Posts Tagged ‘Business’
Sunday, June 12th, 2011
Personal liability for corporate debt has been all the rage in the Ninth Circuit.¬† Within the last year, at least two appellate decisions (discussed here and here) have clarified the doctrine of alter ego liability ‚Äď the idea that a corporate entity and its principals ought to be treated as one and the same, and therefore equally liable for corporate obligations.
It is easy to see why interest in alter ego liability has become so fashionable: When a business slips into insolvency and cannot pay its creditors in full, those creditors naturally go looking for other pockets from which to satisfy their claims.
Cover of Flushed Away (Widescreen Edition)
If creditors can show that the business‚Äô officers effectively ran the business for personal economic purposes rather than as a separate and distinct corporate entity, the doctrine of alter ego permits creditors to hold the officers responsible for the business‚Äô obligations.¬† This is especially the case where it appears the officers used the business to perpetrate a fraud or some other inequity on creditors.¬† One California court noted that ‚Äú[t]he general purpose of the doctrine of alter ego is to look through the fiction of the corporation and to hold the individuals doing business in the name of the corporation liable for its debts in those cases where it should be so held in order to avoid fraud or injustice.‚ÄĚ
Earlier this year, Judge Clarkson of California‚Äôs Central District followed this fashion trend by offering his view on a non-dischargeability claim based on alter ego liability.
The facts of In re Munson are relatively straightforward.¬† Robert and Kimberly Munson were the owners ‚Äď and corporate officers ‚Äď of Munson Plumbing, Inc. (‚ÄúMPI‚ÄĚ), a plumbing subcontractor on several public works projects in the Los Angeles metropolitan area.¬† As is typically required of public works contractors, MPI‚Äôs work was backed by surety bonds issued by SureTec Insurance Company (‚ÄúSureTec‚ÄĚ).¬† As part of the consideration for the issuance of the surety bonds, the Munsons and MPI signed a General Agreement of Indemnity (‚ÄúSureTec Indemnity Agreement‚ÄĚ), in which the Munsons agreed to jointly and severally indemnify SureTec and to deposit collateral with SureTec upon its demand. ¬†The SureTec Indemnity Agreement contained language that all project funds received by MPI would be held in trust for the benefit of SureTec.
Eventually, MPI encountered financial difficulties and could not pay its own subcontractors ‚Äď thereby requiring SureTec to make payments under the bonds and finish MPI‚Äôs work.
Concurrent with MPI‚Äôs demise, the Munsons commenced individual Chapter 7 proceedings.¬† SureTec, which had been left with over $436,000 in losses related to various MPI projects, asserted claims against the Munsons individually.¬† It also sought to have at least a portion of those losses deemed non-dischargeable in the Munsons‚Äô Chapter 7 case.¬† Specifically, it claimed:
- The SureTec Indemnity Agreement created an express trust which placed fiduciary duties upon the Munsons.
- Further, because the Munsons had allegedly defrauded SureTec by diverting at least $95,000 in progress payments on the projects to non-bonded expenses, including their own personal expenses, applicable fiduciary duties upon the Munsons arose by California statutes (including Business & Professions Code ¬ß7108 and Penal Code ¬ß¬ß¬ß 484b, 484c and 506.)
- The Munsons were alter egos of MPI, and therefore were liable for MPI‚Äôs obligations under the surety bonds.
- The Munsons‚Äô obligations were non-dischargeable because they arose as a result of the Munsons‚Äô breach of their fiduciary duties.
The Debtors sought dismissal of SureTec‚Äôs lawsuit.¬† In a brief, 9-page decision, Judge Clarkson found that:
- ¬†The SureTec Indemnity Agreement did not impose fiduciary duties upon the Munsons.¬† ‚ÄúIf a trust was created, it imposed the fiduciary duty obligations on the corporation, the receiver and disburser of the project funds. The [Munsons,] [in] signing the [SureTec Indemnity Agreement] were creating only a creditor-debtor relationship (and a contingent one at that) between SureTec and the [Munsons]. They were ‚Äúindemnifying‚ÄĚ SureTec, as SureTec accurately indicates¬† . . . .‚ÄĚ
- Any alleged trust relationship created on a constructive, resulting, or implied basis (i.e., arising legally as a result of the Munsons‚Äô allegedly bad acts) is not the sort of trust relationship which gives rise to a non-dischargeable debt.¬† ‚ÄúThe core requirements [for asserting non-dischargeability based on breach of a fiduciary duty] are that the [fiduciary] relationship exhibit characteristics of the traditional trust relationship, and that the fiduciary duties be created before the act of wrongdoing and not as a result of the act of wrongdoing.‚ÄĚ
- SureTec‚Äôs allegations of alter ego liability were likewise insufficient to tag the Munsons with the sort of fiduciary obligations that would give rise to a non-dischargeable claim.¬† ‚ÄúIf a finding of alter ego were to be considered as imposing fiduciary duties, any such imposition would be ex maleficio, i.e., trusts that arose by operation of law upon a wrongful act.‚ÄĚ
Judge Clarkson also found that SureTec‚Äôs separate non-dischargeability claim for fraud had not been pleaded with the requisite particularity, and dismissed it with leave to amend.
