Bankruptcy Preference Modification

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					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
                      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

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
    or (2) “constructive fraud”
                (A) transfer for inadequate consideration; and
                 (B) debtor is insolvent (equitable, balance

--- 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
 (2) debtor was insolvent:
             » (A) was balance sheet insolvent or
               became that way 548(a)(2)(B)(ii)(I)
             » (B) unreasonably small capital
             » (C) intended to incur too much debt
             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
  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


What is the trendy name for this transaction?
Was this a fraudulent conveyance?
Could the trustee have recovered under 548? (See
    V.B. Attacking Creditors

• 1. Preferences (Read Section
• 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

    (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
•    March 1st:         No payment has arrived. (Prior
    shipments                 paid on time, which is industry
•    March 5th: Client’s bookkeeper nags debtor for
•    March 10th: Nags again.
•    March 15: Debtor writes a check to pay for half of the
•    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
(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
               Example 6
                 Feb 22

$1500 asset                $1000 Senior
$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

• 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
      The Guarantee Transaction

Company                        Chem Bank
          Potential Right
          of Subrogation

                        Sub’s           $$
                        to repay loan

                The Guarantee Transaction

                      Pays Chem Bank
        Company                           Chem Bank
                      Potential Right of
                      Subrogation becomes Right
                      of Subrogation


Holding Co steps into shoes of Chem Bank to collect
from Sub
     From whom may the trustee
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
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

      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

  -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
      # 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
   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
           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
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)

     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

• 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
               Duties to Creditors?

• New view: board has duty to maximize the value of
  the firm

            » Equals duty to shareholders when highly
            » Equals duty to creditors when highly
            » 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

• If modified, co is worth $4m
             » 70% chance of modification
             » Expected value of modification is $2.8m

• 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
                    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?
•   Under Judge Allen’s formulation, what should
    directors do?
•    Does duty to creditors now conflict with duty to
       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

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