The United States Bankruptcy Court for the District of Delaware recently dismissed equitable subordination and fraudulent transfer claims filed by the Official Committee of Unsecured Creditors of Champion Enterprises, Inc. ("Champion") against more than 100 prepetition lenders to Champion (collectively, the "Defendants")1. The Committee alleged that in the years preceding the bankruptcy, the Defendants acted inequitably by authorizing amendments to a credit agreement that allowed for the issuance of certain unsecured notes, the proceeds of which were used to repay amounts owed to the Defendants under the credit agreement.
In dismissing the equitable subordination claim, the Court found that the Defendants were not insiders of the Debtors and had not otherwise acted inequitably prior to the petition date. The Court also dismissed the fraudulent conveyance claim, finding that the transfers at issue discharged an antecedent debt and thus were made in exchange for fair consideration.
On April 7, 2006, Champion Home Builders Co. ("Champion Opco"), a producer of manufactured and modular housing, and Champion's principal operating subsidiary, executed a credit agreement (the "Credit Agreement") which provided for two term loans maturing on October 31, 2012 (the "Senior Term Loans").2 Champion Opco's obligations under the Credit Agreement were secured by a pledge of all its assets.3
By early 2007, Champion Opco was on the verge of defaulting on the Senior Term Loans and sought to amend the terms of the Credit Agreement.4 Pursuant to October 2007 amendments, Champion was permitted to issue unsecured 2.75% Convertible Senior Notes due in 2037 (the "Subordinated Notes"), and to use the proceeds from the Subordinated Notes to pay down the Senior Term Loans and redeem other secured notes previously issued by Champion due in 2009 (the "2009 Notes").5 Champion raised $180 million through issuance of the Subordinated Notes, and ultimately used $86.4 million of the proceeds to redeem the 2009 Notes, $8 million to prepay the Senior Term Loans, and $14.5 million to prepay other obligations under the Credit Agreement.6 Despite the issuance, Champion's financial condition continued to decline through 2008 and 2009, and on November 15, 2009, the Debtors filed for bankruptcy in the United States Bankruptcy Court for the District of Delaware.7
The Adversary Proceeding
On February 18, 2010, the Committee brought an adversary proceeding on behalf of the Debtors' estates against the Defendants to recover damages arising out of the Credit Agreement amendments and the issuance of the Subordinated Notes.8 In response to the complaint, the Defendants filed motions to dismiss pursuant to Federal Rule of Civil Procedure 12(b)(6).9 In particular, the Defendants argued that they were not insiders of the Debtors, and thus the heightened equitable subordination standard applied to claims against insiders should not apply. With respect to the fraudulent transfer claims, the Defendants argued that the transactions at issue were made in exchange for fair consideration and thus were not fraudulent.
On September 1, 2010, the Bankruptcy Court granted, almost entirely, the Defendants' motions to dismiss.10 The court dismissed all thirteen counts with respect to the Defendants, except Credit Suisse. With respect to Credit Suisse, the Court dismissed all but two counts seeking breach of contract damages for improper assignments of certain debt obligations under the Credit Agreement and disallowance of certain claims.11 Most notably, the Court dismissed the Committee's equitable subordination and fraudulent transfer claims in their entirety. This article details the parties' arguments and the Court's rulings on these two issues.12
Equitable Subordination of Defendants' Secured Claims
In Count I of the complaint, the Committee alleged that the Defendants' claims should be equitably subordinated to the claims of the Debtors' unsecured creditors.13 The Committee argued that the Defendants exploited Champion's distressed situation, and their resulting leverage over Champion, to improperly shift their risk to other creditors and advance their own position through the Credit Agreement amendments and issuance of the Subordinated Notes.14 The Committee also argued that the Defendants failed to correct allegedly materially false and misleading disclosures in the Subordinated Notes prospectuses.