The Munson decision is important in several respects:
- It emphasizes the relatively narrow scope of non-dischargeability claims based on breaches of fiduciary duty in the Ninth Circuit.
- It also emphasizes the similarly narrow scope of liability derived from alter ego status.
- It highlights the importance of the alter ego doctrine as a strategic tool for both creditors and trustees in bankruptcy litigation ‚Äď as well as litigants‚Äô varying success in using it.¬† As detailed in other posts, alter ego liability has been employed (i) unsuccessfully as a ‚Äúblocking device‚ÄĚ in an attempt to capture recoveries for the corporation‚Äôs bankruptcy estate; and (ii) successfully to preserve recoveries from self-settled trusts to which the debtors attempted to convey assets out of the reach of creditors.¬† Here, alter ego was employed (again, without success) to ‚Äúbootstrap‚ÄĚ a creditor‚Äôs claim into ‚Äúnon-dischargeable‚ÄĚ status.
Tuesday, May 31st, 2011
Many insolvency practitioners are familiar with the “high-asset” individual debtor – often a business owner or owner of rental property or other¬†significant business and personal assets – whose financial problems are too large for standard “individual debtor” treatment.
Such debtors are a prominent feature of commercial insolvency practice in California and other western states.¬† These individuals typically have obligations matching the size of their assets:¬†¬†Their restructuring needs are too large for treatment through an “individual”¬†Chapter 13 reorganization, and must instead be handled through the “business” reorganization provisions of a Chapter 11.
When Congress amended the Bankruptcy Code in 2005, it recognized the need of some individuals to use the reorganization provisions of Chapter 11.¬† It provided certain amendments to Chapter 11 which parallel the “individual” reorganzation provisions of Chapter 13.
But certain “individual” reorganization concepts do not translate clearly into Chapter 11′s “business” provisions.¬† Among the most troublesome of these is the question of whether an individual debtor can reorganize by paying objecting unsecured creditors less than 100% while continuing to retain existing property or assets for him- or herself.
In Chapter 13, the answer to this question is “yes.”¬† But in Chapter 11 – at least until 2005 – the¬†answer has historically been “no.”¬† This is because Chapter 11,¬†oriented as it is toward business reorganization, prohibits a reorganizing debtor from retaining any property while an¬†objecting class of unsecured creditors is paid something less than the entirety of its claims.¬† Known as the “absolute priority rule,” this prohibition has been a mainstay of Chapter 11 business practice for decades.
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In 2005, Congress amended Chapter 11′s “absolute priority rule” provisions to provide that despite the “absolute priority” rule, individual Chapter 11 debtors could nevertheless retain certain types of property, even when objecting unsecured creditors are paid less than 100%.¬†¬†For instance,¬†an individual¬†debtor may retain certain wages and earnings earned after the commencement of the debtor’s case.¬† But can the individual debtor retain other types of property (for example, a rental property or closely held stock in a business), while paying objecting creditors less than 100%?
Congress’ “absolute priority rule” amendments for individual debtors are ambiguous – as is the language of a section which expands the definition of “property” included within the individual Chapter 11 debtor’s estate (paralleling similar treatment of individual Chapter 13 debtors).¬† As a result, Bankruptcy Courts are split on the question of whether or not the “absolute priority rule” applies to individual Chapter 11 debtors.
Until very recently, the Central District of California – one of the nation’s largest, and a frequent filing destination for individual Chapter 11 cases – had been silent on the issue.¬† This month, however, Judge Theodor Albert of Santa Ana joined a growing number of courts which conclude that Congress’ 2005 “absolute priority rule” amendments apply only to individual wages and earnings, and that individuals cannot retain other types of property where objecting creditors are paid less than 100%.
In a careful, 13-page decision issued for publication, Judge Albert collected and examined cases on both sides of this question and concluded:
After BAPCPA, the debtor facing opposition of any one unsecured creditor must devote 5 years worth of ‚Äúprojected disposable income,‚ÄĚ at a minimum (or longer if the plan is longer).¬† But [the] debtor is not compelled to give also his additional earnings or after-acquired property net of living expenses beyond five years unless the plan is proposed for a period longer than five years.¬† But there is no compelling reason to also conclude that prepetition property need not be pledged under the plan as the price for cram down, just as it has always been.
Judge Albert’s decision joins several other very recent ones going the same direction, including In re Walsh, 2011 WL 867046 (Bkrtcy.D.Mass., Judge Hillman); In re Stephens, 2011 WL 719485 (Bkrtcy.S.D.Tex., Judge Paul); and In re Draiman, 2011 WL 1486128 (Bkrtcy.N.D.Ill., Judge Squires).
Tuesday, May 10th, 2011
Most insolvency practitioners are familiar with the fighting which often ensues when creditors jockey for position over a troubled firm’s capital structure.¬† From Kansas, a recent¬†decision issued in February highlights the standards which apply to claims that a senior creditor’s claim ought to be “subordinated” to those of more junior creditors or equity-holders.
