It has long been the law that creditors are rarely entitled to contractually prohibit a debtor from filing for bankruptcy, whether such restriction is contained in the debt instruments or in the corporate governance documents. In contrast, governance provisions which condition a bankruptcy filing on the vote or consent of certain equity holders that are unaffiliated with any creditor are frequently enforced. Many equity sponsors, for example, wear two hats: they are both shareholders and lenders to their portfolio companies. In that hybrid case, where the shareholder is also a creditor, can the shareholder enforce corporate governance provisions which restrict the ability of the company to file for bankruptcy? A recent decision from the Fifth Circuit Court of Appeals has answered that question in the affirmative - with caveats.
Aggressive lenders have long sought to block or restrict the ability of their borrowers to file for bankruptcy. Under decades-old case law, the general rule as a matter of public policy has been that a waiver of the right to file for bankruptcy is unenforceable. On the other hand, it has also been the rule that equity holders are generally entitled to enforce the requirements of corporate governance documents in determining whether a bankruptcy filing is authorized, unless they contain an outright prohibition of any bankruptcy filing.
The Fifth Circuit Weighs In
In Franchise Services of North America, Inc. v. Macquarie Capital (USA), Inc. (In re Franchise Services of North America, Inc.), 891 F.3d 198 (5th Cir. 2018), the debtor’s corporate governance documents had been amended, in consideration for a loan, to provide that the debtor could not file for bankruptcy without the consent of a minority preferred shareholder, who was also controlled by the lender. Overruling a motion to dismiss the bankruptcy filing, the Fifth Circuit held that state law determines who has the authority to file a voluntary bankruptcy petition on behalf of a corporation, and bankruptcy law does not strip a minority equity holder of its voting rights to prevent a filing merely because it is also a creditor.
The decision came with some caveats. The court stated that there might be a different result if there were evidence that the creditor had caused the shareholder to block a filing solely as a ruse to collect the debt. In addition, the court noted that, if the shareholder had voting or management control of the corporation, it would have a fiduciary duty to consider whether bankruptcy was appropriate, and could be sued for breach of that duty. Even so, the remedy in that suit would be monetary damages, and would not include allowing an otherwise unauthorized bankruptcy filing to continue.
The Franchise Services case is only binding in the 5th Circuit, and contains a number of caveats. Nevertheless, it should give some comfort to hybrid equity holders/creditors that their corporate governance documents mean what they say.