The Fifth Circuit is being asked to accept a direct appeal and decide whether a creditor can structure a loan agreement to prevent a borrower from filing bankruptcy, sidestepping the principle that public policy prohibits waiving the right to file bankruptcy.
Bankruptcy Judge Edward Ellington of Jackson, Miss., ruled in December that a creditor with a comparatively small claim who is also a minority equity holder can be given the right, wearing its shareholder hat, to preclude the borrower from filing bankruptcy. Consequently, Judge Ellington dismissed the debtor’s chapter 11 petition for lack of proper corporate authorization.
The case raises the question of whether a creditor can utilize a so-called golden share to prevent a borrower from filing bankruptcy. On Jan. 17, Judge Ellington certified the case for direct appeal to the Fifth Circuit.
Judge Ellington said that a “blocking provision or golden share is a relatively new provision created by the credit community in an attempt to work around the prohibition against an entity contracting away the right to file bankruptcy.”
The Golden Share Structure
The debtor owned a car rental company. To finance an acquisition, the debtor received a $15 million investment from a diversified financial group. In return, the investor was given 49% of the debtor’s preferred equity.
An affiliate of the investor was a creditor with a $3 million claim. Judge Ellington said that the investor controlled the affiliate-creditor.
The debtor’s Delaware certificate of incorporation included a golden share provision prohibiting the company from filing bankruptcy without consent from the investor wearing its hat as a preferred stockholder.
After the debtor filed a chapter 11 petition, the investor, in its status as the holder of the golden share, filed a motion to dismiss, contending the filing was accomplished without proper corporate authorization. Judge Ellington granted the motion and dismissed the petition in December when the debtor was in the midst of selling the assets.
Caselaw on Golden Shares
Judge Ellington said there are six opinions from bankruptcy courts and one from a district court shedding light on the ability of a golden shareholder to block the filing of bankruptcy. All of the cases are new. The first was handed down in 2007. The six others date from 2014 or later. None reached a circuit court.
All of the seven cases, according to Judge Ellington, begin with the “general premise that the waiving or contracting away the right to file for relief under the Bankruptcy Code is contrary to public policy.” All of the cases, he said, hold that a blocking power held by a creditor is “void as a matter of public policy.”
On the other hand, Judge Ellington said it is “clear” from the cases dealing with “golden shares or blocking provisions” that “either provision will be upheld as valid if it is held by an equity holder.”
Applying the caselaw to the facts at hand, Judge Ellington concluded that the blocking position held by the “substantial equity holder” was “valid and enforceable and . . . not contrary to public policy under federal law.”
Judge Ellington conceded that the investor-creditor wears two hats, as a creditor owed $3 million and an equity holder with a $15 million investment. Quoting one of the seven cases, the judge said the equity investor had the “unquestioned right” to block a voluntary bankruptcy.
Judge Ellington also concluded that a golden share or blocking provision in articles of incorporation is not invalid under Delaware law.
Should the Fifth Circuit accept the direct appeal, Judge Ellington tasked the appeals court with deciding three issues: (1) Is a blocking provision or golden share, held by either a creditor or equity holder, invalid as a violation of public policy if it prevents a corporation from filing bankruptcy; (2) if the holder is both a creditor and shareholder, is barring bankruptcy invalid as a violation of public policy, and (3) under Delaware law, may a certificate of incorporation contain a blocking provision or golden share, and if permissible, does Delaware law impose fiduciary duties on the holder in exercising its power?
Enforcing the blocking provision may seem reasonable in a case like this where the equity investment was five times larger than the claim as a creditor. But what if the facts were reversed and the claim was five times larger than the equity investment? Where should the Fifth Circuit draw the line on the ratio between debt and equity? Does the creditor’s control invalidate the exercise of shareholder rights? Should the bankruptcy court make a finding of fact and decide whether the shareholder was using its blocking power to collect the debt or eliminate the bankruptcy court as a platform where other creditors might sue the shareholder-creditor?
The validity of a golden share in the hands of someone who is both a shareholder and creditor cries out for a bright-line rule, otherwise the outcome of every case will be uncertain and law could develop in different directions around the country, leading to inconsistent results and forum-shopping.
The December opinion and the certification of a direct appeal are both in In re Franchise Services of North America Inc., 17-2361 (Bankr. S.D. Miss. Dec. 18, 2017 and Jan. 17, 2018).