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QuVIS, Inc. (“QuVIS”),¬†a provider of digital motion imaging technology solutions in a number of industries, found itself the target of an involuntary Chapter 7 filing in 2oo9.¬† The company converted its case to one under Chapter 11 and thereafter sought to reorganize its affairs.
QuVIS ‚Äô debt was structured in an unusual way.¬† When presented with some growth opportunities in the early 2000′s, the company issued secured notes under a credit agreement that capped its lending at $30,000,000.¬† ‚ÄúInvestors‚ÄĚ acquired these notes for cash and received a security interest, evidenced by a UCC-1 recorded in 2002.¬† One of QuVIS’ “investors” was Seacoast Capital Partners II, L.P. (“Seacoast”), a Small Business Investment Company (‚ÄúSBIC‚ÄĚ) licensed by the United States Small Business Administration.¬† Between 2005 and 2007, Seacoast lent approximately $4.25 million through a series of three separate promissory notes issued by QuVIS.¬† In 2006, and consistent with the purposes of the Small Business Investment Act of 1958, under which licensed SBICs are expected to provide management support to the small business ventures in which they invest, Seacoast’s Managing Director, Eben S. Moulton (‚ÄúMoulton‚ÄĚ), was designated as an outside director to QuVIS’ board.
In 2007, it came to Seacoast’s attention that, despite its belief to the contrary, a UCC-1 had never been filed on Seacoast’s behalf regarding its loans to QuVIS.¬† Nor had the earlier (and now lapsed) UCC-1 filed regarding QuVIS’ other “investors” ever been modified to reflect Seacoast’s participation in the company’s loan structure.¬† Seacoast immediately filed a UCC-1 on its own behalf in order to protect its position.¬† Some time after QuVIS found itself in Chapter 11 in 2009, the Committee of Unsecured Creditors (and other, less alert¬†”investors”) sought to subordinate Seacoast’s position.
The Committee’s argument was based exclusively on¬†11 U.S.C. ¬ß 510(c), which provides, in pertinent part:
Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may‚ÄĒ (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim …
“Equitable” subordination is based on the idea of “inequitable” conduct -¬†such as¬†fraud, illegality, or breach of fiduciary duties.¬† Where an “insider” or a fiduciary of the debtor is the target of a subordination claim, however, the party seeking subordination need only show some unfair conduct, and a degree of culpability, on the part of the insider.
Seacoast sought summary judgment denying the subordination claim.¬† In granting Seacoast’s request, Judge Nugent of the Kansas Bankruptcy Court distinguished¬†Seacoast’s¬†Managing Director¬†from Seacoast, finding that though Moulton was indeed an “insider,” Seacoast was not.¬†¬†Therefore, Seacoast’s claim was not subject to subordination for any “unfair conduct” which might be attributable to Moulton.¬† To that end, Judge Nugent also appeared to go to some lengths to demostrate that Mr. Moulton’s conduct was not in any way “unfair” or detrimental to the interests of other creditors.
Subordination claims are highly fact-specific.¬† With this in mind, the facts of the QuVIS decision¬†afford instructive reading for lenders whose lending arrangements may entitle them to designate one of the debtor’s directors.
Saturday, February 12th, 2011
Jones Day’s Charles Oellerman and Mark Douglas have just issued The Year in Bankruptcy: 2010.¬†¬†It is a (relatively) concise, thorough (81 pages), and useful compendium of bankruptcy statistics, trend analyses, case law highlights, and legislative updates for the year.
What to expect for 2011?¬† According to the authors:
[M]ost industry experts predict that the volume of big-business bankruptcy filings will not increase in 2011.¬† Also expected is a continuation of the business bankruptcy paradigm exemplified by the proliferation of prepackaged or prenegotiated chapter 11 cases and quick-fix section 363(b) sales. Companies that do enter bankruptcy waters in 2011 are more likely to wade in rather than freefall, as was often the case in 2008 and 2009. More frequently, struggling businesses are identifying trouble sooner and negotiating prepacks before taking the plunge, in an effort to minimize restructuring costs and satisfy lender demands to short-circuit the restructuring process.¬† Prominent examples of this in 2010 were video-rental chain Blockbuster Inc.;¬†Hollywood studio Metro-Goldwyn-Mayer, Inc.;¬†and newspaper publisher Affiliated Media Inc. Industries pegged as including companies ‚Äúmost likely to fail‚ÄĚ (or continue foundering) in 2011 include health care, publishing, restaurants, entertainment and hospitality, home building and construction, and related sectors that rely heavily on consumers.¬† Finally, judging by trends established in 2010, companies that do find themselves in bankruptcy are more likely to rely on rights offerings than new financing as part of their exit strategies.
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Sunday, December 19th, 2010
The distribution scheme embodied in federal bankruptcy law serves several important functions.¬† In Chapter 7, the detailed statutory distribution scheme imposes order on the chaos that might otherwise attend the liquidation of business assets.¬† In Chapter 11, the fixed order of priority claims and the ‚Äúabsolute priority rule‚ÄĚ ‚Äď along with the requirement that similarly situated classes receive identical treatment ‚Äď provide predictability within the confirmation process and a framework for out-of-court negotiations.
