Delaware Bankruptcy Court Rules that Bankruptcy Blocking Right in Debtor's Corporate Charter Violates Federal Public Policy
Courts sometimes disagree over whether provisions in a borrower's organizational documents designed to prevent the borrower from filing for bankruptcy are enforceable as a matter of federal public policy or applicable state law. There has been a handful of court rulings addressing this issue in recent years, with mixed results. Most recently, the Delaware bankruptcy court overseeing the chapter 11 cases of Pace Industries, LLC and affiliates denied on public policy grounds a motion to dismiss the cases filed by a preferred stockholder on the basis that the debtor group's parent corporation failed to obtain the preferred stockholder's written consent to any bankruptcy filing, which was required in the parent's certificate of incorporation. The court acknowledged 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." Even so, the court stated, "based on the facts of this case, [the court is] prepared to be the first court to do so."
Bankruptcy Risk Management by Lenders
Astute lenders are always looking for ways to minimize risk exposure, protect remedies, and maximize recoveries in connection with a loan, especially with respect to borrowers that have the potential to become financially distressed. Some of these efforts have been directed toward minimizing the likelihood of a borrower's bankruptcy filing by making the borrower "bankruptcy remote," such as by implementing a "blocking director" organizational structure or issuing "golden shares" that, as the term is used in a bankruptcy context, give the holder the right to preempt a bankruptcy filing. Depending on the jurisdiction involved and the particular circumstances, including the terms of the relevant documents, these mechanisms may or may not be enforceable.
As a rule, corporate formalities and applicable state law must be satisfied in commencing a bankruptcy case. See In re NNN 123 N. Wacker, LLC, 510 B.R. 854 (Bankr. N.D. Ill. 2014) (citing Price v. Gurney, 324 U.S. 100 (1945)); In re Gen-Air Plumbing & Remodeling, Inc., 208 B.R. 426 (Bankr. N.D. Ill. 1997); In re Comscape Telecommunications, Inc., 423 B.R. 816 (Bankr. S.D. Ohio 2010). As a result, while contractual provisions that prohibit a bankruptcy filing may be unenforceable as a matter of public policy, other measures designed to preclude a debtor from filing for bankruptcy may be available.
Lenders, investors, and other parties seeking to prevent or limit the possibility of a bankruptcy filing have attempted to sidestep the public policy invalidating contractual waivers of a debtor's right to file for bankruptcy protection by eroding or eliminating the debtor's authority to file for bankruptcy under its governing organizational documents. See, e.g., DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), 2010 WL 4925811 (B.A.P. 10th Cir. Dec. 6, 2010); NNN 123 N. Wacker, 510 B.R. at 862; In re Houston Regional Sports Network, LP, 505 B.R. 468 (Bankr. S.D. Tex. 2014); In re Quad-C Funding LLC, 496 B.R. 135 (Bankr. S.D.N.Y. 2013); Green Bridge Capital S.A. v. Ira Shapiro (In re FKF Madison Park Group Owner, LLC), 2011 BL 24531 (Bankr. D. Del. Jan. 31, 2011); In re Global Ship Sys. LLC, 391 B.R. 193 (Bankr. S.D. Ga. 2007); In re Kingston Square Associates, 214 B.R. 713 (Bankr. S.D.N.Y. 1997).
These types of provisions have not always been enforced, particularly where the organizational documents include an outright prohibition of any bankruptcy filing. See In re Lexington Hospitality Group, 577 B.R. 676 (Bankr. E.D. Ky. 2017) (where an LLC debtor's operating agreement provided for a lender representative to be a 50% member of the debtor until the loan was repaid and included various restrictions on the debtor's ability to file for bankruptcy while the loan was outstanding, the bankruptcy filing restrictions acted as an absolute bar to a bankruptcy filing, which is void as against public policy); In re Bay Club Partners-472, LLC, 2014 WL 1796688 (Bankr. D. Or. May 6, 2014) (refusing to enforce a restrictive covenant in a debtor LLC's operating agreement prohibiting a bankruptcy filing and stating that the covenant "is no less the maneuver of an 'astute creditor' to preclude [the LLC] from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy").
Many of these efforts have been directed toward "bankruptcy remote" special purpose entities. An SPE is an entity created in connection with a financing or securitization transaction structured to ring-fence the SPE's assets from creditors other than secured creditors or investors (e.g., trust certificate holders) that provide financing or capital to the SPE.
