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Kraus Carpet Inc., along with five subsidiaries and affiliates, has filed a petition for recognition of a foreign proceeding under chapter 15 of the Bankruptcy Code in the Bankruptcy Court for the District of Delaware (Lead Case No. 18-12057).  According to the accompanying Declaration, Kraus, based in Waterloo, Ontario, Canada, operates a carpet and flooring distribution network throughout the United States and Canada.  Kraus is seeking recognition of its foreign proceeding under the Companies’ Creditors Arrangement Act, which is pending before the Ontario Superior Court of Justice (File No. CV-18-604759), as a foreign main proceeding.  Kraus is also seeking to sell its distribution business, pursuant to section 363 of the Bankruptcy Code and an order to be entered by the Canadian Court, to Roberts Company Canada Ltd.  The cases have been assigned to the Honorable Kevin Gross.

Contact Norman L. Pernick, G. David Dean or Myles R. MacDonald for more information regarding this matter.

Bankruptcy remote structures have become common in recent years to attempt to prevent a borrower from filing for Chapter 11.  One such structure is commonly referred to as a “golden share.”  The “golden share” typically refers to a noneconomic membership interest provided to a lender whose vote would be necessary for the borrower to file Chapter 11.

The Fifth Circuit in In re FranchiseServs. of N. Am., Inc., 891 F.3d 198, 209

(5th Cir. 2018), as revised (June 14, 2018), recently considered the enforceability of blocking “golden share” provisions and whether a creditor or shareholder could use such a provision to prevent a company from filing for bankruptcy.

In re Franchise Services

Prior to the petition date, the debtor obtained a $15 million investment from an investor, Boketo, LLC (“Boketo”), to finance an acquisition.  Id. at 203.  Boketo was a fully-owned subsidiary of Macquarie Capital Inc. (“Macquarie”), which created Boketo to finance the transaction.  Id.  The debtor agreed to pay Macquarie a $3 million fee for arranging the financing.  Id.  Boketo was given 100% of preferred stock in the form of a convertible preferred equity instrument.  Id.  Boketo was the largest single investor in the debtor and its stake in the debtor  amounted to a 49.76% equity interest if converted.  Id.  As a condition of the investment, the debtor reincorporated in Delaware and adopted a new certificate of incorporation that provided, in part, the majority of all equity classes, voting separately, must approve a bankruptcy filing.  Id.

The debtor filed a chapter 11 petition without requesting or securing the consent of  Boketo and the common shareholders.  Id. at 204.  Boketo and Macquarie moved to dismiss the bankruptcy case claiming the debtor failed to seek shareholder authorization.   Id.  In response, the debtor argued that the consent provision was an invalid restriction on its right to file a bankruptcy petition.  Id.

Following an evidentiary hearing, the bankruptcy court granted the motion to dismiss finding that, because Boketo was an owner, rather than a creditor, conditioning the debtor’s right to file a voluntary petition on the investor’s consent was not contrary to federal bankruptcy policy.  Id.

Thereafter, the bankruptcy court certified three questions for direct appeal to the Fifth Circuit:

(i)  Is a provision, typically called a blocking provision or a golden share, which gives a party (whether a creditor or an equity holder) the ability to prevent a corporation from filing bankruptcy valid and enforceable or is the provision contrary to federal public policy?

(ii)  If a party is both a creditor and an equity holder of the debtor and holds a blocking provision or a golden share, is the blocking provision or golden share valid and enforceable or is the provision contrary to federal public policy?

(iii)  Under Delaware law, may a certificate of incorporation contain a blocking provision/golden share? If the answer to that question is yes, does Delaware law impose on the holder of the provision a fiduciary duty to exercise such provision in the best interests of the corporation?  Id.

The Fifth Circuit observed as an initial matter that a “blocking provision” and “golden share” are not synonymous.  Id.  The term “‘blocking provision’ is a catch-all to refer to various contractual provisions through which a creditor reserves a right to provide debtor from filing for bankruptcy.”  Id.  A “golden share” is a “share that controls more than half of the corporation voting rights and given the shareholder veto power over changes to the company’s charter.”  Id.  The facts at issue did not fit into either definition and would narrow the certified questions.  Specifically, the bankruptcy court requested the Fifth Circuit opine on the legality of “blocking provisions” and “golden shares”, but to do so would result in an advisory opinion.  Id.  Instead, the Fifth Circuit confined its analysis to whether federal and Delaware law permit parties to “amend a corporate charter to allow a non-fiduciary shareholder fully controlled by an unsecured creditor to prevent a voluntary bankruptcy petition.”  Id. at 206.

On appeal, the debtor argued that federal law precluded enforcement of the corporate charter because it violated a “federal public policy against waiving the protections of the Bankruptcy Code.”  Id. at 207.  The debtor also asserted that the case involved “a creditor masquerading as a bona fide equity owner.”  Id. at 207.  The Fifth Circuit, however, found no evidence that the arrangement was merely a ruse to ensure that the investor would pay the affiliate’s bill.  Id. at 207.  Based on the facts presented, the Fifth Circuit 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.”  Id. at 209.

