The Bankruptcy Strategist ® Volume 35, Number 9 • July 2018 Fifth Circuit Affirms Shareholder Veto of Chapter 11 Petition By Michael L. Cook law …”); Klingman v. Levinson, 831 The debtor later encountered F.2d 1292, 1296 n.3 (7th Cir. 1981) financial difficulties and filed a ederal law does not pre- (dicta, same); Fallick v. Kehr, 369 Chapter 11 petition in June, 2017, “ vent a bona fide share- F.2d 899, 904 (2d Cir. 1966) (dicta, without obtaining the consent of Fholder from exercising same). But this case, on its facts, its shareholders, including B, for its right to vote against a bank- does not fall into that category. it feared “that its shareholders ruptcy petition just because it is Facts might nix the filing.” Id., at 1. In also an unsecured creditor,” held The debtor hired an investment response to a motion by M and the U.S. Court of Appeals for the bank (M) to help it acquire a sub- B to dismiss the bankruptcy peti- Fifth Circuit on May 22, 2018. In re sidiary. 2018 WL at 2. M’s subsid- tion on the ground that the debt- Franchise Services of North Amer- iary, “B,” also invested $15 mil- or had failed to seek shareholder ica, Inc., 2018 WL 2325909, 1 (5th lion with the debtor in exchange authorization, the debtor argued Cir. May 22, 2018). According to for 100% of the debtor’s preferred that the “shareholder consent the court, applicable Delaware stock. B’s stake would amount to a provision was an invalid restric- law would not “nullify the share- 49.76% equity interest, if convert- tion” on its right to file a bank- holder’s right to vote against the ed, making it the debtor’s single ruptcy petition and also violated bankruptcy petition.” Id. largest investor. As a condition of Delaware law. Relevance B’s investment, the debtor reincor- The Bankruptcy Court porated in Delaware and adopted Appellate courts have regularly a new certificate of incorporation The bankruptcy court rejected rejected creditors’ attempts to con- essentially providing that a major- the debtor’s argument, finding tract away the debtor’s right to seek ity of each class of the debtor’s that no federal bankruptcy poli- bankruptcy relief. In re Thorpe In- stock had to consent to the filing cy barred a shareholder’s condi- sulation Co., 677 F.3d 869, 1026 of a bankruptcy petition. Also, the tioning a bankruptcy filing on its (9th Cir. 2012) (“… prohibition of debtor agreed to pay M, B’s par- consent. It declined to “deem the prepetition waiver has to be the ent, roughly $3 million in fees shareholder consent provision for its services, but those fees re- contrary to Delaware law, leav- Michael L. Cook is of counsel, at Schul- mained unpaid and were the sub- ing that for Delaware courts to te Roth & Zabel LLP in New York and a member of this newsletter’s Board of ject of litigation between the par- decide in the first instance.” Id. Editors. ties in other courts. at 2. LJN’s The Bankruptcy Strategist July 2018

Direct Appeal to Fifth Circuit The court stressed that “this case was merely a ruse to insure that [does not involve] a ‘blocking pro- [the debtor] would pay [M’s] bill.” The bankruptcy court certified vision’ or a ‘golden share,’ [for the] Id., at 6. B acquired a substantial a direct appeal of its order to the facts do not fit neatly into either equity position in the debtor for Fifth Circuit. The Fifth Circuit ad- definition.” Id. B simply made a $15 million one year before M dressed the following three cer- $15million equity investment and even sent a bill to the debtor for tified questions: 1) Is a “golden received in return convertible pre- its services. M hardly made a $15 share” provision giving a party the ferred stock that carried with it the million equity investment “just to ability to prevent a bankruptcy fil- right to vote on certain corporate hedge against the possibility that ing enforceable under federal law matters. Id. The Fifth Circuit thus [the debtor] might not pay a $3 mil- or public policy? 2) When a party is avoided rendering an advisory lion bill.” Id. In short, “[t]here is no both a creditor and a shareholder opinion on the general enforce- prohibition in federal bankruptcy with a blocking provision or gold- ability of blocking provisions and law against granting a preferred en share, does that violate federal golden shares. It limited its analy- shareholder the right to prevent public policy? and 3) Is a certificate sis “to whether U.S. and Delaware a voluntary bankruptcy filing just of incorporation with a blocking law permit the parties to do what because the shareholder also hap- provision or golden share valid un- they did here: amend a corporate pens to be an unsecured creditor der Delaware law, and if so, does charter to allow a non-fiduciary by virtue of an unpaid consulting Delaware law impose on the hold- shareholder fully controlled by an bill.” Id. er of the provision a fiduciary duty unsecured creditor [i.e., M] to pre- No Imposition of to exercise it in the best interest of vent a voluntary bankruptcy peti- the corporation? Id., at 3. tion.” Id., at 4. Fiduciary Duty on B The court rejected the debtor’s No Blocking Provision State Law Governs argument that would impose a Or Golden Share Corporate Authority fiduciary duty on a shareholder The Fifth Circuit defined a block- The parties agreed that a debtor