On June 14, 2018, the United States Court of Appeals for the Fifth Circuit issued a revised opinion that held that Federal law does not prevent a bona fide shareholder from exercising its right to vote against a bankruptcy petition just because it is also an unsecured creditor. In re Franchise Servs. of N. Am., Inc., 891 F.3d 198, 203 (5th Cir. 2018), as revised (June 14, 2018).
Franchise Services of North America, Inc. (“FSNA”) was once one of the largest rental car companies in North America. Id. at 203. In 2012, FSNA desired to purchase Advantage Rent-A-Car and enlisted an investment bank, Macquarie Capital (U.S.A.), Inc. (“Macquarie”), to assist. Macquarie created a fully-owned subsidiary, Boketo, LLC (“Boketo”), to make a $15 million investment in FSNA.
In exchange for the capital infusion, FSNA gave Boketo 100% of its preferred stock in the form of a convertible preferred equity instrument. Boketo’s stake in FSNA would amount to a 49.76% equity interest if converted, making it the single largest investor in FSNA. As a condition of the investment, FSNA in May 2013 reincorporated in Delaware and adopted a new certificate of incorporation. The new certificate provides that FSNA may not “effect any Liquidation Event” (which included filing for bankruptcy protection) unless it has the approval of both “(i) the holders of a majority of the shares of Series A Preferred Stock then outstanding, voting separately as a class . . . , and (ii) the holders of a majority of the shares of Common Stock then outstanding, voting separately as a class.” Id. FSNA additionally agreed to pay Macquarie a $2.5 million “arrangement fee” and a $500 thousand “financial advisory fee” for its services, but FSNA failed to pay the full amounts of such fees. Id. at 203-04.
Within a year of the acquisition, Advantage Rent-A-Car filed for bankruptcy protection. Id. at 204. In June 2017, FSNA filed its own voluntary petition under Chapter 11. It did so with no attempt to request or secure shareholder approval.
Macquarie and Boketo filed a motion to dismiss the bankruptcy petition, citing FSNA’s failure to seek shareholder authorization. FSNA countered that the shareholder consent provision was an invalid restriction on its right to file a bankruptcy petition. It also asserted that the provision violated Delaware law. Because Boketo was an owner, rather than creditor, of FSNA, the bankruptcy court determined that conditioning FSNA’s right to file a voluntary petition on Boketo’s consent was not contrary to federal bankruptcy policy and granted the motion to dismiss. The bankruptcy court then certified a direct appeal to the Fifth Circuit pursuant to 28 U.S.C. § 158(d)(2)(A) on the following three questions:
- 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?
- 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?
- 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?
The Fifth Circuit proceeded to define and distinguish both blocking provisions and golden shares from the facts of the FSNA case. Courts typically use the term “blocking provision” as a catch-all to refer to various contractual provisions through which a creditor reserves a right to prevent a debtor from filing for bankruptcy. Id. at 205 (citing In re Squire Court Partners Ltd. P’ship, 574 B.R. 701, 706–07 (E.D. Ark. 2017); In re Lake Mich. Beach Pottawattamie Resort LLC, 547 B.R. 899, 911 (Bankr. N.D. Ill. 2016) (describing “blocking director” structures whereby secured creditors appoint directors with the ability to veto a voluntary bankruptcy petition)).
A “golden share” is “[a] share that controls more than half of a corporation’s voting rights and gives the shareholder veto power over changes to the company’s charter.” Id. (citing Golden Share, Black’s Law Dictionary (10th ed. 2014); Mariana Pargendler, State Ownership and Corporate Governance, 80 Fordham L. Rev. 2917, 2967 (2012) (noting that in the context of formerly stated-owned entities, “[g]olden shares are essentially a special class of stock issued to the privatizing government that grants special voting and veto rights that are disproportionate to, or even independent of, its cash-flow rights in the company”)). “As used in the bankruptcy context, the term generally refers to the issuance to a creditor of a trivial number of shares that gives the creditor the right to prevent a voluntary bankruptcy petition, potentially among other rights.”