The Fifth Circuit next addressed, in two parts, whether Delaware law allows the investor to exercise the block right: (i) “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” and (ii) “whether Delaware law would impose a fiduciary duty on a minority shareholder with the ability to prevent a voluntary bankruptcy petition.”  Id.

As to the first inquiry, the Fifth Circuit noted the debtor had waived such argument on appeal, and, having found no Delaware cases on point, the Fifth Circuit assumed that Delaware law would tolerate a provision in a certification of incorporation conditioning a corporation’s right to file a petition on shareholder consent.  Id. at 210-211.  As to the second question involving consent, the Fifth Circuit noted that an investor could only owe a fiduciary duty if it qualifies as a controlling minority shareholder.  Id.  The Fifth Circuit stated the standard for minority control is high and “potential control is not enough.”  Id. at 212Rather, the debtor must prove “Boketo actually dominated the [debtor’s] corporate conduct.  Id. 213 (emphasis included).  The board’s willingness to act without Boketo’s consent undercut the case for control according to the Fifth Circuit.  Id.  Accordingly, the Fifth Circuit found that the record before it did not establish that Boketo was a controlling shareholder.  The Court also observed a fundamental defect in the debtor’s argument.  Id. at 214.  Assuming Boketo was a controlling shareholder and breached its fiduciary duty, the proper remedy was not to “deny an otherwise meritorious motion to dismiss the bankruptcy petition.”   Id.  The debtor must seek “its remedy under state law.”  Id.

The Franchise Services decision touches on difficult questions regarding whether a creditor or shareholder can block a bankruptcy filing pursuant to a corporate charter’s “golden share” or other blocking provisions.  The decision may be viewed as somewhat favorable to creditor’s ability to block a bankruptcy; however, the Fifth Circuit’s decision is limited to the unique set of facts involved in the case.

 

 

Upcoming Committee Formation Meeting: Friday, September 14, 2018 10:00 AM

Case Name: 18-12012 (KJC)

Location: The Doubletree Hotel, 700 King Street, Wilmington, DE 19801

Notice of Formation Meeting for Official Committee of Unsecured Creditors can be found here. See the petition for relief.

Contact Norman L. Pernick, G. David Dean or Myles R. MacDonald for more information regarding this matter.

Creditors often think that an involuntary bankruptcy petition is a great bargaining chip when faced with a recalcitrant debtor. However, the actual filing of an involuntary bankruptcy petition (when that petition is filed in “bad faith”) confers a considerable risk to the petitioning creditors.  Recently, the United States Court of Appeals for the Third Circuit issued an opinion that re-emphasizes just how risky bad faith involuntary petitions can be for creditors.

In that non-precedential opinion authored by Circuit Judge Rendell, the Third Circuit weighed in on whether a creditor can set off damages imposed against it due to a bad faith involuntary bankruptcy petition against its claims against the debtor.  U.S. Bank, N.A. v. Maury Rosenberg, No. 18-1249, 2018 WL 3640987 (3d Cir. July 31, 2018).

Although this case has extensive procedural history the basic facts and procedural history are as follows: Maury Rosenberg established and owned a group of companies and partnerships operating as National Medical Imaging (“NMI”). NMI entered into equipment leases with U.S. Bank’s predecessors-in-interest. After NMI defaulted, U.S. Bank sued NMI and Rosenberg, which eventually settled (resulting in modified lease agreements under which NMI would continue to lease the equipment). As part of the settlement, Rosenberg would be personally liable if NMI again defaulted, which NMI did after twenty-one months.

After the default, entities related to U.S. Bank filed an involuntary bankruptcy petition against Rosenberg in the Eastern District of Pennsylvania, which was transferred to the Southern District of Florida (where Rosenberg lived).  The involuntary bankruptcy petition was subsequently dismissed.  After the dismissal, Rosenberg filed an adversary proceeding against U.S. Bank under 11 U.S.C. § 303(i) seeking the recovery of costs, attorney’s fees, and damages resulting from a bad faith filing of an involuntary bankruptcy petition.  That adversary proceeding was removed to the District Court, and tried before a jury. The jury awarded Rosenberg over $6 million, including $5 million in punitive damages, which are only warranted when the evidence shows that a defendant acted “with intentional malice” or that its conduct was “particularly egregious”.  After an appeal to the Eleventh Circuit (which reinstated the jury’s punitive damage award that had been vacated by the District Court in Florida), a final judgment of $6,120,000 (including the $5 million punitive damage award) was entered against U.S. Bank and its related entities for filing a bad faith involuntary petition against Rosenberg (the “Florida Judgment”).

At the same time, U.S. Bank proceeded with an action in the Eastern District of Pennsylvania for breach of contract against Rosenberg.  The District Court found in favor of U.S. Bank and awarded U.S. Bank approximately $6.5 million in damages, fees, and costs (the “Pennsylvania Judgment”).

