California Creditor's Rights & Business Bankruptcy Lawyer & Attorney : Robert Eisenbach : Business Bankruptcy Blog

The Fall 2009 edition of the Absolute Priority newsletter, published by the Cooley Godward Kronish LLP Bankruptcy & Restructuring group, of which I am a member, has just been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter or to register to receive future editions. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

• Developments in the General Growth Chapter 11 cases;
• Updates on the General Motors and Chrysler bankruptcies;
• Efforts in Congress to repeal certain of BAPCPA's business bankruptcy provisions; and
• The "settlement payment" defense to fraudulent transfer claims against shareholders in leveraged buyouts.

This edition also reports on some of our recent representations, including debtors Pacific Ethanol Holding Co. and Crabtree & Evelyn, Ltd., and our work for official committees of unsecured creditors in Chapter 11 bankruptcy cases involving major retailers. Recent committee cases include Eddie Bauer, Ritz Camera, Filene's Basement, BT Tires Group, Boscov's, Gottschalk's, KB Toys, BTWW Retail, and G.I. Joe's, among others. Also discussed is our work for Levi Strauss & Co. in purchasing 73 outlet stores from the Anchor Blue Retail Group case and for Rackable Systems, Inc. (now known as Silicon Graphics International) in purchasing substantially all of the assets of Silicon Graphics, Inc. in its recent Chapter 11 case.

In addition, a note from my colleague, Jeffrey Cohen, the editor of Absolute Priority, discusses how Section 363 asset sales have become the chief means for companies to restructure in bankruptcy, and how the number of "going concern" sales has grown over the past few months compared to the period following the bankruptcy of Lehman Brothers in September 2008.

I hope you find this Fall's edition of Absolute Priority to be of interest.

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Recently, I posted about SIPA liquidations of brokerage firms, prompted by the Securities Investor Protection Act (known as SIPA) liquidations of Lehman Brothers, Inc. and Bernard L. Madoff Investment Securities LLC. An interesting issue has come up in the Madoff case involving investors who redeemed their accounts before the Madoff bankruptcy was filed. In other alleged Ponzi scheme cases, trustees have sued such investors asserting fraudulent transfer or other claims. The investors in turn often raise defenses, including that they redeemed their accounts in good faith and without any knowledge of the alleged fraud, and lengthy and complex litigation usually results.

Resolution of such litigation can come long after the deadline set for filing proofs of claim (known as a "bar date"). This raises a question: if investors end up paying money back to the estate as a result of the trustee's litigation, will they be able to file proofs of claim -- after the bar date -- for the amounts they have to return? Before turning to that question, let's take a look at how such post-bar date claims are dealt with in non-SIPA bankruptcy cases.

Section 502(h) Of The Bankruptcy Code. Under the Bankruptcy Code, if a person or entity is sued by the bankruptcy estate (usually by a trustee, the debtor in possession, or a creditors' committee) for receipt of an alleged preference or fraudulent transfer, they will be able to file a proof of claim if they end up paying money back to the bankruptcy estate in settlement or as a result of a judgment. Bankruptcy Code section 502(h) expressly covers this situation:

(h) A claim arising from the recovery of property under section 522, 550, or 553 of this title shall be determined, and shall be allowed under subsection (a), (b), or (c) of this section, or disallowed under subsection (d) or (e) of this section, the same as if such claim had arisen before the date of the filing of the petition.

Section 502(h) recognizes that resolution of avoidance actions may come long after the original bar date for filing proofs of claim has past and allows holders of these later-arising claims to share in the estate along with other creditors. The Bankruptcy Code treats these claims as having arisen at the time of the payment back to the bankruptcy estate and allows proofs of claim to be filed months or even years after the bar date. 

