In re Pace Industries, LLC: Minority Shareholder with Bankruptcy Consent Rights Considered Controlling Minority Shareholder with Fiduciary Duties
A recent bench ruling in In re Pace Industries, LLC1 by Judge Walrath for the Bankruptcy Court for the District of Delaware (the “Court”) has validated a chapter 11 bankruptcy filing by certain debtors in the jointly administered cases of Pace Industries, LLC and certain of its affiliates, in spite of the fact that they were filed in contravention of an explicit bankruptcy-filing blocking right held by certain equity holders as set forth in the applicable corporate governance documents. Specifically, the Court denied on public policy grounds a motion to dismiss filed by Macquarie Septa (US) I, LLC (“Macquarie”), as a 62.5% holder of Series A preferred stock whose written consent to any bankruptcy filing was required as set forth in the KPI Intermediate Holdings, Inc. Amended and Restated Certificate of Incorporation, but which consent was not obtained before the bankruptcy filing.
Despite the fact that this ruling is an important one as it may create a split of authority between the Delaware Bankruptcy Court and the Fifth Circuit Court of Appeals on this issue, there is no published opinion. Instead, the Court entered a short order on May 11, 2020 denying the motion to dismiss “for the reasons stated by the Court on the record at the hearing held on May 5, 2020.”2 Moreover, there is nothing in the record from the hearing or on the docket indicating that any opinion is forthcoming.
At the May 5, 2020 hearing and in court papers, Macquarie argued3 that the Court lacked subject matter jurisdiction over the Debtors’ bankruptcy petitions because the Debtors did not obtain the requisite consent of Macquarie under the applicable contractual provisions of the corporate governance documents, as required under applicable Delaware law. Macquarie acknowledged existing case law finding that shareholder bankruptcy consent rights violate public policy where they are exercised by a shareholder who is also a creditor who holds a “golden share.” See, e.g., In re Intervention Energy Holdings, LLC, 553 B.R. 258, 265 (Bankr. D. Del. 2016). But, here, Macquarie was not wearing two hats; Macquarie held only preferred equity and was not a creditor of the Debtors. Accordingly, Macquarie argued that the Court was constrained by United States 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. Macquarie also cited to other cases, including recent Fifth Circuit precedent, in support of that position. See In re Franchise Servs. of N. Am., Inc., 891 F.3d 198, 206-08 (5th Cir. 2018), as revised (June 14, 2018).
In Franchise Services, the Fifth Circuit, applying Delaware law, held that a shareholder with a bankruptcy filing consent right did not have actual (as opposed to theoretical) 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. Id. at 213. Consistent with the Fifth Circuit ruling in Franchise Services, Macquarie argued that a minority shareholder, such as Macquarie, is not a controlling minority shareholder who is a fiduciary, and the fact that Macquarie was not given opportunity to even exercise its consent shows that it, in fact, did not control the board.
Macquarie further argued the irrelevance of the Debtors’ arguments that they need to be in chapter 11 (despite the consent of Macquarie not being given) and the fact that certain other creditors have threatened to file an involuntary petition4 if the cases were to be dismissed by the Court. And Macquarie further argued that the only things the Debtors were trying to do in bankruptcy that they could not do outside of bankruptcy was to obtain releases and other benefits for the Directors, the equity sponsor, and other insiders and wipe out preferred equity interests without any consideration and without an opportunity to participate in the process while general unsecured creditors were proposed to be paid in full. Macquarie further argued that any involuntary petition would face challenges were it to be filed and would not automatically be granted.
The Debtors’ Arguments
The Debtors argued before the Court and in their filed response to the motion to dismiss5 that they were forced to close facilities and terminate a large portion of their workforce as a result of the COVID-19 pandemic and that the directors, as fiduciaries of the Debtors, determined that a bankruptcy filing was in the best interests of the Debtors. The Debtors argued that Macquarie was objecting only to gain negotiating leverage to which it would not otherwise be entitled in bankruptcy. Specifically, the Debtors argued under Basho Techs. Holdco B, LLC v. Georgetown Basho Investors, LLC, 2018 WL 3326693 (Del. Ch. 2018), aff’d, 221 A. 3d 100 (Del. 2019), that Delaware law imposes fiduciary obligations on minority shareholders when they control a particular transaction, and argued that a bankruptcy blocking right gives such shareholders an extraordinary level of control over a company. Here, where chapter 11 was asserted to be the Debtors’ only lifeline, the Debtors argued that Macquarie’s exercise of control over that lifeline renders Macquarie a fiduciary obligated to consider the Debtors’ best interests. The Debtors also argued that those same facts rendered the blocking right in this case to be against federal public policy because it completely cuts off the Debtors’ constitutional right to seek bankruptcy relief. The Debtors also argued that the Fifth Circuit in Franchise Services was simply wrong when it failed to conclude that a shareholder with a bankruptcy blocking right did not owe fiduciary duties to the company.
The Court’s Bench Ruling
At the hearing on the motion to dismiss,6 Judge Walrath summarily stated: “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.”
The Court pointed out that there was no contest that the Debtors are in financial straits, and even more so as a result of COVID-19. The Court also observed that the bankruptcy case will benefit most stakeholders and concluded that “a lack of access to the Bankruptcy Code and the Bankruptcy Courts would violate the federal public policy  to allow a debtor to file bankruptcy.” Accordingly, the Court determined that the provision in the applicable corporate charter giving Macquarie a blocking consent right over a bankruptcy filing “violates public policy and is void as it is exercised by a minority shareholder” because it is a “restriction of that constitutional right [to file bankruptcy and] is against federal public policy.” The Court “respectfully declined” to follow Franchise Services and 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.”
Further, the Court “under Delaware state law, contrary to the Fifth Circuit’s interpretation of that law [in Franchise Services], would and does find that a blocking right, 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 also to all creditors.” The Court specifically found that, pursuant to Basho, other factors combined with the blocking right—that the Debtors were in the zone of insolvency, lacked liquidity, and could not pay their debts as they came due without debtor-in-possession financing, coupled with severe disruption of operations due to COVID-19—supported the finding that, on the circumstances of this case, the blocking right held by Macquarie created a fiduciary duty.
Accordingly, the Court determined that federal public policy requires consideration of “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” and denied the motion to dismiss in light of the fact that Macquarie “has said clearly it is not considering the rights of others in its decision to file the motion to dismiss.”
The case is In re Pace Industries, LLC, Case No. 20-10927(MFW) (Bankr. D. Del.).
1 Bench Ruling, May 5, 2020 (Case No. 20-10927(MFW) (Bankr. D. Del.).
2 See Docket No. 173.
3 See Docket No. 88, 128.
4 See Docket Nos. 116, 117
5 See Docket No. 115.
6 See Transcript of Hearing, dated May 5, 2020 (Case No. 20-10927(MFW) (Bankr. D. Del.)).
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.