Thereafter, U.S. Bank filed a motion with the Eastern District of Pennsylvania requesting that the District Court offset the Florida Judgment against the Pennsylvania Judgment. If such motion were granted, U.S. Bank would owe Rosenberg nothing and, importantly, would not have been required to come out of pocket for the Florida Judgment.  Reasoning that (i) the judgments lacked mutuality (because, among other things, the parties involved were not identical) and (ii) “equitable principles embodied in § 303 of the United States Bankruptcy Code preclude setoff”, the District Court, exercising its discretion consistent with Pennsylvania state law, denied the motion.  U.S. Bank appealed.

Determining that it need not reach the question of whether there was a lack of mutuality, the Third Circuit determined that the District Court did not abuse its discretion in denying U.S. Bank’s motion for mutual judgment satisfaction based on equitable principles.  Rosenberg, 2018 WL 3640987 at *2.  Accordingly, the Third Circuit affirmed the District Court.  In so doing, the Third Circuit cited with approval several other courts that have concluded that § 303(i)’s equitable purpose would be frustrated if bad faith filers were allowed to offset a § 303(i) judgment.  Citing In re Macke Int’l Trade, Inc., 370 B.R. 236, 255 (B.A.P. 9th Cir. 2007); In re Diloreto, 442 B.R. 373, 377 (E.D. Pa. 2010); In re Forever Green Athletic Fields, Inc., Bankr. No. 12-13888-MDC, 2017 WL 1753104, at *7 (Bankr. E.D. Pa. May 4, 2017); In re K.P. Enter., 135 B.R. 174, 185-86 (Bankr. D. Me. 1992); In re Schiliro, 72 B.R. 147, 149 (Bankr. E.D. Pa. 1987).

Setoff rights are an important remedy for creditors especially when a debtor becomes insolvent or files for bankruptcy. Frequently, it may be the only way a creditor can collect on such debt. However, under Pennsylvania law, “[s]etoff is an equitable right to be permitted solely within the sound discretion of the court.” Foster v. Mut. Fire, Marine & Inland Ins. Co., 531 Pa. 598, 614 A.2d 1086, 1095 (Pa. 1992). Therefore, courts may weigh whether setoff is equitable or if other equitable concerns are tantamount. Sanctions under § 303(i) seek to deter the improper filing of involuntary petitions. These sanctions play “a key role in deterring bad faith filing and remedying the negative effects of improperly-filed petitions.” Rosenberg, 2018 WL 3640987 at *2. The Third Circuit’s decision recognizes that permitting U.S. Bank to set off the § 303(i) award would severely undermine § 303(i)’s equitable purpose. Thus, it held that in light of U.S. Bank’s conduct and the equitable principles underlying § 303(i), the District Court did not abuse its discretion in denying U.S. Bank the equitable remedy of setoff.

This case is but another warning to creditors considering the use of an involuntary petition for a bad faith purpose.  In this case, U.S. Bank’s decision to commence an involuntary petition exposed it to a substantial award that made a bad situation worse – it must now write a large check and only hope that it can collect against a judgment debtor that may be judgment proof.   This is the quintessential lose/lose situation for any creditor.

 

Upcoming Committee Formation Meeting: Thursday, August 23, 2018 10:00 AM

Case Name: 18-11814 (BLS)

Location: Office of the US Trustee, 844 King Street, Room 3209, Wilmington ,DE 19801

Notice of Formation Meeting for Official Committee of Unsecured Creditors can be found here. See the petition for relief.

Contact Norman L. Pernick, G. David Dean or Myles R. MacDonald for more information regarding this matter.

Upcoming Committee Formation Meeting:  Friday, August 17 10:00 AM

Case Name: 18-11975 (MFW)

Location:The Doubletree Hotel, 700 King Street, Wilmington, DE 19801

Notice of Formation Meeting for Official Committee of Unsecured Creditors can be found here. See the petition for relief.

Contact Norman L. Pernick, G. David Dean or Myles R. MacDonald for more information regarding this matter.

Upcoming Committee Formation Meeting:  Thursday, August 16 10:00 AM

Case Name: 18-11818 (KJC)

Location: The Du Pont Hotel, 42 W. 11th Street, Wilmington, DE 19801

Notice of Formation Meeting for Official Committee of Unsecured Creditors can be found here. See the petition for relief.

Contact Norman L. Pernick, G. David Dean or Myles R. MacDonald for more information regarding this matter.

Upcoming Committee Formation Meeting:  Thursday, August 16 10:00 AM

Case Name: 18-11801 (LSS)

Location:The Doubletree Hotel, 700 King Street, Wilmington, DE 19801

Notice of Formation Meeting for Official Committee of Unsecured Creditors can be found here. See the petition for relief.

Contact Norman L. Pernick, G. David Dean or Myles R. MacDonald for more information regarding this matter.

Upcoming Committee Formation Meeting:  Tuesday, August 14 10:00 AM

Case Name: 18-11699 (MFW)

Location:The Doubletree Hotel, 700 King Street, Wilmington, DE 19801

Notice of Formation Meeting for Official Committee of Unsecured Creditors can be found here. See the petition for relief.

Contact Norman L. Pernick, G. David Dean or Myles R. MacDonald for more information regarding this matter.