Shareholder Rights in Bankruptcy
By George Howard and Lawrence Elbaum
Given the recent rise of retail traders, meme stocks, and the investor echo chamber in the blogosphere, shareholder activists may emerge more frequently in Chapter 11 bankruptcy cases and agitate for new directors in a bid to preserve perceived equity value. On the one hand, distressed companies facing activist campaigns may reach an agreement with dissident shareholders to resolve their concerns. But in some instances, companies need to seek bankruptcy court intervention to resolve a key governance issue. However, absent “clear abuse” by shareholders, courts have been hesitant to impede shareholders’ corporate governance rights.
Two recent bankruptcy cases serve as examples of the different approaches a company may take against activists. In PG&E’s Chapter 11 cases, when threatened with a proxy fight over its company-driven board refreshment process, the company reached an agreement with certain shareholders that eliminated the need for a proxy contest or court intervention. See In re PG&E, Case No. 19-30088-DM, (Bankr. N.D. Cal. Jan. 29, 2019).
However, in Mallinckrodt PLC’s Chapter 11 cases, a shareholder pursued a campaign for equity recoveries, including an attempt to call a special shareholder meeting to elect new, more shareholder-friendly directors. See Mallinckrodt PLC v. The Buxton Helmsley Group (In re Mallinckrodt PLC) Adv. No. 21-50242-JTD, (Bankr. D. Del. March 12, 2021). The debtors successfully blocked this attempt by obtaining a temporary restraining order (TRO) from the bankruptcy court, and subsequently the shareholder agreed to a preliminary injunction barring further efforts to call a special shareholder meeting.
The facts in Mallinckrodt are somewhat unique in that, for example, the parent debtor is incorporated in Ireland rather than Delaware (a popular incorporation state) where the state courts routinely safeguard statutes requiring companies to hold meetings and elect directors every 13 months. The arguments set forth by the debtors in Mallinckrodt, however, may serve as a template for future battles when shareholders seek to replace directors during an in-court restructuring process.
Similar to the shareholders in PG&E and notwithstanding the outcome in Mallinckrodt, activists likely will continue seeking ways to preserve their investments and influence the Chapter 11 process, while debtors likely will continue seeking ways to prevent shareholder interference when equity is perceived to be out of the money.
Shareholder Activism in Distressed Businesses
Distressed businesses are often targeted by shareholder activists who believe they can unlock value by changing the board, management and/or corporate strategy. Activists typically try to achieve this informally by increasing private and public pressure until the requested changes are made. However, when informal efforts are unsuccessful, formal campaigns (“proxy contests” or “proxy fights”) are used to replace directors through an election contest. Because most public companies are required by law to allow shareholders to elect directors at least every calendar year, a proxy contest typically occurs at the annual shareholders’ meeting. Companies’ articles of incorporation and bylaws and government regulations control the timing and procedural requirements of a legally compliant proxy fight.
Activists in distressed businesses must be aware of any “proxy penalty” provisions contained in a company’s third-party agreements. Such provisions can yield significant financial penalties if a majority of the board changes in an unsolicited manner (e.g., a proxy fight). If triggered, these provisions in agreements such as debt and credit agreements, can cause imminent financial obligations that could drive an already distressed company into bankruptcy.
In PG&E, activists used the threat of a proxy contest to reach agreement with the company changing the size and makeup of the board. There, the company announced a board refreshment process at the next annual meeting where many incumbent directors would remain in place. Certain shareholders disagreed with the nominations and pushed for a new slate of directors. Rather than deal with a proxy fight during its bankruptcy, the company reached a settlement with these shareholders on the size and composition of the board.
Shareholder Activism and Court Intervention
Traditionally, shareholders’ corporate governance rights are not impacted by the pendency of a Chapter 11 case. See In re Marvel Ent. Grp., 209 B.R. 832 (D. Del. 1997). However, debtors confronting activists are not defenseless. If a debtor believes an annual or special election of directors will seriously jeopardize a debtor’s reorganization efforts, a debtor may file an adversary proceeding and seek to enjoin shareholder attempts to elect new directors. See In re SS Body Armor I, 527 B.R. 597 (Bankr. D. Del. 2015).
