtor had few genuine assets besides a 40,000 square-foot commercial property where it manufactured ammunition. Its liabilities included $4.4 million owed to Matador Brass Partners, LLC ("Matador") under a line of credit facility (the "Credit Facility") secured, among other things, by the membership interests in the Debtor and convertible into the Debtor's equity at Matador's discretion.

As required by the Credit Facility, the Debtor executed an Amended and Restated LLC Agreement (the "LLC Agreement"), providing that the Debtor must obtain Matador's written consent before taking "any action that results in a liquidation or dissolution of the Company" (the "Blocking Provision"). The LLC Agreement also provided that upon a default under the Credit Facility, Roberson's voting rights would cease and vest in Matador.

Although the Debtor defaulted on its obligations under the Credit Facility, Matador never converted any portion of its debt, nor did it foreclose on the pledged membership interests in the Debtor.

Shortly after the Debtor filed its petition, Matador moved to dismiss the case or, in the alternative, to convert the case to chapter 11. Matador argued that the Debtor filed the case without authority because, among other things, the Debtor did not obtain Matador's consent prior to filing the bankruptcy case and Roberson lost his authority to authorize the filing due to the loss of his voting rights upon the default. Both the chapter 7 trustee and the Debtor opposed the motion.

The Decision

Following a three-day trial, the Court denied Matador's motion to dismiss and found that (i) the Blocking Provision was unenforceable as a matter of public policy, and (ii) Roberson retained his ability to approve the bankruptcy filing notwithstanding the default under the Credit Facility.

Blocking Provision

The Court first concluded that the liquidation consent requirement in the LLC Agreement was a "blocking provision" as colloquially understood in caselaw. Relying on precedents, the Court observed that only an equity holder may properly exercise a blocking provision. The Court acknowledged that in Franchise Servs. of N. Am. v. U.S. Tr. (Franchise Servs.), 891 F.3d 198 (5th Cir. 2018), the Fifth Circuit held that federal law does not prohibit a "bona fide shareholder" from exercising its right to vote against a bankruptcy where the shareholder is also an unsecured creditor. That holding was limited, however; as the Fifth Circuit suggested the result would be different if "confronted with a case where a creditor has somehow contracted for the right to prevent a bankruptcy or where the equity interests is just a ruse."

Finding no other applicable Fifth Circuit precedent, the Court turned to the decisions of other bankruptcy courts that addressed the rights of creditors to contract around bankruptcy. The Court observed that, in those cases, many courts found that blocking provisions are void on public policy grounds when a creditor, with no ownership interest, retains the ability to veto the filing of a bankruptcy petition. The Court of Appeals for the Ninth Circuit observed in Huang, 275 F.3d 1173,1177, that a: "prohibition of prepetition [bankruptcy] waiver has to be the law; otherwise, astute creditors would routinely require their debtors to waive" the authority to file. Following this line of cases, the Court held that the Blocking Provision was void as against public policy since Matador had no ownership interest in the Debtor.

Voting Rights

Under the LLC Agreement, the Debtor was managed by its managers rather than its members, and the managers had the authority to act on its behalf. At the time of the bankruptcy filing, Roberson was the Debtor's sole manager and, as such, had the power under the LLC Agreement and Texas law to authorize the filing. As the Court observed, in authorizing the filing, Roberson did not exercise his pledged voting rights as a member. Therefore, even if he lost his member voting rights due to the default, a point that the Court left undecided, Roberson maintained his unpledged power as a manager.

Conclusion

The delicate dance among lenders, attempting to restrict their borrowers' access to bankruptcy, and borrowers and other parties in interest, who wish to use the bankruptcy process, goes on. Courts are left to address the tension, facing new legal and factual scenarios and vastly different reliance and market expectations. As we said before, the saga continues.

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