Just one year after Lyondell Chemical Company (Lyondell) and Basell AF (Basell) consummated a nearly $20 billion merger of their businesses, the merged business of LyondellBasell Industries (LBI) “failed in a colossal manner.”1 As part of the bankruptcy process that followed, a court-appointed litigation trust (the Trust) filed suit for the benefit of unsecured creditors against numerous parties involved in the merger, bringing actual and constructive fraudulent conveyance claims, breach of fiduciary duty claims, and breach of contract claims to recover billions of dollars in merger consideration paid to third parties. Following years of discovery, litigation, testimony and trial, Judge Glenn of the Bankruptcy Court for the Southern District of New York issued a 173-page decision on April 21, 2017, rejecting all but one of the Trust’s claims.2 This article reviews the court’s opinion with respect to the actual and constructive fraudulent conveyance claims and offers insights on the issues addressed by the court.
Prior to the merger, Basell was a worldwide supplier of polypropylene and advanced polyolefin products and a leader in the production of polyethylene, while Lyondell was a large producer of ethylene and owned a large oil refinery in Houston, Texas. In 2007, Basell began seeking to merge with Lyondell to diversify its business. After initial attempts were unsuccessful, Leonard Blavatnik, an indirect owner of Basell, acquired a “toehold position” of almost 30 million shares (or around 9.84%) of Lyondell stock. At around that time, Lyondell — at the direction of its CEO, Dan Smith — “refreshed” its business and EBITDA projections “over several days with limited input from others at the company.” The refreshed projections provided a more optimistic outlook for Lyondell, and were presented to Basell and banks looking to finance the merger as part of their due diligence.
In July 2007, the parties executed a merger agreement that provided Lyondell shareholders with $48/share. In the months that followed, Lyondell disclosed that it would miss its third- and fourth-quarter 2007 EBITDA projections. Nevertheless, the merger closed on Dec. 20, 2007. The merger was financed with over $20 billion in debt, which was used to pay Lyondell shareholders $11.2 billion, repay $7.5 billion of Lyondell and Basell’s existing debt, and pay for Blavatnik’s $1.1 billion “toehold position.” Upon closing, LBI had approximately $2.3 billion in liquidity.
In the year that followed, a number of “unplanned and, to some extent, unforeseeable events” severely stressed LBI’s business. First, there was a deadly crane accident at the Houston refinery on July 18, 2008, causing a prolonged shutdown of the refinery. Second, there were two “unusually destructive” hurricanes along the Gulf Coast in September 2008, which caused unplanned outages at the Houston and Gulf Coast plants, resulting in lower production for the year. Third, the price of oil began “widely fluctuating” in 2008, “strain[ing] LBI’s ABL facilities.” Fourth, LBI’s sales, profits and inventory value were severely impacted by the global economic recession, which began in late 2008. To improve liquidity during this time, LBI drew upon and then repaid a $300 million revolver provided by Access Industries (an entity owned by Blavatnik and a prior indirect owner of Basell). After Access refused a redraw request in December 2008, LBI filed for bankruptcy in early January 2009.
The Trust’s Claims and Legal Standards
Tasked with investigating and pursuing claims that could benefit unsecured creditors, the Trust conducted an analysis of the merger transaction and other significant transfers by LBI in the year prior to the bankruptcy. Ultimately, the Trust initiated claims against Smith, Blavatnik, and affiliates of Basell owned by Blavatnik (including Access), among others. The Trust sought to avoid, as constructive and actual fraudulent transfers, the payments on the toehold position, and, as preferential transfers, the $300 million repayment on the revolver by LBI.3
A constructive fraud claim allows a plaintiff to avoid transfers that were made for less than reasonably equivalent value at a time when the debtor was either insolvent or rendered insolvent as a result of the transfer. Insolvency under this section can be shown in one of three ways: (i) the “balance sheet” test, (ii) inadequacy of capitalization, or (iii) an intent to leave the debtor unable to pay its debts as they come due. The balance-sheet test is aimed at establishing whether a company’s debts are greater than its assets at a fair valuation and often involves an analysis of multiple valuation methodologies. The undercapitalization test looks to whether a company will have the ability to “generate sufficient profits to sustain operations,” and compares projected working capital with capital needs for a period of time post-transfer.
Preference claims, in contrast to fraudulent transfer claims, allow a plaintiff to avoid payments on antecedent debt made within a certain time frame prior to bankruptcy, so long as the debtor was insolvent or rendered insolvent as a result of the transfer. Insolvency may only be established through the balance-sheet test in the preference analysis; whether the debtor received reasonably equivalent value is not a factor.
An actual fraud claim does not require a showing of insolvency. It does, however, require proof that the debtor made a transfer “with actual intent to hinder, delay, or defraud” its creditors. To find actual fraud, courts often look to whether any badges of fraud are present in the transaction, including whether the transfer was made to an insider, was concealed, was of all the debtor’s assets, or was for less than reasonably equivalent value, and whether the debtor was insolvent or rendered insolvent shortly after the transfer.
The Court’s Ruling on Constructive Fraud and Preference Claims
The Trust’s constructive fraud and preference claims were based on allegations that Lyondell was insolvent when the merger closed in December 2007 and when the Access revolver was repaid in October 2008. To show insolvency, the Trust relied on expert testimony to establish balance-sheet insolvency and undercapitalization.4
The main issue in dispute was Lyondell’s pre-merger projections: The Trust argued that the projections were “fraudulently prepared and wildly inflated” and that reasonable projections would have indicated insolvency. The Trust’s expert testifying that management’s projections should be disregarded was CMAI, which prepared revised projections on behalf of the Trust that were designed to correct the flaws in management’s “refreshed” projections. Primarily using CMAI’s projections, the Trust’s other experts arrived at a valuation for LBI at the time of the merger which showed that LBI was balance-sheet insolvent by billions of dollars. Moreover, they testified that LBI was substantially undercapitalized at the time of the merger. LBI’s solvency, therefore, largely hinged on which set of projections the court would find most credible.
