Part V. Recovering Assets and Reranking Claims A. Attacking shareholders (including Parent/Holding Cos) B. Attacking other creditors C. Attacking managers A. Attacking shareholders (including parent and holding companies) 1. Substantive consolidation 2. Illegal dividends 3. Veil piercing 4. Fraudulent conveyances 5. Equitable subordination Substantive consolidation • The assets and liabilities of 2 related firms are merged (all creditors share in all of the assets) • Used when the financial relationships between the firms themselves and between the firms and creditors are tangled and confused. Saves administrative costs. Can be used to bring parent’s assets into sub bankruptcy proceeding. • Judicial doctrine (not statutory) Illegal Dividends Dividend Statutes • Statutes differ from state to state • Prohibit dividends under balance sheet tests or equitable insolvency tests • Balance sheet tests: E.g, cannot issue dividend when assets < liabilities • Equitable tests: E.g, cannot issue dividend if can’t pay debts as come due • Remedy: Dividend can be recovered, managers sued. Veil piercing 1. 1 or more creditors can attempt to recover value from shareholder. 2. Requirements (a) Failure to follow corporate formalities; and (b) Unfair not to pierce veil (e.g, owner has deceived creditors) 3. Judicial doctrine; rarely used Fraudulent Conveyances Transfers of value (incurring of obligation) may be voided if either (1) actual fraud – intent to hinder, delay, defraud creditors, or (2) “constructive fraud” (A) transfer for inadequate consideration; and (B) debtor is insolvent (equitable, balance sheet) --- A fraudulent conveyance reduces the net worth of the debtor and therefore hurts creditors as a group. --- Preferential payment to favored creditor is not an FC. Fraudulent Conveyances:Actual Fraud Can void transfer if there is actual intent to defraud, delay, hinder creditors.548(a)(1) Solvency is irrelevant. . Fraudulent Conveyances: Constructive Fraud Void transfer if: (1) transfer without reasonably equivalent value and (2) debtor was insolvent: » (A) was balance sheet insolvent or became that way 548(a)(2)(B)(ii)(I) » (B) unreasonably small capital (B)(ii)(II) » (C) intended to incur too much debt 548(a)(2)(ii)(III) Intent not relevant Fraudulent Conveyances: Remedies (subject to 548(c)) (1) Annul obligation (2) Recover value Section (550) (a) May recover value from (1) initial transferee, or beneficiary (2) subsequent transferees (b) May not recover under (a)(2) from (1) transferee takes for value, good faith, w/out knowledge (2) or any subsequent transferee Notes on Washington Plate Glass Equitable Subordination of Stockholder’s Claim A and B own Corporation C. A sells his stock to Corporation C in exchange for note secured by C’s assets. No fraudulent intent or anticipation of bankruptcy. Three years later, C becomes insolvent. Court: “Equitable subordination of A’s claim because unfair to unsecured creditors. Assets should be available first to creditors, and only then to shareholders. To retire stock corporation must have sufficient capital without prejudice to creditors.” Washington Plate Glass Bottom line:: courts do not require inequitable conduct to subordinate claim of equityholders, but usually do require such conduct to subordinate claim of creditors. Questions: What is the trendy name for this transaction? Was this a fraudulent conveyance? Could the trustee have recovered under 548? (See 548(a)(1)) V.B. Attacking Creditors • 1. Preferences (Read Section 547) • 2. Equitable subordination • 3. Fraudulent Conveyances (Reread Section 548) • 4. Lender liability Basic Elements of Preference Under 547 1. Debtor makes payment (transfers value) to/for benefit of creditor 2. Within 90 days of filing 3. On antecedent debt 4. When debtor is insolvent (presumption of insolvency within 90 days) 5. Gives recipient more than would otherwise get in Chapter 7 Exceptions to 547 Preference 547(c) Trustee cannot avoid a transfer... (1) Contemporaneous exchange A. Intended to be a contemporaneous exchange for new value B. Was in fact a substantially contemporaneous exchange (2) Ordinary Course Repayments in payment of ordinary course debt; made in ordinary course of business between debtor and transferee; and made according to ordinary business terms (there are others) Example 1 Client is fully secured. Loan is in default. After numerous collection calls, debtor repays client in full. One week later, debtor fails. Preference Basics: Example 2 -Client is unsecured and worried about getting paid. Asks for payment. -Debtor says that it has no cash, but “here is a security interest to make you happy.” -Next day the debtor files. -There is not enough value to pay off all of the unsecured creditors. Preference? Preference Basics: Example 3 1. Client has no security interest, has not lent yet. 2. Today, extends loan to debtor and takes security interest in property of debtor. 3. Tomorrow, the debtor files for bankruptcy. 