The South Bay Law Firm Law Blog highlights developing trends in bankruptcy law and practice. Our aim is to provide general commentary on this evolving practice specialty.
 





 
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    Posts Tagged ‘Business and Economy’

    Flushed Away

    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 – 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

    Cover of Flushed Away (Widescreen Edition)

     

    If creditors can show that the business’ 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’ 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 “[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.”

    Earlier this year, Judge Clarkson of California’s 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 – and corporate officers – of Munson Plumbing, Inc. (“MPI”), a plumbing subcontractor on several public works projects in the Los Angeles metropolitan area.  As is typically required of public works contractors, MPI’s work was backed by surety bonds issued by SureTec Insurance Company (“SureTec”).  As part of the consideration for the issuance of the surety bonds, the Munsons and MPI signed a General Agreement of Indemnity (“SureTec Indemnity Agreement”), 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 – thereby requiring SureTec to make payments under the bonds and finish MPI’s work.

    Concurrent with MPI’s 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’ 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 §7108 and Penal Code §§§ 484b, 484c and 506.)

    – The Munsons were alter egos of MPI, and therefore were liable for MPI’s obligations under the surety bonds.

    – The Munsons’ obligations were non-dischargeable because they arose as a result of the Munsons’ breach of their fiduciary duties.

    The Debtors sought dismissal of SureTec’s lawsuit.  In a brief, 9-page decision, Judge Clarkson found that:

    –  The SureTec Indemnity Agreement did not impose fiduciary duties upon the Munsons.  “If 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 “indemnifying” SureTec, as SureTec accurately indicates  . . . .”

    – Any alleged trust relationship created on a constructive, resulting, or implied basis (i.e., arising legally as a result of the Munsons’ allegedly bad acts) is not the sort of trust relationship which gives rise to a non-dischargeable debt.  “The 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.”

    – SureTec’s 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.  “If 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.”

    Judge Clarkson also found that SureTec’s 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 – as well as litigants’ varying success in using it.  As detailed in other posts, alter ego liability has been employed (i) unsuccessfully as a “blocking device” in an attempt to capture recoveries for the corporation’s 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 “bootstrap” a creditor’s claim into “non-dischargeable” status.

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    Southern California – America’s Small Business Bankruptcy Leader

    Monday, August 2nd, 2010

    In a globalized business environment, it should be no surprise that some of the more interesting – and better – economic reporting on the US economy now comes from offshore.

    Last month, China’s Xinhua news agency reported that California leads the nation in small-business bankruptcies.  The report – based on data reported by Equifax – covers small business filings under all applicable chapters of the Bankruptcy Code (i.e., Chapters 7, 11, and 13).  The Xinhua report (it broke the story a day before the Orange County Register) is here.

    Equifax’s reporting shows that California remains the most impacted state, with the Los Angeles and Riverside/San Bernardino MSA’s leading the nation in small business bankruptcy flings by a significant margin.  

    The chart below provides a closer look at this trend.

                                                        # of
                     MSA         # of Bankruptcies Bankruptcies  % of Increase
                                        Q1 2009        Q1 2010
        Los Angeles-Long
         Beach-Glendale, CA                899          1035          15.13%
        Riverside-San
         Bernardino-Ontario,
         CA                                663           736          11.01%
        Sacramento-Arden-
         Arcade-Roseville,
         CA                                462           522          12.99%
        Houston-Sugar Land-
         Baytown, TX                       365           399           9.32%
        San Diego-Carlsbad-
         San Marcos, CA                    345           387          12.17%
        Portland-Vancouver-
         Beaverton, OR-WA                  276           386          39.86%
        Denver-Aurora, CO                  304           382          25.66%
        Santa Ana-Anaheim-
         Irvine, CA                        359           370           3.06%
        California -Rest of
         State                             233           335          43.78%
        Phoenix-Mesa-
         Scottsdale, AZ                    234           327          39.74%
        Dallas-Plano-
         Irving, TX                        348           323          -7.18%
        Chicago-Naperville-
         Joliet, IL                        395           314         -20.51%
        Atlanta-Sandy
         Springs-Marietta,
         GA                                336           304          -9.52%
        Oregon -Rest of
         State                             235           299          27.23%
        ---------------                    ---           ---          -----
        New York-White
         Plains-Wayne, NY-
         NJ                                335           272         -18.80%
        ------------------                 ---           ---         ------

    Inc. Magazine picked up the story last week, commenting that “no area has been insulated from the recession and the economy clearly isn’t rebounding quickly enough.”

    No kidding.

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    Fraudulent Transfers and LBOs – It’s All In the Numbers . . . Or Is It?

    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 ‘N Things, Simmons, LyondellBasell, Capmark Financial Group Inc., and Tribune Co.  Others, including Clear Channel Communications, Harrah’s Entertainment, and TXU, have defaulted on their LBO debt.  Indeed, nearly half of non-financial American companies that defaulted on Moody’s-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.

    {{en|1=Diagram of leveraged buyout transaction...
    Image via Wikipedia

     

    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 “reasonably-equivalent value” 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 “unreasonably small capital” 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’s 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’s 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’s 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.

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