Two recent court decisions may affect an equity sponsor’s options when deciding whether and how to put money into - or take money out of - a portfolio company. The first may expand the scope of “inequitable conduct” that, in certain Chapter 11 settings, could lead a court to equitably subordinate a loan made by a sponsor to its portfolio company, placing the loan behind all of the company’s other debt in the payment queue. The second decision muddies the waters of precedent under the U.S. Bankruptcy Code on the issue of the avoidability of non-U.S. transfers, casting some doubt on the previously held notion that transfers outside the U.S. are beyond the scope of avoidability under U.S. law.
Inequitable Subordination? Illinois Bankruptcy Court Lowers Bar for Finding of “Misconduct”
In Stapleton v. Newkey Group, LLC,1 the Bankruptcy Court for the Northern District of Illinois equitably subordinated two secured loans made to Keywell, LLC (Keywell) by its equity holders, thereby subordinating them in payment priority to all other Keywell debt, including all unsecured debt.
Keywell’s business had consisted primarily of the processing of scrap metal into recycled stainless steel scrap. It priced its stainless steel based on the market price of nickel, meaning that Keywell’s margins would fluctuate along with nickel prices. Keywell chose not to hedge against fluctuations in such prices. Generally the company kept little cash on hand and funded purchases through its collections on its accounts receivable and drawings under its revolving credit facility.
In 2008, nickel prices and sales volumes at Keywell declined dramatically, forcing Keywell to make substantial drawings under its revolving credit facility with its bank lender. Needing additional liquidity beyond that, Keywell considered a US$20 million rights offering, and circulated an offering memorandum to raise the equity capital from its members. Keywell ultimately chose not to raise that equity capital, fearing that it would be lost in the event of a business failure and inure only to the benefit of Keywell’s creditors. Instead, Keywell’s equity holders formed a new entity, NewKey I, LLC (NewKey I), owned by them, which in turn made a US$3.5 million secured subordinated loan to Keywell. It was structured as second-lien debt behind the revolving credit facility first-lien debt. The proceeds of the NewKey I loan were used to reduce Keywell’s revolving loan balance and otherwise meet its short-term working capital needs; no payments were made to insiders or other affiliates.
In 2010, falling nickel prices led Keywell to a financial covenant default under its revolving credit facility. Given the default, Keywell was unable to continue accessing its revolver, and Keywell’s equity owners then proceeded to form another new entity, NewKey II, LLC, owned by them as well, which in turn made a US$5 million secured subordinated loan to Keywell, on terms similar to those of the NewKey I loan. The NewKey II loan, like the NewKey I loan (together, the NewKey Loans), was structured as second-lien debt behind the revolving credit facility first-lien debt. The proceeds of the NewKey II loan were used to pay down Keywell’s indebtedness under its revolver and to induce the revolving lender to refrain from exercising remedies under its credit documentation that were otherwise available to it. Keywell’s business and financial condition continued to deteriorate and, by early 2013, Keywell had committed multiple defaults under its revolving credit facility and approached insolvency. It filed for bankruptcy shortly thereafter.
The bankruptcy trustee sought various remedies under the U.S. Bankruptcy Code that would have the effect of eliminating the effective priority of the secured NewKey Loans over the claims of Keywell’s unsecured creditors. These included actions to recharacterize the NewKey Loans as equity rather than debt or, alternatively, to equitably subordinate them to all other Keywell debt, including its unsecured debt. The court rejected the recharacterization argument, because the NewKey Loans were both properly documented and executed as loans. The court noted as well that Keywell was neither insolvent nor made insolvent at the time or as a result of the relevant transactions.
The court then proceeded to consider the equitable subordination argument. It began by noting the essential elements of equitable subordination, which include that the party against whom subordination is sought has engaged in inequitable conduct and that the conduct must have caused harm to other parties with claims.