At the outset, the court stated that its analysis would begin with a review of management’s projections. To the extent these projections were “reasonable and prudent” when made, they may be relied on by the court. If management’s projections were fraudulently prepared and overinflated, they could be disregarded. Further, the Court said it would look to the views of the market and sophisticated investors involved in the transaction.
After an exhaustive review of the evidence at trial, the court criticized the method and circumstances under which Lyondell’s refreshed projections were prepared, but nevertheless found that they were reasonable when made. The court relied heavily on the fact that “nearly all of the parties involved in the Merger viewed the industry outlook at the time” to be “conducive to a healthy LBI.” The court found it particularly persuasive that the financing banks which invested “billions of dollars” in the merger ran independent projections and analyses and, based on their own analyses, concluded that the business had viability and would be adequately capitalized going forward. Further, the court found that the refreshed projections did not differ dramatically from Lyondell’s prior set of projections. Ultimately, the court blamed the various unforeseeable events post-closing for LBI’s poor performance after the merger.
In contrast, the court said the Trust’s experts lacked credibility, finding issues with the methodology that led to their conclusions. Importantly, the court pointed out that this was not the first time CMAI had offered opinions regarding LBI’s financial viability in connection with the merger: CMAI was retained by Basell in 2007 prior to the closing of the merger, and at that time found that management’s projections were “conservative” and supported the reasonableness of Lyondell’s business plan. The 2007 projections endorsed by CMAI were then relied upon by the banks that were financing the merger transaction.
Similarly problematic for the Trust was the fact that the model it used to create its proffered projections was incapable of being reproduced or tested by the defendants’ experts, creating a “black box” that could not be properly evaluated by the court or any other party. The court found it suspicious that the projections offered by CMAI at trial — which were supposed to reflect a 2007 perspective — “almost exactly matched LBI’s actual 2008 performance” despite the fact that multiple independent, unpredictable events occurred in 2008.
Since CMAI’s litigation-based projections were relied upon by the Trust’s other experts for purposes of establishing that LBI was insolvent, all of the Trust’s experts’ opinions were largely discredited. Moreover, the Trust’s valuation expert admitted that had he used management’s projections and his own valuation methodologies, LBI would have been solvent at the time of the merger. The court likewise found that the Trust had not provided sufficient evidence to establish balance-sheet insolvency when the Access revolver was repaid, finding that emails documenting that the company was considering a bankruptcy filing were insufficient to actually establish insolvency.
Based in part on the reasonableness of the projections, the court found that LBI was solvent when the merger closed in December 2007 and when the revolver was repaid in October 2008. Given its solvency findings, the court dismissed the Trust’s constructive fraud and preference claims and determined it was not necessary to reach a conclusion on whether the transfers were made for less than reasonably equivalent value.
The Court’s Ruling on Actual Fraud
The Trust’s actual fraud claims were premised on allegations that Smith acted with fraudulent intent in preparing the revised projections, and that Smith’s fraudulent intent could be attributed to Basell through a novel application of the “collapsing doctrine.” The Trust also argued that Blavatnik had a fraudulent intent to render the toehold payments actual fraudulent transfers.
After a review of the evidence related to the Trust’s allegations, the court dismissed all the actual fraud claims outright. While the court again recognized that Smith’s process for creating the refreshed projections was flawed, it found no evidence that the refreshed projections were used to defraud creditors, nor any evidence that Smith directed subordinates to create fraudulent projections or overinflated outcomes. The court further noted that Smith sought to continue working at LBI after the merger and found it instructive that the Trust could not explain “why Smith would volunteer to captain a ship he had engineered to sink.” Likewise, the court found that even if Smith’s fraudulent intent could be imputed vertically to the corporation for which he served as an officer (Lyondell), there was no legal basis (or evidence) to ascribe this fraudulent intent horizontally to Basell, the transferee. Lastly, the court found that “no amount of mental gymnastics” could justify a fraud claim against Blavatnik, a person who “lost billions on LBI’s failure.”
While the court’s review of the claims included an extensive factual analysis, a few key takeaways are worth noting.
First, where management has provided projections and/or a business plan contemporaneous with the time of the transfers that illustrate solvency or adequate capital, the reasonableness of these projections will often be critical to the defendants’ case in opposition to fraudulent transfer and preference claims. A party challenging contemporaneous projections will have to show those projections were unreasonable when made, as any contrasting projections prepared in connection with litigation run the risk of being tainted with hindsight — especially where there are significant unplanned or unforeseeable intervening events that independently impacted the business. Indeed, the court in Lyondell found management’s projections prepared for the merger reasonable even though there were obvious issues in the manner and circumstances under which they were prepared.
Second, plaintiffs and defendants alike should be cognizant of any previous opinions expressed by experts — whether formal or informal — that could directly undermine testimony given in litigation. In particular, where an expert has previously contradicted the positions he or she is taking in litigation (including in advice provided to other parties in the same matter), the resulting credibility issues will be difficult (if not impossible) to overcome.
Finally, the court placed significant reliance on the financing banks’ independent analysis and determination that management’s projections were reasonable and the merger was a good deal. The court did not appear, however, to directly address the fact that the banks were lending on a secured, rather than an unsecured basis. And while the court recognized that the financing banks received fees in connection with lending to LBI and were unable to syndicate the LBI debt, it nevertheless found that the banks’ independent analyses supported a finding of solvency at the time of the merger. It remains to be seen whether a court faced with similar facts and credible contradicting testimony from the plaintiffs would yield a similar result.