4. Is the taking of a security interest a preference? Preference Basics: Example 4 The case of the innocent recipient • Feb 1st: Client ships good to debtor, payable in one month • March 1st: No payment has arrived. (Prior shipments paid on time, which is industry practice) • March 5th: Client’s bookkeeper nags debtor for payment. • March 10th: Nags again. • March 15: Debtor writes a check to pay for half of the goods. • March 20th: Check clears. • March 25th. Debtor files for bankruptcy. Preference? Preferences for insiders Why a longer recovery period for insiders The trustee may avoid any transfer of an interest of the debtor in property (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor (3) made while the debtor was insolvent [rebuttable presumption of insolvency if within 90 days of filing] (4) made (A) on or within 90 days before the .... filing of the petition; or (B) between 90 days and one year before the filing, if such creditor was an insider; and (5) that enables such creditor to receive more than such creditor would receive if (A) the case were under Chapter 7; and (B) the transfer had not been made ----------------- 101(31) if debtor is a corporation, insider includes: Officer, director, person in control of the debtor, or relative Payment to Insider: Example 5 • Director lends $2000 to her own company, when it has assets of $10,000 and other liabilities of $2000 • After the company’s value has declined to $2000, director pesters the bookkeeper and gets repaid. • Is the repayment a preference in the bankruptcy six months later? After Director’s Loan (Put on board) $12,000 $2000 General Creditors $2000 Director’s Loan Director’s loan • What result if the corporation had $10,000 in assets at the time of the transfer (6 months before bankruptcy)? • What result if the $2000 payment was a scheduled payment of principal under the terms of a longstanding loan to the corporation? Preferences Example 6 Feb 22 $1500 asset $1000 Senior Secured $1000 cash $1000 Junior Secured $2000 Unsecured March 1 $1500 asset $1000 Junior $2000 Unsecured Preferences and the Holding Company: Example 7 (put on board/story next slide) Holding Company Assets Guarantee to Chemical Bank C/S Chem Sub Other Creditors C/S Other Sub Chem Bank Chem Sub $5K (then goes $1000 Chem Bank Down to $1K) $500 Other Creditors Preferences and the Holding Company: Example 7 • Bank lends $1000 to Sub when Sub is solvent; gets guarantee from Holding • Sub assets decline in value from $5K to $1K. • Bank seeks repayment. Holding asks Sub to pay Bank $1000. • 6 months later, Sub files for Chapter 11. Was $1000 payment to Bank a preference? (Back to 547:) Claims and creditors • Is the holding company a creditor of the sub/debtor? • Section 101 defines terms needed for 547 • (10) “creditor” means.. An entity that has a claim against the debtor that arose at the time of or before the [bankruptcy filing] • (5) “claim” means...a right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undispute, legal, equitable, secured or unsecured.... The Guarantee Transaction Guarantee Holding Company Chem Bank Potential Right of Subrogation Sub’s $$ obligation to repay loan Subsidiary The Guarantee Transaction Pays Chem Bank Holding Company Chem Bank Potential Right of Subrogation becomes Right of Subrogation $? Subsidiary Holding Co steps into shoes of Chem Bank to collect from Sub From whom may the trustee recover? The holding company of course. Can it recover against the bank? Section 550, before 550(c) added: (a) the trustee may (under 547, 548, 544) recover...the property transferred [or] the value of such property from – (1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or (2) any immediate or mediate transferee of such initial transferee 550 (b) the trustee may not recover under section (a)(2)... from (1) a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer; or (2) any immediate or mediate good faith transferee of such transferee Congress amends Section 550 (c) Section 550(c)says (c) if a transfer made between 90 days and one year before filing (1) is avoided under 547(b); and (2) was made for the benefit of a creditor that was an insider The trustee may not recover under subsection (a) from a transferee that is not an insider. V.B. Attacking Creditors 1. Preferences 2. Equitable Subordination 3. Fraudulent conveyances 4. Lender liability Equitable Subordination: American Lumber History: -Jan 17, 1975: American Lumber (ALC) commences operation with financing from Bank. -October 21, 1975: ALC in trouble. # Bank realizes that it has no security interest in inventory of ALC. # Bank officer comes up with plan: take security interest in inventory, advance funds to ALC so that ALC could increase value of accounts in which Bank has security interest (Q: how is this possible?) History (continued) -- October 24: ALC under duress gives Bank security in inventory. Bank forecloses on A/R, begins liquidating ALC. -- Post October 24: Most employees fired. # Bank pays creditors only if increases value of its collateral. # Uses advances from creditors to complete project in whose assets are subject to its security interest. # Lies to credit association about Bank’s intentions (says that Bank is trying to help general creditors) and ALC’s situation (says that ALC solvent). ALC was balance sheet insolvent. --Feb 11, 1976: ALC pushed into bankruptcy by Bank Court: Transfer of security interest on October 24th was a preference b/c (1) to secure antecedent debt (2) made within 4 months of bankruptcy (note: today it is 90 days) (3) allowed defendant to get more than would have received in Chapter 7 (4) ALC was insolvent Transfer on October 24th was