But not all resolutions of business insolvency afford this level of predictability.¬† In particular, state and federal receiverships afford the prospect of considerably greater flexibility and discretion on the part of the appointed receiver and the appointing court.
The scope of a receiver‚Äôs discretion was illustrated early this month by the 7th Circuit Court of Appeals‚Äô approval of a federal receiver‚Äôs proposed pro rata distribution of the assets of six insolvent hedge funds.
SEC v. Wealth Management LLC, ‚ÄĒ F.3d ‚ÄĒ 2010 WL 4862623 (7th Cir., Dec. 1, 2010) involved an SEC enforcement action against Appleton, Wisconsin-based investment firm Wealth Management LLC and its principals, alleging, among other things, misrepresentation and fraud.¬† At the SEC‚Äôs request, the Wisconsin District Court appointed a receiver for Wealth Management and its six unregistered pooled investment funds.
The receiver‚Äôs plan, approved by the District Court, was relatively straightforward:¬† All investors would be treated as equity holders, and would receive pro rata distributions of the over $102 million invested in the funds.¬† Two investors who had sought redemption of their investments pre-petition disagreed and appealed the receiver‚Äôs plan.¬† The essence of their argument was that Wisconsin law (and Delaware law, which governed several of the funds), required that investors who sought to redeem their investments be treated not as equity holders, but as creditors of the failed funds.¬† As a result, their redemption claims were of a higher priority than investors who had not sought to withdraw their funds.¬† The investors also relied on 28 USC ¬ß 959(b), which provides that receivers and trustees must ‚Äúmanage and operate‚ÄĚ property under their control in conformity with state law.
The 7th Circuit rejected this argument, finding instead that federal receivers and trustees need not follow the requirements of state law when distributing assets under their control. Holding that ‚Äúequality is equity,‚ÄĚ the court found that to give unpaid redemption requests the same priority as any other equity interest ‚Äúpromotes fairness by preventing a redeeming investor from jumping to the head of the line . . . while similarly situated non-redeeming investors receive substantially less.‚ÄĚ
The Wealth Management decision highlights the flexibility and ambiguity of the receivership system ‚Äď itself a critical distinction from the well-defined priorities of federal bankruptcy law.¬† Though the 7th Circuit‚Äôs reasoning ‚Äď rooted in ‚Äúsimilarly situated claims‚ÄĚ ‚Äď is consistent with the policy objectives of the Bankruptcy Code, the result is diametrically opposed to the scheme of priorities on which Wealth Management‚Äôs investors undoubtedly relied.
Wealth Management ‚Äď like many receivership cases ‚Äď is a case¬†based on¬†federal securities fraud.¬† But federal and state receiverships are applicable in a variety of contexts – including¬†business dissolutions, directorship disputes, marital dissolutions, and judgment enforcement.¬† Where a proposed distribution to creditors can be fairly characterized as ‚Äúequitable‚ÄĚ under the circumstances of the case and where it represents a fair exercise of the receiver’s fiduciary duty on behalf of the receivership estate, the flexibility of a receivership may justify its typically high cost.
Sunday, July 18th, 2010
A recent post over the July 4 holiday weekend offered a “30,000 foot view” of the 2008 world-wide financial meltdown and offered some broad observations about its causes – and remaining challenges to recovery.
From the Federal Bank of New York last week comes yet another broad overview – this one of the “shadow banking” system that has come to comprise a significant portion of the US’s (and the world’s) financial infrastructure – particularly that of the world financial markets.
In Shadow Banking, researchers Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky describe the financial components of this¬†ad hoc¬†banking system, its role in recent asset bubbles, its brittleness under stress, and the role of the Federal Reserve and other federal agencies in relieving that stress.
As described in the abstract:
The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, ‚Äúshadow banks‚ÄĚ are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.
Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo.
This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.
We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve‚Äôs discount window, or public sources of insurance, such as federal deposit insurance.¬† The liquidity facilities of the Federal Reserve and other government agencies‚Äô guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks.¬† Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.
Monday, June 14th, 2010
The Advisory Committee on Bankruptcy Rules of the Administrative Office of the U.S. Courts has pulled back from its earlier position on the disclosure required of hedge fund and other distressed debt investors participating as ad hoc committees or other, loosely organized creditor groups in Chapter 11 cases.
An earlier version of proposed amendments to Federal Rule of Bankruptcy Procedure 2019 would have required such investors to disclose the dates and prices paid for their purchases of distressed securities.¬† These changes were resisted by investor groups such as the Loan Syndications and Trading Association, and created some press coverage last year (an earlier post on the amendments¬†is available here).
That said, investors will still be required to reveal the ‚Äúdisclosable economic interest‚ÄĚ they each hold in a company, including debt and derivatives. This includes the identity of specific investors and the date such investors acquired their interests.
Morever, Committee notes to the proposed rule indicate that the previously-contested disclosures of pricing and purchase dates may be compelled through discovery or by the Court acting under its own authority outside the proposed rule.