When determining whether to enjoin such shareholder actions, a court must determine whether a shareholder’s actions amount to “clear abuse” of their corporate governance rights. Courts may look to whether: (1) shareholders are willing to risk the prospect of any successful rehabilitation; (2) permitting a shareholder meeting would result in a real threat to rehabilitation, as opposed to mere delay; and (3) an alternative plan resolving shareholders’ concerns could be formulated in a reasonable time. See In re Johns-Manville, 801 F.2d 60 (2d Cir. 1986). Notably, courts have found that it is not clear abuse for shareholders to call a meeting to elect new directors in order to improve their bargaining position in Chapter 11.
In Mallinckrodt, the court granted the debtors’ request for a TRO preventing a shareholder from calling a special shareholder meeting to elect a new board. The debtors asserted that the shareholder’s attempts to call a special shareholder meeting violated various securities laws, contained false and misleading statements, and constituted clear abuse by putting Mallinckrodt’s reorganization in jeopardy. In addition, the shareholder’s efforts to elect a new board came after a failed attempt to appoint an official equity committee and a determination that shareholders had “no economic interest” in the Chapter 11 cases. Subsequent to the TRO, the debtors and the shareholder agreed to a permanent injunction preventing numerous shareholder actions that would potentially interfere with the debtors’ reorganization efforts.
Implications and Considerations Going Forward
As a proactive measure, companies facing potential distress should update their bylaws and establish corporate governance practices to mitigate the potential negative impact and disruption of shareholder activism. This should include a regular refreshing of companies’ advance notice bylaws which set forth the requirements activists must meet to run a proxy fight replacing directors. Robust advance notice provisions can deter activists, particularly for distressed companies where an activist’s investment may be underwater, and a proxy fight might be prohibitively expensive. It is possible lenders and other stakeholders may agitate for provisions that deter activist behavior based on board changes (e.g., proxy penalties and other change of control events of default).
Companies should also have shareholder rights plans (“poison pills”) ready for immediate adoption. Rights plans put a cap on how much stock shareholders can buy (often as low as 4.95% for distressed companies to protect valuable tax attributes). Shareholders that trigger a rights plan face significant financial consequences because rights plans permit non-triggering shareholders to dilute the triggering shareholders, sometimes by as much as 90%. As stock prices of distressed companies decrease, an “in case of emergency” rights plan is often the only way to block opportunistic shareholders from buying control or control-like stakes that can destabilize companies and reduce a board’s negotiating leverage. Some courts have suggested that a board’s failure to promptly adopt a shareholder rights plan under certain circumstances could give rise to liability.
Once in Chapter 11, companies must make a value-maximizing decision that considers all stakeholders. Depending on the circumstances, options a debtor might consider include: (1) expanding the board to include a shareholder’s preferred directors; (2) proposing a Chapter 11 plan that provides for potential shareholder recoveries; (3) consenting to the appointment of an official equity committee; or (4) seeking injunctive relief barring a shareholder’s attempts to elect new directors.
When a debtor does seek injunctive relief, the circumstances likely will be particularly important. Following precedent, a bankruptcy court may be more likely to enjoin such shareholder actions if: (1) there is another reasonable alternative to mitigate a shareholder’s concerns, such as the appointment of an official equity committee or alternative plan structure; (2) there is pending litigation or an ongoing proxy dispute involving the same parties; (3) a shareholder is also a creditor and using its equity voting rights to improve its position as a creditor; (4) substantial progress has already been made in negotiations with creditors prior to a shareholder’s actions; (5) the bankruptcy court has already rejected an official equity committee and held shareholders have no likelihood of recovery; and (6) a shareholder’s actions demonstrate a willingness to completely derail, rather than merely delay, the process to try to win a larger equity recovery.
Given the current climate and the likely increase in shareholder activism, directors of companies facing potential distress would be well-advised to prepare for potential shareholder activism well in advance and alongside other liability management and contingency planning.
Dallas-based restructuring and reorganization associates Trevor Spears and Sara Zoglman assisted in the preparation of this article.
Reprinted with permission from the “June 4, 2021″ edition of the “New York Law Journal” © 2021 ALM Media Properties, LLC. All rights reserved.
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