Exploring the Enforceability of Pre-Petition Hindrance Mechanisms to Prevent Bankruptcy

(Excerpt) Insolvency and bankruptcy pose great risks to a creditor’s investments. Although business entities can never be truly bankruptcy-proof, certain techniques are commonly deployed to make debtors as bankruptcy-remote as possible. Creditors and practitioners have devised and employed a multitude of “hindrance mechanisms” to significantly discourage bankruptcy petitions, while not directly causing debtors to waive their right to voluntarily file for bankruptcy. Creditors will often require debtors to accept these contractual provisions to make it more difficult, or practically impossible, for debtors to declare bankruptcy. However, as a rule of law, courts will render a hindrance mechanism per se invalid if the agreement operates as an ipso facto clause, violates state or case law, or otherwise violates the Bankruptcy Code. This memorandum discusses two commonly used hindrance mechanisms. Each part will explore one of the mechanisms, describe how it is used in practice, review recent relevant case law, and consider the advantages and flaws of the mechanism. Part I discusses the “independent” designee mechanism. This mechanism hinders the filing of bankruptcy petitions by allowing the creditor to appoint an “independent” director to the borrower’s board of directors and by requiring unanimous board approval to file a petition for bankruptcy. Part II discusses pre-petition waivers, which are contracts “entered into by the debtor and a creditor where the debtor voluntarily waives a right guaranteed in bankruptcy in exchange for consideration by the creditor.” This article discusses two types of pre-petition waivers: (1) automatic stay waiver, and (2) bad faith agreement. An automatic stay waiver is a promise by the debtor to waive the automatic stay protections once bankruptcy is filed. A bad faith agreement is a stipulation by the debtor that any bankruptcy petition subsequently filed shall be considered made in “bad faith” and warrant for cause dismissal of the case