The Court of Appeals for the Fifth Circuit missed an opportunity to address some important questions about golden shares, an alternative form of bankruptcy proofing that requires the consent of certain equity holder(s). On May 22, it affirmed the dismissal of a bankruptcy petition that was filed without obtaining the consent of the preferred shareholder, whose consent was required under the debtor’s amended certificate of incorporation. In doing so, it side-stepped the main issue of interest, finding that the case did not involve a blocking provision.

Left unaddressed were several questions that the Bankruptcy Court for the Southern District of Mississippi had certified in the case, Franchise Services of North America. They include whether a blocking provision, i.e. a golden share, enabling a party to block a bankruptcy filing, is contrary to federal public policy and whether the veto right violates Delaware law.

Nevertheless, the opinion is noteworthy for several of its observations.

Before filing for bankruptcy, the debtor retained a financial advisor in connection with an acquisition. The acquisition turned badly, and the financial advisor was not paid its $3 million in fees. To assist in financing the acquisition, the financial advisor set up a wholly owned subsidiary, “Boketo,” that invested $15 million in the debtor in exchange for convertible preferred equity, which, upon conversion would represent 49.76% of the debtor’s equity. As a condition of the investment, the debtor reincorporated in Delaware and its new certificate of incorporation required the consent of the majority of its common stockholders and preferred stockholders, voting as separate classes, for a bankruptcy filing. Boketo was the sole preferred shareholder. The debtor filed for bankruptcy without asking for the required consents. The financial advisor and Boketo moved to dismiss the petition as an unauthorized filing and the bankruptcy court dismissed the case.

Was Federal Public Policy Violated?

The debtor argued that the majority approval requirement was akin to a waiver of Bankruptcy Code’s protections, which many courts have found to violate public policy. The circuit court disagreed.

First, the circuit held that it should narrow the certified questions, since the case did not really involve a blocking provision; the majority approval requirement was part of an equity investment granted to a bona fide shareholder. The fact that the shareholder (or its parent) was also an unsecured creditor seemed irrelevant to the court, especially since it lacks credibility to argue that the creditor made a $15 million equity investment to protect its $3 million debt claim. The circuit emphasized the importance of the bona fide status of the shareholder. “We are not confronted with a case where a creditor has somehow contracted for the right to prevent a bankruptcy or where the equity interest is just a ruse,” the decision reads. In fact, the court specifically observed that the result might be different if the veto power was held by a creditor with no equity stake or that the creditor took an equity stake as a ruse to guaranty repayment of a debt.

Second, the circuit found that the majority approval requirement does not violate federal law. As the circuit put it: “[T]his case does not involve a contractual waiver of the right to file for bankruptcy. ... Instead, this case involves an amendment to a corporate charter, triggered by substantial equity investment, that effectively grants a preferred shareholder the right to veto” a bankruptcy filing. The court also rejected the argument that for the veto right to be respected, the holder must have a fiduciary duty finding no legal or logical rationale for such a requirement.

Does the Veto Right Violate Delaware Law?

Finding no violation of federal public policy and consistent with the longstanding principle that for entities organized under state law, state law governs their authority to file for bankruptcy, the court turned to examine Delaware law.

First, the court discussed whether the shareholder consent provision in the certificate of incorporation violated the Delaware General Corporation Law. While noting that Delaware corporate law is viewed as the most flexible in nation and that a “provision is not contrary to Delaware law just because it withdraws traditional power from the board,” the court nevertheless refused to resolve the issue since the debtor waived the argument. Yet, although the court assumed that the provision passed muster under Delaware law, it noted that neither the parties, nor the court’s own research identified any Delaware cases on point.

Second, the debtor argued that due to its ability to block a bankruptcy filing, Boketo would be deemed a controlling minority shareholder under Delaware law and the fiduciary duties imposed on it would invalidate its attempt to veto the bankruptcy filing. The circuit found that Boketo did not qualify as a minority controlling shareholder since domination through actual control of the corporation’s conduct is required. The debtor failed to prove that Boketo actually dominated its conduct.

Interestingly, the court held that even assuming that Boketo qualified as a minority controlling shareholder, the proper remedy for a breach of fiduciary duty is not to disregard the corporate charter; state law is the source of remedies for breach of fiduciary duties and bankruptcy courts do not gain jurisdiction over a bankruptcy case whose filing was not properly authorized.

Implications

In light of the certified questions, the court’s opinion is rather anticlimactic. The court’s observations, however, are a lot more interesting. The court’s indication that the result may be different, i.e. federal public policy may be implicated, where the veto power is given to a creditor or to a creditor who is given equity as a ruse, seems to support the doubts we expressed in our earlier note as to the usefulness of the golden share.

Next, by discussing the legality of shifting from the board to the shareholders the power to authorize a bankruptcy filing but not resolving it due to debtor’s waiver and lack of precedent, was the court merely conservative in its judicial approach or was it shining light on an issue of first impression?

Finally, the holding that a breach of fiduciary duty (to the extent that such a duty exists), may not serve as a basis for the bankruptcy court to deny a motion to dismiss based on lack of proper authorization, might significantly enhance the utility of bankruptcy blocking provisions, to the extent that a particular veto power provision survives the federal public policy test. In those circumstances, the putative debtor is not in bankruptcy, the automatic stay does not apply and the creditor who negotiated for the provision is free to exercise remedies.