A copy of the proposed rule, along with a summary of comments received on earlier versions and the Committee’s advisory notes,¬†is available here.
Monday, May 10th, 2010
Leveraged buy-outs (LBO’s) are a time-honored means of financing the acquisition of companies.¬† They tend to occur in waves, finding greatest popularity when credit is easy and money is cheap.
Because of their dependence on favorable credit conditions, LBO’s are also rather risky.¬† When credit markets tighten and asset values drop – as they did most recently during the “Great Recession” of 2008 – the risk is borne primarily by unsecured creditors of the acquisition target.¬†
LBO’s, popular during the “roaring 80′s” and again during the “go-go” years of the George W. Bush Administration, are once again crashing and burning in significant numbers.¬† Recent victims include household names like Chrysler, Hawaiian Telcom, Linens ‚ÄėN Things, Simmons, LyondellBasell, Capmark Financial Group Inc., and Tribune Co.¬† Others, including Clear Channel Communications, Harrah‚Äôs Entertainment, and TXU, have defaulted on their LBO debt.¬† Indeed,¬†nearly half of non-financial American companies that defaulted on Moody‚Äôs-rated debt instruments in 2009 were reportedly leveraged acquisitions of private-equity funds.
Companies with overburdened balance sheets are forced to “de-leverage” and restructure their debt, typically at the expense of these creditors.¬† Because the essence of an LBO is the use of secured debt to finance an acquisition,¬†the historical response to¬†”de-leveraging” has been for unsecured creditors to attempt to unwind the security interests encumbering the company’s assets.¬†¬†These efforts are¬†typically¬†undertaken through fraudulent transfer claims – which are reportedly on the rise in the wake of last year’s financial turmoil.
The original idea behind fraudulent transfer¬†claims – which trace their roots back nearly half a millenium in Anglo-American commercial law – was that debtors shoudln’t be able to place valuable assets beyond the reach of their creditors.¬† The idea is a simple one, but proving a debtor’s subjective intent is often far more difficult than it looks.
In light of this difficulty, courts have developed certain “objective tests” to determine whether a transaction is “construtively fraudulent.”¬† Though a number of modern variations exist, their primary theme is that transfers made (or liabilities incurred) by a debtor in a financially precarious position may be “avoided” (i.e., unwound).
A debtor is generally considered to be in a financially precarious position if¬†it receives less than ‚Äúreasonably-equivalent value‚ÄĚ in exchange for property or debt while the debtor (1) is insolvent at the time of the exchange; (2) is rendered insolvent by the exchange; (3) is left, following the exchange, with ‚Äúunreasonably small capital‚ÄĚ for the business in which it is engaged or is about to engage; or (4) intends to or believes it will incur, debts it would be unable to pay as they matured.
Where an LBO is found to have been a fraudulent transfer, the court‚Äôs order that the transfer is avoided may include: (1) stripping the lender of its liens; (2) recovery of loan payments and fees; (3) subordination or disallowance of lender‚Äôs claims in bankruptcy; and (4) recovery of fees paid to professionals in connection with a leveraged buyout.
As attractive as all this might sound for unsecured creditors, unwinding an LBO¬†as “constructively fraudulent”¬†is unfortunately only slightly less difficult than establishing subjective fraudulent intent.¬† As a result, such creditors have little recourse but to settle fraudulent transfer claims very cheaply.¬† LBO participants, on the other hand, are incentivized to take on risky acquisitions at the creditors’ [potential] expense.
That, at least, is the argument put forth by John Ginsberg in his recently-uploaded draft article entitled “Remedying Law‚Äôs Failures to Remedy Fraudulent Transfers in Leveraged Buyouts” (downloadable at SSRN).
Ginsberg, an in-house lawyer at an unnamed federal agency, focuses on the “unreasonably small capital” test (the test most commonly used in attacking an LBO) and argues that the standard for¬†meeting that test – whether¬†insolvency is¬†”reasonably foreseeable” – requires far greater certainty in order for creditors to realize the protections intended for them by fraudulent transfer law.
In essence, Mr. Ginsberg argues that rather than asking whether insolvency is “reasonably foreseeable,” courts ought to clarify “reasonable foreseeability” in probabalistic terms.¬† It should be easier to attack (or to defend) a fraudulent transfer if it can be shown, for example, that the “probability” of insolvency at the time of an LBO was 50% – or 60%, or 75%.¬† Further, courts ought to articulate what, for them, constitutes an acceptable margin of error (say, 40% risk of insolvency with a margin of error of +/- 15%).
Finally, Mr. Ginsberg argues that a “probabalistic” approach eliminates the potential confusion arising when a subsequent “insolvency triggering event” is blamed for sinking a perhaps-somewhat-risky-but-otherwise-perfectly-viable LBO: If the probability of insolvency is established ahead of such a “trigger¬†event,” it is far easier to determine whether or not that event is, in fact, a significant factor in the company’s failure.
Mr. Ginsberg’s article (a working copy of which is available on SSRN) is an interesting read – not least because it offers a succinct and accessible snapshot of recent decisions addressing fraudulent transfers and LBOs.
