A recent decision from the Southern District of New York may reopen a door — which many had believed was all but closed — for disgruntled creditors seeking to challenge failed leveraged buyouts (“LBOs”) as fraudulent conveyances. In In re Lyondell Chemical Co., 2016 WL 4030937 (S.D.N.Y. July 27, 2016), District Judge Denise Cote reinstated an intentional fraudulent conveyance claim seeking to claw back $6.3 billion in distributions made to Lyondell Chemical’s shareholders through an LBO that failed quickly and dramatically. Absent judicial reversal (which seems unlikely), the District Court’s decision will be valuable support for similarly situated plaintiffs.
Lyondell received an unsolicited merger offer in August 2006. After nearly a year of hard bargaining, a deal was struck at almost twice the initial offer, and the transaction closed in December 2007. Barely two months later the company was “fighting for its life”; a bankruptcy petition was filed in January 2009, with creditors — including lenders who financed the apparently overpriced acquisition — receiving pennies on the dollar, together with an interest in a trust formed to seek redress through litigation.
Failed LBOs are fertile ground for litigation. Creditors who have lost the lion’s share of their debt investment after former shareholders have pocketed large profits understandably feel that the ordinary relationship of debt and equity has been turned upside down, and look for legal theories to reverse the outcome. Initially, the most attractive avenue appeared to be constructive fraudulent conveyance, a statutory cause of action under both section 548(a)(1)(B) of the Bankruptcy Code and the laws of every state. This cause of action provides for the unwinding of any transaction made (1) when the transferor was insolvent (or rendered insolvent), and (2) for less than reasonably equivalent value. In the case of failed LBOs, which are financed by debt that is putatively greater than the value of the acquired business, these two elements amount to the same thing, and the litigation path appears straightforward.
The straightforward path is derailed, however, by Bankruptcy Code section 546(e), which generally provides a “safe harbor” for, among other things, any transfer made to redeem commercial paper. In Enron Creditors Recovery Cor. v. Alfa, S.A.B. de C.V., 651 F.3d 329, 334-35 (2d Cir. 2011), the Second Circuit held that this safe harbor applies to LBO payouts to shareholders. The other shoe for creditors dropped earlier this year, when the Second Circuit held further that the safe harbor bars state law constructive fraud claims as well. In re Tribune Co. Fraudulent Conveyance Litig., 818 F.3d 98, 109-12 (2d Cir. 2016).
After Enron and Tribune, creditors such as the Lyondell trustee were left with only the potential to assert claims for actual fraudulent transfer, a separate cause of action under the Bankruptcy Code (section 548(a)(1)(A)) that is not covered by the safe harbor. But this cause of action has an entirely different element, requiring the plaintiff to plead and prove that the defendant had “actual intent to hinder, delay, or defraud any entity to which the debtor was or became . . . indebted.” This is a high and difficult hurdle to overcome. How the task can be accomplished was the subject of the recent District Court opinion.
The first issue raised is familiar whenever the state of mind of a corporation is involved. What does it mean to say that an enterprise has an “intent”? As corporations can act only through individuals, the question becomes, when can the state of mind of an individual be imputed to the business? In the Lyondell complaint, plaintiff relied on some strong allegations suggesting that Dan Smith, the CEO and chairman of the Lyondell board of Directors, knowingly presented false financial information in negotiating the LBO and obtaining its board approval. The bankruptcy court found such allegations insufficient, reasoning that, because under Delaware law only the full board could approve a merger, the relevant state of mind had to be alleged as to the entire board — or at least a majority of its members. Alternatively, it might be sufficient to show that Smith so dominated and controlled the board that his will alone was relevant. Because the complaint lacked facts supporting either of these situations, the bankruptcy court dismissed the complaint.
The District Court reversed, holding that under Delaware law “the knowledge and actions of a corporation's officers and directors, acting within the scope of their authority, are imputed to the corporation itself.” Stewart v. Wilmington Trust SP Servs, Inc., 112 A.3d 271, 302-03 (Del. Ch. 2015). The bankruptcy court, applying this principle, had concluded that while Smith had negotiated the merger within the scope of his authority — and hence the buyer may have had a cause of action for misrepresentation — Smith lacked the authority to approve the merger. Judge Cote disagreed, holding that under Delaware law whenever a corporation acts, even through a board vote, it is charged with all knowledge gained by its officers acting within the scope of their agency. Thus, for purposes of assessing the actual fraud claim, Smith’s knowledge and actions were the actions of Lyondell.
This leaves the important question of how one could establish that Lyondell had “actual intent to hinder, delay, or defraud” creditors. Read literally, this would seem to require that the defendant wanted creditors to suffer a loss, which is almost never true even in the most extreme case. Surely Smith, even on the most egregious interpretation of the facts, wanted the post-LBO Lyondell to succeed. Applying relatively well-settled law, Judge Cote held that the standard actually means something less: It is sufficient to demonstrate that the defendant acted either with a desire to cause the harmful consequences (unlikely) or with substantial certainty that the consequences will result (much easier). Applying that standard, and a list of “badges of fraud” commonly applied in such cases (including, for example, the fact that Smith stood to and did make vast personal profits from the merger), Judge Cote found that the complaint had adequately alleged fraudulent intent — as to Smith and, by imputation, as to the defendant corporation.
The defendant shareholders are currently urging reconsideration of this decision, stressing the public policy implications of holding thousands of innocent shareholders responsible for the actions of an individual. Alternatively, they seek leave to take an interlocutory appeal directly to the Second Circuit; ordinarily no appeal can be taken until a final judgment on the merits is reached, which could be many more years down the road. Given the vast amount at issue and the substantial resources that would be spent to litigate this case to conclusion, absent interlocutory appeal or a defense win on summary judgment, it is likely that this case will settle, leaving the District Court opinion as an important precedent for future busted LBO plaintiffs.