Recent Delaware cases have clarified that minority stockholders merely rolling over shares alongside an independent and unrelated controlling stockholder do not form a control group in most cases—the controlling stockholder must cede a “material attribute of its control.”
Minority stockholders exercising charter-provided consent rights to block a corporation from making a voluntary bankruptcy filing may be found to have a fiduciary duty that effectively runs indirectly to all of those with an interest in the corporation, including creditors.
Parties should exercise particular discretion on matters implicating fiduciary duties in the wake of the COVID-19 pandemic and its unprecedented economic effects.

Under Delaware law, there can be two types of “control” over the business and affairs of a corporation—pervasive and transactional. If a minority stockholder exercises actual and not just potential control over a transaction, it owes the common law fiduciary duties of loyalty and care to the corporation. The following cases demonstrate that actual control is an evolving concept and not always clear-cut.

Case Highlights—In re Gilbert, et al. v. Perlman

In In re Gilbert, et al. v. Perlman, et al., 2020 WL 2062285 (Del. Ch. Apr. 29, 2020), in the context of a complaint challenging a take-private transaction of Connecture, Inc., the Delaware Court of Chancery held that two minority stockholders were not “controllers” of the corporation (with concomitant fiduciary duties) merely by virtue of agreeing to roll over their shares alongside the majority stockholder. The Court of Chancery explained that, unlike the inquiry into whether two or more minority stockholders have formed a group, not only the first but the second of the following conditions must be met for one or more minority stockholders to be deemed to form a control group with a majority stockholder:

  • (i) there must be an arrangement by the stockholders to act in concert towards a shared goal (merely sharing parallel interests is insufficient), and
  • (ii) the majority stockholder “must perceive a need” to include the minority stockholder(s) to accomplish this goal such that the majority stockholder “has ceded some material attribute of its control” to the minority stockholder(s) in order to achieve such assistance.

The Court determined that the second condition was not met in this case. The majority stockholder held 56% of the voting shares and could have closed the transaction “entirely on its own” without the participation of either of the minority stockholders. No facts were alleged that indicated that the majority stockholder had shared or limited its control power in a material way in order to obtain the minority stockholders’ participation. The fact that the majority stockholder agreed to dilute its proportionate stake in the post-transaction corporation as a result of the rollover (i.e., merely permitting participation in the transaction) was insufficient to meet the test articulated by the Court of Chancery. In other words, the minority stockholders were not deemed to be exercising (or even to possess) control in connection with effecting the transaction, and accordingly were not deemed to have fiduciary responsibilities to the other stockholders of the corporation.

Case Highlights—In re Pace Industries LLC

In In re Pace Industries LLC, No. 20-10927 (Bankr. D. Del. May 5, 2020), the Bankruptcy Court for the District of Delaware diverged from the Fifth Circuit’s holding in In re Franchise Servs. of N. Am., Inc., 891 F.3d 198, 206-08 (5th Cir. 2018), as revised (June 14, 2018) and held that a “blocking right” granted to a preferred stockholder with respect to voluntary bankruptcy filings,1 when exercised while the debtor was facing insolvency,2 would create a fiduciary duty on the part of such stockholder that was “owed not only to other stockholders, but also to all creditors.” The Bankruptcy Court found that, under the circumstances, the blocking right vested in the preferred stockholder the requisite degree of actual control.

Pace Industries LLC, an aluminum and zinc die casting manufacturer and supplier, and its related entities, voluntarily filed for Chapter 11 bankruptcy protection in April of 2020 in the wake of the COVID-19 pandemic. Such filing was made in contravention of an express blocking right granted to preferred stockholders within the Certificate of Incorporation of one of the debtor entities, KPI Intermediate Holdings, Inc. The preferred stockholder argued that, as a stockholder who was not a creditor, it was not precluded under existing federal public policy from exercising its right to block the corporation’s bankruptcy filing. It argued that the bankruptcy petition filing was ultra vires, and that therefore it should be dismissed since the debtor lacked the authority to file under applicable state law.

