Everyone has read something about how sponsors have engineered weakened loan documents and exploited those documents under so-called "liability management transactions." The hook, for those who favor those sorts of liquidity maneuvers, is freedom of contract. Lenders should have protected themselves with tighter loan documents, so the argument goes. Clear contract rights, however, also can be a sword and not just a shield. Many secured lenders require equity pledges, typically from the holding company where the sponsors made their equity investment. The equity pledge, properly drafted, usually includes provisions that allow secured creditors to exercise voting rights upon default. Voting proxies are the tools created to enforce those voting rights.
Well-drafted stock pledges focus on the mechanics for exercising voting rights via proxy upon any (or specifically designated) events of default. Importantly, the secured lender wants to be able to exercise voting rights to replace all board members (colloquially called a "board flip") or remove certain board members (a "board strip"). Sponsors want advance notice. Lenders do not want to provide it. If advance notice is required by contract, the holding company pledgor could file Chapter 11 bankruptcy to block the exercise via the automatic stay imposed by the Bankruptcy Code. Just as important, the proxy granted under the initial closing documents must be irrevocable until the secured debt is paid in full. State law varies on proxy duration and the language required for irrevocability. Once the irrevocable proxies are exercised, without advance notice, the boards of the direct and indirect subsidiaries are placed under the control of a new set of fiduciaries.
If the holding company files bankruptcy after the subsidiary boards have been flipped, what then? The pledgor, now debtor, asks a bankruptcy court to make a determination that the lender's control over the power to vote, and to therefore appoint or replace the new board, somehow violates the automatic stay. Or, the debtor argues that the proxy was not exercised validly, perhaps with insufficient notice (see In re MTE Holdings LLC, No. 19-12269 (Bankr. D. Del. Dec. 19, 2019)) or perhaps with a proxy that had expired. Freedom of contract now is the sword. If the pledge document requirements are clear and satisfied, then that should be the end of the inquiry. The automatic stay should not apply because the lender's actions to flip the board occurred pre-filing. If prior notice is not expressly required, the reviewing court should not imply a prior notice requirement. And if the proxy is granted as part of secured financing, then it should be irrevocable if the right words are used in the pledge documents. Lenders want to know that exercising these rights, to the letter, will be enforced by courts.
Recently, the Delaware Bankruptcy Court has done just that. The important opinion can be found here: In re CII Parent, Inc., No. 22-11345 (Bankr. D. Del. Apr. 12, 2023). It remains to be seen whether the Chapter 11 case will be dismissed or converted to a case under Chapter 7. In the meantime, the holding company continues to own the equity in its subsidiaries, but the voting rights are separated from other stock rights by operation of the proxy. New fiduciaries are in place who will be obligated to exercise their fiduciary duties in accordance with state law.
Goldberg Kohn has assisted its lending clients with exercising proxy voting rights for years, and we welcome this opinion as a clear statement of the lender's proxy rights before and after a bankruptcy filing by the pledgor. The opinion highlights the importance of careful front-end documentation and strategic proxy exercise.