February 2019: Bankruptcy Litigation Update

Quinn Emanuel Urquhart & Sullivan, LLP

Quinn Emanuel Urquhart & Sullivan, LLP

Can Equity Investors or Creditors Prevent a Debtor from Filing for Bankruptcy – Two Recent Circuit Level Decisions Shed Some Light. Federal bankruptcy law generally governs who is eligible to file for bankruptcy. See 11 U.S.C. § 109. Assuming a debtor is eligible, any purported waiver of the right to file is generally unenforceable as a matter of federal bankruptcy policy. See, e.g., Bank of China v. Huang (In re Huang), 275 F.3d 1173, 1177 (9th Cir. 2002). But while this rule is straight-forward for individuals, it raises complicated questions for corporations and other business entities. This is because of another, well-established principle of federal bankruptcy law—while federal law governs whether a company is eligible to file for bankruptcy, state law governs who has the authority to file a voluntary bankruptcy petition on behalf of the company. Price v. Gurney, 324 U.S. 100, 106-07 (1945).

Creditors have attempted to use state-law rules of corporate governance to effectively render their borrowers ineligible for bankruptcy. This has included requiring a borrower to include in its operating agreement or charter (i) an outright prohibition on filing for bankruptcy, or (ii) approval mechanisms that require the creditor’s (or someone loyal to it) consent to a filing through its vote as a member, shareholder, or director. Although a few courts have upheld these structures, see, e.g., DB Capital Holders, LLC v. In re DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), 2010 WL 4925811 (10th Cir. BAP 2010), more often than not they have not been enforced if implemented at the behest of a 

creditor. See, e.g., In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016), In re Bay Club Partners–472, LLC, 2014 WL 1796688 (Bankr. D. Or. 2014).

A recent Circuit court case sheds some further light on the circumstances in which a creditor or investor can restrict a debtor’s right to file for bankruptcy protection through provisions in the debtor’s organic corporate documents. See In re Franchise Services of North America, Inc., 891 F.3d 198 (5th Cir. 2018) (“FSNA”). A second case illustrates an alternative path that may be available in some cases—seeking the appointment of a receiver who can wrest authority to file away from the debtor’s existing board or management. See In re Sino Clean Energy, Inc., 901 F.3d 1139 (9th Cir. 2018) (“Sino Clean Energy”).

In re Franchise Services of North America, Inc., 891 F.3d 198 (5th Cir. 2018). In FSNA, the Fifth Circuit held that a shareholder could exercise its approval rights to prevent a corporation from filing for bankruptcy, even though that shareholder was controlled by a creditor of the company. The debtor in that case (“Franchise”) was a rental car company that had sought to expand its business by buying Advantage Rent a Car. Franchise retained an investment bank (“Macquarie”), which in turn created a subsidiary (“Boketo”) to invest $15 million in Franchise in exchange for 100% of Franchise’s preferred stock. As a condition of Boketo’s investment, Franchise reincorporated in Delaware, and adopted a new certificate of incorporation that provided that it could not file for bankruptcy unless it had approval of the holders of a majority of the preferred shares (i.e. Boketo).

Franchise’s acquisition of Advantage was ill-fated. Advantage filed for chapter 11 bankruptcy within a year, and Franchise followed a couple of years later. Franchise did not, however, obtain Boketo’s approval of its chapter 11 filing—notwithstanding the requirement in its certificate of incorporation. At the time, Macquarie was an unsecured creditor of Franchise that was allegedly owed $3 million in unpaid transaction fees.

Boketo and Macquarie moved to dismiss Franchise’s chapter 11 case on the ground that the bankruptcy petition was filed without corporate authority. In response, Franchise argued, among other things, that (i) the blocking provision was an invalid bankruptcy restriction contrary to federal bankruptcy policy, (ii) the blocking provision was unenforceable under Delaware law, and (iii) Boketo’s fiduciary obligations 

as a controlling minority shareholder prevented it from blocking Franchise from filing for bankruptcy.

The Fifth Circuit held that “[f]ederal law does not prevent a bona fide shareholder from exercising its right to vote against a bankruptcy petition just because it is also an unsecured creditor.” FSNA, 891 F.3d at 203. That is true even if the shareholder does not owe any fiduciary duties to the debtor. Id. at 209. Although federal law authorizes corporations to file for bankruptcy, it does not specify who has the authority to decide whether the corporation should file: “the issue of corporate authority to file a bankruptcy petition is left to state law.” Id.

The court rejected Franchise’s arguments that (1) Macquarie used Boketo to make a $15 million equity investment so that Macquarie could hedge on its ability collect on its $3 million invoice, and (2) Boketo was trying to force Franchise to draw on a $7.5 million line of credit. Id. at 209 & n.8. The court, however, was careful to note that it was only considering the case before it, i.e., one in which the equity investment made by the shareholder at issue was $15 million and the debt just $3 million. The court suggested that the result may be a different in a case where “a creditor with no stake in the company held the right” to block a bankruptcy, or where “there was evidence that a creditor took an equity stake simply as a ruse to guarantee a debt.” Id. at 203 n.1, 209. The court did not decide whether, as a general matter, a provision in a corporate charter granting a creditor a blocking right is enforceable, but cited several cases that have held such provisions to be unenforceable. Id.at 207.

