With its landmark ruling in Deutsche Bank Trust Co. Ams. v. Large Private Beneficial Owners (In re Tribune Co. Fraudulent Conveyance Litig.), 818 F.3d 98 (2d Cir. 2016) ("Tribune 1"), the U.S. Court of Appeals for the Second Circuit held that claims asserted by creditors of the Tribune Co. ("Tribune") seeking to avoid payments to shareholders during a 2007 leveraged buyout ("LBO") as constructive fraudulent transfers were preempted by the "safe harbor" under section 546(e) of the Bankruptcy Code. According to the court, even though section 546(e) expressly provides that "the trustee" may not avoid certain payments under securities contracts unless such payments were made with the actual intent to defraud, section 546(e)’s language, its history, its purposes, and the policies embedded in the securities laws and elsewhere lead to the conclusion that the safe harbor was intended to preempt constructive fraud claims asserted by creditors. On September 9, 2016, the plaintiffs filed with the U.S. Supreme Court a petition for a writ of certiorari, which is currently pending, as well as a petition filed in another case involving the same issue. See Deutsche Bank Trust Co. Ams. v. Robert R. McCormick Foundation, No. 16-317 (U.S. Sept. 9, 2016).
Tribune 1, however, is only half the story in the litigation to recover payments made to Tribune’s shareholders in connection with the LBO. Tribune’s official creditors’ committee (succeeded by the litigation trustee (the "Trustee") appointed under Tribune’s confirmed chapter 11 plan) separately sued to avoid the payments as actual, rather than constructive, fraudulent transfers.
In Kirschner v. FitzSimons (In re Tribune Co. Fraudulent Conveyance Litig.), 2017 BL 5202 (S.D.N.Y. Jan. 6, 2017) ("Tribune 2"), the district court overseeing the consolidated avoidance litigation held that, in the context of an action to avoid an intentionally fraudulent transfer under section 548 of the Bankruptcy Code: (i) when determining whether a debtor corporation had the intent to hinder, delay, or defraud its creditors, courts must examine the intent of the corporate actors who effectuated the transaction on behalf of the corporation; (ii) the intent of a debtor corporation’s officers can be imputed to the debtor only if the officers were in a position to control the disposition of the debtor’s property; and (iii) the Trustee failed to plead facts sufficient to allege that Tribune’s corporate actors possessed the intent to hinder, delay, or defraud Tribune’s creditors through the LBO.
The Tribune LBO
In 2007, Tribune was the target of an LBO that paid its shareholders more than $8 billion in exchange for their shares in the company (the "Shareholder Transfers"). Prior to the LBO, Tribune’s board of directors (the "Board") created a special committee (the "Special Committee") to consider the LBO. The Special Committee included seven independent directors (the "Independent Directors") that served on the Board. There were two separate parts to the contemplated LBO. First, Tribune would borrow approximately $7 billion and purchase approximately 50 percent of its outstanding shares for $34 per share in a tender offer. Second, the company would purchase its remaining shares and borrow an additional $3.7 billion in a go-private merger with a newly formed Tribune entity. The Board engaged Duff & Phelps to provide a solvency opinion for both steps. Duff & Phelps issued a "viability opinion" in which it concluded that, considering potential tax savings, Tribune would be able to pay its debts as they became due after the LBO.
After considering opinions on the fairness of the proposed transaction, a majority of the Board, including six of the Independent Directors, voted in favor of the LBO on April 1, 2007. Ten days afterward, the Board retained Valuation Research Company ("Valuation Research") to render solvency opinions concerning both parts of the transaction. Valuation Research rendered the solvency opinions shortly before the completion of each part of the LBO.
Shortly after the LBO was completed in December 2007, Tribune experienced financial difficulties due to declining advertising revenues and failed to meet projections. The company filed for chapter 11 protection in December 2008 in the District of Delaware.
The court confirmed Tribune’s chapter 11 plan in July 2012. The plan assigned certain of the estate’s avoidance claims to a litigation trust. Thus, the Trustee became the successor plaintiff in litigation that had been commenced in November 2010 by the unsecured creditors’ committee (with leave of the court) seeking to avoid and recover the Shareholder Transfers as actual fraudulent transfers under sections 548(a)(1)(A) and 550 of the Bankruptcy Code. The shareholder defendants moved to dismiss the complaint.
The District Court’s Ruling
The district court granted the motion to dismiss. At the outset, the court explained that, when considering whether a debtor had the actual intent to hinder, delay, or defraud its creditors within the meaning of section 548(a)(1)(A), "courts focus on the intent of the transferor, not the intent of the transferee." However, if the transferor is a corporation, courts assessing intent in this context look to the intent of the corporate agents who effectuated the transaction on behalf of the corporation. Under certain circumstances, the court noted, the intent of such corporate actors to defraud can be imputed to the corporation.
The district court then analyzed whether Tribune’s officers (the "Officers") or the Independent Directors effectuated the LBO with the intent to hinder, delay, or defraud the company’s creditors and, if so, whether that intent could be imputed to Tribune.
The district court acknowledged that the Second Circuit has not yet articulated a test for determining when an officer’s intent should be imputed to a corporation in actual fraudulent transfer litigation.
