Several months ago the U.S. Court of Appeals for the Fifth Circuit agreed to hear a direct appeal from a bankruptcy court decision dismissing a Chapter 11 case as being unauthorized due to a failure to comply with its articles of incorporation. See Corinne Ball, A Case to Watch: The Fifth Circuit Accepts Direct Appeal Respecting Enforcement of Corporate Restraints Preventing Bankruptcy, NYLJ (Feb. 21, 2018). The questions certified posed the issue of whether a blocking provision or a golden share, which gives a party the ability to prevent a corporation from filing bankruptcy is valid and enforceable or contrary to federal public policy. Further, the certified question asked whether, under Delaware law, such a blocking provision imposes upon the holder of the provision a fiduciary duty to exercise such provision in the best interests of the corporation. Rather than address these broad questions, the Fifth Circuit narrowed the questions to whether U.S. and Delaware law permits what happened here, notably, amending the corporate charter to allow a non-fiduciary shareholder fully controlled by an unsecured creditor to prevent a voluntary bankruptcy filing. The appellate court ruled in the affirmative. Franchise Servs. of N. Am. v. United States Trs. (In re Franchise Servs. of N. Am.), No. 18-60093, 2018 U.S. App. LEXIS 13332 (5th Cir. May 22, 2018).
This case arose from the failed acquisition of Advantage Rent-A-Car by Franchise Services of North America, Inc. (FSNA). An investment bank assisted FSNA in the acquisition acting as an advisor and providing, through a wholly owned affiliate, an investment of $15 million in convertible preferred equity issued by FSNA. The preferred stock was convertible to 49.76 percent in common equity. Concurrently with the investment, FSNA, which was originally incorporated in Canada, was required to reincorporate in Delaware and include in its certificate of incorporation that FSNA could not “effect any liquidation event,” including “preparatory steps towards or filing a petition for bankruptcy,” without the consent of the holders of a majority of the preferred stock, voting separately as a class, and the holders of majority of the shares of common stock, voting as class. Advantage filed for bankruptcy within a year of the acquisition. FSNA did not pay the investment bank its advisory fees. Litigation ensued. FSNA sought bankruptcy relief without requesting or obtaining the consent of its preferred shareholder. The investment bank, acting through its shareholder affiliate, moved to dismiss the Chapter 11 case as unauthorized. The bankruptcy court granted the preferred shareholder’s motion and dismissed the Chapter 11 case. FSNA successfully sought certification and direct appeal to the Fifth Circuit.
The Fifth Circuit first addressed the question of whether the consent right provided to the investment bank affiliate violated federal public policy against waiving the protections of the Bankruptcy Code. In its analysis, the court accepted that the shareholder affiliate was “fully controlled” by the investment bank, “meaning that the veto right in fact belongs to” the investment bank, which is an unsecured creditor by virtue of its unpaid fees. The court assumed for purposes of its analysis that the investment bank and its affiliate were a single entity. Importantly, the court observed that there was no evidence that the consent right was a “mere ruse” to ensure that FSNA would pay the investment bank its fee, noting that the investment was more than five times the amount of the fee. Because the amendment to the corporate charter was triggered by a concurrent substantial equity investment, the court concluded that this case did not involve a “contractual waiver of the right to file for bankruptcy.” The court turned to Price v. Gurney, 324 U.S. 100, (1945), wherein the Supreme court held that corporate authority to file for bankruptcy finds its source in local law. The Fifth Circuit reasoned that here, just as in Price, absent a duly authorized bankruptcy petition, the bankruptcy court has no power to intervene in corporate disputes. The court determined that the bankruptcy court cases cited by FSNA were not controlling and not to the contrary. With respect to the federal policy question, the court held that there was no compelling federal law rationale for depriving a bona fide equity holder of its voting rights just because it is also a creditor.
Despite the prior broad certification, only one Delaware law question was addressed: whether Delaware law would impose a fiduciary duty on a minority shareholder because it held consent rights over the corporation’s ability to file a bankruptcy petition. The court assumed that Delaware law would permit such a provision, and the parties conceded that Delaware law imposed fiduciary duties on two kinds of shareholders: majority shareholders and controlling minority shareholders. Given that the preferred shares were convertible into a 49.76 percent equity interest, the analysis focused on whether the investment bank affiliate was a controlling minority shareholder.
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