A court may equitably subordinate a claim when a creditor has improved its position relative to other creditors through unjust or unfair means.15 The claim of the offending creditor is subordinated to the claims of the injured creditors, to the extent necessary to remedy the harm caused by the offending creditor's conduct. In analyzing equitable subordination claims, courts "typically differentiate between insider and non-insider claimants and apply special scrutiny to the conduct of insiders."16 Accordingly, courts only subordinate the claims of non-insiders upon a finding of unlawful or egregious conduct, while attempts to equitably subordinate claims of insiders are subject to a more rigorous three-part test that requires "(i) inequitable conduct; (ii) resulting in injury to creditors or unfair advantage to the claimant; and (iii) an outcome that is not otherwise inconsistent with the Bankruptcy Code."17
The Committee alleged that the Defendants were "insiders" of Champion and thus their role in the amendments to the Credit Agreement required a higher degree of scrutiny. Specifically, the Committee alleged that the Defendants were insiders (i) under section 101(31) of the Bankruptcy Code, which defines insiders to include persons in control of a debtor,18 and (ii) under applicable case law related to "non-statutory insiders." Summarizing these allegations, the Court observed that "[t]he Committee's theory is that the [Defendants] were able to coerce Champion's actions and, therefore, had sufficient control over Champion to merit statutory and non-statutory insider status."19
In addressing the Committee's argument, the Court first observed that in the context of equitable subordination claims against lenders, "courts have refused to apply insider status absent a showing of a high level of control by the lender."20 The Court added that "control sufficient to merit insider status may be established by facts showing that the lender dictated day-to-day management and operation of the debtor or made decisions for the debtor regarding replacement of management or filing for bankruptcy."21
In analyzing the allegations in the complaint, the Court devoted significant attention to a recent Third Circuit decision, Schubert v. Lucent Technologies, Inc. (In re Winstar Communications, Inc.).22 In that case, Third Circuit held that the claims of Lucent, a vendor and prepetition lender, should be equitably subordinated - even though Lucent did not meet the definition of an insider under section 101(31) of the Bankruptcy Code - because Lucent was a non-statutory insider able to coerce the debtors into taking actions that were only in Lucent's best interests.23 The Third Circuit stated that when addressing non-statutory insider status, courts should focus on "whether there is a close relationship [between the debtor and creditor] and . . . anything other than closeness to suggest that any transactions were not conducted at arm's length."24 Finally, the Third Circuit found that the transactions at issue in Winstar were not conducted at arm's length because Lucent had used "Winstar as a mere instrumentality to inflate Lucent's own revenues" and the transactions at issue clearly were not in the Debtors' best interest.25
The Champion Court distinguished Winstar, and dismissed the Committee's argument that the lenders were subject to stricter scrutiny as non-statutory insiders. The Court first noted that unlike in Winstar, where Lucent was the debtor's primary supplier, the Defendants here were "traditional lenders."26 Specifically, in distinguishing Winstar the Court stressed that Lucent's "economic survival" as a supplier depended on Winstar's inventory purchases and business development.27 Here, although the Defendants had access to Champion's financial information and successfully negotiated amendments to the Credit Agreement, the Court stressed that "where a lender's influence on a debtor's actions merely arises by operating of bargained-for rights under a credit agreement, those 'reasonable financial controls negotiated at arms' length between a lender and a borrower do not transform a lender into an insider.'"28 The Court concluded that "the Complaint's allegations are indicative of nothing more than a normal distressed-borrower/lender relationship and do not provide a basis from which the Court could infer that Defendants' relationship or dealings with Champion merit applying insider status to Defendants pursuant to 11 U.S.C. § 101(31)(B)(iii) or non-statutory insider law."29 The Court, thus, found that the Defendants were not either "statutory" or "non-statutory" insiders, and their actions were not subject to heightened scrutiny.
Inequitable Conduct of Non-Insiders
Because the Court determined that the Defendants were non-insiders, the Committee needed to prove that the Defendants engaged in "egregious conduct, such as fraud, spoliation or overreaching" in order to equitably subordinate their claims.30 In the complaint, the Committee alleged that (i) the Defendants generally abused the Credit Agreement amendment process to shift the credit risk from themselves to others, (ii) the Defendants failed to correct allegedly materially false and misleading disclosures in the Subordinated Notes prospectuses, and (iii) the Defendants acted egregiously in assigning certain obligations under the Credit Agreement to MAK Capital Fund, LP.31
The Court dismissed each of the Committee's arguments regarding egregious conduct. With respect to the Committee's first argument that the Defendants "abused" the Credit Agreement amendment process, the Court stated that the Defendants had acted as normal lenders and that "[n]ormal lender conduct does not amount to inequitable conduct for equitable subordination purposes."32 The Court further stressed that "[a]lthough the [Defendants] may have forcefully negotiated, the fact that one party to a contract has more leverage does not indicate that the dealings are not at arm's length."33
