Any buyer of assets from a company in any degree of financial stress should be concerned about the transaction being attacked as a fraudulent transfer. Officers and directors of a selling entity also have concerns about this risk due to potential personal liability. Such an attack can result in the transaction being “undone” (with the parties being returned to their positions prior to the transaction) or, since it is often difficult to return the parties to their prior positions, such an attack can result in a judgment against the buyer and selling officers and directors for the difference between what the buyer paid and what the court determines the buyer should have paid. Most parties mitigate this risk by getting certain information prior to closing their transaction. But the adequacy of that information is debatable until litigation is pursued.
On December 12, 2013, after 34 trial days involving 68 witnesses (including 14 expert witnesses) and over 6,000 exhibits, the U.S. Bankruptcy Court for the Southern District of New York entered a 166 page memorandum opinion holding that certain affiliates of Anadarko Petroleum owed Tronox somewhere between $5 billion and $14 billion as damages for a fraudulent transfer that began in 2002 and was completed in 2006. Several months later, the parties settled for about $5 billion, subject to a public comment period and court approval that remains pending.
The ruling addresses many issues, each of which was hotly contested. A complete discussion of all these issues is beyond the scope of this post. However, this article and a couple others will focus on a few highlights, with an emphasis on lessons learned for buyers in future transactions.
Summary of Key Facts
In 2000, Kerr McGee was a large, successful company that had two main lines of business – a chemical company that historically had been involved in many different businesses, and an oil and gas exploration business. The chemical business had a low profit margin and significant legacy environmental and mass tort liabilities. In contrast, the oil and gas business was booming. Senior management believed that the stock price of the combined businesses was depressed due to the legacy liabilities of the chemical business. So they commenced a series of activities that ended in March, 2006, with the chemical business and oil and gas business being completely separated.
Essentially, the chemical assets were placed in one set of companies that were “spun off” into a separate public company under the Tronox name. The remaining oil and gas business was a public corporation under the Kerr McGee name. A few months after the separation was completed in 2006, Anadarko Petroleum bought the stock of Kerr McGee for $17 billion. The funds were paid to Kerr McGee’s shareholders and not to Tronox, and Kerr McGee became a subsidiary of Anadarko.
Tronox raised $225 million in equity, obtained $450 million in secured debt, and obtained $350 million in unsecured debt as a separate public company. It then proceeded to operate on its own until it filed bankruptcy in January, 2009. As part of the bankruptcy case, Tronox sued the Kerr McGee subsidiary of Anadarko, claiming that Kerr McGee only paid Tronox about $2.6 billion for the assets that Anadarko ended up buying for $17 billion, and Kerr McGee left Tronox insolvent when it acquired the oil and gas assets. Accordingly, Tronox requested the difference of about $14 billion. The bankruptcy court agreed to these damages as the high end of a range that started at about $5 billion. Either way, when added to the $17 billion Anadarko had already paid the Kerr McGee shareholders, the judgment exposed Anadarko to paying a total of $22 – $31 billion for the oil and gas business.
Background on Fraudulent Transfers
By way of background, there are two kinds of fraudulent transfers – those with “actual” fraud, and those with “constructive” fraud. “Actual” fraud requires proof of “intent to hinder, delay or defraud” a seller’s creditors. “Constructive” fraud requires proof of (1) a transfer for less than “reasonably equivalent value”, and (2) at a time when the transferor is insolvent or rendered insolvent (with insolvency measured in several ways, including “unreasonably small capital”). Finally, the Bankruptcy Code has a fraudulent transfer provision that only covers transactions within two years before a bankruptcy case is filed. Most states have separate fraudulent transfer statutes that only cover transactions within four years before a bankruptcy case is filed.
Most sellers and buyers in transactions involving sellers in financial distress gather the following kinds of information to minimize the risk of a court finding the transaction was a fraudulent transfer:
- Proof of a Legitimate Business Purpose Other than to Hinder, Delay or Defraud Creditors. Most sellers will create board minutes, and buyers may insist on recitals, explaining the business reasons for entering a transaction. These explanations often acknowledge the financial stress of the seller, but note other independent reasons for doing a transaction (such as anticipated business opportunities and issues and personal needs of owners of closely held businesses).
- Proof of “Reasonably Equivalent Value”. Most sellers and buyers also will attempt to determine the fair market value of the transaction through appraisals, fairness opinions, marketing efforts, and the like.
- Proof of “Solvency”. Finally, most sellers and buyers also will attempt to establish that the seller was “solvent” after entering the transaction based on accounting statements and various measures of “business enterprise value” (such as discounted cash flow analysis and comparable company valuations).
Lessons from Tronox: Part 1 – Statute of Limitations
In the Tronox ruling, the bankruptcy court held that a separate federal statute only applicable to claims by the federal government could be used to set aside transactions within six years before the bankruptcy case was filed. Moreover, the bankruptcy court held that the litigation trustee for Tronox could use this federal statute for the benefit of all creditors of Tronox, not just the federal government. Since the federal government is a creditor in most business bankruptcy cases, the first lesson from Tronox is that most transactions are subject to attack for up to six years after the transaction closes. If the federal government has a potential tax claim, then the statute of limitations may extend to ten years under Section 6502 of the Internal Revenue Code.
The Tronox ruling also “collapsed” a series of transfers that occurred over a four year period, with only the last steps in the transfers occurring within six years before the bankruptcy case was filed. This had the effect of essentially extending the limitations period about nine years prior to the bankruptcy case being filed. Thus, the second lesson from Tronox is that a series of transfers may be combined into one overall “transfer” that effectively extends the limitations period indefinitely.
So what should a buyer learn from these lessons? First, due diligence for any material transaction should include a determination of whether there are any potential fraudulent transfer issues. For example, were the assets in question acquired by the target company in a prior transaction? If so, what were the terms of the prior transaction? Do those terms create any fraudulent transfer issues?
Second, if due diligence identifies any potential fraudulent transfer issues, then try to determine the potential damages, the time remaining on the statute of limitations, the likelihood of any party bringing a fraudulent transfer action, and possible ways to minimize the risk in the transaction. Possible alternatives to minimize the risk include buying the assets out of a bankruptcy case, delaying a closing, paying the purchase price over time with a right of setoff for any fraudulent transfer claims, and getting an indemnity from the selling owners who otherwise will be receiving any proceeds.