Mr. Ginsberg’s proposed approach is also not the only one available to those seeking a more “objective” treatment of LBO financing.¬† A number of authors have suggested that the “foreseeability of insolvency” may be best determined by reference to prevailing industry liquidity and solvency ratios.¬† These are easily accessible through research databases, and provide some objective benchmarks as to what the participants in an LBO transaction might reasonably have anticipated at the time of the transfer.
That said, even these more “objective” approaches are not without their problems.
For example, if courts in a particular jurisdiction have enunciated a 50% or greater probability as the threshold for “reasonably foreseeable” insolvency, won’t the parties engaging in an LBO simply adjust their forward-looking assumptions to be certain that the “probability” is something less than 50%?¬† And what level of probability rises to the level of “reasonably foreseeable” in the first place?¬† Ginsberg’s article acknowledges this last uncertainty, and leaves the matter open for discussion.
Ratio-based tests also have their own problems.¬† Which solvency ratios are most meaningful to a particular industry?¬† And which¬†ones is a court most likely to apply to a particular transaction?¬† Though ratios are comparatively easy to compute, their application has been a subject for juducial hand-wringing and scholarly suggestions for the better part of 8 decades.
Something to think about.
Monday, May 3rd, 2010
A recent post by University of Illinois’ Professor Bob Lawless over at the always-stimulating “Credit Slips” blog focuses on an often-ignored, but important, corner of the Chapter 11 world: “Small Business” Chapter 11′s.¬†¬†Perhaps more accurately, the post focuses on Chapter 11′s that could be – but aren’t – formally designated as “Small Business” Chapter 11′s.
Prof. Lawless – whose research interests include empirical methodologies in legal studies – recently reviewed bankruptcy data from 2007, observing that of 2,299 chapter 11s filed in 2007 where the debtor (i) was not an individual; (ii) claimed predominately business debts; and (iii) scheduled total liabilities between $50,000 and $1,000,000, only 36.8% were designated “small business” bankruptcies.¬† Anecdotally, Prof. Lawless refers to one of the cases he surveyed:¬† a manufacturer that scheduled about $800,000 in debt and yet did not self-designate as a small-business debtor.
So why don’t more “small businesses” that commence Chapter 11 proceedings (many don’t, but this is a different issue) claim “small business” status?
The answers from practitioners – some of whom responded on the post, and others who voiced their views on a national list-serve also maintained by Prof. Lawless. – appear to coalesce around the following:
- Congress’ 2005 amendments impose additional filing requirements.¬† Section 1116 requires the provision of “the most recent” balance sheet, profit-and-loss statement, and statement of cash flows, as well as the most recent Federal income tax return.¬† One busy LA practitioner noted that he avoids the “Small Business” designation for this reason.
- The “small business” deadlines are too compressed.¬† For example, the Code’s exclusivity provisions generally “caps” the time period in which a “Small Business” debtor may file a Chapter 11 Plan and Disclosure Statement at 300 days.¬† This period can, of course,¬†be extended within the original 300-day period if the debtor can demonstrate that plan confirmation within a “reasonable period” is “more likely than not.”¬† But as a practical matter, the debtor has about 10 months to get a Chapter 11 Plan and Disclosure Statement filed.
- The combination of increased reporting and compressed deadlines puts any “small business” case on a hair-trigger under the expanded dismissal provisions of Section 1112.
- Some practitioners simply overlook the designation – which appears as a “check-the-box” on the face page of the petition’s official form.
- The concept of separate “small business” treatment emerges out of “local practices” implemented by bankruptcy judges for the purpose of streamlining their own dockets, but¬†which were never¬†really¬†a¬†good idea from a practical perspective.
With the possible exception of attorney oversight, these all appear emininently practical reasons for staying away from “Small Business” Chapter 11′s.
But are they always?
It may be that ‚Äúsmall business‚ÄĚ cases are perceived as problematic because, in fact, they cut against the grain of the traditional law firm business model.¬† For example:
- Additional filing requirements.¬† There may be circumstances where the client‚Äôs non-compliance with income tax filing requirements preclude any ‚Äúsmall business‚ÄĚ self-designation.¬† But most businesses ‚Äď even troubled ones ‚Äď can generate a very rudimentary set of financial statements.¬† Even for clients who generally operate without them, it should be possible to generate such statements (albeit very cursory ones) at the initial client interview or very shortly thereafter.¬† It’s worth noting that in California‚Äôs Central District, the additional ‚Äúup-front‚ÄĚ filing requirements are offset, at least to some degree, by the dramatically reduced monthly reporting requirements with the US Trustee‚Äôs Office.¬† In one ‚Äúsmall business‚ÄĚ Chapter 11 case handled last year by South Bay Law Firm, the extremely relaxed monthly operating reporting requirements were one ‚Äď though certainly not the only ‚Äď reason a ‚Äúsmall business‚ÄĚ filing was recommended for the client.
