A federal bankruptcy court decision in May has called into question the validity of certain “bankruptcy-remote” structures frequently used by businesses, particularly in project financing.

The court rejected the right a shareholder held to block a bankruptcy filing by the company in which it owned shares. The shareholder had negotiated for the right when it made an investment in the company.

The case is In re Pace Industries.

The court also said that such blocking rights impose full fiduciary duties on minority equity holders holding such rights to consider the interests of the company itself (and, by extension, those of other equity holders and creditors) before exercising them.

There are key distinguishing features between the facts in the Pace Industries case and those likely to be found in project finance transactions.

First, in particular, the Pace Industries case involved a corporation, rather than a limited liability company, which is what would normally be used in a project financing. This distinction may be critical, because the bankruptcy court’s negative decision depended, in part, on the fiduciary duties of the shareholder. Such fiduciary duties usually are much more limited in the context of an LLC.

Second, the rejected blocking right was held by a shareholder, rather than by a professional independent director with no economic interest in the result. When the right to block a bankruptcy filing is requested by a lender, the structure may involve the appointment of a disinterested independent director.

Tax equity and true equity investors should not rely heavily on blocking rights given directly to them as equity owners.

Finally, the corporation in this case was in real financial distress. This was not a case of a parent company trying to bring its otherwise healthy subsidiaries into bankruptcy with it. As a result, while the decision creates additional risk for bankruptcy-remote structures and will need to be closely monitored, it should not be seen as the end of bankruptcy remoteness for the structures most commonly used in the project finance market.

The arguments

Pace Industries, Inc. and 10 affiliates filed for bankruptcy protection in Delaware.

As part of their first-day filing package, they proposed a so-called “prepackaged” plan of reorganization that would restructure the company’s more than $300 million of debt, largely by swapping debt for equity. A preferred shareholder in Pace asked the bankruptcy court to dismiss the bankruptcy filing entirely, claiming that it possessed a negotiated-for blocking right over any bankruptcy filing by the company and that it had not given its consent.

Pace opposed dismissal of the case, arguing that allowing a shareholder to block a “last-resort” decision such as a bankruptcy would represent an extraordinary and impermissible level of control over the company.

Although counsel for Pace acknowledged that there was no case precedent for overriding such a contractual provision, he argued that “[w]hile the Delaware General Corporation law is flexible, we do think Delaware’s Supreme Court would put limits on this kind of blocking right, in this context.”

TCW Asset Management, a secured creditor that supported the proposed prepackaged plan, also argued against dismissing the case. Taking a practical angle, TCW argued that even if the case were dismissed, the creditor would simply commence an involuntary bankruptcy case, against which there would be no defense given that Pace was not paying, and was unable to pay, its debts as they came due.

The shareholder responded that the bankruptcy court should not deprive it of its bargained-for protection, which was a critical element of its agreement to purchase more than $37 million of equity in Pace.

The shareholder also said that a blocking right, without more, could not mean it has improper control over the business, and that any suggestion that it controls the business is particularly unsupportable given that the board had, without its consent, decided to file for bankruptcy. Responding to TCW, the preferred shareholder noted that there was no involuntary bankruptcy petition before the court, and that any involuntary petition would face obstacles.

The ruling

The bankruptcy court declined to dismiss the bankruptcy filing.

Although it acknowledged that there was no Delaware authority on point, and that no bankruptcy court had previously overridden a shareholder’s veto right over bankruptcy filings, the judge said that “based on the facts of the case, I am prepared to be the first court to do so.”

The judge focused less on the negotiation of the contractual veto right and more on the financial condition of the company.

She said it was “no contest that the debtor needs a bankruptcy” given that it was in “financial straits even before COVID-19.” She said the company, in order to survive, would need the special protections and liquidity measures only available in bankruptcy.

