In In re Pace Industries, LLC, Judge Mary Walrath of the United States Bankruptcy Court for the District of Delaware denied a motion to dismiss a chapter 11 where the debtor circumvented a preferred stockholder’s blocking rights by filing bankruptcy petitions without the preferred stockholder’s consent. Judge Walrath ruled, in a decision that has not yet been published, that she was “prepared to be the first court” to find a stockholder’s blocking rights were invalid. Judge Walrath held that use of a blocking right to preclude access to bankruptcy relief was against public policy, and that a stockholder in possession of such a right has a fiduciary duty to act in the best interests of the corporation, and not its own interests. This decision suggests that blocking rights, which are commonly used in structured finance and real estate transactions to prohibit voluntary bankruptcy filings, may not always be effective.
In January 2018, Macquarie Septa (US) I, LLC and an affiliate (“Macquarie”) entered into an investment agreement with KPI Intermediate Holdings and KPI Holdings, LLC by which Macquarie purchased shares of Series A Preferred Stock. As part of the deal, KPI amended its Certificate of Incorporation to provide Macquarie with blocking rights to certain actions, which included a voluntary bankruptcy filing. Beginning in 2019, KPI and its subsidiaries (including Pace Industries, LLC) began negotiations with their creditors because their sales were slumping, which sales dramatically worsened with the Covid-19 crisis. During this period, KPI reached agreements in principle with its major creditor groups for a restructuring, but which Macquarie opposed. To implement that plan, on April 12, 2020, KPI and its Pace subsidiaries filed chapter 11 cases in Delaware without getting the consent of directors appointed by Macquarie.
Macquarie filed a motion to dismiss the debtors’ chapter 11 cases, arguing that because its consent had not been obtained, the filings were not validly authorized. KPI opposed, saying that the blocking provisions were inconsistent with federal public policy favoring access to bankruptcy relief, and that the voluntary filing was its best, and only, available option.
Legal Arguments on the Motion to Dismiss:
Macquarie argued that the Court was required to dismiss the chapter 11 filings because they were not consented to or authorized by Macquarie. State law governs the authority to file bankruptcy petitions. KPI and its subsidiaries are Delaware corporations and Delaware law allows corporations to contract and delegate authority within their organizational documents for broad management of the company. KPI’s certificate of incorporation gave Macquarie the right to block any voluntary filing without its consent. Macquarie’s motion to dismiss pointed to its contractual rights and argued that they must be honored unless they contravene public policy. Macquarie cited cases from the Fifth Circuit and a bankruptcy court in Georgia to support its argument that equity owners can control whether an entity may file voluntary bankruptcy and that exercising such rights is not blocked by federal law. KPI opposed Macquarie’s motion to dismiss on several grounds, arguing that Macquarie’s blocking rights are unenforceable as a matter of federal public policy because they prevent debtors from obtaining necessary and constitutionally protected bankruptcy relief. Citing prior Delaware bankruptcy cases, KPI pointed out that while state law authorizes blocking rights, those rights cannot supersede federal public policy and “deny a corporation’s right to seek bankruptcy relief.” KPI also argued the facts of its case, where it said that bankruptcy was the only available avenue to it and its Pace subsidiaries in their current financial state. It pointed out that Macquarie made no bad faith claims against KPI and did not propose any viable alternative to the filing.
KPI also argued that Macquarie’s goal was to derail its negotiated restructuring plan because it didn’t like the treatment of its investment, and to restart negotiations where it would have more leverage. KPI pointed its difficult financial condition and to the lengthy negotiations it had conducted with its creditors prior to filing to demonstrate that the filing was truly its only option. KPI also argued that if Macquarie were allowed to exercise the blocking rights to gain a favorable position in new rounds of negotiations, it would set a precedent for entities to be “held hostage by self-interested out-of-the money parties.”
KPI’s final argument was that because Macquarie would be exercising “actual control over the corporation” by “channel[ing] the corporation into a particular outcome by blocking or restricting other paths,” per the Court of Chancery, Macquarie would be violating a fiduciary duty owed to KPI and its Pace subsidiaries. KPI emphasized that Macquarie’s actions implied that the best interests of the debtor are irrelevant, and that Macquarie could exercise its blocking right irrespective of any harm the debtor may suffer. KPI argued that such conduct would be a breach of a fiduciary duty of Macquarie owed to the debtor given the amount of control Macquarie is exerting and its clear self-interest in thwarting the filings for leverage.
Outcome and Takeaways:
On May 5, 2020, Judge Walrath denied Macquarie’s motion to dismiss, and stated that “under Delaware law, contrary to the Fifth Circuit, my interpretation of the law would and does find that blocking rights, such as exercised in the circumstances of this case, would create a fiduciary duty on the part of the shareholder.” The court further held that allowing Macquarie to block a bankruptcy filing to advance its own interests was contrary to public policy and interfered with a company’s constitutional right to seek bankruptcy relief. The Court rejected Macquarie’s argument about its purported contractual rights and further held that Macquarie’s blocking rights contravened its imputed fiduciary duty obligations. The Court found that it would be improper if Macquarie, solely to further its own interests, could prevent KPI from filing for bankruptcy, where the exercise of its blocking right would be against the debtors’ best interests and deprive the debtors of their constitutional rights to access bankruptcy relief.
In re Pace Industries, LLC, et al. provides two key takeaways regarding blocking rights provisions. First, blocking provisions may be unenforceable due to public policy concerns. The Pace Industries ruling presented a clear case where a party holding blocking rights was attempting to lever those rights to improve its position in a pre-negotiated restructuring, which the Court found improper. So, while each case will need to be analyzed on its own facts, debtor’s lawyers facing a similar roadblock to a chapter 11 filing will likely argue that the logic of Judge Walrath’s decision should be followed. But even where blocking rights do not offend public policy, stockholders and investors will still need to be wary that in enforcing such rights they do not breach an imputed fiduciary duty. Stockholders and investors will need to weigh the motives for advancing their own positions against claims by the debtor of a need for bankruptcy relief without alternative options.
This article was first distributed as a Restructuring & Bankruptcy Alert on May 26, 2020.
 Pace Industries, LLC, Case 20-10927 (Bankr. D. Del. 2020).