- Compressed deadlines.¬† Part of South Bay Law Firm’s pre-petition planning involves a review of the client‚Äôs ‚Äúexit strategy.‚ÄĚ¬† The fundamental question is: What is the client‚Äôs perceived business objective for the contemplated Chapter 11?¬† If there isn‚Äôt one,¬†the client has more fundamental issues to consider ‚Äď and the conversation typically turns to a discussion of whether or not Chapter 11 makes business sense.¬† If there is a business purpose for the contemplated Chapter 11, the business purpose and the “exit strategy”¬†are typically reduced to an informal ‚ÄúPlan Term Sheet‚ÄĚ which will, itself, become the nucleus of a combined Chapter 11 Plan-Disclosure Statement.¬† At South Bay Law Firm, our¬†experience is that the combined document is generally a bit easier and less time-consuming to draft than 2 separate documents.¬† And with the ‚Äúend game‚ÄĚ relatively well-defined at or near the outset of the case, getting to a successful exit just got a lot easier.¬† This¬†is a factor critical to the speed that is so important to an economically successful Chapter 11.
- More reasons for dismissal.¬† It is certainly true that Section 1112 imposes draconian consequences for failure to make required filings.¬† But more often, the real challenge isn‚Äôt Section 1112 ‚Äď or the US Trustee‚Äôs Office.¬† Instead, it‚Äôs helping the ‚Äúsmall business‚ÄĚ Chapter 11 debtor focus on the administrative requirements of a Chapter 11 ‚Äď and in California‚Äôs Central District, there are many.¬† To that end, the extra discipline required up-front for a ‚Äúsmall business‚ÄĚ Chapter 11 is, in fact, an important test of the debtor‚Äôs ability and willingness to get through the process with success.¬† If the debtor can‚Äôt even comply with a few additional filing requirements, it’s preferable to know right away that this debtor will have difficulty dealing with the myriad other contingencies that are certain to emerge in even a small Chapter 11 case.
- It‚Äôs all an impractical (though perhaps well-intended) judicial idea.¬† For the reasons described above, the additional filing requirements and compressed deadlines of a “Small Business” Chapter 11 may, in fact, bt¬†very practical ‚Äď at least in the larger scope of Chapter 11 economics.¬† But even if the practicalities are questionable (practicality is, after all, in the eye of the practitioner),¬†their result -¬†docket efficiency and speed of administration ‚Äď are both great sources of judicial pleasure.¬† The judicial clerkship experience resident at South Bay Law Firm attests that there really is no¬†better way to make friends with everyone behind the bench than making their job easier ‚Äď even if the job is just a tad bit harder on counsel’s end.¬† We’ll gladly invest a little extra effort if it will mean the benefit of the doubt on a ‚Äújump ball‚ÄĚ in front of the person wearing the black robe.
All of this may be very interesting, but how does it implicate the law firm business model?
Only this way: In an industry predominated by an ‚Äúhourly fee‚ÄĚ pricing model and on bringing as much business in the door as possible, the pressure on increased speed and discipline in a “small business” Chapter 11, requires more focus (and time) up-front, drives down administrative costs, demands an internal adherence to business process, and ‚Äúweeds out‚ÄĚ many candidates unsuitable for Chapter 11 ‚Äď ‚Äúsmall business‚ÄĚ or otherwise.¬† This, in turn, has the effect of making ‚Äúsmall business‚ÄĚ Chapter 11‚Äôs generally quicker and cheaper ‚Äď and therefore potentially less profitable, at least from an ‚Äúhourly fees‚ÄĚ point of view.¬† It also tends, at least initially,¬†to restrict or limit overall client “volume.”
However, it also has the effect of creating a relatively well-defined ‚Äúproduct‚ÄĚ which is potentially salable to a larger segment of troubled small businesses.¬† And a larger overall market segment means a larger absolute number of ‚Äúsmall business‚ÄĚ debtors who are possessed of the discipline and determination to reorganize their businesses successfully.
Monday, March 1st, 2010
With both the global and regional Southern California economies showing early signs of life ‚Äď but still lacking the broad-based demand for goods and services required for robust growth ‚Äď opportunities abound for strong industry players to make strategic acquisitions of troubled competitors or their distressed assets.
Ray Clark, CFA, ASA and Senior Managing Director of VALCOR Consulting, LLC, is no stranger to middle-market deals.¬† His advisory firm provides middle market restructuring, transactional and valuation services throughout the Southwestern United States from offices in Orange County, San Francisco, and Phoenix.
As most readers are likely aware, distressed mergers and acquisitions can be handled through a variety of deal structures.¬† Last week, Ray dropped by South Bay Law Firm to offer his thoughts on a process commonly known in bankruptcy parlance as a ‚ÄúSection 363 sale.‚ÄĚ
In particular, Ray covers the ‚Äúpros and cons‚ÄĚ of this approach.
The floor is yours, Ray.
Today‚Äôs economic environment has created an opportunity to acquire assets of financially distressed entities at deeply discounted prices, and one of the most effective ways to make those acquisitions is through a purchase in the context of a bankruptcy under Section 363 of the Bankruptcy Code (the ‚ÄúCode‚ÄĚ).¬† When purchasing the assets of a failed company under Section 363, there are distinct advantages to being first in line.¬† Depending on the circumstances, however, it may be best to wait and let the process unfold – and¬†then, only after surveying the entire landscape, submit a bid.
