In a recent bench ruling, the Delaware bankruptcy court denied a motion to dismiss a chapter 11 bankruptcy filing, notwithstanding the fact that the filing contravened an express bankruptcy-filing blocking right, or “golden share,” held by certain preferred shareholders. The Court diverged from the Fifth Circuit’s holding in In re Franchise Services of North America, Inc., in which the Fifth Circuit, applying Delaware law, concluded that a minority shareholder was not prevented from exercising its voting right to prevent a corporation from filing for bankruptcy, and that the blocking right as exercised did not impose a fiduciary duty on the shareholder because the shareholder did not exercise “actual control” over the corporation’s board.
The Delaware bankruptcy court, however, declined to follow Franchise Services, and concluded that, under Delaware law, a blocking right as exercised by the preferred shareholder would create a fiduciary duty that, “with the debtor in the zone of insolvency, is owed not only to other shareholders, but also to all creditors.” Addressing an issue left unanswered by the Fifth Circuit, the Court also found that federal public policy requires courts to consider what is “in the best interest of all” and favors debtors’ constitutional right to file bankruptcy, especially where the blocking party “has said clearly it is not considering the rights of others in its decision to file the motion to dismiss.” In re Pace Industries, LLC, Transcript of Hearing, Case No. 20-10927 (MFW) (Bankr. D. Del. May 5, 2020).
Pace Industries, an aluminum and zinc manufacturer, had been experiencing severe liquidity issues during the period leading up to its filing for chapter 11 relief and, as a result of the COVID-19 pandemic, the company had closed its plants and furloughed most of its employees. At the time of its bankruptcy filing, it had less than $150,000 in cash. Pace Industries filed its petition for relief without consent from certain preferred shareholders who, after investing US$37 million in the company, had negotiated the addition of certain provisions into the LLC agreement, which prohibited the board of directors from filing for bankruptcy without the preferred shareholders’ consent. Consequently, Macquarie, the majority holder of the preferred stock, filed a motion to dismiss, arguing that the Court lacked subject matter jurisdiction over the debtors’ bankruptcy petition because the debtors had no authority to file without the shareholders’ consent, as required by Delaware law.
Delaware Law Creates Fiduciary Duty
Under Delaware law, a minority shareholder owes a fiduciary duty to a company if it exercises actual control over the company. Macquarie argued that the shareholders could not owe a fiduciary duty to the company under Delaware law, as having a bankruptcy-filing control right does not equate to exercising the requisite degree of control over the company. Like in Franchise Services, Macquarie contended that, if anything, the fact that the debtors filed without obtaining the preferred shareholders’ consent only demonstrated that they did not, in fact, control the debtors.
The Court disagreed, concluding that, “contrary to the Fifth Circuit’s interpretation of [Delaware] law,” the blocking right exercised by Macquarie demonstrated a level of control sufficient to impose a fiduciary duty on the part of the preferred shareholders. The Court also noted the importance of the particular circumstances of each case in determining the existence of a fiduciary duty. Here, in addition to the preferred shareholders’ exercise of the blocking right, the fact that the debtors had no liquidity at the time of filing, were in “the zone of insolvency,” and could not pay their debts as they came due in the absence of a DIP loan were all factors that the Court believed support its conclusion that the preferred shareholders did owe a fiduciary duty to the debtors. The Court found it clear that Macquarie was not fulfilling its fiduciary duty, as demonstrated by its own statement that “it is not considering the rights of others in its decision to file the motion to dismiss.”
Federal Public Policy Supports Debtors’ Right to File Bankruptcy
Macquarie argued that an equity holder, as opposed to a creditor, may retain bankruptcy-filing blocking rights that are explicitly set forth in a company’s corporate governance documents, as permitted by Delaware law and that the Court had no choice but to dismiss a bankruptcy petition because it was filed by parties who lacked authority to do so under state law. Macquarie also relied on the Fifth Circuit’s holding in Franchise Services, where a minority shareholder was allowed to exercise its blocking rights to prevent a corporation from filing for bankruptcy, despite the fact that the shareholder was controlled by a creditor of the corporation.
The Court, however, agreed with the Debtors that the bankruptcy filing was in the best interests of the debtors and would also benefit most stakeholders. Considering the severe financial circumstances of Pace Industries at the time of filing, the Court noted that there was “no contest that the debtor needs a bankruptcy,” and that blocking the debtors’ “access to the Bankruptcy Code and Bankruptcy Courts would violate the federal public policy.” Although it acknowledged that there is no case law directly aligned with the facts of this case, the Court stated that it was “prepared to be the first court to do so,” and it expressly declined to follow Fifth Circuit precedent in Franchise Services, finding “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.” Ultimately, the Court declined to “bind the debtor-in-possession to a course of action without regard to the impact on the bankruptcy estate, other parties with a legitimate interest in the process, or the debtor-in-possession’s fiduciary duty to the estate.”
Although there is no published opinion, the Court’s holding marks an important split in authority between the Delaware Bankruptcy Court and the Fifth Circuit on the correct application of Delaware law and federal public policy to this issue. Those shareholders considering whether to exercise a “golden share” by blocking a Delaware-incorporated company’s bankruptcy filing should remain wary of the split and of the Delaware bankruptcy court’s imposition of fiduciary duties on a minority shareholder who attempted to exercise its blocking right—a right explicitly set forth in the incorporation documents and expressly invalidated by the Court.