also fraudulent conveyance b/c (1) w/out fair consideration (note: under 548(d)(2), which is not in Appendix, securing of antecedent debt considered “value” received by debtor) (2) Bank knew could not pay debts (3) transfers made with intent to hinder, delay, defraud existing and future creditors (4) ALC was insolvent Court: All of the cash transferred from ALC to Bank since October 24th must be returned. (Is this a preference or a fraudulent conveyance?) American Lumber - cont. And, since Bank was in control of ALC, it owed a fiduciary duty to ALC and all unsecured creditors to deal fairly and impartially with them. It violated this duty and its claim must therefore be equitably subordinated. What did equitable subordination add to the other punishments? Lender Liability: Farah Corp. A lender’s worst nightmare Background to Farah Corp Case 1972-76: Labor Dispute/Boycott: Massive Losses. CEO Farah, held responsible, forced out by Board in favor of Leone 1976-77: Bank extends credit. New loan agreement contains “management clause” making change of management adverse to Bank a default 1977: Leone does poorly; Farah tries to make comeback. Banks say to Board: Elect Farah and we will not waive the default but did not say explicitly would call default (Banks would not call default b/c they would be hurt by the resulting bankruptcy) Under threat, Board chooses Conroy as CEO 1977. Conroy and his successor Galef both run Farah Corp poorly. 1978 Farah eventually takes over and restores company after Banks waive management clause Farah Corp FMC Claim: Banks are liable because through fraud and coercion caused losses to FMC (Conroy, Galef) and made it lose profits (absence of Farah) Allegations: 1. Threat to call default fraudulent b/c no concrete intention to do so. Banks did not act in good faith. Court: threat to call default with no intention to do so is fraud (even if Bank was uncertain) because it is a false threat and a misrepresentation 2. Banks put Farah under duress Court:- “economic duress may be evidenced by forcing a victim to choose between distasteful and costly situations, i.e., bow to duress or face bankruptcy, loss of credit rating, or loss of profits from a venture” “Even where an insecurity clause is drafted in the broadest possible terms, the primary question is whether the creditor’s attempt to accelerate stemmed from a reasonable, good-faith belief that its security was about to become impaired....They do not permit acceleration when the facts make its use unjust or oppressive.” $20m damages Farah Corp Questions • Who controlled Farah? • Was Farah Corp under a duty to mitigate? How could it have mitigated? • Was Bank acting in a self-serving manner, as in American Lumber? Attacking Managers: Credit Lyonnais Duties to Creditors? • Standard theory: no duties apart from contract, which the company must comply with in good faith » Creditors are “outside” of the corporation » Occasionally courts will need to fill a gap: they will ask what the parties would have done Duties to Creditors? • New view: board has duty to maximize the value of the firm » Equals duty to shareholders when highly solvent » Equals duty to creditors when highly insolvent » But what if barely solvent or insolvent? Credit Lyonnais Famous footnote from Credit Lyonnais case: 1. Company owns single asset, judgment for $51m 2. Judgment is on appeal 3. Company owes bondholders $12m Credit Lyonnais • If affirmed, co is worth $51m. » 25% chance of affirmance » Expected value of affirmance is $12.75m (25%)($51M) • If modified, co is worth $4m » 70% chance of modification » Expected value of modification is $2.8m (70%)($4M) • If reversed, company is worth $0. Credit Lyonnais .25 chance affirmance ($51m) $12.75m .7 chance modification ($4m) $2.8m .05 chance reversal ($0) 0 EV= $15.55M • There is a settlement offer for $17.5m. What maximizes the value of the company? Credit Lyonnais Value to equity of appeal: 25% chance affirmance ($51-$12)m $9.75m .7 chance modification $0 $0 .05 chance reversal $0 EV = 9.75m • Value to equity of settlement: $5.5m • If duty to stockholders, do what? If duty to creditors, do what? Credit Lyonnais • Allen: directors should “recognize that in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the stockholders....would make if given the opportunity to act. Thus the option perspective can support a rule that gives directors’ fiduciary duties to debtholders when a firm approaches insolvency.” Credit Lyonnais • Duty to corporation, or to creditors? • What is insolvency? In the previous example is the company insolvent? Credit Lyonnais What if: 25% chance of affirmance ($80m) $20m 70% modification ($4m) $2.8m 5% reversal $0 EV = $22.8m • And the settlement is (again) for $17.5m • What is best for the corporation? Stockholders? Bondholders? • Under Judge Allen’s formulation, what should directors do? • Does duty to creditors now conflict with duty to corporation? Judge Allen and Credit Lyonnais What is the duty and how can a judge verify the duty’s implementation? • Duty to maximize value of the firm • What is duty when two strategies have equal (risk- adjusted value), and one favors equityholders, the other bondholders? • Precision of numbers? • Does ambiguity support use of business judgment rule here? If so, does that make implementation unverifiable?