The Claims Bar Date In SIPA Liquidations. In a SIPA liquidation, there are generally two claims bar dates. The first bar date set is for customer claims, in which customers of the failed brokerage firm seek to recover the securities in their accounts (or more likely in the Madoff case, the securities that were supposed to have been in their accounts). The Securities Investor Protection Corporation insurance of up to $500,000 applies to customer claims. A second bar date, usually a few months later, is for general claims. General creditors may include customers with claims in excess of the $500,000 SIPC protection or those who have more traditional trade creditor or other claims. 

The Madoff Case. In the Madoff case, last month several investors filed a motion seeking to have the bar date order clarified with regard to their potential claims in the event that the Madoff trustee later sued them and they were forced to return funds under a fraudulent transfer or other avoidance (sometimes called a  "clawback") cause of action after the general claims bar date.

• These investors had previously redeemed some or all of their investments, and were seeking an order holding that claims arising from avoidance actions could be filed within 30 days after the judgment giving rise to the claim became final, a provision common in non-SIPA bankruptcy bar date orders due to Bankruptcy Code section 502(h).
• The moving parties were concerned that without this clarification, any such claims they filed after the bar date might be held to be barred. On the other hand, if they were forced to file a protective claim before the bar date, they would submit to the court's equitable jurisdiction and may be held to have waived their right to a jury trial in any avoidance action brought against them.
• The Madoff trustee filed an opposition to the motion (copy available at the prior link) arguing, among other things, that these investors were not creditors, had not been sued, and as a result did not present an actual case or controversy ripe for adjudication. In addition, the trustee argued that Section 502(h) of the Bankruptcy Code was inapplicable, contending that it was inconsistent with an absolute bar date provision under SIPA. (The SIPA statute provides that Bankruptcy Code provisions are generally applicable in SIPA cases to the extent consistent with SIPA.)
• The SIPC also filed a response to the motion (copy available at the prior link) making arguments similar to those advanced by the trustee. In particular, the SIPC argued that Section 502(h) was inconsistent with what the SIPC called SIPA's "immutable" bar date.

The Court's Decision. In a five-page decision issued on February 24, 2009, U.S. Bankruptcy Judge Burton R. Lifland denied the motion, first holding that the Court did not have the discretion to extend the bar dates involved. (A copy of the decision is available by clicking on the link in the prior sentence.) The Court then stated that the motion essentially sought a determination of whether Section 502(h) of the Bankruptcy Code was applicable in SIPA liquidations. Because no avoidance action had yet been filed, the Court held that the requested relief, if granted, would amount to an improper advisory opinion.

• As a result, the Court refused to decide whether Bankruptcy Code Section 502(h) applies in SIPA cases, commenting as follows: "Although section 78fff(b) of SIPA specifies that the provisions of the Bankruptcy Code shall apply in SIPA liquidation proceedings, to the extent that they are consistent with SIPA, it is unclear whether section 502(h) of the Code would apply. 15 U.S.C. § 78fff(b) (1981)."
• The Court concluded by noting that the investors could file a protective proof of claim before the general claims bar date, although that would subject them to the Court's equitable jurisdiction.

An Open Question. Although the Court denied the motion, it left open the ultimate issue involved -- whether Section 502(h) of the Bankruptcy Code applies in SIPA liquidations and permits parties to file proofs of claim after the bar date if they are sued by a trustee and later have to return funds or other property. With the issue undecided for now, some investors may choose to file a protective proof of claim before the bar date passes.

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Leveraged buyouts, known as LBOs, have frequently been the subject of fraudulent transfer challenges when the target company later files bankruptcy. As its name implies, the classic LBO involves the use of leverage -- debt -- to finance the acquisition of the target company's stock. Often that new debt is secured by the assets of the target company. This post highlights a new article that addresses one of the hot issues in LBO fraudulent transfer litigation, but before doing that it may help to give some context to the discussion.