The Fifth Circuit noted that Boketo made a $15 million equity investment in FSNA in return for convertible preferred stock that carried with it the right, granted in the certificate of incorporation, to vote on certain corporate matters. Because Boketo’s rights arose from its role as an equity owner – not a creditor – the case did not concern a blocking provision. And because Boketo’s voting rights were proportionate to its ownership interest, no “golden share” was at issue. In order to avoid issuing an advisory opinion, the Fifth Circuit refused to address the propriety of blocking provisions or golden shares under Delaware law. Id. at 205-06.
The narrowed question the Fifth Circuit chose to answer was simply “whether U.S. and Delaware law permit the parties to do what they did here: 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.
State law determines who has the authority to file a voluntary petition on behalf of the corporation. Id. (citing Price v. Gurney, 324 U.S. 100, 106-07 (1945); In re Nica Holdings, Inc., 810 F.3d 781, 789 (11th Cir. 2015)). But FSNA contended that even if Delaware law authorized the arrangement requiring shareholder consent for filing, federal law would prohibit it because it violates a federal public policy against waiving the protections of the Bankruptcy Code. Id. at 207. The Fifth Circuit noted that this case did not involve any contractual waiver of the right to file for bankruptcy, but merely a corporate prerequisite to filing triggered by a “substantial equity investment.” Id. (emphasis added). Because Boketo’s rights were obtained in exchange for an equity investment, the Fifth Circuit was able to distinguish cases where creditors extracted blocking provisions in exchange for forbearance. Id. Even treating Boketo and Macquarie as a single entity for purposes of its analysis, the Fifth Circuit said it “strains credulity to believe that Macquarie made a $15 million equity investment just to hedge against the possibility that FSNA might not pay a $3 million bill.” Id. at 208.
“There is no prohibition in federal bankruptcy law against granting a preferred shareholder the right to prevent a voluntary bankruptcy filing just because the shareholder also happens to be an unsecured creditor by virtue of an unpaid consulting bill. . . . In sum, there is no compelling federal law rationale for depriving a bona fide equity holder of its voting rights just because it is also a creditor of the corporation.” Id.
The Fifth Circuit was careful to limit its holding to the facts of this case. “A different result might be warranted if a creditor with no stake in the company held the right. So too might a different result be warranted if there were evidence that a creditor took an equity stake simply as a ruse to guarantee a debt. We leave those questions for another day.” Id. at 209.
As to Delaware law, the Fifth Circuit declined to address whether the shareholder provisions were valid under Delaware law because FSNA expressly waived any such argument. Id. at 210.
Finally, FSNA contended that under Delaware law, Boketo should be classified as a controlling, minority shareholder (because of its ability to block a bankruptcy filing) which would give rise to fiduciary obligations and invalidate any attempt to exercise the bankruptcy veto right. The Fifth Circuit disagreed.
First, under Delaware law, for a minority shareholder to owe fiduciary duties, it must “dominat[e]” the corporation “through actual control of corporation conduct.” Id. at 211 (citing Kahn v. Lynch Commc’n Sys., Inc., 638 A.2d 1110, 1114 (Del. 1994)). A minority shareholder exercises “actual control” only when it has “such formidable voting and managerial power that [it], as a practical matter, [is] no differently situated than if [it] had majority voting control.” Id.
Here, the Fifth Circuit held that FSNA failed to show that Boketo actually dominated FSNA’s corporate conduct, and noted that FSNA’s board’s apparent ability and willingness to act without Boketo’s consent undercuts the case for control. “Indeed, the very fact that Boketo had to resort to filing a motion to dismiss the bankruptcy petition—an action hotly contested by FSNA in the bankruptcy proceedings and on appeal—only emphasizes its inability to control FSNA. To reuse a phrase: if Boketo is a controlling shareholder of FSNA, then the tail is wagging the dog.” Id. at 213. We question whether the result would have changed had FSNA actually sought Boketo’s consent before filing. Because the Fifth Circuit found that Boketo was not a controlling shareholder, it did not reach the question of whether it breached (inapplicable) fiduciary duties.
The Fifth Circuit was careful to caution that its opinion applies only to the narrow facts of the case. However, for creditors willing to form a subsidiary to purchase an equity interest, the case arguably provides a blueprint for obtaining veto powers over any potential bankruptcy filing.