The extent of misconduct required for equitable subordination generally is substantial. As noted by one Circuit Court in this context, “The statute authorizing equitable subordination does not indicate what conduct justifies that Draconian remedy, but there is general agreement in the case law that the defendant’s conduct must be not only ‘inequitable’ but seriously so (‘egregious,’ ‘tantamount to fraud,’ and ‘willful’ are the most common terms employed) and must harm other creditors.”2 It is true that a heightened level of judicial scrutiny, and correspondingly lesser standard of misconduct, is generally held to apply in the context of loans made by insiders. Even in such cases, however, some actual misconduct or wrongdoing is needed for such a finding. As another Circuit Court has noted, “[U]ndercapitalization alone, without evidence of deception about the debtor’s financial condition or other misconduct, cannot justify equitable subordination of an insider’s debt claim. Extraordinary circumstances might provide an exception . . . .”3
The court in Stapleton found that the combination of several factors present in the case constituted inequitable conduct sufficient to meet the standard for equitable subordination of the NewKey Loans.
First, the court noted Keywell’s failure to hedge against changes in the market price of nickel, choosing to pay dividends to shareholders in good years without leaving a “substantial equity cushion”4 that would have been “required . . . if the company was to be protected from extended periods of low income.” This practice, according to the court, “[left] the company and its unsecured creditors unprotected against a sharp market decline.”5 It may be noted that business decisions such as those relating to hedging would more customarily be viewed as within a company’s broad discretion under the business judgment rule, and not subject to second-guessing by a court.
Second, the company considered and pursued, but ultimately chose not to consummate, an equity contribution that would have left the company “adequately capitalized with no harm to trade creditors.”6Despite the fact that the equity contribution was approved by the relevant Keywell shareholders, the transaction ultimately was not consummated after consultations with bankruptcy counsel indicating that the funds could be lost if Keywell’s bank lender would refuse to waive Keywell’s default under its revolving credit facility, and that secured debt would better position the equity holders in a downside scenario versus adding an equity cushion through the equity contribution, thus “diminishing the funds available to support the trade creditors.”7
Finally, the court emphasized that Keywell kept its financial situation entirely hidden from its trade creditors, which made it “impossible for any of its trade creditors to know about its shareholder distributions, its initial steps to restore healthy capitalization, or its decision to substitute secured debt.”8Although Keywell was under no contractual obligation to make specific financial disclosures to its various unsecured trade creditors who had not bargained for such disclosure, the fact that such creditors could have no way of knowing of the high default risk they were facing was sufficient misconduct for the court, when combined with the other factors noted above, to warrant equitable subordination of the NewKey Loans.
What This Means for Sponsors
The Stapleton decision seems to lower the bar for what may constitute prejudicial misconduct sufficient for a finding of equitable subordination of loans held by insiders. The court appeared to justify its decision by citing a confluence of factors that, when combined, met the standard. But the factors cited by the court leave important questions unanswered, and the decision may thus be viewed as somewhat of an “outlier.” Is failure to provide financial information to creditors who have not bargained for it truly prejudicial to them and a form of misconduct? Would the court have decided differently if any of the junior secured loans in question had not originally been conceived and drafted as an equity contribution? If so, why should that matter? Does a company’s failure to hedge commodity prices that would be protective of certain of its creditors, when under no contractual obligation to do so, constitute prejudicial misconduct towards them?
The Stapleton decision is that of a lower court, a bankruptcy court, within the Seventh Federal Circuit. It should therefore have limited precedential or persuasive impact, for example, within the Second or Third Circuits (which include New York and Delaware, respectively), where many of the decisions on related issues are likely to be rendered. Yet, despite the limited impact and the unanswered questions, Stapletonis a reminder that transactions between a sponsor and its portfolio company need to be considered carefully not only for compliance with relevant contractual covenants, but also in light of the totality of the relevant facts and circumstances, for a complete assessment of the related risks and benefits.
SDNY Goes Extraterritorial on Fraudulent Transfer Avoidance
In Weisfelner v. Blavatnik,9 the Bankruptcy Court for the Southern District of New York extended the potential reach of fraudulent transfer actions under the U.S. Bankruptcy Code to transfers made outside the U.S., from one non-U.S. entity to another, thereby creating a split within the Second Circuit and within the Southern District of New York itself.10
In 2007 Basell AF S.C.A., a Luxembourg entity (Basell), acquired Lyondell Chemical Company, a Delaware corporation (Lyondell). The acquisition was funded entirely by debt taken on by the target and its subsidiaries in the approximate amount of US$21 billion, secured by substantially all their assets. Of the US$21 billion of secured debt, about US$12.5 billion of the proceeds went to pay Lyondell’s shareholders for their shares, with the balance being used to pay off certain existing target debt, to make change-of-control and management benefits payments, and to pay transaction expenses and other items. Less than thirteen months later, Lyondell filed for Chapter 11 protection.
