As private fund lenders may have observed, loan documents are expanding (with added contractual language) for one primary reason: lenders are battling to minimize risk and lower the costs of enforcing a contractual term.
One example of this is the addition of various waivers and releases in favor of the GP (or lender). But despite being part of “standard issue” loan packages, private debt investors and other lenders should be aware that enforcement of these provisions remains controversial.
In the bankruptcy context, enforceability of pre-bankruptcy waivers has generated a host of litigation involving private equity lenders. While certain waivers among creditor classes have survived court scrutiny (e.g., a junior creditor waiving the right to object to actions by a more senior creditor), others have been found to impinge fundamental bankruptcy rights and have been struck down. For example, contractual provisions that prevent a borrower from filing bankruptcy have almost universally been found to be unenforceable. The usual rationale cited is that such provisions violate public policy and prevent the orderly reorganization that Chapter 11 is designed to foster.
Until recently, however, at least some commentators suggested that a restraint (but not an outright prohibition) on a borrower’s right to file for bankruptcy included in the borrower’s corporate documents, as opposed to the same constraint in a loan agreement, might withstand scrutiny if otherwise valid under applicable law. An Oregon bankruptcy court that faced this issue recently ruled otherwise. The court found inclusion of the provision in an operating agreement rather than in a loan agreement, a “distinction without a meaningful difference.”
In the Oregon case, in order to obtain a loan, members of an Oregon limited-liability company agreed to include a provision in their operating agreement precluding the company from filing for bankruptcy until the secured debt was repaid. When the company filed for bankruptcy anyway after defaulting on the loan, the lender filed a motion to dismiss the bankruptcy case for cause, arguing that the restrictive covenant in the operating agreement was consistent with Oregon state law and, therefore, also enforceable in the bankruptcy proceeding.
The bankruptcy court denied the lender’s motion, finding enforceability of prepetition bankruptcy waivers in a Chapter 11 case governed by federal law and not state law. Under federal law, the court held the waiver unenforceable on public policy grounds. That the LLC members signed the operating agreement among themselves rather than acquiescing to similar language in their loan agreement was found to be immaterial.
Based on this decision, private equity lenders should anticipate that pre-bankruptcy waivers of the right to file for bankruptcy will continue to be difficult to enforce; however, not all waiver and release provisions will suffer the same fate. Lenders should be prepared for courts to view their waivers and releases as inherently suspect and to review them carefully, on a case-by-case basis. As courts have not been consistent in their rulings and even in their approaches to analyzing such provisions, it is important to know the law of the jurisdiction to which the issue may be presented.
Jennifer Feldsher is a partner, and Jonathan Lozano an associate, in Bracewell & Giuliani’s New York financial restructuring practice.