Turning to the applicable state law (that of Delaware), the Fifth Circuit declined to resolve whether the shareholder consent provision in Franchise’s articles of incorporation violated Delaware law, because Franchise waived any such argument on appeal. The court did note, however, that “the parties have not identified, and we have not discovered, any on-point Delaware cases.” 891 F.3d at 198.

Lastly, the Fifth Circuit held that Boketo did not owe any fiduciary duties, including a duty to consent to the bankruptcy filing. Boketo was a minority shareholder (its preferred stock was convertible to 49.67% of the total equity), and under Delaware law, minority shareholders only owe fiduciary duties if they are “controlling.” Franchise argued that Boketo’s right to veto the bankruptcy rendered Boketo a controlling shareholder. The court disagreed, applying the “actual control” test under Delaware law. The court reasoned that Boketo held only two of the five board seats, and 

the “very fact that Boketo had to resort to filing a motion to dismiss the bankruptcy petition . . . only emphasizes its inability to control [Franchise].” Id. at 213. Because Boketo did not exercise actual control, it did not owe fiduciary duties that might have been violated in not allowing Boketo to file its voluntary petition. The Fifth Circuit noted however, that if Boketo were a controlling shareholder, the proper remedy for breach of fiduciary would be bringing a breach of fiduciary duty claim against Boketo; the remedy would not be to allow Franchise to violate its charter by declaring bankruptcy with the requisite shareholder consent.

The Fifth Circuit’s ruling in FSNA shows that federal bankruptcy law does not prevent a bona fide equity holder from exercising its voting rights to prevent the corporation from filing a voluntary bankruptcy petition, just because it is also a creditor. But there could be a different result if the equity holder’s principal interest was that of a creditor, or if there was evidence that the creditor took an equity stake simply to facilitate repayment of its debt.

In re Sino Clean Energy, Inc., 901 F.3d 1139 (9th Cir. 2018). In Sino Clean Energy, the Ninth Circuit outlined another way that creditors or investors may be able to prevent a corporation from filing for bankruptcy: through the appointment of a receiver. The Ninth Circuit held that a company’s board of directors lacked authority to file a bankruptcy petition for the company after the directors had been removed by a state-court appointed receiver for nonfeasance and gross mismanagement.

The debtor had been under control in major part by its former chairman and CEO. Starting in 2011, the debtor became the subject of legal controversy. The Securities and Exchange Commission deregistered the debtor after it abruptly stopped filing required forms and financial information, and trading in the debtor’s stock was suspended. A group of forty-three shareholders then filed a Nevada state-court petition in an attempt to acquire financial information from the debtor. After more than a year of the debtor’s disregard of the Nevada state-court action, the plaintiffs filed for entry of default, which the state court granted. A few months later, the shareholder plaintiffs moved for the appointment of a receiver. Finding that the debtor’s board of directors failed to properly manage the debtor’s affairs, the state court appointed a receiver and granted him the power to reconstitute the board of directors, which he did by replacing all of the directors.

The former chairman and CEO then purported to “reconstitute” the former board of directors, and thereafter purported to file a voluntary petition for chapter 11 bankruptcy on behalf of the debtor. The bankruptcy court dismissed the chapter 11 case, holding that at the time the petition was filed by the former board members, the petition was filed without corporate authority because the board of directors had been replaced by the receiver. The district court and Ninth Circuit both affirmed.

The Ninth Circuit held that “[s]tate law determines who has authority to file a voluntary bankruptcy petition on behalf of a debtor.” 901 F.3d at 1141. The relevant Nevada statute provides that “[u]nless the articles of incorporation or the bylaws provide for a greater or lesser proportion, a majority of the board of directors of the corporation then in office … is necessary to constitute a quorum for the transaction of business, and the act of directors holding a majority of the voting power of the directors … is the act of the board of directors.” Id. (quoting Nev. Rev. Stat. § 78.315). Applying Nevada law, the Ninth Circuit found that the individuals who filed the bankruptcy petition were not members of the board of directors of the corporation at the time of filing, and thus they were not authorized to file a bankruptcy petition on behalf of the debtor. The corporation was able to file for bankruptcy through valid filings made by its current eligible board of directors. The Ninth Circuit suggested, however, that the result might be different if a state court purported to enjoin a bankruptcy filing entirely. Id. at 1142.

The utility of seeking a receiver to prevent bankruptcy may be limited, because in most cases the debtor’s existing management would be able to act before they are divested of authority. But as Sino Clean Energy demonstrates, that is not always the case. And Sino Clean Energy further underscores the importance of state law in determining who decides whether a corporation files for bankruptcy.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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