On Jan. 17, 2018, the U.S. Bankruptcy Court for the Southern District of Mississippi granted a debtor's request for certification of a direct appeal to the U.S. Court of Appeals for the Fifth Circuit of the Bankruptcy Court's memorandum opinion considering the validity of a blocking provision given to an equity holder of the debtor. In re Franchise Servs. of N. Am., No. 1702316EE, 2018 Bankr. LEXIS 105, at *5 (Bankr. S.D. Miss. Jan. 17, 2018). The certification followed the Bankruptcy Court's dismissal of the bankruptcy case filed by Franchise Services of North America (FSNA) because the filing was made without the consent of a party holding the so-called “golden share.” In re Franchise Services of North America, Case No. 1702316EE (Bankr. S.D. Miss. Dec. 18, 2017). In this case, the articles of incorporation of the Delaware putative debtor prohibited the corporation from seeking bankruptcy relief without the consent of a minority shareholder. In certifying direct appeal, the Bankruptcy Court noted the divergent Bankruptcy Court level decisions ranging from declaring such provisions void as against public policy to enforcement. In some of those decisions, the courts observed that with revisions such provisions might be enforceable. In this case, the Bankruptcy Court certified three questions: (1) whether a provision which gives a party (whether a creditor or equity holder) the ability to prevent a corporation from filing bankruptcy valid and enforceable or contrary to public policy; (2) same question, but in a scenario where the holder of blocking provision is both a creditor and an equity holder; and (3) whether Delaware law permits such provisions and, if so, whether Delaware law imposes on the holder of the provision a fiduciary duty to exercise such provision in the best interests of the corporation. On Feb. 8, 2018, the Fifth Circuit entered an order granting leave to appeal and permitting expedited consideration of the appeal. Franchise Svc. of North America v. United States Trustee, et al., Case No. 18-90006-GJC (5th Cir. Feb. 8, 2018). The Circuit will be the highest court to consider validity of such a provision.

Opinion on Motion to Dismiss

The controversy in this case stems from a multi-step M&A transaction resulting in a putative debtor's acquisition of a car rental company. The transaction was spearheaded by an investment bank. In order to facilitate the acquisition, a wholly owned subsidiary of the investment bank invested $15 million in the putative debtor. In exchange, the subsidiary received 49.76 percent interest in the debtor in the form of preferred stock, becoming the largest single shareholder. For its work on the transaction, the investment bank was owed an advisory fee of $500,000, and an arrangement fee of $2,500,000 from the debtor. These fees remained unpaid after the closing of the acquisition transaction.

In addition, the putative debtor, which was originally incorporated in Canada, was re-domiciled as a Delaware corporation. Its Delaware Certificate of Incorporation included a provision (§4(j)) pursuant to which the company had to seek written consent or an affirmative vote of the holders of a majority of the preferred stock and holders of a majority of the common stock before filing for bankruptcy.

On June 26, 2017, FSNA filed a petition for relief under Chapter 11 of the Bankruptcy Code. Shortly after the filing, the investment banking company filed a motion to dismiss the case, arguing that the debtor filed the petition without proper corporate authority for failure to obtain the investor subsidiary's consent as required by §4(j) of the Certificate of Incorporation. The subsidiary filed a joinder to the motion to dismiss. In response, the debtor asserted that a golden shares or blocking provision, such as §4(j) contained in its Certificate of Incorporation, was void as a matter of public policy.