with a bankruptcy veto right. Ac- ing provision “as a catch-all to refer “cannot contract away the protec- cording to the court, “[n]o statue to various contractual provisions tions of bankruptcy.” Id. at 5. Ac- or binding case law licenses this through which a creditor reserves cording to the Fifth Circuit, though, court to … deprive a bona fide a right to prevent a debtor from “this case does not involve a con- shareholder of its voting rights, filing for bankruptcy.” Id. A golden tractual waiver of the right to file and reallocate corporate authority share “controls more than half of for bankruptcy or to a discharge.” to file for bankruptcy just because a corporation’s voting rights and Id. “Instead, this case involves an the shareholder also happens to gives the shareholder veto power amendment to a corporate char- be an unsecured creditor …. As over changes to the company’s ter, triggered by a substantial eq- a matter of federal law, fiduciary charter.” Id. In the bankruptcy uity investment, that effectively duties are not required to allow context, “the term generally refers grants a preferred shareholder the a bona fide shareholder to exer- to the issuance to a creditor of a right to veto the decision to file for cise its right to prevent a voluntary trivial number of shares that gives bankruptcy.” Id. bankruptcy petition.” Id. In this the creditor the right to prevent a Even assuming that B and M case, no creditor without a “stake voluntary bankruptcy petition, po- were a single entity, there was “no in the company held the right” to tentially among other rights.” Id. evidence that their arrangement veto the bankruptcy petition. Id., LJN’s The Bankruptcy Strategist July 2018 at 7. Also, no “creditor took an eq- B’s “influence was so pervasive (held, debtor may orchestrate in- uity stake simply as a ruse to guar- that it would qualify as a control- voluntary bankruptcy petition to antee a debt.” Id. ling shareholder under Delaware avoid bylaw provisions requiring law.” Id. at 9. Indeed, the debtor’s unanimous vote of directors to file Consent to Seek “apparent ability and willingness voluntary bankruptcy petition and Bankruptcy Relief to act without [B’s] consent under- appointment of independent non- The court assumed, without de- cuts the case for control.” Id. at 10. insider director; debtor’s principal ciding, that Delaware law would solicited and funded “friendly” State Law Governs Any permit a certificate of incorpora- creditors (two trade creditors and Breach of Fiduciary tion to condition a corporate debt- five professionals) to prosecute Duty Claim or’s right to seek bankruptcy relief involuntary petition; petitioning upon shareholder consent. Id., at The debtor’s asserted breach of creditors had “no interest” in the 8. In fact, the debtor waived any fiduciary claim should have been bankruptcy case). See, Note, “As- contrary argument. Id. brought “under state law,” held the set Securitization: How Remote Is court. Id. The claim did not belong Bankruptcy Remote?,” 26 Hofstra B Was Not Subject to in the context of a response to “an L. Rev. 929, 939, 944 (1998) (Kings- Any Fiduciary Obligation otherwise meritorious motion to ton Square court failed to “consid- er how ill-suited the case may be The Fifth Circuit also rejected the dismiss the bankruptcy petition.” Id. for [bankruptcy] adjudication … debtor’s argument that B’s “con- Comment and reached what many will argue trolling minority shareholder” sta- is an erroneous decision, a model tus entailed fiduciary obligations Franchise Services is eminently of form over substance …. These that would invalidate B’s vetoing correct. It properly avoided general orchestrated petitions were ‘ripe’ legal maxims (e.g., “pre-bankruptcy for dismissal.”); NY City Bar, “New bankruptcy waivers are void as a The court rejected the debt- Developments in Structured Fi- matter of public policy.”). Instead, nance” 56 Bus. Law. 95, 162 (2000) or’s argument that would the Fifth Circuit focused on the (Kingston Square raises “questions impose a fiduciary duty on facts to reach a sensible, practical concerning the viability of corpo- result. See also, DB Capital Hold- a shareholder with a bank- rate governance mechanisms in ings LLC, 2010 Bankr. LEXIS 4176 bankruptcy remote vehicles.”). ruptcy veto right. (B.A. P. 10th Cir. 2010) (bankruptcy prohibition in operating agreement —❖— the bankruptcy petition here. Id. not void; no creditor coercion; “[A Delaware] shareholder owes a state law and operating agreement fiduciary duty only if it owns a ma- governed). jority interest in or exercises con- The Fifth Circuit also under- trol over the business affairs of the mined the infamous Kingston corporation.” Id., quoting Ivanhoe Square Associates decision hand- Partners v. Newmont Min. Corp., ed down by a New York bank- 535 A.2d 1334, 1344 (Del. 1987). ruptcy court in 1997, which this

Not only did B lack majority con- author succeeded in losing. In re Reprinted with permission from the July 2018 edition of the Law Journal Newsletters. © 2018 ALM Media Properties, trol here, reasoned the court, but Kingston Square Associates, 214 LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877.257.3382 or reprints@ the debtor offered no evidence that B.R. 713 (Bankr. S.D.N.Y. 1997) alm.com. # 081-07-18-02