What Is A Fraudulent Transfer? There are two types of fraudulent transfers. The first is a transfer made with an actual intent to hinder, defraud, or delay creditors. However, transfers may be considered fraudulent, even in the absence of actual fraud, if the transfer has a similar effect on creditors. This second type of fraudulent transfer involves what is known as "constructive fraud." A court may find that a transfer involves constructive fraud if a company, at a time when it is already financially impaired or is made so by the transaction itself, does not receive "reasonably equivalent value" in return for the transfer in question. Section 548, the Bankruptcy Code's fraudulent transfer statute, and state fraudulent transfer laws, cover both actual and constructive fraudulent transfers.

The LBO Fraudulent Transfer Lawsuit. When an LBO is followed sometime later by a bankruptcy, a fraudulent transfer lawsuit may be filed to challenge the LBO itself. Although actual fraud may be asserted, more often the case involves a constructive fraud claim.

• The argument usually made is that the use of the target company's assets to secure loans (the leverage), the proceeds of which were then paid to selling shareholders (the buyout), rendered the company insolvent, made it otherwise unable to pay its debts when they became due, or left it with an unreasonably small capital with which to conduct its business. Since the target company does not receive anything in exchange for the payment to the selling shareholders, the lack of reasonably equivalent value element is usually present.
• The plaintiff in a fraudulent transfer lawsuit may be the company itself as Chapter 11 debtor in possession, the official committee of unsecured creditors, or a bankruptcy trustee or post-confirmation plan trustee.
• The defendants may include the new shareholders, the lenders who obtained security interests in the target company's assets, and the shareholders who sold their stock for cash to the acquirer.

The Settlement Payment Defense. When selling shareholders are sued, they often assert a defense based on the "settlement payment" exception to certain fraudulent transfer claims found in Section 546(e) of the Bankruptcy Code. This exception was added to the Bankruptcy Code to prevent disruptions to the functioning of capital markets that might occur if long-settled trades were able to be unraveled by a fraudulent transfer action years down the road. Some courts, interpreting the term "settlement payment" to include payments made from a financial institution, have held that payments to selling shareholders, made by means of wire transfers using a bank or other financial institution, qualify as just such a "settlement payment" protected from avoidance as a fraudulent transfer under Section 546(e). Those courts, in effect, hold that the fact that a bank made wire transfers rendered an otherwise potentially fraudulent transfer immune from challenge.

Two Recent Articles Tackle This Issue. Two articles, including one published last week, take a look at how courts have been addressing the reach of the Section 546(e) defense in the context of these wire transfer payments.

• My Cooley Godward Kronish LLP Bankruptcy & Restructuring group colleagues Michael Klein and Ronald R. Sussman wrote an article for the May 2008 edition of the Turnaround Management Association's The Journal of Corporate Renewal examining that issue. Their article is entitled "Do Wire Transfers Really Protect Shareholders in Private LBOs?  Not in the 2d -- and Perhaps Other -- Circuits." 
• An earlier article, written by Faye B. Feinstein and Lauren N. Nachinson, is entitled "Wire Transfers May Protect Shareholders in LBOs: 3d Circuit Says Payments by Financial Institutions Are Unavoidable" and focuses on Third Circuit law. 

How Far Does The Defense Go? The new article discusses case law from outside of the Third Circuit. In particular, it examines a recent decision from a New York bankruptcy court that rejected the Section 546(e) defense in a situation involving an LBO of a private, rather than publicly traded, target company. The article sums up the differences this way:

The application of the settlement payment defense in the context of an LBO has been far from uniform. While courts in the 3d Circuit have utilized Section 546(e) to shield virtually all LBO payments from avoidance, even in the context of private transactions, a significant number of courts have limited the scope of this safe harbor provision.           

Accordingly, the extent to which wire transfers may insulate LBO payments from attack under fraudulent transfer laws will likely be determined as much by the venue of the bankruptcy proceedings as much as the facts of the transaction at issue.

Worth Reading. Anyone involved in LBOs, including acquirers, target company directors or management, selling shareholders, and of course their professionals, will find these articles very interesting reading.

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