On the Friday before Labor Day, Judge James Peck of the United States Bankruptcy Court for the Southern District of New York shocked the distressed bond market by dismissing the preference and fraudulent transfer counts of Iridium LLC Creditors Committee’s $3.7 billion adversary proceeding against Motorola, Inc. Judge Peck found that the Committee had failed to prove that Iridium was insolvent at any time—even the day before bankruptcy. Iridium’s $1.6 billion in bonds dropped from the mid-20s to low single digits in days.
Judge Peck’s ruling, however, came as no surprise to Yehudis Lewis, the principal author of this article and a senior litigator at our firm. She had been monitoring the proceedings for almost a year. After the Committee rested its case, she advised our clients that the Committee had failed to prove that Iridium was insolvent.
The Iridium System was conceived and built by engineers at Motorola. It was designed to provide satellite voice communication and paging services anywhere in the world by linking specially built handsets to a network of 66 satellites. Iridium began as a division of Motorola but was later separately incorporated, first as a private, and ultimately as a public, company. Pursuant to various contracts, Iridium purchased the Iridium System from Motorola for approximately $3.7 billion financed through a combination of bank loans, private and public equity offerings, and bond offerings. Despite the market’s enthusiasm for the Iridium System—Iridium common stock had a positive value at all times prior to bankruptcy —Iridium filed a chapter 11 petition on August 13, 1999, only nine months after it launched commercial activation. The System was ultimately sold for only $25 million.
The Unsecured Creditors Committee sought damages from Motorola under theories of fraudulent conveyance, preference, breach of warranty, breach of fiduciary duty and equitable subordination. By agreement of the parties, the first phase of the trial was limited to the question of whether Iridium was insolvent or had unreasonably small capital within the four year statute of limitations period between 1995 and 1999.
Following 50 days of trial and testimony from over 50 witnesses, Judge Peck ruled in a much anticipated decision that, although Iridium’s rapid decline into bankruptcy was a “business failure of epic proportions,” the contemporaneous market data presented by Motorola—the constant positive market value of Iridium common equity and Iridium’s continuous access to debt financing—was “simply too voluminous and compelling” and never, in his view, sufficiently addressed or challenged by the Committee or its experts.
Judge Peck Rejects the Committee’s Theory of Insolvency and Its Expert’s Opinion
The Committee argued that Iridium was doomed to fail from its inception because the Iridium System had technical limitations—the phones worked only with lineof- sight to a satellite, and rarely from buildings and vehicles—which led to its rejection by business travelers accustomed to ever-widening cellular service. The Committee’s experts, a recognized financial advisor, developed their own projections for Iridium’s cash flow, adjusting for the loss of expected payments from business travelers, and concluded that Iridium would never be able to generate enough cash flow to repay the bonds issued and bank loans obtained to pay Motorola for the System. They rejected Iridium’s own contemporaneous projections and never addressed Motorola’s argument that Iridium’s equity at all relevant times traded at a substantial market capitalization.
Judge Peck rejected the Committee’s theory of insolvency and experts’ opinion.
Judge Peck found that there was no evidence in the record that the service limitations caused Iridium’s spectacular failure or that Iridium’s projections were unreasonable when prepared. To the contrary, Judge Peck noted that even Counsel for the Committee admitted in closing argument that the cause of Iridium’s failure is still an open question and found that the System performed “within expected ranges, albeit at the lower end.” The fact that Iridium’s contemporaneous projections turned out to be terribly wrong did not, in Judge Peck’s opinion, mean that they were unreasonable at the time they were created. When the projections were created was important to Judge Peck’s analysis because, in his view, “[t]his was very much a nineties project that was being developed at a time when the markets were hot and fueled by a sense of optimism in a future of global connectivity.” He criticized the committee’s experts for “second-guessing” Iridium’s projections and for rewriting the projections for the express purpose of supporting insolvency and concluded that they had “credibility problems”.
