In a recent decision, the U.S. Court of Appeals for the Third Circuit held in VFB LLC v. Campbell Soup Co.,1 that market capitalization is a proper means for determining “reasonably equivalent value” in analyzing whether a leveraged spin-off of a parent corporation’s wholly-owned subsidiary constituted a fraudulent transfer.2 By using market capitalization to determine reasonably equivalent value, the Third Circuit adopted an objective test which will make it more difficult to challenge these types of spin-off transactions in the future.

Interplay Between Spin-Offs and Fraudulent Transfers

For almost two decades, spin-offs have been a favored restructuring mechanism for business entities seeking to enhance their value.3 In a typical spin-off, a parent company divests a wholly-owned subsidiary through the distribution of the subsidiary’s stock to the parent’s stockholders in the form of a dividend.4 A number of these transfers, however, are later challenged both under the United States Bankruptcy Code and/or state versions of the Uniform Fraudulent Transfer Act (the “UFTA”) as constructive fraudulent transfers on grounds that (i) the transaction was made for less than “reasonably equivalent value” and (ii) the transferor was insolvent or had unreasonably small capital at the time of the transaction or as a result of the transaction.5 Because neither the Bankruptcy Code nor UFTA offers clear guidance as to what constitutes “reasonably equivalent value” for transfer purposes, it is often difficult to determine beforehand whether a spin-off will be avoided as a constructive fraudulent transfer on “reasonably equivalent value” grounds.6 Additionally, because “reasonably equivalent value” is a question of fact determinable on a case by case basis, courts have been given wide latitude to determine equivalency.7

VFB LLC v. Campbell Soup Co.

Factual Background

In Campbell, the parent corporation, Campbell Soup Company, sought to increase its stock price through the divesture of certain of its underperforming subsidiaries (collectively, the “Transferred Subsidiaries”). To effectuate the disposition of the Transferred Subsidiaries, Campbell consummated a “leveraged spin” transaction. Under the transaction, which closed on March 30, 1998, Campbell incorporated a new wholly-owned subsidiary, Vlasic Food International, Inc. (“VFI”), and VFI took on bank debt in order to purchase the Transferred Subsidiaries from Campbell for $500 million. Campbell then transferred VFI’s stock to Campbell’s shareholders as a dividend, removed the Transferred Subsidiaries from its balance sheet, and received cash for the sale of the Transferred Subsidiaries.

In the two years prior to the spin-off, Campbell employed a number of techniques to inflate the sales, earnings and projections figures related to the Transferred Subsidiaries. These techniques were unknown both to the public securities markets and to the banks providing financing for VFI’s acquisition of the Transferred Subsidiaries. Shortly after the spin-off, however, the misleading sales and earnings numbers corrected themselves; and within two months of the transaction, VFI was forced to lower its 1998 fiscal year earnings estimates substantially. As a result of these lowered projections, VFI and the banks negotiated and entered into a new credit facility approximately six months after the spin-off. Under the new credit facility, the banks required VFI to issue $200 million of unsecured bonds.

For almost a year after the spin-off, the price for VFI’s stock remained steady. In particular, for the nine months following the spin-off, VFI’s market capitalization consistently remained above $1.1 billion. During this period, VFI successfully issued the unsecured debt required under its new credit facility. In January 2000, however, VFI discovered that for fiscal year 1999 it significantly underestimated its trade spending. This underestimation decreased VFI’s earnings for fiscal year 2000, triggered a default under the credit facility, and caused VFI’s unsecured debt to trade below par value. One year later, VFI filed for bankruptcy.

Prior to and following the commencement of its bankruptcy case, VFI engaged in a piecemeal disposition of the Transferred Subsidiaries. These sales generated proceeds equaling an amount substantially less than the price VFI paid for the Transferred Subsidiaries. Based on these facts and Campbell’s prior manipulation of the earnings and sales figures for the Transferred Subsidiaries, VFI’s successor in interest in the bankruptcy case (“VFB”)8 commenced an action against Campbell seeking, among other things, to set aside the spin-off as a constructively fraudulent transfer.9

District Court’s Analysis10

The primary issue before the district court in determining whether the spin-off constituted a fraudulent transfer focused on the value of the Transferred Subsidiaries at the closing of the transaction – particularly, whether such entities were worth the $500 million that VFI paid for them. To determine whether VFI received “reasonably equivalent value” under the transaction, the parties offered as evidence: (i) the price of VFI’s publicly traded stocks and bonds, which remained above $1.1 billion after the market became aware of VFI’s actual earning prospects; (ii) various valuations of the Transferred Subsidiaries and VFI prepared before and after the spin-off, which were uniformly above $500 million; and (iii) expert testimony offering value estimates of the Transferred Subsidiaries ranging from $377 million to $1.8 billion.

Relying for the most part on the value of VFI’s stock price after the spin-off, the district court concluded that the value of the Transferred Subsidiaries exceeded $500 million, and as a result, the spin-off did not constitute a fraudulent transfer. The district court found that the market price was a reasonable valuation of VFI in light of all of the information available to market participants. The district court explained that although VFI’s stock price was affected by Campbell’s manipulations, it did not decline after accurate projections of VFI were known by the market. Thus, the district court found that VFI’s market capitalization several months after the transaction represented the proper value of VFI as of the date of the spin-off. Based on the market’s value of VFI, the district court found that the Transferred Subsidiaries constituted reasonably equivalent value under the transaction, and as a result, refused to set aside the spin-off as a fraudulent transfer.

