Left to right: Andrew Kassner and Joseph Argentina , Drinker Biddle & Reath ()
Over the years, the real estate industry relied heavily on securitization vehicles to finance commercial real estate projects. The loans are packaged and then sold in pools to investors. Various mechanisms have been developed to facilitate collection of the loans without the uncertainty of a borrower bankruptcy filing that could delay and increase the costs of collection. Lenders in these secured transactions often use special purpose entities, or SPEs, to attempt to limit the risk of a borrower bankruptcy filing. While these structures can vary, the concept is to create a separate corporate entity whose only purpose and asset is the one real estate project, and the only significant obligation is the mortgage loan. The SPE is isolated from the financial affairs of the corporate parent or affiliates. The lender requires the borrower to appoint an independent director to the board from a mutually acceptable source, and unanimous board approval for certain key decisions, such as the decision to file for bankruptcy. Consequently, a lender is able to reduce the risk of delay after default and high costs of collection, and the borrower benefits from lower interest rates and fees from the lower cost loan.
A number of companies now provide independent directors to serve on these SPE borrower boards. These individuals are often professionals with experience in secured transactions. The idea is that they will use that experience in a crisis and, presumably, head off ill-advised or impulsive decisions by the developer/owner. The ability of such an independent director not to approve a borrower decision to file a bankruptcy case was addressed recently in a decision by the U.S. Bankruptcy Court for the Northern District of West Virginia in In re Tara Retail Group, Case No. 17-bk-57 (May 4). In that case, an independent director who never affirmatively voted in favor of authorizing the filing of a bankruptcy case was found to have tacitly ratified the borrower’s decision to file when the independent director remained silent and did not object after the case was filed.
The Debtor Sinks After the Flood
According to the opinion, the debtor, a Georgia limited liability company, managed and operated a shopping center in Elkview, West Virginia. The shopping center was its only asset, and the rents from leases were its only source of revenue. In June 2016, a series of thunderstorms caused “calamitous flooding” and destroyed a culvert and bridge that provided the only public access to the shopping center. Prior to the flood, the debtor had been current on its obligations to its lender, but following the storms it was unable to generate any rents and defaulted on its loan.
The SPE’s independent director at the time of the debtor’s bankruptcy filing was John Hosmer, an employee and majority owner of SPE Independent Director, LLC, which the court described as “a company that offers corporate services specifically for single-asset entities, particularly focusing on providing independent directors or trustees.” Hosmer had also worked as an attorney at several national law firms in mortgage-backed security matters.
The debtor retained bankruptcy counsel to prepare for a bankruptcy filing. The debtor’s bankruptcy counsel contacted Hosmer on the eve of bankruptcy to obtain his approval to file the bankruptcy petition. Hosmer declined, stating he would need at least a week and additional information. In response, the debtor’s counsel drafted a resolution purporting to replace the SPE as the debtor’s manager with individuals willing to authorize the filing. The debtor filed its Chapter 11 petition on
COMM2013 CCRE 12 Crossing Mall Road LLC (lender) filed a motion to dismiss the case, arguing that the debtor failed to secure the appropriate corporate authority to commence the case as required by the debtor’s organizational documents. The debtor conceded that it did not strictly comply with its governing documents, but alleged it substantially complied with the documents and obtaining proper authorization was legally impossible.
The court held four hearings on the motion to dismiss. At the first hearing, the court observed that ratification of the petition was a possible issue for adjudication. During subsequent hearings, the court also ruled that the debtor’s attempt to replace the SPE as its manager was void, leaving the SPE in place as the debtor’s manager and Hosmer as the independent director. The court also rejected the debtor’s argument that it had substantially complied with its organization documents and that strict compliance was legally impossible. However, the court did not grant the lender’s motion to dismiss.
The opinion states that Hosmer was notified the court was considering the issue of ratification of the debtor’s bankruptcy filing. Hosmer was deposed, and at his deposition, he was asked if he believed that he ratified the debtor’s bankruptcy, either affirmatively or by silence. He responded that while he did not affirmatively ratify the filing and did not intend to do so by silence, the question of whether he ratified the petition by silence was a legal question. The court agreed, and disregarded Hosmer’s additional statements that he did not intend to ratify the filing by silence.
The court wrote that neither Hosmer nor anyone on his behalf “filed anything with the court, appeared at a hearing, or otherwise attempted to voice any concern with the Debtor’s bankruptcy filing.” The court issued a bench ruling denying the motion to dismiss. After the lender filed a notice of appeal (which was dismissed on the grounds the appeal was taken from an interlocutory order), the court issued a written opinion to create a full
The Court’s Analysis
The analysis in the opinion begins by noting the bankruptcy code does not establish the internal corporate action required for authorizing the filing of a bankruptcy case. Instead, the authority to file a bankruptcy petition is based on state law. Depending on applicable state law, an unauthorized bankruptcy filing might be ratified by ensuing conduct by the people who had the power originally to authorize the filing. Under Georgia state law, which applied to this case, “an unauthorized act may be ratified by failing to promptly disavow that act upon its discovery.” However, while ratification by silence may sometimes be inferred, courts should not infer ratification if the silence results from the complexity of the situation rather than intent.
The court reviewed the debtor’s “murky” organizational documents. The debtor’s sole limited purpose was to own and operate the shopping center. The debtor’s articles of incorporation provided that it could not voluntarily file a bankruptcy petition without the unanimous consent of its members. So long as COMM2013 CCRE 12 Crossing Mall Road (lender) held a mortgage on the shopping center, the debtor was required to have an SPE as its manager. The debtor and the SPE’s articles of incorporation made clear that the lender required the independent director to be a “professional” independent director:
“Independent director” shall mean an individual who has at least three years prior employment experience and continues to be employed as an independent director, independent manager or independent member by CT Corp., Corporation Service Co., National Registered Agents, Inc., Wilmington Trust Co., Stewart Management Co., Lord Securities Corp., SPE Independent Director, LLC, or, if none of those companies is then providing professional independent directors, independent managers, and independent members, another nationally recognized company that provides such services and which is reasonably approved by the lender … .”
The documents also provided that the SPE “will not cause the board of directors to take any action requiring the unanimous affirmative vote of the members of its board of directors unless each independent director participated in that vote … and shall not approve the filing of a bankruptcy petition without unanimous consent of its board of directors.”
In this case, the court found that Hosmer had full knowledge of all the facts pertinent to exercising his veto of the bankruptcy filing no later than March 31. Despite that knowledge, Hosmer took no action to object to the filing prior to the court’s ruling on April 14, despite being notified of his right to be heard on the issue at a hearing on April 6.
The lender asserted Hosmer’s silence was a result of the complexity of the situation, and further, 15 days was too short a time to make his decision. The court rejected that argument. First, the court reasoned the decision Hosmer needed to ratify was the decision to file bankruptcy without proper authorization. That decision required no analysis of the debtor’s financial condition. Second, the court found that 15 days was a reasonable time and opportunity for Hosmer, a trained attorney, to make his objections, if any, known to the debtor and the court. Instead, he remained silent. The court concluded that the Debtor had complied with its governing documents and obtained the necessary authority to file bankruptcy.
Agreements that prohibit a company to file bankruptcy generally are not enforceable and legal structures that have the same effect are not favored by the courts. This decision serves as a reminder to lenders that in these situations, the independent director may need to make his position known when requested to authorize the filing of a bankruptcy case, and mere silence may not suffice. This court required the independent director—not the lender—to act affirmatively in one way or another either before or after the filing. Lenders and practitioners are well advised to consider this possibility in these situations. •