Delaware Bankruptcy Court Holds That Minority Shareholder Blocking Rights Are Void
A little over two years ago, I reviewed a handful of decisions confirming the public policy against permitting limited liability companies from contracting away the right to seek bankruptcy protection in operating agreements.[1] In those cases, courts held that notwithstanding state law policy of freedom of contract in LLC agreements, so called blocking rights that give a creditor the ability to bar an entity from filing a bankruptcy petition may be void under federal law.[2]
Whereas “parties to an operating agreement generally have the freedom to contract limited only by the parameters in the relevant articles of organization and statutory law,” courts have recognized “a strong federal public policy in favor of allowing individuals and entities their right to a fresh start in bankruptcy.” Last month, in a ruling from the bench,[3] the Bankruptcy Court for the District of Delaware affirmed and strengthened that public policy as it relates to a debtor’s minority shareholder’s blocking rights, setting up a potential split between the Third and Fifth Circuits.[4]
On May 5, 2020, in In re Pace Industries, LLC, Case No. 20-10927 (MFW) (Bankr. D. Del.), Bankruptcy Judge Mary Walrath, in denying a motion by Macquarie Septa (US) I, LLC (Macquarie) to dismiss the debtor’s chapter 11 case, ruled that a minority shareholder’s blocking rights were “void” in the face of the debtor’s constitutional right to file bankruptcy. Judge Walrath explained:
I do recognize that there is no case directly on point, holding that a blocking right by a shareholder who is not a creditor is void as contrary to federal public policy that favors the constitutional right to file bankruptcy. But I think that, based on the facts of this case, I am prepared to be the first court to do so, and therefore conclude that the motion to dismiss must be denied.[5]
After Pace Industries and certain affiliates commenced their chapter 11 cases, Macquarie moved to dismiss the filings. Macquarie, which had made a $37 million investment in the debtor’s preferred stock, argued that the filing was unauthorized because the debtor did not obtain Macquarie’s consent, as provided for in the applicable corporate governance agreements. Macquarie argued that its right to block a bankruptcy filing was a heavily negotiated and critical component of its investment.
Macquarie acknowledged the cases holding that blocking rights in the hands of certain creditors might violate public policy, but attempted to distinguish those cases—including Intervention Energy and Lake Michigan[6]—on the basis that those cases involved shareholders who were also creditors, and that the equity stakes at issue were in the nature of “golden shares” intended only to vest the creditor with the blocking right. Here, however, Macquarie held only preferred equity—indeed, a substantial, albeit minority, stake—and was not a creditor. Accordingly, Macquarie argued that the court was constrained by U.S. Supreme Court precedent in Price v. Gurney, 324 U.S. 100, 106 (1945), to dismiss the bankruptcy petition where those who purported to act on behalf of the corporation lacked authority to do so under applicable state law. Based on the Fifth Circuit’s Franchise Services decision, which applied Delaware law, Macquarie argued that as a minority shareholder, it was not a controlling shareholder that owed any fiduciary duties and, specifically, the fact that Macquarie was not given opportunity to even exercise its consent rights prior to the chapter 11 filing shows that it did not control the board. In Franchise Services, the Fifth Circuit held that a shareholder with a blocking right did not have control over the debtor’s conduct and concluded that not being consulted as to a bankruptcy filing where it held such a consent right was indicative of a lack of control; accordingly, the Fifth Circuit did not reach the issue of whether it breached any purported fiduciary duty.[7]
Judge Walrath rejected those arguments, however, and denied Macquarie’s motion to dismiss, holding that:
under Delaware state law, contrary to the Fifth Circuit, my interpretation of the law would and does find that blocking rights, such as exercised in the circumstances of this case, would create a fiduciary duty on the part of the shareholder; a fiduciary duty that, with the debtor in the zone of insolvency, is owed not only to other shareholders, but to all creditors.[8]
In declining to follow Franchise Services, Judge Walrath began by focusing on the debtor’s clearly deteriorated financial condition, stating that “[t]here is no contest that the debtor needs a bankruptcy,” having closed its plants and furloughed workers, and having effectively no liquidity.[9] She went on to find that the bankruptcy case would “benefit most stakeholders” because the debtor’s lenders had agreed to a proposal that would pay all creditors in full if the plan were confirmed.[10] The court determined that under such circumstances, Macquarie’s blocking rights did create a fiduciary duty, and that allowing a shareholder like Macquarie to block a bankruptcy filing to advance its own interests offends federal public policy and interferes with a company’s constitutional right to seek bankruptcy relief. The court saw “no reason to conclude that a minority shareholder has any more right to block a bankruptcy—the constitutional right to file a bankruptcy by a corporation than a creditor does,” and therefore broke from the Franchise Services decision.[11]
In conclusion, Judge Walrath stated, “whether or not the person or entity blocking access to the Bankruptcy Courts is a creditor or a shareholder, federal public policy does require that the Court consider what is in the best interest of all, and . . . whether the party seeking to block [the filing] has a fiduciary duty that it appears it is not fulfilling[.]”[12] Importantly, Macquarie had conceded that it was “not considering the rights of others in its decision to file the motion to dismiss.”[13] Thus, Judge Walrath’s decision should put minority shareholders seeking to block a chapter 11 case—at least one filed in Delaware—on notice that such efforts will likely be met with strong resistance, and could even give rise to liability for breach of fiduciary duties if the efforts to prevent a debtor’s filing result in harm to other stakeholders. In addition, minority shareholders seeking to negotiate such blocking rights in connection with an investment should understand that going forward, such provisions in an entity’s corporate governance documents may be of little value. Thus, if the blocking rights are so essential to the deal terms, an investor might be well-advised to walk away.
[1] Brett S. Theisen is the director and vice-chair of the Financial Restructuring and Creditors’ Rights department at Gibbons P.C.
[2] See, e.g., In re Lexington Hosp. Grp., LLC, 2017 WL 4118117 (Bankr. E.D. Ky. Sept. 15, 2017); In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016); In re Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).
[3] See Docket No. 173. At present, the court’s docket does not indicate that a written decision will be forthcoming.
[4] See In re Franchise Servs. of N. Am., Inc., 891 F.3d 198, 206–08 (5th Cir. 2018), as revised (June 14, 2018).
[5] Tr. of Hr’g, dated May 5, 2020 (Case No. 20-10927(MFW) (Bankr. D. Del.), at 38:10-13.
[6] See infra, note 1.
[7] 891 F.3d at 213.
[8] Tr. of Hr’g, dated May 5, 2020 at 40:22–41:3.
[9] Id. at 38:17-25.
[10] Id. at 39:1-4.
[11] Id. at 40:14-17.
[12] Id. at 41:24–42:4.
[13] Id. at 42:5-7.
