Courts Differ on Enforcement of Contractual Restrictions on Bankruptcy Filing
When a corporate debtor files for bankruptcy protection, its lender often takes a big financial hit due to the time it must expend and expenses it must incur to protect its collateral. Accordingly, if lenders had their way, most would opt to prevent their corporate borrowers from filing for bankruptcy or at least limiting their power to do so.
One way to do this, it would seem, is for a lender to simply include a provision in its lending documents blocking or otherwise restricting the ability of borrowers to file for bankruptcy. However, it’s not that simple. While there are ways that lenders can minimize the likelihood of a borrower's bankruptcy filing, outright prohibitions are generally, as a matter of public policy, unenforceable.
Instead of outright prohibitions in lending documents, sophisticated lenders who seek to minimize bankruptcy risk have sought to sidestep public policy concerns by insisting on provisions that limit a debtor's authority to file for bankruptcy under its governing organizational documents.
Such provisions often include the requirement that a certain independent appointed director’s consent is given or that a majority, supermajority, or all shareholders give consent before an entity is permitted to file. In other instances, a share known as a “golden share” affords an individual shareholder veto power over an entity’s decision to file a bankruptcy petition.
The U.S. Court of Appeals for the Fifth Circuit, in the case of Franchise Servs. of N. Am. v. United States Trs., offered a useful distinction between the terms “blocking provision” and “golden share,” explaining that a blocking provision was a general term for anything that allowed creditors to limit the individual’s ability to enter bankruptcy. Golden shares, on the other hand, were classified as “[a] share that controls more than half of a corporation's voting rights and gives the shareholder veto power over changes to the company's charter.”
Depending on the jurisdiction, and the underlying circumstances, these provisions may or may not be enforceable.
For example, in the case of In re Global Ship Systems, LLC, the holder of a blocking provision was both a shareholder and creditor of the debtor. In granting the creditor’s motion to dismiss the chapter 11 case, the Georgia bankruptcy court held that the creditor wore "two hats" in the case, and "as a Class B shareholder, it [had] the unquestioned right to prevent, by withholding consent, a voluntary bankruptcy case." In its ruling, the court explained that the same right given to an individual that only held status as a creditor/lender would constitute a waiver of the right to file bankruptcy that violates public policy.
However, facing similar circumstances, some courts have reached a different conclusion. In the case of In re Intervention Energy Holdings, LLC, the court distinguished Global ShipSystems because "the method by which the creditor . . . received its equity interests was not subject to question or analysis." The Delaware bankruptcy court, in ruling that the provision blocking bankruptcy was unenforceable, emphasized the need to uphold federal public policy, which "assure[s] access to the right of a person, including a business entity, to seek federal bankruptcy relief as authorized by the Constitution and enacted by Congress."
The court explained that such a provision:
"the sole purpose and effect of which is to place into the hands of a single, minority equity holder [by means of a "golden share"] the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor—not equity holder—and which owes no duty to anyone but itself in connection with an LLC's decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, is void as contrary to federal public policy."
The balancing act between bankruptcy and contract rights illustrated by In re Global Ship Systems and In re Intervention Energy Holdings continues to be the main point of contention in recent cases involving similar scenarios.
Courts that have considered the enforceability of bankruptcy blocking provisions and golden shares have generally conducted fact-intensive inquiries resulting in narrow rulings. It is clear that public policy concerns related to freedom of contract and bankruptcy rights weigh heavily in the courts’ determinations, but that neither interest has clearly outweighed the other across different jurisdictions.
The courts have generally held that if a blocking provision or golden share serves to waive the right to file for bankruptcy entirely the scales will tip towards protections of bankruptcy rights. However, provisions that serve as mere obstacles to filing do not always constitute a waiver and may result in a ruling in favor of the right to contract freely. For lenders and debtors, understanding the case law of the jurisdiction(s) that may be a venue(s) for a bankruptcy filing can inform what blocking provisions, if any, may be upheld by a court.