About two weeks before the Lyondell acquisition and in contemplation of it, Basell, a Luxembourg entity and one of Lyondell’s direct equity owners, distributed €100 million to its general partner, Basell AF GP S.a.r.l., another Luxembourg entity, and to its other equity owner, BI S.a.r.l., also a Luxembourg entity (the Basell Distribution).
One of the litigation trustees appointed in the Chapter 11 case to prosecute avoidance and other actions in order to maximize the bankruptcy estate and the recovery of unsecured creditors, sought avoidance and recovery of the €100 million Basell Distribution as a fraudulent transfer under Section 548 of the U.S. Bankruptcy Code. The recipients of the Basell Distribution moved the court to dismiss the claim on the ground that the fraudulent transfer avoidance power of the Bankruptcy Code could not apply to the distribution, since it was an extraterritorial transfer, by a Luxembourg entity to its two Luxembourg equity owners, and thus outside of the reach of § 548 of the Bankruptcy Code.
In denying the motion to dismiss, the court began by acknowledging that, while “Congress has the authority to enforce its laws beyond the territorial boundaries of the United States,"11 there is a general presumption against the extraterritorial reach of a statute, “which serves to protect against unintended clashes between our laws and those of other nations….”12 The court then outlined and applied a two-prong test to determine whether the presumption against extraterritoriality should control.
First, it considered whether the relevant conduct occurred outside of the U.S. The distribution in this case was made by Basell to its parents, both Luxembourg entities. The court noted that the extraterritoriality of a transaction is determined through a “center of gravity test,”13 which may consider “all component events of the transfer . . . such as whether the participants, acts, targets, and effects involved in the transaction at issue are primarily foreign or primarily domestic.”14 Nevertheless, the court concluded that the Basell Distribution was indeed extraterritorial, given the underlying circumstances, thus triggering the presumption against the extraterritorial application of the U.S. law.
Second, the court considered whether this presumption should in fact prevent the application of § 548 of the Bankruptcy Code to avoid the Basell Distribution. The court acknowledged that the statute “does not contain any express language or indication that Congress intended the statute to apply extraterritorially,”15but held that the context provided by the surrounding provisions of the Bankruptcy Code indicates that Congress nonetheless intended the statute to apply outside the U.S. as well.
According to the court, because the Bankruptcy Code elsewhere16 grants the court “in rem jurisdiction over all of the debtor’s property, whether foreign or domestic,"17 and defines “property” of the estate to include property that the trustee ultimately recovers,18 the relevant statutory provisions when read in conjunction “[demonstrate] congressional intent to apply § 548 extraterritorially.”19 The court relied on a Fourth Circuit case20 holding that § 548 can be given extraterritorial application “not because it provides for recovery of property that is already property of the estate, but rather, because [it] provides for the recovery of property that would have been property of the estate—i.e. property worldwide in which the debtor would have had an interest—but for the fraudulent transfer.”21
In other words, the court reasoned that, because Congress has declared that the fraudulently transferred assets would become property of the estate once recovered under § 541(a)(3), Congress must have also intended to grant the bankruptcy courts international jurisdiction to recover those very assets under the trustee’s fraudulent transfer avoidance power.
The court acknowledged in a footnote22 that other decisions had not agreed with its analysis, simply stating that the court respectfully disagreed with those decisions,23 whose rationale had principally been that fraudulently conveyed property does not become part of the bankruptcy estate until it has been recovered, and that while still in the hands of a third party it is not yet property of the estate, and thus not subject to the Bankruptcy Court’s jurisdiction.
What This Means for Sponsors
The Weisfelner decision raises the specter that transfers made outside the U.S. by non-U.S. entities could become subject to the fraudulent transfer provisions of the U.S. Bankruptcy Code. Careful consideration is warranted in this regard, especially in the context of transactions surrounding the financing of a leveraged acquisition, which may raise related issues down the road if performance at an acquired company falls substantially short of expectations.