For example, in In re Gen. Growth Props., Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), the court denied a motion by secured lenders to dismiss voluntary chapter 11 filings by several SPE subsidiaries of a real estate investment trust. The lenders argued, among other things, that the loan agreements with the SPEs provided that an SPE could not file for bankruptcy without the approval of an independent director nominated by the lenders. The lenders also argued that, because the SPEs had no business need to file for bankruptcy and because the trust exercised its right to replace the independent directors less than 30 days before the bankruptcy filings, the SPEs' chapter 11 filings had not been undertaken in good faith.
The General Growth court ruled that it was not bad faith to replace the SPEs' independent directors with new independent directors days before the bankruptcy filings because the new directors had expertise in real estate, commercial mortgage-backed securities, and bankruptcy matters. The court determined that, even though the SPEs had strong cash flows, bankruptcy remote structures, and no debt defaults, the chapter 11 filings had not been made in bad faith. The court found that it could consider the interests of the entire group of affiliated debtors as well as each individual debtor in assessing the legitimacy of the chapter 11 filings.
Among the potential flaws in the bankruptcy remote SPE structure brought to light by General Growth is the requirement under applicable Delaware law for independent directors to consider not only the interests of creditors, as mandated in the charter or other organizational documents, but also the interests of shareholders. Thus, an independent director or manager who simply votes to block a bankruptcy filing at the behest of a secured creditor without considering the impact on shareholders could be deemed to have violated his or her fiduciary duties of care and loyalty. See In re Lake Mich. Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016) (a "blocking" member provision in the membership agreement of a special purpose limited liability company was unenforceable because it did not require the member to comply with its fiduciary obligations under applicable non-bankruptcy law).
Courts disagree as to the enforceability of blocking provisions and, in particular, "golden shares" that, as the term is used in a bankruptcy context, give the shareholder the right to preempt a bankruptcy filing. For example, in Lexington Hospitality, the bankruptcy court denied a motion to dismiss a bankruptcy case filed by an entity wholly owned by a creditor that held a golden share/blocking provision because the court concluded that the entity was not truly independent. 577 B.R. at 684–85. In addition, in In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016), the court ruled that a provision in a limited liability company's governance document:
the sole purpose and effect of which is to place into the hands of a single, minority equity holder [by means of a 'golden share'] the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor—not equity holder—and which owes no duty to anyone but itself in connection with an LLC's decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, is void as contrary to federal public policy.
Id. at 265; see also In re Tara Retail Group, LLC, 2017 WL 1788428 (Bankr. N.D. W. Va. May 4, 2017) (even though a creditor held a golden share or blocking provision, it ratified the debtor's bankruptcy filing by its silence), appeal dismissed, 2017 WL 2837015 (N.D. W. Va. June 30, 2017).
By contrast, in Squire Court Partners v. CenterLine Credit Enhanced Partners (In re Squire Court Partners), 574 B.R. 701, 704 (E.D. Ark. 2017), the court ruled that, where a partnership agreement required the unanimous consent of the partners before the limited partnership could "file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy," the bankruptcy court properly dismissed a bankruptcy filing by the managing partner without the consent of the other partners.
One of the seminal cases addressing this issue is In re Franchise Services of North America, Inc., 891 F.3d 198 (5th Cir. 2018). In Franchise Services, a bank invested $15 million in Franchise Services of North America ("FSNA") as part of a transaction to purchase an FSNA competitor in exchange for 100% of FSNA's convertible preferred stock. The preferred stock was convertible to slightly less than 50% of FSNA's common stock. FSNA was also obligated to pay certain investment fees to the bank's parent in connection with the transaction. As a condition to the investment, FSNA amended its certificate of incorporation to provide that FSNA could not "effect any Liquidation Event" (defined to include a bankruptcy filing) without the approval of the holders of a majority of both its preferred and common stock.
FSNA filed for chapter 11 protection in 2017 without obtaining the consent of a majority of its preferred and common stockholders. FSNA still owed certain amounts to the bank's parent at time of the bankruptcy filing. The bank moved to dismiss the petition as having been filed without proper authorization. The bankruptcy court found that the bank itself was an owner, rather than a creditor, of FSNA and ruled that the shareholder consent provision was not contrary to federal bankruptcy policy. The court opted to leave to Delaware state courts the determination as to whether the provision violated Delaware law. It accordingly dismissed FSNA's chapter 11 case.
On direct appeal, the U.S. Court of Appeals for the Fifth Circuit affirmed. It rejected FSNA's argument that, even if Delaware law authorized the corporate charter provision at issue, federal law forbids such a provision due to the public policy against waiving the right to file for bankruptcy protection. The court wrote that "[t]here is no prohibition in federal bankruptcy law against granting a preferred shareholder the right to prevent a voluntary bankruptcy filing just because the shareholder also happens to be [controlled by] an unsecured creditor…."
