In the first decision by a Delaware court to address this issue, a Delaware bankruptcy judge denied a shareholder's motion to dismiss a Chapter 11 bankruptcy case based on the shareholder's contractual blocking right. While the decision focused on the particular facts and circumstances of the case, it serves as an indicator that the public policy surrounding bankruptcy may override negotiated shareholder protections in a company's governing documents.
On April 12, 2020, KPI Holdings, LLC and 10 of its U.S. subsidiaries, including Pace Industries, LLC (collectively, the Debtors), filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court for the District of Delaware.1 The Debtors entered Chapter 11 with a pre-packaged plan which provided for a restructuring of the company's debt and a new $50 million term loan facility that would be available to the Debtors upon their emergence from bankruptcy. The plan provided for noteholders to receive 100 percent of the equity of the reorganized Debtors and for payment of general unsecured creditors in full.
Motion to Dismiss
Macquarie Septa (U.S.) I LLC (Macquarie), the majority holder of the Series A Preferred Stock of Debtor KPI Intermediate Holdings, Inc. (KPI Intermediate), moved to dismiss the Chapter 11 cases of KPI Intermediate and its subsidiaries (which include most of the Debtors), alleging that KPI Intermediate's directors were "unauthorized" to file voluntary Chapter 11 petitions and initiate the bankruptcy cases.
Macquarie's motion was premised on a protective clause contained in KPI Intermediate's certificate of incorporation that gave Macquarie a "blocking right," a type of shareholder consent right that prevented the company from "directing, adopting, or approving any plan of liquidation, dissolution or winding-up" or "any voluntary bankruptcy or similar filing" by the company or any of its subsidiaries without the consent of the holders of a majority of the Series A Preferred Stock. In January 2018, Macquarie had purchased 400 shares, or $37,150,000 worth of KPI Intermediate's Series A Preferred Stock and conditioned its investment, in part, on the company's agreement to amend its certificate of incorporation to include the blocking right to control whether the company could file for bankruptcy.
Macquarie framed the issue before the bankruptcy court as a simple question: Did Macquarie's right to freely contract under Delaware state law—in this case, by obtaining a veto power via KPI Intermediate's corporate charter in exchange for making an equity investment in the company—supersede the federal policy of providing debtors access to federal bankruptcy protections?
Debtors' Response in Opposition to Motion to Dismiss
In response to Macquarie's motion to dismiss, the Debtors conceded that KPI Intermediate had indeed amended its certificate of incorporation to include a protective blocking right provision in favor of Series A Preferred Stockholders as a means to induce Macquarie to purchase its preferred shares.
While acknowledging the existence of the shareholder consent right, the Debtors argued that such a right could be disregarded by the court in instances where enforcement of the right would conflict with the federal policy goals of 1) affording needed bankruptcy protection to distressed debtors and/or 2) preventing inequity.
The Debtors recited a number of factors, including the company's dire liquidity position, its overleveraged capital structure, the forced closure of five of its seven domestic-based die-casting facilities, and the laying off of approximately 70 percent of its employees as indicia of the Debtors' fitness for bankruptcy protection. The Debtors also explained that under their prepackaged plan, noteholders would receive 100 percent of the equity in new notes issued by the reorganized debtors, and, most importantly, that all general unsecured creditors would be paid in full—an unusually positive outcome in a bankruptcy case. Therefore, the Debtors argued, Macquarie's motion to dismiss was at odds with the best interests of the Debtors' bankruptcy estates, and the consent right was being invoked for the sole purpose of extracting leverage to renegotiate the prepackaged plan in furtherance of Macquarie's own self-interest. Finally, the Debtors were joined by their secured noteholders in asserting that even if the bankruptcy court upheld Macquarie's blocking right, the noteholders would immediately commence involuntary petitions and swiftly force the Debtors back into bankruptcy. This process, the Debtors argued, would clearly require the expenditure of additional time and expense, unnecessarily harming the Debtors and their creditors, while conferring no benefit upon Macquarie.
