In February, we sent a client alert concerning “golden shares” and informed you that the United States Fifth Circuit Court of Appeals had accepted an extraordinary appeal of the question whether a “golden share” provision in articles of incorporation in favor of an entity that is both a creditor and an equity investor is valid to prevent a bankruptcy filing, or is void under federal public policy.
The Fifth Circuit recently issued its opinion, deciding on narrow grounds that federal law does not prevent a bona fide shareholder from exercising its right to vote against a bankruptcy petition just because it’s also a creditor. The court expressly declined to answer the broader question whether a golden share held by a creditor generally is unenforceable to prevent a bankruptcy filing as a violation of federal public policy. See Franchise Servs. of North America, Inc. v. U.S. Trustee (In re Franchise Servs. of North America, Inc.), _____ F.3d ________, No. 18-60093, 2018 WL 2325909 (5th Cir. May 22, 2018).1
A “golden share” or “blocking provision” in an entity’s organizational documents (e.g, articles of incorporation or operating agreement) is typically negotiated by a creditor during workouts. In exchange for forbearance from collecting a debt, the creditor is granted a de minimis equity stake in the company or the right to appoint a manager or director. In addition, the organizational documents are amended to require unanimous consent of equity holders or unanimous manager/board approval of a bankruptcy filing. Many bankruptcy courts invalidate these arrangements and allow a bankruptcy filing even without approval from the creditor holding the golden share or blocking right, reasoning that they violate a longstanding federal public policy preventing a party from waiving the right to file for bankruptcy.
In Franchise Services, the Fifth Circuit concluded that the shareholder was a “bona fide” shareholder that invested $15 million in the company in exchange for a significant equity stake. The shareholder’s parent was a creditor with a disputed claim in the amount of $3 million. Under these facts, the Fifth Circuit held that “there is no compelling federal law rationale for depriving a bona fide equity holder of its voting rights [to prevent a voluntary bankruptcy filing] just because it is also a creditor of the corporation.” Therefore, the Fifth Circuit affirmed the dismissal of the bankruptcy petition because it was not authorized under applicable state law. The Fifth Circuit also analyzed when minority shareholders owe fiduciary duties to the company and the appropriate remedies if such a duty were breached by refusing to authorize a bankruptcy filing, finding no such duties and no breach in the case.
The lesson from Franchise Services is that facts matter. The circumstances under which a creditor can acquire an equity stake in a company and block a bankruptcy filing are nuanced and also carry the risk of possible state law claims for breach of fiduciary duty. But if this case—which represents the highest federal court to have considered the question—is followed by other courts, it provides a mechanism for bona fide equity holders to prevent a potential loss of both their equity and debt investments through a bankruptcy filing.