However, it agreed with decisions from other courts that the intent of a debtor’s officers may be imputed to the debtor if the officers were in a position to control the disposition of the transferor’s property and, exercising that control, effectuated the fraudulent transfer (citing In re Roco Corp., 701 F.2d 978 (1st Cir. 1983); In re Lehman Bros. Holdings Inc., 541 B.R. 551 (S.D.N.Y. 2015); In re Adler, Coleman Clearing Corp., 263 B.R. 406 (S.D.N.Y. 2001); In re Lyondell Chem. Co., 503 B.R. 348 (Bankr. S.D.N.Y. 2014) ("Lyondell 1"), abrogated in part on other grounds in Tribune 1, 818 F.3d at 118; In re Elrod Holdings Corp., 421 B.R. 700 (Bankr. D. Del. 2010); In re L & D Interests, Inc., 350 B.R. 391 (Bankr. S.D. Tex. 2006)).
"In other words," the district court wrote, "an officer’s wrongful intent may be imputed to the corporation ‘by establishing that [the officer], by reason of the ability to control’ members of the board, ‘caused the critical mass’ to form ‘an actual intent to hinder, delay or defraud creditors’ " (quoting Weisfelner v. Fund 1 (In re Lyondell Chem. Co.), 541 B.R. 172, 177–78 (Bankr. S.D.N.Y. 2015) ("Lyondell 2"), rev’d and remanded, 554 B.R. 635 (S.D.N.Y. 2016) ("Lyondell 3"). According to the court, "[T]his test appropriately accounts for the distinct roles played by directors and officers under corporate law, while also factoring in the power certain officers and other actors may exercise over the corporation’s decision to consummate a transaction" (citing Lyondell 1, 503 B.R. at 388).
In Lyondell 3, the district court reversed the bankruptcy court’s ruling in Lyondell 2, holding that, under Delaware law, the knowledge and actions of a corporation’s officers and directors are imputed to the corporation when the officers and directors are acting within the scope of their authority, even when the agents act fraudulently. The Tribune 2 court acknowledged the reversal but found the reasoning in Lyondell 2 to be "highly compelling." Moreover, the Tribune 2 court found Lyondell 3 to be distinguishable, noting that the allegations of control and profit motive in Lyondell 3 were significantly more compelling than in the case before it.
"To the extent that [Lyondell 3] also concluded that it was unnecessary for the trustee to allege control by the CEO to impute his intent to the transferor corporation," the Tribune 2 court wrote, "the Court disagrees." Noting that other courts applying federal law have also concluded that a finding of control is a prerequisite for imputation, the Tribune 2 court further observed that "even assuming, [as Lyondell 3] concluded, that Delaware law (as opposed to the Bankruptcy Code or federal common law) controls the imputation analysis, the relevant inquiry—and the outcome—would be the same."
The Tribune 2 court rejected the argument that only the directors’ intent is relevant in assessing the corporation’s intent because "it is too restrictive and ‘effectively disregards any influence on the Board that [officers] may have exercised’ " (quoting Lyondell 1, 503 B.R. at 386). The court also rejected the argument that an officer’s intent is always attributable to the corporation in actual fraud cases.
Instead, the court held that, for the purpose of imputing fraud in this context, if a party who does not own a majority of a corporation’s shares is alleged to control the corporation, the plaintiff must show " ‘such formidable voting and managerial power that [he], as a practical matter, [is] no differently situated than if [he] had majority voting control’ of the corporation’s shares" (quoting In re Morton’s Rest. Grp., Inc. Shareholders Litig., 74 A.3d 656, 665 (Del. Ch. 2013)).
The district court concluded that the Officers had neither voting power nor managerial control of Tribune. The court found, among other things, that: (i) although Tribune’s CEO was affiliated with an entity which owned 13 percent of Tribune’s stock, that percentage was far below the amount typically found to constitute "formidable" voting power under Delaware law; (ii) the Trustee failed to offer evidence that the Officers had the right to appoint directors, veto Board action, or remove or reduce compensation for Board members who did not vote in favor of the LBO; and (iii) because the Special Committee reviewed projections before approving the LBO, were advised by an independent financial advisor, and obtained solvency and viability opinions from outside experts, the Trustee’s arguments that the Officers deceived—and thus controlled—the Special Committee by, among other things, creating inflated projections and flawed solvency opinions and manipulating information were unavailing.
The court also rejected the Trustee’s argument that the Officers had misled Valuation Research into issuing a flawed solvency opinion, thereby indirectly deceiving the Board and the Special Committee. According to the court, "[A]llowing the Trustee’s expansive conception of the imputation doctrine sweeps the corporate landscape too broadly." Relying on Tribune 1, the court concluded that the Trustee’s "multi-layered imputation theory" would undermine Congress’s policy of protecting securities markets by introducing substantial uncertainty to the law governing actual fraudulent transfer claims. "[G]iven the ease with which one could allege that the misrepresentation of a material fact—originating from any source—manipulated the board’s decisionmaking," the court wrote, "it is important to confine the imputation doctrine to those actors who deliberately and directly exert control inside the boardroom."