A Matter of First Impression
U.S. Bankruptcy Court Judge Mary F. Walrath, a 22-year veteran of the Delaware District Court bankruptcy bench, acknowledged that in the absence of case law on point, her decision would be precedential. In delivering the bench ruling, Judge Walrath noted that the ongoing economic and business constraints facing the Debtors clearly qualified them for bankruptcy under normal circumstances.
While acknowledging the existence of the blocking right contained in KPI Intermediate's certificate of incorporation, Judge Walrath agreed with the Debtors that denying them access to the bankruptcy court would violate the well-established federal public policy of affording debtors the unique protections provided by the Bankruptcy Code. Faced with resolving an obvious tension between federal public policy and Macquarie's state-law-derived contractual rights, the court examined the practicality, or lack thereof, of dismissing the Debtors' bankruptcy cases where no viable alternatives to bankruptcy seemed to exist.
Judge Walrath found that the Series A Preferred Stockholders' contractually-derived blocking right would not serve the interests of any party in the bankruptcy cases besides Macquarie, and given the circumstances, should be subordinated to federal public policy. In delivering the ruling, Judge Walrath explained, "[w]hether the person or entity blocking access to the bankruptcy courts is a creditor or a shareholder, federal public policy does require what is in the best interest of all."
Relatedly, at the May 5, 2020 dismissal hearing, the Debtors asserted that a blocking right, such as the one held by Macquarie, would create an inference of control over the company, and thus give rise to a fiduciary duty for shareholders exercising such a right. Macquarie's counsel argued that the very fact that the company's directors had filed for bankruptcy against the will of Macquarie demonstrated that it did not exercise "control" over the company. In defense of its position, Macquarie introduced In re Franchise Services of North America, a case in which the Fifth Circuit held that actual control of corporate conduct was required to give rise to the creation of a fiduciary duty owed by shareholders and that a blocking right, standing alone, does not constitute actual control.
Takeaways
While certainly notable, the implications of the bankruptcy court's decision to elevate federal public policy over parties' rights to freely contract remain ambiguous.
In her bench ruling, Judge Walrath pointed to several factors, the confluence of which are somewhat unique to the Pace Industries Chapter 11 cases and likely influenced the court's decision to disfavor the blocking right. Specifically, Judge Walrath's remarks concerning the Debtors' desperate financial condition and lack of viable alternatives to bankruptcy indicate that the court could reach a different conclusion under similar circumstances where a debtor maintains plausible options to restructure outside of bankruptcy. In the same vein, the ruling simultaneously championed substance over form by acknowledging the pointlessness of dismissing the Chapter 11 cases in anticipation of the inevitable involuntary filings that would be sought by the Debtors' creditors, a situation which would only serve to further harm the Debtors and depreciate the value of the estates.
Finally, Macquarie was unable to adequately counter assertions that it would not quantifiably benefit even in the event the court granted its motion to dismiss the Chapter 11 cases. The Debtors' pleadings portrayed Macquarie's motion to dismiss as a desperate attempt to extract some benefit for itself at the expense of a heavily negotiated plan that benefited most other stakeholders. It is probable that future shareholders possessing a blocking right and seeking to invalidate an unauthorized bankruptcy filing could distinguish the Pace Industries ruling in a situation where either no prepackaged plan exists or there is no evidence that such a plan would provide for full creditor recoveries.
Though the Pace Industries decision should give shareholders and potential investors some level of pause when evaluating the value of a bankruptcy-related veto power, the scope of Judge Walrath's bench ruling remains to be seen and may ultimately be quite narrow. Investors grappling with the impact of this decision should seek the counsel of legal advisors specializing in corporate bankruptcy and continue to monitor related developments in subsequent case law.
For more information, please contact corporate restructuring attorneys Ben Hoch, Marsha Sukach, or Michael Greenblatt of Wilson Sonsini Goodrich & Rosati.
[1] In re Pace Industries et al., 1:20-bk-10927, in the U.S. Bankruptcy Court for the District of Delaware.
