Given the potential of an insolvency filing to shift power away from creditors and to distressed debtors, debt investors have long sought ways to prevent companies from filing for bankruptcy. The U.S. courts have been quite resistant to the various techniques bondholders and other lenders have engaged to achieve this goal, but the latest word from the Fifth Circuit holds out some hope and reconfirms that, in insolvency law as in real estate, location is (almost) everything.
The direct approach of simply obtaining from a debt-issuing company a contractual prohibition on, or waiver of the right, to file for insolvency is a no-go. It is a long-established proposition in the U.S. that debtors cannot effectively give up the right to file for bankruptcy. Insolvency proceedings are designed to save jobs, maximize returns for all creditors, and preserve communities, among other benefits. U.S. bankruptcy policy prohibits one large debt investor (or group) from undermining these potential benefits for the many other constituencies involved.
Indirect inhibitions on bankruptcy filing have been slightly more successful. Savvy debt investors have leveraged corporate governance rules to engineer bankruptcy-remoteness without technically prohibiting debtor-companies from filing for insolvency. A business entity cannot take the extraordinary step of seeking insolvency relief without explicit authorization from a corporate governance power center, either the board of directors or the shareholders. The closer a series of restrictions approaches to conclusively preventing an insolvency filing, however (such as by requiring creditor consent), the more likely a court will regard even less-than-absolute prohibitions as similarly unenforceable.
A highly controversial approach to achieving the functional equivalent of creditor consent has been to require, in the entity’s organizational documents, unanimous board approval to authorize any company insolvency filing. The crucial next step is to grant a debt investor the power to appoint one member of the board. This “blocking director” thus has the all-but-uninhibited power to prevent an insolvency filing that would disfavor the director’s benefactor-creditor(s).
The blocking director’s fiduciary duty of loyalty poses a substantial risk, however, if disgruntled shareholders are able to mount a challenge to either the exercise or the result of that blocking vote. A court might simply disregard the unanimous authorization provision as per se inducing a violation of the blocking director’s fiduciary duty of loyalty to the corporation and all of its shareholders. Worse yet, a damages claim against the director, and perhaps the debt investor(s) on whose behalf that director prevented an insolvency filing, might well vitiate any benefit of having prevented a loss by blocking an insolvency filing.
Moving to another level of the corporate governance hierarchy minimizes these dangers. Unlike directors, equity investors do not as a general matter owe fiduciary duties to the entity and their fellow shareholders/members. Delaware jurisprudence has introduced a confusing twist by imposing fiduciary duties on controlling corporate shareholders, but an insolvency-blocking position might nonetheless be established by a non-controlling shareholder whose vote just happens to be essential to authorizing the company to seek insolvency relief. Such a shareholder is said to hold a “golden share.” Pushing the envelope, such an equity investor might hold only a few shares or a minimal membership interest, largely or entirely as an adjunct to its principal relationship to the company as debt investor-creditor.
The effective power of such a golden share/membership to prevent an insolvency filing seems to depend upon which regional court one asks. The Delaware Bankruptcy Court has come down (as one would expect) solidly against such tactics, preventing the golden shareholder (or LLC member) from exercising blocking power, at least in the context where the blocking equity position seems to have been obtained to advance the interests of a company creditor.
Things might be different in the Fifth Circuit, whose territory covers a swath of the Deep South stretching from Texas across its headquarters in Louisiana to Mississippi. In the case of a Mississippi car-rental company called Franchise Services, the Fifth Circuit in mid-2018 was presented with a classic blocking position by golden shares held by (essentially) a creditor of the company. Franchise Services’ charter required the approval of a majority of the company’s common and preferred shares to authorize, among other things, any insolvency filing. All of the company’s preferred shares, however, were held by one investor, a subsidiary of an investment bank who had advised the company in connection with a major acquisition and whom the company owed a substantial advisory fee. The preferred shares had been issued in connection with the very acquisition deal on which the investment bank-parent had advised – and the fee for which remained unpaid. The acquisition deal turned out poorly for Franchise Services, who filed for Chapter 11 reorganization in Mississippi without obtaining shareholder approval.
The preferred shareholder (and creditor subsidiary) asked the court to dismiss the bankruptcy petition as having been filed without authority, as the filing lacked the required shareholder authorization. Franchise Services countered that the shareholder consent provision was effectively a blocking position that gave the sole preferred shareholder a veto over any insolvency filing, and given that preferred shareholder’s status as subsidiary of one of the company’s major creditors, the blocking position constituted an improper interference with the company’s right to seek insolvency relief.
The bankruptcy court rejected this argument and dismissed the petition, and the Court of Appeals for the Fifth Circuit affirmed. It characterized the question presented as whether a non-fiduciary shareholder, fully controlled by a creditor, could be allowed effectively to prevent the company’s bankruptcy filing. It answered this question in the affirmative. Even though the preferred shareholder had no fiduciary duty to exercise its effective veto power in the interests of anyone but itself (and its parent-creditor), the Fifth Circuit rejected the notion that federal bankruptcy policy prohibited this, more or less squarely opposing the position of the Delaware Bankruptcy Court. If the blocking position were “just a ruse” to protect the creditor’s much larger debt position, perhaps if the equity stake were de minimis, the court might have been swayed, but lacking such indicia of sharp dealing, it left in place the preferred shareholder’s power to block an insolvency filing.
Contrasting the positions of the Deep South Fifth Circuit with the Mid-Atlantic Delaware Bankruptcy Court, it seems clear that bankruptcy policy depends crucially on the same three factors as real estate value: location, location, and location.