Third Circuit’s Analysis

The Third Circuit stated that for VFB to succeed on its appeal to set aside the spin-off as a fraudulent transfer it had to “show that on March 30, 1998, the [Transferred Subsidiaries were] clearly worth less than $500 million.”11 In that regard, the Third Circuit reviewed New Jersey’s version of the UFTA, made applicable to VFI’s bankruptcy case by section 544(b)(1) of the Bankruptcy Code.12 The court noted that under New Jersey law, the spin-off was avoidable if VFB could show that (i) the transaction was made for less than reasonably equivalent value and (ii) VFI was insolvent or had unreasonably small capital at the time of the transaction or as a result of the transaction. The Third Circuit concluded that based on VFI’s market capitalization after the spin-off, VFB could not carry its burden.

In affirming the district court decision, the Third Circuit found that, notwithstanding Campbell’s manipulation of the Transferred Subsidiaries’ sales and earnings figures prior to the spin-off, VFI’s market capitalization constituted a proper measure of its value. In reaching its holding, the court dismissed VFB’s contention that market capitalization was an inappropriate method for determining reasonably equivalent value, as a result of the market’s reliance on projections of future income that may ultimately be inaccurate. The court found that “[the market] allows participants to voluntarily take on and transfer risk that their projections may later be inaccurate [and that] fraudulent transfer law cannot be utilized to undermine [such] function.” 13 Further, the court noted that market capitalization is a proper mechanism for valuing a business because it reflects all publicly available information at the time of valuation, and that “[a] company’s actual subsequent performance is something to consider when determining ex post the reasonableness of a valuation . . . but it is not by definition, the basis of a substitute benchmark.”14 The Third Circuit also affirmed the district court’s use of market capitalization in valuing VFI, even after considering Campbell’s manipulation of the sales and earnings figures of the Transferred Subsidiaries prior to the spin-off. Specifically, the court found that the district court’s reliance on VFI’s market capitalization was appropriate because it focused on a valuation of VFI several months after the spin - when public equity and debt markets had an accurate picture of VFI’s true financial situation - as opposed to at the time of the transaction. The Third Circuit rejected VFB’s expert’s valuations, which focused on post spin-off performance by “discounted cash flow analysis.”15 Particularly, the court noted that valuation techniques such as discounted cash flow analysis are “inapt tools” for determining the value of a publicly traded entity.16 The court observed that “[a]bsent some reason to distrust it, the market price is ‘a more reliable measure of the stock’s value than the subjective estimates of one or two expert witnesses.’”17

The court noted that neither VFB nor Campbell disputed that VFI’s value had not increased at any time after the transaction. Thus, the court found that because VFI’s market capitalization was at least $500 million several months after the transaction (at the time when it was no longer affected by Campbell’s earlier manipulations), its value at the time of the spin-off had to be worth more than $500 million. Using similar reasoning, the court also noted that because the market valued VFI as solvent in fiscal year 1999, this was strong evidence that it was solvent in fiscal year 1998 and that VFI received reasonably equivalent value for the consideration it paid for the Transferred Subsidiaries.

Finally, the Third Circuit found that VFB’s experts failed to provide specific detail as to how Campbell’s manipulation of the Transferred Subsidiaries affected the market capitalization as of March 30, 1998. The court noted that “[VFB’s] approach is simply to note that Campbell played with its operations and suggest that the market capitalization numbers may have been wrong to some undetermined degree.”

Case Analysis

The Third Circuit’s decision in Campbell is significant because of the court’s reliance on an objective marketbased test for determining whether VFI received reasonably equivalent value in exchange for the assets purchased in connection with the spin-off, as opposed to subjective expert determinations of what constitutes reasonably equivalent value. As the court noted, the market capitalization approach is highly efficient in that it reflects the true value of a company as determined by the market and not by other subjective considerations. Under the facts of Campbell, the court’s use of the market capitalization approach was clearly appropriate because the stock of VFI was freely traded on the New York Stock Exchange and therefore readily susceptible to valuation by the market. Additionally, the court’s valuation of VFI several months after the spin-off rather than at the time of the transaction was also appropriate in light of the fact that the value of VFI did not increase after the transaction, and the market’s continued valuation of VFI at an amount considerably greater than the price VFI paid Campbell for the Transferred Subsidiaries - despite the market’s knowledge of VFI’s true financial projections.

The Third Circuit’s decision in Campbell signals that it will be difficult for creditors to unwind leveraged spin-offs without establishing either that (i) at the time of the transfer in question, the market viewed the value received by a transferring party under the transaction as clearly insufficient, or (ii) the parties involved in the transaction engaged in actual fraud. Moreover, the decision also signals an attempt by the Third Circuit to curtail litigation relating to spin-offs based on a party’s dissatisfaction with the financial results of the transaction.

Conclusion

The Third Circuit’s ruling in Campbell should provide useful insight as to what constitutes reasonably equivalent value for publicly traded entities planning and structuring the spin-off of a subsidiary. Based on the court’s ruling, it would be prudent for publicly traded companies seeking to transfer assets in a spin-off to first determine the market value for the assets to be transferred prior to consummating the contemplated transaction.