The 363 Sale Process
A so-called ‚Äú363 Sale‚ÄĚ is a sale of assets of a bankrupt debtor, wherein certain discrete assets such as equipment or real estate ‚Äď or substantially all the debtor’s business assets ‚Äď are sold pursuant to Section 363 of the Bankruptcy Code (11 USC ¬ß363).¬† Upon bankruptcy court approval, the assets will be conveyed to the purchaser free and clear of any liens or encumbrances. Those liens or encumbrances will then attach to the net proceeds of the sale and be¬†paid as ordered by the Bankruptcy Court.
A Section 363 sale looks much like a traditional controlled auction.¬† Basic Section 363 sale mechanics include an initial bidder, often referred to as the ‚Äústalking horse,‚ÄĚ who reaches an agreement to purchase assets – typically from the Chapter 11 debtor, or “debtor-in-possession” (DIP). ¬†The buyer and the DIP negotiate an asset purchase agreement (APA), which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to ‚Äúhigher and better‚ÄĚ or ‚Äúover‚ÄĚ bids.¬† The Bankruptcy Court will approve the bidding procedures, including the incentives, i.e., a ‚Äúbust-up‚ÄĚ fee, for the stalking horse bidder, and will pronounce clear rules for the remainder of the sale process. ¬†Notice of the sale will be given, qualified bids will arrive and there will be an auction. ¬†The sale to the highest bidder will commonly close within four to six weeks after the notice and the stalking horse will either acquire the assets or take home its bust-up fee and expense reimbursement as a consolation.¬†
Advantages for the Stalking Horse Bidder
Bidding Protections - During negotiations with the debtor for the purchase of assets, the stalking horse will also typically negotiate certain protections for itself during the bidding process.¬† These bidding protections, which include a bust-up fee and expense reimbursement, will be set forth in the 363 sale motion and are generally approved by the bankruptcy Court.¬† As a result, stalking horse bidders seek to insulate themselves against the risk of being out-bid.¬† To do so, proposed stalking-horse bidders commonly require that any outside bidder will typically have to submit not only a bid that is higher than that of the stalking horse, but will also need to include an amount to cover the stalking horse’s transactional fees and expenses.
Bidding Procedures – The stalking horse will also negotiate certain bidding procedures with the debtor, which will be set forth in the 363 sale motion that will be evaluated, and most likely approved, by the Court.¬† The sale procedures generally include the time frame during which other potential bidders must complete their due diligence and the date by which competing bids must be submitted.
Other delineated procedures typically included in the motion include the amount of any deposit accompanying a bid and the incremental amount by which a competing bid must exceed the stalking horse bid. ¬†In addition, if the sale procedures provide for an abbreviated time frame in which to complete an investigation of the assets, a competing bidder will be at a distinct disadvantage and may be unable, as a result, to even submit a bid.
Deal Structure ‚Äď As the first in line, the stalking horse bidder will also negotiate all of the important elements of the transaction, including which assets to acquire, what contracts ‚Äď if any ‚Äď to assume, the purchase price and other terms and conditions.¬† In doing so, it establishes the ground rules by which the sale process will unfold and the framework for the transaction, which will be difficult, if not impossible, for another outside bidder to change.¬†
‚ÄúFirst Mover‚ÄĚ Advantage – The stalking horse bidder will typically be viewed by the Court as the favored asset purchaser in that it will have negotiated all of the relevant terms and procedures, and established its financial ability and intent to acquire the assets.¬† As a result, short of an overbid by an outside party, which typically involves an additional amount to cover the stalking horse‚Äôs bust-up fee and expenses, the stalking horse bidder will prevail.
Cooperation of Stakeholders ‚Äď As the lead bidder, the stalking horse also has an opportunity to negotiate with other key stakeholders in the process and establish a close relationship with those parties that may prove advantageous when all offers are evaluated.
Bust-up Fee and Expense Coverage ‚Äď Lastly, if an outside party happens to submit the high bid, the stalking horse will typically receive its bust-up fee and expense reimbursement. This generally includes items such as due diligence fees, legal and accounting fees, and similar expenses, but is limited by negotiation.¬†
Disadvantages to the Stalking Horse Bidder
Risk of Being Outbid ‚Äď As noted, the stalking horse will expend a great deal of time, energy, and resources analyzing and negotiating for the purchase of the assets.¬† All a competing bidder must do is show up to the sale and submit an over-bid.¬† If the competing over-bidder prevails, the stalking horse runs the risk of walking away with only its bust-up fee and expense reimbursement.
Risk of Bidding Too High ‚Äď After negotiating the APA, the stalking horse then participates in the 363 sale process.¬† If no other bidders materialize, it may be because the stalking horse effectively over-paid for the assets.¬†
Inability to Alter Terms ‚Äď If some new information comes to light that would otherwise suggest a reduction in the price or alteration of the terms, the stalking horse may have difficulty altering either of these and may be locked in to the negotiated structure.
Contact email@example.com¬†or firstname.lastname@example.org.
Meanwhile, happy hunting.