Critically, and in contrast with a recent decision by the US court of appeals for the fifth circuit, the bankruptcy court found that “under Delaware state law . . . [bankruptcy] blocking rights, such as exercise in the circumstances of this case would create a fiduciary duty on the part of the shareholder.” That fiduciary duty, the court found, would compel the preferred shareholder to approve a bankruptcy filing in light of the company’s economic circumstances.

Implications

The court’s analysis, if carried to a logical conclusion, could adversely affect the bankruptcy-remote structures relied on by numerous businesses.

Bankruptcy block rights, and so-called “golden-share” provisions in which a particular shareholder’s consent is required for a bankruptcy filing, are fundamental to bankruptcy remoteness.

However, there are several reasons to question whether the risk caused by the decision may be contained. Most important, the decision was made about a Delaware corporation. Most bankruptcy-remote arrangements use limited liability companies. While Delaware law provides some flexibility for managing or disclaiming fiduciary duties owed to a corporation, it provides almost unlimited flexibility for duties owed to limited liability companies. Accordingly, the conclusion that a blocking right creates fiduciary duties that would have compelled the shareholder to authorize the bankruptcy filing would not necessarily translate to an LLC.

That said, courts outside Delaware considering the laws of other states have not necessarily distinguished between a corporation and an LLC.

For example, a bankruptcy court in Illinois rejected a blocking provision held by a “special member” of a Michigan LLC. However, the special member was also a lender to the LLC. The LLC agreement provided that the lender was specifically excused from all fiduciary duties. It only needed to consider its own interests when deciding whether to authorize a bankruptcy filing. The court rejected the blocking provision. It said blocking provisions are only acceptable where the party possessing the blocking right is obligated to exercise “normal director fiduciary duties” when deciding whether to file. In other words, any provision that purports to give a lender (or, presumably, an equity holder) free rein to reject a company’s bankruptcy filing without considering the interests of the company itself is unacceptable and unenforceable.

Combining the court decisions in both Delaware and Illinois, the conclusion may be that any effort to impose a meaningful contractual barrier to a bankruptcy filing is simply unenforceable.

While that result may be what the Delaware bankruptcy court has in mind going forward, not all courts have taken that view, even when considering Delaware law.

In a relatively recent decision, the fifth circuit US court of appeals (which includes Texas, Mississippi and Louisiana) enforced similar bankruptcy blocking rights. In that case, the court held that “federal bankruptcy law does not prevent a bona fide equity holder from exercising its voting right to prevent the corporation from filing a voluntary bankruptcy petition just because it also holds a debt owed by the corporation and owes no fiduciary duty to the corporation or its fellow shareholders.”

After resolving that threshold question, the appeals court considered “whether Delaware law allows parties to provide in the certificate of incorporation that the consent of both classes of shareholders is required to file a voluntary petition.” After noting the general flexibility provided by Delaware corporate law, the court concluded that it would not prohibit corporate provisions that condition bankruptcy filing on shareholder consent.

Finally, the court found that potential control of a company is not enough to create fiduciary duties; actual control is required. Unlike in the Pace Industries case, the appeals court found that the company’s willingness to file for bankruptcy without obtaining the required consent undercut any suggestion of actual control. In closing, it said that even if such a blocking provision did create fiduciary duties, the proper remedy for any breach of a fiduciary duty would not be to deny an otherwise valid motion to dismiss the bankruptcy case, but rather for the company to see remedies against the breaching party under state law.

Market reaction to the Pace Industries decision has been muted, perhaps in part because the particular facts of the case — the company’s acute financial distress — may limit its broader application.

The decision also may not necessarily be seen as a large shift in the law given that at least one other bankruptcy decision in Delaware held earlier that a minority equity holder may not use a bankruptcy blocking right for its own purposes where its primary relationship with the company was as a creditor.

While the latest decision appears to dispense with that second element, it does little to disrupt the general market understanding that any provisions that attempt to impose a firm bar to bankruptcy — whether expressly or implicitly — are unlikely to be upheld in Delaware courts.