The Fifth Circuit also rejected FSNA's contention that, even if a shareholder-creditor can hold a bankruptcy veto right, such a right "remains void in the absence of a concomitant fiduciary duty." No statute or binding case law, the court explained, "licenses this court to ignore corporate foundational documents, deprive a bona fide shareholder of its voting rights, and reallocate corporate authority to file for bankruptcy just because the shareholder also happens to be an unsecured creditor." In the absence of evidence showing that the bank was a controlling minority shareholder, the Fifth Circuit found that the bank did not have fiduciary duties to FSNA. Even if it were a controlling shareholder, the Fifth Circuit noted, the proper remedy for a breach of fiduciary duty "is not to allow a corporation to disregard its charter and declare bankruptcy without shareholder consent," but to seek redress under state law.
Another notable case is In re Insight Terminal Solutions, LLC, 2019 WL 4640773 (Bankr. W.D. Ky. Sept. 23, 2019). In 2018, Autumn Wind Lending, LLC ("Autumn Wind") provided up to $6.8 million in financing under a term loan facility to Delaware limited liability company Insight Terminal Solutions, LLC ("ITS"). The original maturity date of the loan was December 31, 2018. The loan was guaranteed by an ITS affiliate holding all of the outstanding ITS membership units and secured by a lien on substantially all of the assets of ITS and the guarantor. The pledged collateral included the ITS membership units held by the guarantor as well as certain warrants for ITS membership units.
In connection with an extension of the maturity date of the loan to June 30, 2019, Autumn Wind amended the loan agreement to include a bankruptcy rights waiver. The waiver provided that: (i) if the loan was not paid in full on or before June 30, 2019, and Autumn Wind refused to grant an additional extension of the maturity date, the guarantor agreed to relinquish its rights to the pledged ITS membership units; and (ii) ITS and the guarantor agreed to amend their respective organizational documents so that neither would be permitted to file for bankruptcy protection unless they first obtained the prior written consent of all holders of ITS membership units and any party holding warrants for such units. Both ITS and the guarantor later amended their operating agreements to include the bankruptcy rights waiver.
On July 1, 2019, ITS and the guarantor defaulted on the loan. The following day, Autumn Wind notified ITS and the guarantor that it intended to retain the pledged ITS membership units and that, in accordance with the Uniform Commercial Code ("UCC"), they had 20 days to object. After further amending their operating agreements to authorize a bankruptcy filing and adopting resolutions authorizing such a filing, ITS and the guarantor (collectively, "debtors") filed for chapter 11 protection in the Western District of Kentucky on July 17, 2019—prior to the expiration of the 20-day period.
Autumn Wind moved to dismiss the chapter 11 cases, arguing that, in accordance with the bankruptcy rights waiver, the debtors lacked the authority to file for bankruptcy. According to Autumn Wind, when the debtors defaulted on the loan, the guarantor's right to exercise voting and/or consensual rights and powers over the ITS membership units ceased immediately, and such rights became vested solely and exclusively in Autumn Wind. Moreover, Autumn Wind contended that, in its capacity as a holder of warrants for ITS membership units, Autumn Wind's consent was required for any bankruptcy filings by the debtors.
The bankruptcy court denied the motion to dismiss. Initially, the court found that, by amending their operating agreements in July 2019 and adopting resolutions authorizing a bankruptcy filing, the debtors had authority under Delaware law to file for chapter 11 protection.
The debtors argued that the ITS membership units were never transferred to Autumn Wind because it did not comply with the UCC's strict foreclosure requirements. The court acknowledged that "this is a compelling argument." However, the court noted that it need not address this argument because "there is a more compelling reason" to deny the motion to dismiss—specifically, the bankruptcy rights waiver violated federal public policy.
The court explained as follows:
Autumn Wind's primary witness testified that it was well aware that a contractual provision limiting a debtor's right to seek relief under the Bankruptcy Code was legally unenforceable as against public policy. It was for this very reason that Autumn Wind included terms in the waiver and amendment that if Debtors did not achieve additional financing during the 3-1/2 month period they provided, then the agreement would provide a prohibition on filing for bankruptcy under this amendment. On July 1, 2019, the collateral would be turned over to Autumn Wind. Autumn Wind believed that by using this provision, they would avoid the public policy issue … However, the terms of the surrender of the collateral were not fully consummated as there was no completion of the strict foreclosure process. Furthermore, the attempt to circumvent the bankruptcy laws and public policy by "circuitry of arrangement," were ineffective. Autumn Wind tried to get around this argument by making itself an equity holder, however, the process to achieve this was not completed. Autumn Wind did not become an equity holder, nor did they become the owner of the collateral through the strict foreclosure process. Furthermore, attempts to limit the Debtors' access to the bankruptcy process were against public policy and invalid.
