In re Franchise Services of North America, Inc., 891 F.3d 198 (5th Cir. 2018)
QUESTION: May a shareholder of the bankrupt debtor, who is also a significant creditor of the debtor, effectively invoke its veto power vested in the debtor’s internal corporate documents to have the debtor’s bankruptcy petition dismissed?
ANSWER: Yes. 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.” In re Franchise Services of North America, Inc., 891 F.3d 198, 209 (5th Cir. 2018). Moreover, although the Fifth Circuit declined to determine Delaware law in the first instance, in dicta, the Fifth Circuit “assume[d]” that Delaware law would allow “a provision in the certificate of incorporation conditioning the corporation’s right to file a bankruptcy petition on shareholder consent.” Id. at 210.
FACTS: Franchise Services of North America, Incorporated (“Debtor”) was one of the largest car rental companies in North America. In 2012, through a series of investments and mergers, an investment bank, Marcquarie Capital (U.S.A.), Inc. (“Macquarie”) and two of its fully-owned subsidiaries, Adreca Holdings Corporation (“Adreca”) and Boketo, LLC (“Boketo”), invested $15 million dollars to allow Debtor to purchase Advantage Rent-A-Car (“Advantage”) from one of its main competitors.
This quickly turned out to be a bad investment. Within a year of these transactions, Advantage filed for Chapter 11 protection; and within a few years later, Debtor filed its own voluntary bankruptcy petition under Chapter 11.
As a condition of the investment, Debtor agreed to be reincorporated in Delaware and to adopt a new certificate of incorporation that provided that Debtor may not “effect any Liquidation Event” unless it has the approval of both “(i) the holders of a majority of the shares of Series A Prefered 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.” In exchange for its $15 million investment, Debtor gave Boketo 100% of its preferred stock in the form of a convertible preferred equity instrument. Boketo’s stake in Debtor would amount to 49.76% equity intertest if converted, making it the single largest investor in Debtor.
Also as part of this transaction, Debtor agreed to pay Marquarie a $2.5 million “arrangement fee” and a $500 thousand “financial advisory fee” for its services. These fees remained unpaid at the time of the ultimate bankruptcy petition filed by Debtor; therefore, Boketo and Marquarie were both equity shareholders and creditors of Debtor.
Debtor did not seek shareholder authorization pursuant to its internal corporate governance documents prior to filing for bankruptcy. Macquarie and Boketo filed a motion to dismiss the bankruptcy petition because Debtor lacked authority to do so; in other words, Boketo maintained that it had the right to veto the Debtor’s decision to file for bankruptcy protection. The Debtor countered that the shareholder consent provision of its corporate documents was an invalid restriction on its right to file a bankruptcy petition pursuant to federal law and was unenforceable pursuant to Delaware law.
Finding that Boketo was both a substantial shareholder in the Debtor and a significant creditor of the Debtor, the bankruptcy court held that conditioning the Debtor’s right to file a voluntary petition on Boketo’s consent was neither contrary to federal bankruptcy law nor Delaware law, and granted Boketo’s motion to dismiss. The Fifth Circuit affirmed this result.
DISCUSSION: Although federal law governs whether a corporation or other business entity is eligible to file for bankruptcy, state law governs who has authority to file for bankruptcy on behalf of the company.
As a general proposition, a provision in a contract between a debtor and creditor which attempts to prevent the debtor from filing for bankruptcy is typically unenforceable. See, e.g., In re Lexington Hosp. Grp., LLC, 577 B.R. 676 (Bankr. E.D. Ky. 2017)(and cases cited in Franchise Services); but see, e.g., In re DB Capital Holdings, LLC, 2010 WL 4925811 (10th Cir. BAP 2010). In other words, a creditor of the debtor with no meaningful stake in the company probably cannot prevent the debtor from filing for bankruptcy pursuant to a contractual “blocking provision” or “golden share” provision. However, corporate governance documents, in general, can effectively authorize shareholders to “block” or veto bankruptcy filings according to state law.
Because the entity challenging the bankruptcy filing in Franchise Services was both a substantial shareholder and a significant creditor of Debtor, the specific issue before the Fifth Circuit was somewhat novel. According to the Fifth Circuit, the issue in Franchise Services involved “a substantial equity investment, that effectively grants a preferred shareholder the right to veto the decision to file for bankruptcy.” Id. at 207. Beketo argued that as a shareholder of Debtor, regardless of whether it was also a creditor, neither federal law nor Delaware law prohibited the shareholder consent provisions found in Debtor’s corporate governance documents. Debtor argued that Boketo was really just a creditor in disguise, and therefore its attempt to prevent the debtor from filing for bankruptcy should be denied. The Fifth Circuit disagreed.
“There is no prohibition in federal bankruptcy law,” wrote the Fifth Circuit, “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.” Id. at 208. “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. at 209.
The Fifth Circuit made it a point to state that its holding in Franchise Services was restricted to the specific facts before it. Significantly, the Fifth Circuit in Franchise Services refused to address or answer a number of related issues raised by the litigants, including: (1) whether, in general, “blocking provisions” and “golden share” provisions are enforceable; (2) whether a pre-petition contractual waiver of the benefits of bankruptcy is contrary to federal law and therefore unenforceable; (3) whether a creditor with no stake in the company could effectively use such a veto power; and (4) whether, if it appeared that a creditor took an equity stake in the company as a ruse simply to guarantee its debt, such a shareholder / creditor could effectively use such a veto power. The Fifth Circuit left these “questions for another day.” Id. at 209.