The Bankruptcy Court, in a case of first impression directly considering the issue, extended the federal public policy prohibition on creditors exercising such blocking rights to their exercise by stockholders as well based on the facts and circumstances presented. The judge was keenly focused on a corporation’s right to “access” the Bankruptcy Courts and on the dire circumstances facing Pace Industries, as there was “no contest that the debtor need[ed] a bankruptcy” (and the preferred stockholder had not offered any viable alternatives).

The preferred stockholder also challenged the claim that the existence of its consent right supported a finding of control and a concomitant fiduciary duty. Indeed, it pointed to the corporation’s filing for bankruptcy without such stockholder’s consent as proof of its lack of control over the corporation. The Bankruptcy Court however disagreed—rejecting the Fifth Circuit’s 2018 analysis of the issue, it found that the existence of such right subjected the stockholder to fiduciary duties under Delaware law,3 and that the preferred stockholder had breached those duties by considering only its own interests when moving to dismiss the bankruptcy filing.4

Key Takeaways

These cases provide a few key takeaways for investors:

  • A minority stockholder can be connected to a controlling stockholder in a legally significant way (e.g., by contract, common ownership, or collaboration on a transaction (including a rollover of equity)) without assuming the fiduciary duties of a “controller”. For that minority stockholder to be deemed part of a controlling stockholder group with concomitant fiduciary duties, the controlling stockholder must perceive a need for the participation of such minority stockholder and cede some material attribute of its control for the purpose of furthering its objective(s).
  • As investors will often seek control rights over a corporation’s voluntary bankruptcy filings, the Delaware Bankruptcy Court’s decision may necessitate a re-evaluation of the efficacy of “blocking right” provisions, and perhaps similar consent rights. Investors should consider seeking legal advice prior to negotiating for and exercising such rights in order to understand how their expectations might diverge from what a court may ultimately determine to be enforceable.
  • Practically, investors may want to consider negotiating additional layers of protection in a company’s governing documents that provide not only a blocking right to voluntary bankruptcy filings but require that a company consult such investor for liquidity options prior to entering the pre-insolvency stage.

 1. See Section 6.1.3 of the Amended and Restated Certificate of Incorporation of KPI Intermediate Holdings, Inc. As the majority holder of the preferred stock, the preferred stockholder contractually had the benefit of numerous protective provisions.

2. The Bankruptcy Court, ruling from the bench, used the term “zone of insolvency.” This was likely unintentional. See note 4 below.

3. As support for its conclusion, the Bankruptcy Court cited 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 Basho court had emphasized that blocking rights standing alone are highly unlikely to support either a finding or a reasonable inference of control, and that, more generally, exercising contractual rights––even to force an outcome that is beneficial to the stockholder––is not a breach of fiduciary duty. The Basho court ultimately found the defendant to have actual control and to have breached the resulting fiduciary duties, the former due to the totality of circumstances peculiar to the defendant (the blocking right and several general and not just transactional indicia of control, as well as the defendant’s abusive behavior with respect to the foregoing, which also supported the breach). The Bankruptcy Court read Basho to support the conclusion that the blocking right and the totality of external circumstances affecting the entity—a lack of liquidity sufficient to pay debts as they came due without debtor-in-possession financing, and the severe disruption of operations due to COVID-19—were sufficient factors to impose fiduciary duties.

4. Interestingly, the Bankruptcy Court found that since Pace Industries was in the zone of insolvency, the preferred stockholder’s duties extended not just to the other stockholders but also to the creditors of the corporation. As a matter of Delaware law, such a conclusion would seem to be in direct conflict with N. Am. Catholic Educ. Programming Found. v. Gheewalla, 930 A.2d 92 (Del. 2007). In Gheewalla, the Delaware Supreme Court made clear that even when a corporation becomes insolvent, fiduciary duties are not owed directly to its creditors: to impose on directors direct fiduciary duties to creditors would conflict with “those directors’ duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it.” Id. at 103. Moreover, in further interpreting Gheewalla, the Delaware Court of Chancery has made clear that there is “no legally recognized ‘zone of insolvency’ with implications for fiduciary duty claims” and that the only “transition point” is insolvency itself. Quadrant Structured Products Co. v. Vertin, 2015 WL 2062115 (Del. Ch. May 4, 2015).

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