Delaware corporation KPI Intermediate Holdings, Inc. ("KPI") and direct and indirect subsidiaries, including Pace Industries, LLC (collectively, "debtors"), filed pre-packaged chapter 11 cases in April 2020 in the District of Delaware to effectuate a debt-for-equity swap that would wipe out preexisting equity interests while paying general unsecured claims in full. In 2018, certain entities ("preferred shareholders") acquired 62.5% of KPI's preferred stock for approximately $37 million. In connection with the stock purchase, KPI amended and restated its certificate of incorporation to provide that any voluntary bankruptcy filing by KPI or its affiliates "shall require the written consent or affirmative vote of the holders of a majority in interest of the Series A Preferred Stock…, and any such action taken without such consent or vote shall be null and void ab initio, and of no force or effect."
The preferred shareholders moved to dismiss the chapter 11 cases. They argued that the court lacked subject matter jurisdiction over the cases because the debtors did not obtain the shareholder consent required by KPI's certificate of incorporation. They acknowledged court rulings finding that shareholder bankruptcy consent rights violate public policy if exercised by a shareholder that is also a creditor holding a "golden share." However, the preferred shareholders noted, they were preferred stockholders only, not creditors.
In addition, the preferred shareholders argued that, consistent with Franchise Services, a minority shareholder is not a controlling minority shareholder with fiduciary duties, and the failure of KPI even to ask for their consent to the bankruptcy filings demonstrated that they did not control KPI's board. The preferred shareholders also impugned the legitimacy of the chapter 11 filings, claiming that they were motivated not by genuine financial distress, but by the debtors' desire to obtain releases and other benefits for KPI's directors, KPI's equity sponsor, and other insiders and to wipe out preferred equity interests.
The debtors countered 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 their directors, as fiduciaries, resolved that a bankruptcy filing was in the best interests of the companies. According to the debtors, the preferred shareholders' objection to the filings was merely a ploy to gain negotiating leverage.
Citing Basho Techs. Holdco B, LLC v. Georgetown Basho Investors, LLC, 2018 WL 3326693 (Del. Ch. 2018), aff'd, 221 A. 3d 100 (Del. 2019), the debtors argued that Delaware law imposes fiduciary obligations on minority shareholders when they control a particular transaction, and the preferred shareholders' bankruptcy blocking right was tantamount to control. In addition, the debtors argued, the blocking right violated federal public policy because it eviscerated their constitutional right to seek bankruptcy relief. According to the debtors, to the extent that the Fifth Circuit concluded in Franchise Services that a shareholder with a bankruptcy blocking right did not owe fiduciary duties to the company, that court was simply wrong.
Ruling from the bench on May 5, 2020, Bankruptcy Judge Mary Walrath denied the motion to dismiss, holding as a matter of first impression that, on these facts, "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." According to Judge Walrath, there was no question that the debtors were in financial straits, particularly because of the pandemic. She also noted that the bankruptcy cases would 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." Judge Walrath accordingly ruled that the bankruptcy blocking provision in KPI's corporate charter "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."
In so ruling, she "respectfully declined" to follow Franchise Services, noting that she 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." Moreover, Judge Walrath explained, contrary to the Fifth Circuit's interpretation of Delaware law in Franchise Services, under Delaware law, "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." In accordance with Basho, she noted, other factors combined with the blocking right (i.e., the debtors were in the zone of insolvency, lacked liquidity, and could not pay their debts as they matured without debtor-in-possession financing, coupled with severe operational disruption due to the pandemic) supported a finding in this case that the preferred shareholders' blocking right created a fiduciary duty.
Judge Walrath later entered a bare-bones order denying the preferred shareholders' motion to dismiss without any indication that a more detailed written opinion would be forthcoming. See In re Pace Industries, LLC, Case No. 20-10927(MFW) (Bankr. D. Del. May 11, 2020).
Recent court rulings have not resolved the ongoing dispute over the enforceability of blocking provisions, golden shares, and other provisions designed to manage access to bankruptcy protection. Pace Industries, Franchise Services, Insight, and other relevant decisions reinforce the importance of knowing what approach the courts have endorsed in any likely bankruptcy venue.
Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our “Contact Us” form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.