Thus, the court ruled that, because the Officers did not exercise voting or managerial control, "the Trustee’s attempt to impute the Officer Defendants’ intent to the corporation is unjustified."
The Independent Directors
The Trustee alleged that the Independent Directors, who were delegated authority by the Board to approve the LBO and who were "clearly" in a position to control the outcome of the Board’s vote, possessed fraudulent intent. On the basis of these allegations, the district court ruled that any intent to defraud on their part could be imputed to Tribune for purposes of the Trustee’s fraudulent transfer claim.
The court explained that, in determining whether a party possesses actual intent to hinder, delay, or defraud creditors, many courts apply: (1) the "purposeful harm test," whereby the plaintiff must provide either direct proof of actual intent or, because fraudulent intent is rarely susceptible to direct proof, a strong inference of fraudulent intent by relying on certain "badges of fraud"; or (2) the "securities law test," which requires either evidence that the debtor had both the motive and the opportunity to hinder, delay, or defraud its creditors or strong circumstantial evidence of conscious misbehavior or recklessness. The court concluded that the Trustee failed to allege actual fraudulent intent on the part of the Independent Directors under either standard.
The district court also observed that some courts consider the following badges of fraud when determining whether an inference can be made to support a finding of actual intent to hinder, delay, or defraud:
(1) the lack or inadequacy of consideration; (2) the family, friendship or close associate relationship between the parties; (3) the retention of possession, benefit or use of the property in question; (4) the financial condition of the party sought to be charged both before and after the transaction in question; (5) the existence or cumulative effect of a pattern or series of transactions or course of conduct after the incurring of debt, onset of financial difficulties, or pendency or threat of suits by creditors; and (6) the general chronology of the events and transactions under inquiry.
In re Kaiser, 722 F.2d 1574, 1582 (2d Cir. 1983).
Among other things, the court rejected the argument that the Independent Directors acted with fraudulent intent because Tribune received less than reasonably equivalent value in connection with the LBO and because the LBO rendered Tribune insolvent. Allowing such allegations to raise a strong inference of fraudulent intent, the court wrote, would "turn every constructive fraudulent conveyance claim into an actual fraudulent conveyance claim and thereby undermine the distinction between the two claims."
The court acknowledged that the claim that an allegedly fraudulent transfer was made to an insider or "close associate" can support an inference of fraudulent intent. However, it found that the only proceeds that the Independent Directors received from the Shareholder Transfers were from selling their shares in Tribune and that "any inference of scienter that could be drawn from the Independent Directors’ receipt of a miniscule fraction of the Shareholder Transfers is weak at best."
The court also rejected the argument that the fifth badge of fraud had been satisfied. It explained that LBOs, by their nature, are transactions outside the ordinary course of business which require the incurrence of new debt. Accepting the Trustee’s argument, the court wrote, "would mean that every LBO that ends in a bankruptcy within two years of its effectuation would subject transferring shareholders to an actual fraudulent conveyance claim."
Addressing the securities law test, the court acknowledged that the Independent Directors had the motive and opportunity to hinder, delay, or defraud Tribune’s creditors because the Independent Directors would receive consideration in exchange for their shares only if the LBO was consummated. However, the court concluded, "the mere fact that the Independent Directors received Shareholder Transfers in connection with the LBO fails to support a strong inference of scienter, since a corporate director’s desire to realize personal benefits in connection with a merger is a motive shared by every corporate director in America."
The court rejected the Trustee’s argument that the Independent Directors had acted recklessly when they approved the LBO. Because the Special Committee hired its own advisor and worked with the Board’s advisors, the court explained, the Special Committee did not "blindly" accept the projections of Tribune’s management. Moreover, the court noted, failure to conduct more rigorous downside testing of the LBO would support a finding of negligence, not conscious misbehavior or recklessness.
With respect to the subsidiary guaranties, the court stated that a company’s guaranty of new debt which subordinates old debt cannot, by itself, provide sufficient evidence of actual fraudulent intent. Similarly, the court determined that, although the Independent Directors considered negative trends in the newspaper industry and concluded that the trends weighed in favor of the LBO, the Trustee’s argument amounted to "little more than a meatless assertion that the Independent Directors should have known better," which was not enough to establish fraudulent intent.
On the basis of these findings, the court ruled that the Trustee had failed to plead facts sufficient to allege that the Independent Directors possessed actual intent to hinder, delay, or defraud Tribune’s creditors through the LBO.
Tribune 2 provides important guidance regarding the elements of an actual fraudulent transfer claim under section 548(a)(1)(A) as well as the circumstances under which the fraudulent intent of corporate actors may be imputed to the corporation. The ruling sets a high standard for imputing fraud.
The legal landscape is unsettled because the Tribune 2 fraud imputation standard differs from the approach adopted by the court in Lyondell 3. Both rulings considered whether the fraudulent intent of officers and directors can be imputed to a Delaware corporation for purposes of fraudulent transfer litigation, yet the courts disagreed as to whether control must be adequately alleged as a prerequisite to imputation and as to which law—Delaware or federal—should apply. Confusion on these issues is likely to remain unless and until the Second Circuit ultimately resolves them.