As discussed in Part 1 and Part 2 of this series, any buyer of assets from a company in any degree of financial stress should be concerned about the transaction being attacked as a fraudulent transfer. Officers and directors of a selling entity also have concerns about this risk due to potential personal liability. Such an attack can result in the transaction being undone (with the parties being returned to their positions prior to the transaction) or, since it is often difficult to return the parties to their prior positions, such an attack can result in a judgment against the buyer and selling officers and directors for the difference between what the buyer paid and what the court determines the buyer should have paid. Most parties mitigate this risk by getting certain information prior to closing their transaction. But the adequacy of that information is debatable until litigation is pursued.
On December 12, 2013, after 34 trial days involving 68 witnesses (including 14 expert witnesses) and over 6,000 exhibits, the U.S. Bankruptcy Court for the Southern District of New York entered a 166-page memorandum opinion holding that certain affiliates of Anadarko Petroleum owed Tronox somewhere between $5 billion and $14 billion as damages for a fraudulent transfer that began in 2002 and was completed in 2006. Several months later, the parties settled for about $5 billion, subject to a public comment period and court approval that remains pending.
The ruling addresses many issues, each of which was hotly contested. A complete discussion of all these issues is beyond the scope of this post. Part 1 of this series discussed the facts in Tronox, the typical methods used to minimize fraudulent transfer liability, and the first lesson from Tronox – the relevant statute of limitations. Part 2 of this series discussed the second lesson from Tronox – disproving actual intent to hinder, delay, or defraud the seller’s creditors. This article discusses a third lesson from Tronox – proving the transferor was solvent at the time of the transfer.
Proof of Solvency.
This was the subject of most of the Tronox opinion. Under the Bankruptcy Code and the Uniform Fraudulent Transfer Act, solvency is measured in three key ways: (1) whether total assets exceed total liabilities, (2) whether the transferor is left with “unreasonably small capital,” and (3) whether the transferor incurred, or believed that it would incur, debts beyond its ability to pay as they matured. Disputed evidence included a solvency opinion, management cash flow projections, officer and director opinions, expert witness reports, substantial evidence of positive “market” valuations of Tronox after the last transfer was completed, a private offer from a financial buyer, and evidence showing that the ultimate bankruptcy filing by Tronox was attributable to declining sales from the worst recession since the Great Depression, as opposed to the legacy liabilities of Tronox. The bankruptcy court ruled against Anadarko on virtually all of these points, as follows.
Solvency Opinion. When Tronox was “spun off” from Kerr McGee, the parties obtained a “solvency opinion” from a well-known investment banker. In relevant part, the opinion stated “the fair value and present saleable value of [Tronox’s] assets would exceed [Tronox’s] stated liabilities and identified contingent liabilities.” However, the bankruptcy court dismissed this evidence because it was based on what the court determined were inadequate reserves for disputed liabilities.
Management Projections. At the same time that Tronox got the above solvency opinion, Tronox also generated its own internal projections of future assets, liabilities, and cash flow. But the bankruptcy court concluded that these projections “make no pretense of being thorough” about anticipated future environmental or mass tort liabilities. In fact, the projections assumed that environmental liabilities would be eliminated by 2010 based on conclusions that were “anecdotal and not rooted in reality.” Thus, the lesson from this part of the Tronox opinion is that solvency opinions and management projections are only as good as the assumptions used.
Audited Financial Statements. When Tronox went public in 2006, Tronox obtained audited financial statements from a large public accounting firm which showed balance sheet and cash flow solvency. But the bankruptcy court concluded that these financial statements were not controlling because the balance sheet relied on “book values” for assets and “generally accepted accounting principles” for liabilities, neither of which is controlling for fraudulent transfer analysis. Thus, the lesson from this part of the Tronox opinion is that accounting values are of limited utility.
Public Market Information. Tronox sold its stock into the public markets for over $224 million, and maintained a market equity value of over $500 million for several years after the split with Kerr-McGee. In addition, during this time, Tronox raised $450 million in senior secured debt and $350 million in unsecured bonds. Many court opinions and scholarly articles, and even the experts in the case, acknowledged in various ways that public market prices and activities (like stock and bond sales) are among the best evidence of value.
Yet the court found all of this evidence unavailing. The secured debt offering was dismissed because it involved secured debt that had priority over legacy liabilities, virtually all of which were unsecured. And the remaining public market evidence involving unsecured notes and stock was not considered persuasive because the SEC filings supporting the public market activities did not contain accurate estimates of legacy liabilities, and “generally accepted accounting principles” used in the SEC filings did not require it. Thus, the lesson from this part of the Tronox opinion is that public market information cannot be used to establish solvency unless the underlying financial data includes accurate asset and liability values, whether based on “generally accepted accounting principles” or not.
Apollo Offer. Before Tronox became a separate public entity, Tronox went through a full-scale effort to sell its assets to the highest bidder. This resulted in a well known private equity firm, Apollo Investors, submitting an offer to purchase Tronox’s assets for $1.3 billion about four months before Tronox went public. As is typical in such situations, Apollo had significant access to material nonpublic information about Tronox, including internal documents and discussions with senior management.
Yet the court found this information unpersuasive as well, finding that it was unclear what legacy liability information Apollo studied in its proposal, and the proposal (a) contained open items, (b) included about $504 million in indemnities for legacy liabilities, and (c) was not even presented to the Tronox board. In short, an unaccepted proposal was not entitled to much weight in the court’s opinion.
Expert Witness Testimony. The key evidence used by the plaintiffs was an expert witness report suggesting that total liabilities at the time of the spinoff were around $2.1 billion and the value of the assets at the time of the spinoff was around $1 billion. Anadarko did not present any independent expert witness testimony on total assets or liabilities, but instead presented expert witness testimony attacking the plaintiff’s expert witness report and concluding total liabilities should be estimated between $300 and $400 million, and total assets should be estimated around $1.7 billion.
The bankruptcy court found the plaintiff’s expert report was persuasive, and Anadarko’s expert report was not. Among other points made by the court, Tronox had spent about $160 million on environmental liabilities alone each year for the five years prior to its spinoff, making Anadarko’s total liabilities estimate not credible. And Anadarko’s expert’s estimate of total asset value was based on flawed projections and comparisons to other companies and transactions that were not similar to Tronox.
Of particular concern to the court was that there was no evidence that Kerr-McGee or Tronox or Anadarko ever, before or after the case was filed, prepared a comprehensive analysis of the legacy liabilities left with Tronox. The court characterized it as “a major failure of proof.” Thus, a lesson from this part of the Tronox opinion is that parties involved in a transaction that might be attacked as a fraudulent conveyance should consider obtaining a comprehensive solvency assessment by someone who could act as an expert witness at trial. Of course, any such report involves time, effort, expense and risk, especially if it shows the transferor will be left insolvent.