Reprinted with permission from the August 2, 2018 issue of The Legal Intelligencer. © 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
The Bankruptcy Code and accompanying Rules of Procedure attempt to create a nationwide legal framework for administering bankruptcy cases. However, to initially determine whether a corporate entity can seek bankruptcy protection, courts must also consider the state law where it is chartered to determine who possesses the requisite authority to file on a debtor’s behalf. To further complicate matters, the bankruptcy court must remain mindful of well-established federal public policy prohibiting an entity from waiving its right to seek bankruptcy relief. The U.S. Court of Appeals for the Fifth Circuit was recently called upon to consider and possibly resolve the tension between federal policy and state corporate law in a case which involved “blocking” or “golden share” provisions contained within a debtor’s corporate charter, which were apparently designed to enable a shareholder to prevent a bankruptcy filing, see In re Franchise Services of North America, 891 F.3d 198 (5th Cir. 2018).
In Franchise Services, the Fifth Circuit declined the request for it to broadly opine on the legality of “blocking provisions” and “golden shares” on the grounds that advisory opinions are impermissible. However, its analysis confirmed that unless a provision violates the federal public policy prohibiting an outright pre-petition waiver by the debtor of its right to seek bankruptcy relief, it must turn to state law to determine what persons or entities have authority to file the bankruptcy petition on its behalf. Based on the facts before it, the Fifth Circuit held that federal bankruptcy law does not prevent a bona fide equity holder from exercising its voting rights to prevent the corporation from filing a voluntary bankruptcy petition solely because it also holds an unsecured debt owed by the corporation and owes no fiduciary duty to the corporation or its fellow shareholders.
Prior to filing, Franchise Services of North America, hired Macquarie, as its investment banker, to assist in a transaction. Macquarie created a new, wholly-owned subsidiary, Boketo, to finance the deal and also invested $15 million of its own money in the debtor through Boketo in exchange for 100 percent of the debtor’s preferred stock. Macquarie separately charged the debtor a $3 million investment banking fee. As a condition of Boketo’s investment, the debtor was required to reincorporate in Delaware and include a provision in its corporate charter requiring the respective majorities of both the general and preferred shareholder classes to consent before the debtor could initiate bankruptcy proceedings. Since Boketo owned 100 percent of the preferred stock, it could effectively block any attempt to file bankruptcy.
Notwithstanding Boketo’s blocking position, the debtor voluntarily entered Chapter 11. Macquarie and Boketo moved to dismiss the bankruptcy, arguing that the debtor lacked authorization to file because it did not have the requisite shareholder consent under the corporate charter. The Bankruptcy Court agreed, but certified the debtor’s appeal to the Fifth Circuit. Although the Fifth Circuit declined to answer the broader certified questions concerning the legality of blocking provisions and golden shares generally, it did issue a narrow opinion based upon the facts before it.
The court first addressed the federal issue. The debtor argued that Boketo’s blocking right was contrary to federal public policy prohibiting waiver of the right to file bankruptcy and that Boketo, as a wholly-owned subsidiary of Macquarie, should be considered merely an unsecured creditor due to Macquarie’s unpaid $3 million fee. The court disagreed, holding that federal public policy does not prohibit granting a bona fide preferred shareholder the right to prevent a voluntary bankruptcy filing just because the shareholder is also an unsecured creditor. Here, there was no contractual waiver by the debtor of its right to file bankruptcy and, even if Boketo and Macquarie were deemed to be a single entity, the $15 million equity contribution in proportion to the $3 million unsecured claim evidences that Boketo was a bona fide investor. The Fifth Circuit expressly noted that this matter involved a bona fide shareholder, and was not a case where a mere creditor had contracted for a right to prevent a bankruptcy or where the equity interest was a ruse. Moreover, as a matter of federal law, the court found that fiduciary duties are not required to allow a bona fide shareholder to exercise its right to prevent a voluntary bankruptcy petition. Thus, there was no rationale under federal law to deprive Boketo of its voting rights.
After holding that federal bankruptcy law does not prevent a bona fide equity holder from exercising its voting rights to prevent bankruptcy simply because the shareholder also holds an unsecured claim and owes no fiduciary duty to the corporation or its fellow shareholders, the Fifth Circuit turned to Delaware law to complete its analysis. In doing so, the Fifth Circuit noted that the Supreme Court held more than 70 years ago that corporate authority to file for bankruptcy “finds its source in local law” and that the “main event” was whether Delaware law allowed the exercise of the blocking right. Although the Fifth Circuit declined to rule on the issue of whether the shareholder consent provision was enforceable under Delaware law, citing waiver of the issue by appellant and a lack of on-point Delaware cases, its analysis confirmed that state law controls on the issue absent a finding that the restrictions in question violate federal public policy prohibiting a pre-petition waiver by the debtor of its right to seek bankruptcy relief.
In Franchise Services, the Fifth Circuit issued a much more narrow opinion than was initially sought through certification. The court did not opine generally on whether it would enforce a contractual waiver of the right to file for bankruptcy or a charter provision which gives a creditor the right to veto a bankruptcy, while noting that both have been found to be unenforceable in other circuits. It also did not decide whether the provision giving Boketo the right to veto a voluntary bankruptcy filing would have been enforceable if there was evidence that its investment was simply a ruse to protect its unsecured debt. Nevertheless, despite the absence of sweeping guidance on the issues, this decision provides additional insight into how courts will likely analyze the enforceability of golden share and other blocking provisions. Parties relying on the these provisions to protect themselves from a debtor’s “abusive” bankruptcy petition must remain apprised of the developing federal and state case law in this area and are best served to ensure that such provisions are not crafted as an absolute waiver of an entity’s right to seek bankruptcy relief.
Sarah Patterson, a 2018 summer associate with Pepper Hamilton, contributed to the article. Ms. Patterson is not admitted to practice law.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.