In reaching its decision, the Bankruptcy Court analyzed seven existing cases which have addressed validity of the grants of golden shares or blocking provisions. Each case turned on whether the blocking right was claimed to be held by a creditor or equity holder of the debtor. For instance, In re Global Ship Systems concerned a motion to dismiss Global Ship's bankruptcy case filed by Drawbridge, an equity owner and creditor of the debtor. 391 B.R. 193 (Bankr. S.D. Ga. 2007). The debtor's operating agreement granted Drawbridge a blocking provision, and Drawbridge sought dismissal based on its lack of consent to the filing. The court found that a blocking provision that absolutely waived a debtor's right to file for bankruptcy violated public policy if it was asserted by a lender. However, because Drawbridge was both a creditor and a shareholder, the court found that it had the unquestioned right to prevent a voluntary bankruptcy case by withholding consent. The case was, therefore, dismissed. On the other hand, in In re Lake Michigan Beach Pottawattamie Resort, the court denied a motion to dismiss because the party was deemed to mainly be a creditor. 547 B.R. 899 (Bankr. N.D. Ill. 2016). In this case, after the debtor defaulted on a loan, the debtor's operating agreement was modified to make the creditor a special member with the power to block the filing of any bankruptcy petition. When the debtor filed for bankruptcy, the creditor moved to dismiss. The court, however, found that the special member was kept totally separate from the debtor in that it had no interest in the profits or losses of the debtor and was not required to make capital contributions. Further, it held no duty or obligation to the debtor in any manner. The blocking provision here only allowed the special agent to consider its own interests. Therefore, the court determined the provision was void and denied the motion to dismiss.

In this case, the Bankruptcy Court first found that the investment company was a creditor of the debtor on account of unpaid advisory and arrangement fees, and the blocking provision was thereby void as a matter of public policy. As a result, its motion to dismiss was denied. However, no evidence was presented to show that the investment company's subsidiary was a creditor. The only evidence introduced was the fact that the subsidiary invested in the debtor and owned 49.76 percent interest, thereby allowing the rights in §4(j) to be deemed valid and enforceable in regards to the subsidiary.

Before granting the subsidiary's motion to dismiss, the court considered three additional points. First, it considered the debtor's argument that the investment company and its indirectly wholly owned subsidiary were, in fact, the same entity, because the parent acknowledged that it completely controlled the subsidiary. The court concluded that even if so, the result would not change. Like Drawbridge in Global Ship, the investment company would be wearing “two hats” (of creditor and equity holder), thus giving it a right to prevent commencement of a voluntary bankruptcy case.

Next, the court considered the debtor's argument that only its board of directors had the power to decide whether it was in the best interest of the debtor to file bankruptcy, and therefore, the blocking provision was invalid because it gave that authority to the investor's subsidiary instead of the company's board. The court disagreed, pointing to the business judgment rule and §141(a) of the Delaware Code, which allows business affairs to be decided by others outside of the board of directors if indicated in a corporation's formation documents. The court presumed that the board acted in good faith and in the best interest of the debtor when it agreed to add §4(j) to the Certificate of Incorporation. Moreover, as a minority shareholder of the debtor, the investor's subsidiary did not owe a fiduciary duty to the debtor, and was thus entitled to vote in its own interest.

Finally, the court addressed the debtor's argument that §4(j) violated §102(b)(1) of the Delaware Code, which requires decisions to be made by the board of directors. However, because the debtor's board included §4(j) in the Certificate of Incorporation, the court found that a conscious decision was made to take the authority for filing bankruptcy out of the board's hands and place it in the hands of the investor, thus delegating authority to decide whether the debtor would file bankruptcy to an equity holder. Therefore, the investor shareholder had the right to consent to or deny debtor's bankruptcy filing. Since the debtor did not provide proof that the investor consented to the bankruptcy filing, the court held that the debtor filed without corporate authority, and dismissed the case.

Certification of Direct Appeal

Given the lack of controlling authority on the issue, and the relative novelty and recent frequency of use of blocking provisions, rendering a controlling circuit court ruling on the issue a matter of public importance, the Bankruptcy Court concluded that conditions for certification had been met. The Fifth Circuit agreed.

Conclusion

This case is important. The outcome of the controversy may significantly impact many future transactions, especially in private company settings. Interestingly, this case involves a Delaware question on appeal to the Fifth Circuit. Obviously, depending on the ruling there can be a substantial impact on investors, as well as their lenders. The outcome could also influence the behavior of other corporate stakeholders, including unions, and banking and financing institutions, especially when funding is sourced from alternative capital. Moreover, “rescue finance” may take on some new features. But what about those players that cannot influence what provisions should be included in the corporate formation documents? Or that became stakeholders before a blocking provision was included in such documents? It is a controversial subject sitting on the edge where federal bankruptcy law meets and perhaps, preempts, state corporate law.

Corinne Ball is a partner at Jones Day.