In two decisions this year, in July and against in a re-affirmance in October, the U.S. District Court for the Southern District of New York has reinstated a claim brought by Trustee of the creditors of the bankrupt chemical company Lyondell, looking to recover distributions made to the company’s shareholders in connection with an infamous leveraged buyout.
This is important and unusual because the Bankruptcy Code contains a “safe harbor” for securities transactions, blocking efforts to treat them as fraudulent conveyances. The Manhattan district court’s position is that the safe harbor [section 546(e)] is not quite as safe as advertised: it does not protect transfers when it can be shown that the seller’s management has acted with the actual intent to hinder, delay, or defraud creditors, even if the management was acting behind the back of its board.
This may be good news for those who seek alpha in the debt instruments of insolvent companies, if they are willing to litigate such claims aggressively: but I repeat myself. The latter is part of the job description of the former.
The History
Back in 2007, when there were plenty of tremors but before the devastating financial earthquake of the following year (heck, at a time when there were many distinguished voices telling us that the tremors were ‘contained,’) a publicly traded petrochemicals company, Basell AF, acquired Lyondell Chemical.
In the early stages of the negotiations leading to this transaction, Lyondell CEO Dan Smith instructed his underlings to pretty up the company’s projections, to put some lipstick on the pig as it were. They added nearly $2 billion of additional EBITDA to their Long Range Plan. Lyondell then used the phony numbers to negotiate a higher valuation from the buyer, Basell.
The deal closed in December of that year, and the combined company went under the name of LyondellBasell (hereafter, simply Lyondell). Soon thereafter, the company distributed $12.5 billion to its shareholders. In January 2009 (in the midst of the financial earthquake mentioned above) the company filed for chapter 11 protection.
Creditors of the now insolvent concern figured out what had happened. The combined entity had saddled itself with a lot of debt in the course of putting itself together, and the looked-for synergies hadn’t come, in part because the management of the target had been lying to the acquirer. Also, the company had deprived itself of resources via its payout to shareholders. Given all of this, it was ill-prepared to survive the global crisis.
A trustee tried bringing an action in the bankruptcy court to recover the shareholder pay-outs as fraudulent transfers. That court twice dismissed his efforts, on the ground that he had failed to plead facts that would have supported intent to hinder, delay, or defraud “on the part of a critical mass of the directors” who favored the LBO. The bankruptcy court seemed to concede, especially the second time it dismissed these efforts, that Smith himself might have intended to defraud creditors, but it said the Trustee had failed to plead that he controlled the necessary critical mass on the board.
U.S. District Court
That is the point on which the District Court has now spoken. A corporation can lose the safe harbor through the actions of its agents “even when the agent” [Smith] “acts fraudulently or causes injury” and without reference to whether there was a consciously fraudulent critical mass on the board.
After the July ruling to this effect, the defendant shareholders filed a motion for reconsideration, a motion then joined by several individuals and entities, such as ZLP Master Opportunity Fund and Cato Enterprises LLC.
The Hon. Denise Cote noted in response, on October 5 that the defendants had failed to “identify any new or controlling authorities to support this argument.” They had essentially offered reinterpretations of the authorities on which the Court had relied in its July judgment, arguing that the Court had misunderstood them the first time around. Said Court, perhaps unsurprisingly, was unpersuaded.
Going Forward
Given all that, there is an unusual mass of de novo material in the October opinion refusing to reconsider.
In essence, the court was working from what it calls a “bedrock principle of agency law,” that is, the idea that the knowledge of an agent acquired while acting within the scope of his agency is imputed to the principal. Thus, for example, if Smith knew that the EBITDA numbers were phony, then Lyondell knew that the numbers were phone.
The fraudulent transfer claim, then, will proceed to discovery and, in the absence of any settlement, it will proceed to trial.
In other situations in the same jurisdiction going forward, the door has been opened to similar lawsuits and similar clawbacks, even though the burdens the litigants will have to carry remain heavy ones.