For decades, financial engineers have been searching for a perfect solution to a vexing problem: Designing a bulletproof bankruptcy control mechanism.
For example, bankruptcy remote entities, or special purpose entities (SPVs), the legal entities at the heart of securitization structures, serve this purpose as long as the SPV provides sufficient certainty that it would not file for bankruptcy, and if it did (voluntarily or otherwise), that it would not be substantively consolidated with its parent entity and its affiliates.
The strength of the legal isolation of the SPV from its affiliates is one of the pillars of the rating system which assigns higher ratings to securities issued by SPVs than the rating that would have been assigned to the securities had they been issued by a non-SPV issuer.
As has been repeatedly noted, however, bankruptcy remote is not bankruptcy proof as a small percentage of SPVs have ended up in bankruptcy over the last few decades.
Market standard for bankruptcy isolation
The bankruptcy proofing of SPVs is a road well-traveled. The standard features include: (i) the SPV’s organizational document limits the permitted purposes of the SPV to activities related to the transaction, (ii) the SPV’s governance requires that major decisions, which include filing for bankruptcy and related actions, be made unanimously, and thus require the consent of an independent member, director or manager, (iii) the independent person owes his or her fiduciary duties to the SPV as a whole, (iv) the SPV’s must operate in compliance with strict requirements designed to ensure its separateness from its affiliates, and (v) holders of the SPV’s securities are subject to a no-petition clause essentially agreeing not to file an involuntary petition against the SPV.
This standard has performed admirably well as very few SPVs ended up in bankruptcy. For the SPVs which did end up in bankruptcy, some cases were dismissed due to an unauthorized filing (because the filing resolution was not approved by the independent person as required by the organizational documents). In addition, fewer yet were subjected to non-consensual substantive consolidation.
Yet, the standard structure is not bullet proof so the search for a better one is never ending. One approach that continues to rear its ugly/golden head is the golden share.
The golden share refers to an organizational structure that requires certain equity holder(s) to consent to a bankruptcy filing and related actions. The shares, rights or other equity instrument held by such holders is referred to as a golden share. Many doubt the enforceability of the golden share and therefore, it’s utility. To begin with, directors and managers generally owe some form of fiduciary duties to the entity (even in cases of limited liability companies where fiduciary duties are disclaimed) and thus are expected to act for the benefit of the entity. Equity holders, on the other hand, are expected to act in their own self-interest.
Furthermore, without substantial equity investment in exchange for the golden share(s), the mechanism looks and smells like one that hands out a bankruptcy veto power to its holder, who in truth is really a creditor pursuing its own self-interested agenda.
Not surprisingly, courts have often refused to enforce bankruptcy veto powers granted to creditors. See e.g., Bay Club Partners-472 LLC, 2014 WL 1796688 (Bankr. D. Or. May 6, 2014) (requiring creditor’s approval for a bankruptcy filing); Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016) (borrower’s operating agreement was amended to add the creditor as a special member whose consent was required for a bankruptcy filing); Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016) (creditor received one share and the operating agreement required unanimous members’ consent to a bankruptcy filing); Tara Retail Group, LLC, 2017 WL 1788428 (Bankr. N.D. W. Va. May 4. 2017) (not ruling on the validity of the independent director provision; finding that the independent’s lack of action constituted consent to the filing); Lexington Hospitality Group, LLC, 577 B.R. 676 (Bankr. E.D. Ky. 2017) (creditor was granted equity in an amount that prevented the entity’s ability to file without the creditor’s consent).
A few cases, however, have respected the golden share requirement where the veto power was granted to a true equity holder. In Global Ship Systems, LLC, 391 B.R. 193 (Bankr. S.D. Ga. 2007), the court enforced a bankruptcy blocking provision included in the operating agreement where the equity holder was also a creditor. In Squire Court L.P., 574 B.R. 701 (Bankr. Ed. Ark. 2017), the partnership agreement required consent of all partners to a bankruptcy filing. When the general partner requested the limited partners to consent, they refused. The court dismissed the petition filed by the general partner as being unauthorized under the partnership agreement.
Most recently, in Franchise Servs. of North Am., Inc., Case No. 1702316EE (Bankr. S.D. Miss. Dec. 18, 2017), the court enforced a bankruptcy blocking provision granted to an investor who paid $15 million for a 49.76% of the debtor’s Series A preferred stock, becoming its largest shareholder.
The debtor’s certificate of incorporation required the consent of the majority of both the series A holders and the common shareholders to a bankruptcy filing. It was undisputed that such consent was not obtained. The bankruptcy court dismissed the case, holding that the provision requiring consent to a bankruptcy filing is valid and enforceable since it required the consent of equity holders, not creditors. As such, the provision did not grant creditors a veto power on the debtor’s ability to file for bankruptcy.
Is the golden share truly useful?
The short answer is probably not; at least not yet. First, the distinction between veto powers given to a creditor vs. an equity holder is unsatisfactory as it can be easily manipulated by financial engineering. For example, how much equity does a dual hat creditor/shareholder have to hold for the provision to be enforceable?
Second, does the context matter – does it and should it make a difference whether the blocking provision is included in an SPV’s organizational document or in the organizational document of a “normal,” i.e. non-SPV entity, which was not deliberately structured to be bankruptcy remote? And if it does matter, what is the legal basis for treating these two entities differently?
Finally, the vast majority of entities that file for bankruptcy are insolvent. As a result, equity is not entitled to any distribution until all creditors are paid in full. It would appear, therefore, that enforcing equity’s veto power on bankruptcy filing could provide equity with inordinate leverage-it can block a reorganization (including a going concern sale in bankruptcy) although it is an out-of-the-money constituency. Is that consistent with federal bankruptcy policy?
The Court of Appeals for the Fifth Circuit accepted the bankruptcy court’s certification of its decision in Franchise Servs. of North Am for a direct appeal. We hope that as the case law further develops, courts will address these important questions.