With respect to the Committee's second argument that the Defendants failed to correct statements in the prospectus, the Court held that "the Complaint's allegations regarding these Defendants' specific actions consist solely of factually unsupported conclusory statements."34 Accordingly, the Complaint did not meet the applicable Rule 12(b)(6) standard which required "sufficient facts from which the Court could draw the inference" that the Defendants "assisted Champion in making materially misleading disclosures or that these Defendants had an independent disclosure duty."35
Finally, the Court rejected the Committee's arguments with respect to the prepetition assignment of Credit Agreement obligations from the Defendants to MAK Capital Fund, LP. The Committee argued that the Defendants "actively supported and furthered MAK's efforts to forc[e] Champion into bankruptcy so that MAK could acquire all or a controlling interest in Champion's assets at a fire sale price."36 In dismissing these arguments, the Court found that although Credit Suisse, as agent under the Credit Agreement, may have breached its contractual obligations by allowing for the prepetition transfer of obligations to MAK Capital Fund, LP without Champion's consent, this "conduct does not rise to the level of inequitable behavior necessary for equitable subordination."37 The Court added that "the remainder of the allegations regarding Credit Suisse's motivations and MAK's long-term plan are factually-unsupported conclusions" and concluded that the complaint's equitable subordination claims should be dismissed against all Defendants.38
Avoidance of Constructively Fraudulent Transfers
The Committee also alleged that it could avoid the $86.4 million paid to redeem to 2009 Notes, the $8 million prepayment of the Senior Term Loans, and the approximately $14.5 million in prepayments of other portions of the Credit Agreement, as constructively fraudulent transfers under section 544(b) of the Bankruptcy Code and section 274 of the New York fraudulent conveyance statute.39 Section 274 of the New York fraudulent conveyance statute states that "[e]very conveyance made without fair consideration when the person making it is engaged or about to engage in a business or transaction for which the property remaining in his hands after the conveyance is unreasonably small capital, is fraudulent as to creditors . . . ."40 "Fair consideration" is provided when, in good faith, the conveyance is an exchange of fairly equivalent interests, the conveyance satisfies an antecedent debt, or the conveyance is to secure an advance or an antecedent debt.41 Section 544 of the Bankruptcy Code incorporates applicable non-bankruptcy fraudulent transfer law (including the New York fraudulent transfer law) into the Bankruptcy Code.
The Committee premised its fraudulent transfer allegations on the notion that the redemption of the 2009 Notes, the paydown of the Senior Term Loans, and other payments under the Credit Agreement, all of which were funded by the issuance of the Subordinated Notes, were not made in exchange for fair consideration. In response, the Defendants argued that the transfers were made for fair consideration, because the transfers resulted in the repayment of outstanding indebtedness. The Court agreed, citing a recent Second Circuit case, In re Sharp International, which it described as "factually and procedurally on-point."42
In Sharp, the chapter 11 trustee alleged that State Street Bank and Trust Company, a lender to the debtor, discovered that the controlling shareholders of the debtor were committing fraud.43 Instead of revealing the fraud to the public, State Street requested that the debtor incur additional debt to pay off its loan.44 The chapter 11 trustee argued that the repayment of State Street's loan by incurring new debt was a constructively fraudulent transfer.45 The Sharp court found that the transfers were supported by fair consideration because they discharged an antecedent debt, noting that "bad faith does not appear to be an articulable exception to the broad principle that 'the satisfaction of a preexisting debt qualifies as fair consideration for a transfer of property.'"46
The Court stated that the Defendants, like the Sharp defendants, "were alleged to have orchestrated the issuance of new debt to better position [themselves] and to quietly shift risk to other creditors," and that the Defendants, like State Street, did not violate the law or the terms of any financing agreements.47 Accordingly, the Court held "that the Complaint fails to allege that the Transfers in satisfaction of the [Credit Agreement] lacked fair consideration," because although the transfers may have been preferential, they were made on account of an antecedent debt and thus were not fraudulent under applicable New York law.48 As a result, the Court dismissed this count of the complaint.
The Court's dismissal of the equitable subordination and fraudulent transfer claims in Champion is instructive for a number of reasons. First, the Court emphasized that the exercise of remedies under a prepetition loan agreement is not a sufficient basis for concluding that a lender has sufficient control of or influence over the debtor to be a non-statutory insider. The Court stressed that even where the exercise of lender remedies gives the lender increased leverage, this conduct does not rise (or sink) to the inequitable or egregious level necessary for equitable subordination. Moreover, the Court held unequivocally that where a prepetition payment extinguishes an existing debt, the payment is made in exchange for fair consideration and thus is not a fraudulent transfer. The Court's willingness to knock out these counts of the complaint on a motion to dismiss should provide comfort to lenders that the robust exercise of their remedies and use of their leverage when dealing with distressed borrowers is unlikely to subject them to equitable subordination or fraudulent transfer liability.