Judge Peck was especially critical of the committee’s experts for failing to explain the conflict between their opinion that Iridium was insolvent on and prior to March 31, 1997 and Iridium’s substantial equity market capitalization during the same period. Relying on the Third Circuit’s recent decision in VFB LLC v. Campbell Soup Co., 482 F.3d 624 (3d Cir. 2007), Judge Peck held that the public trading market “remains the best and most unbiased measure of fair market value and, when available to the Court, it is the preferred standard of valuation.”
While Judge Peck acknowledged that the law affords him the “broad discretion to find that the markets somehow were distorted and did not fairly reflect the underlying enterprise value of Iridium,” he found that the Committee offered “no persuasive evidence to justify any deviation from the valuation implied by the public trading markets.” Specifically, Judge Peck rejected the Committee’s consistent theme throughout the trial that neither the market nor Iridium fully understood the System’s service limitations.
Finally, Judge Peck criticized the Committee for failing to value Iridium as of any date later than March 31, 1997. While Judge Peck expressly acknowledged that there was “a very real possibility that Iridium may have been in the zone of insolvency or may have actually slipped into insolvency at some point between the date of commercial activation and before bankruptcy,” he refused to make such a finding absent direct evidence of insolvency during that particular period. This is significant because the payments Iridium made to Motorola between commercial activation and the petition date totaled over $400 million.
What Happens Now?
The Committee is almost certain to appeal the decision. However, it is difficult for any appellate court to challenge a trial court’s findings of fact. Judge Peck sat through 50 days of trial, and his 110-page opinion contains detailed findings of fact. Whether or not Judge Peck’s reliance on VFB was warranted (and whether VFB is correct, discussed below), Judge Peck’s rejection of the Committee’s expert testimony on credibility grounds leaves little evidence in the record of insolvency under any legal theory.
Technically, the solvency ruling does not end the adversary proceeding. The Committee’s breach of warranty, breach of fiduciary duty and equitable subordination claims have not yet been tried. However, Judge Peck’s findings that Iridium understood the System’s limitations and that the System worked within the expected range of performance almost certainly signal a death knell for the remaining claims.
Lessons for the Future: Is Actual Fraud Required to Prove a Public Company Insolvent?
Both Iridium and VFB have put on a pedestal the valuations implied by the trading prices of securities in the public markets. In the future, how can publicly traded debtors ever succeed in proving insolvency for the purpose of pursuing preference or fraudulent transfer actions?
The most obvious line of attack will be fraud: If the publicly traded debtor did not disclose material information to the market, the market’s prices cannot be trusted as an indicator of value.
The problem in VFB was that the debtor’s equity did not decline after the allegedly material information was disclosed. The problem in Iridium was that problems with the System were disclosed and Iridium still managed to consummate one last equity offering on January 27, 1999.1
If fraud cannot be shown, a future debtor (or its creditors) will have to adopt more sophisticated attacks on equity trading values. Even out-of-the-money equity securities will always trade at some “warrant” value. Future debtors will have to prove that equity trading value is, in fact, no more than “warrant” value, perhaps by proof that debt securities are trading at a total discount to par—after excluding interest-rate discount—that exceeds the equity market cap.
A future debtor (or its creditors) will have to prove insolvency at multiple points in time, to avoid the possibility that the Bankruptcy Judge will find that failure to prove insolvency at the beginning of the voidable transfer period means failure to prove it at any time during the period.
Finally, there are tactical lessons to be learned from Iridium. Judge Peck criticized the Committee for presenting testimony through videotaped depositions instead of summoning (or persuading) witnesses to testify live, in court. Most important, Judge Peck’s rejection of testimony by the Committee’s financial advisor in favor of testimony by Motorola’s academic experts, like Judge Carey’s reliance on testimony by a business school professor in In re Exide Techs., Inc., 303 B.R. 48 (Bankr. D. Del. 2003), suggests that professionals who provide insolvency advice may not be the best witnesses to provide insolvency testimony.