[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] The Texas Two-Step: The Code Says it’s a Transfer

By Mark Roe and William Organek (Harvard Law School)

Note: This is the seventh in a series of posts on the Texas Two-Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts), here (by Jonathan C. Lipson), here (by Jared A. Ellias), here (by Anthony Casey and Joshua Macey), here (by David Skeel), and here (by Ralph Brubaker).

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Mark Roe
William Organek

Considerable attention is now being paid to the Texas Two-Step in bankruptcy. The Two-Step anticipates the movement of assets and liabilities from one corporate entity to another, via a divisive merger that splits the assets and liabilities of the original entity. After the movement of the assets and liabilities, the liabilities sit in one entity (often a subsidiary of a larger enterprise). Meanwhile, the liabilities are separated from many of the assets (in the most controversial form of the Two-Steps), which sit in another entity. The entity with the bulk of the liabilities then files for bankruptcy. The Two-Step is central to the Johnson & Johnson (“J&J”) bankruptcy of a subsidiary, aiming to separate the talc liabilities from J&J’s extensive assets.

When assets are transferred from a firm that is thereby rendered insolvent, or when the assets are transferred with actual intent to hinder, delay or defraud creditors, the transferred assets can, of course, be recovered by the transferring firm as a fraudulent transfer.  Bankr. Code § 548.  Similar transactions are regularly accomplished under corporate structures as spinoffs: the firm moves assets into a subsidiary, for example, and then “spins” off the subsidiary’s stock to the firm’s stockholders. After the spinoff the old stockholders own two companies, one with the assets (and possibly some of the liabilities of the just-created subsidiary) and the other with the liabilities (and any remaining assets) of the original company.

The Texas divisive merger statute creates a fraudulent transfer conundrum, because it says movements of assets pursuant to a divisive merger are not transfers.  If there’s no transfer, there’s no fraudulent transfer liability, as there must first be a transfer for there to be liability.

If the bankruptcy process were ousted of power to control fraudulent transfers, then the debtor firm would have more freedom to move assets and liabilities in ways that would allow the firm to escape liability. No judge would get to the meaty issues (e.g., was the transferring firm insolvent? were the transfers done with intent to hinder, delay, or defraud creditors? is the bankrupt firm with the bulk of the liabilities an alter ego or successor of the original firm?) because there’d never have been a triggering transfer.

The Texas statute itself is clear on its face that there’s no transfer under Texas law:

When a merger takes effect . . . all rights, title and interests to all . . . property owned by each . . . party to the merger is allocated . . . as provided in the plan of merger without . . . any transfer or assignment having occurred . . .

Tex. Bus. Orgs. Code § 10.008(a) (emphasis added).

Commentators have noted that a Two-Stepping debtor might make such an argument. While it has not yet been explicitly raised in the LTL bankruptcy, the commentators anticipated correctly that such an argument was coming.  In another pending Texas Two-Step bankruptcy, In re DBMP, the debtor made this argument at length. In an oral ruling1 delivered a little more than a week ago, on July 7, Judge Craig Whitley agreed with the key plain meaning premises of the Two-Step argument but ultimately rejected it as facilitating “wholesale fraud.”

The court began by accepting the debtor’s interpretation that, under a plain meaning reading of the Texas statute, no transfer occurred; and under a plain meaning reading of section 548 of the Bankruptcy Code, a transfer is a necessary predicate for a fraudulent transfer to have occurred. Hence, a plain meaning construction of section 548 and the Texas statute means no fraudulent transfer exposure.

Judge Whitley saw where such a plain meaning reading led, but refused to go there, rejecting the debtor’s conclusion. Going down the plain meaning route would, he said, lead to absurd results, leaving plaintiffs with “no recourse whatsoever.” And such a reading would contradict another provision of the Texas statute, which states that a divisive merger is not meant to “abridge any . . . rights of any creditor under existing law,” Tex. Bus. Orgs. Code § 10.901. Finally, Judge Whitley went deep: such a plain language reading of the Texas statute would run contrary to longstanding general principles of Anglo-American fraudulent transfer law.

Judge Whitley’s conclusion was in our view correct. But the conclusion can be reached more directly—by a plain meaning reading of the Bankruptcy Code.

The bankruptcy courts have already been instructed by Congress not to pay attention to the Texas statute, even when the state statute declares that an asset disposition in a divisive merger is not a transfer.  True, considerable policy issues (e.g., supremacy of federal law, the extent to which state property and contract law is incorporated into the bankruptcy process) could well be brought to bear if the Bankruptcy Code were unclear here. But the most straightforward way to answer the question raised in DBMP comes from a parsimonious textual analysis of the Code.

Here’s the Bankruptcy Code’s two-step ouster of the Texas Two-Step:

Step 1:

The text of the fraudulent transfer statute, section 548, begins: “The trustee may avoid any transfer . . .  of an interest of the debtor in property . . . ” (emphasis added). If we stop there, a basis might be had for examining state law for whether a transfer cognizable under the Bankruptcy Code has taken place.  Property is, after all, transferred under state law.

But the Code does not say that state law governs whether a movement of property is a bankruptcy transfer. The Code itself defines the term “transfer” and does so independently of state laws’ appellations, leading to Step 2 of the ouster.

Step 2:

Section 101(54) defines what a “transfer” is for bankruptcy purposes, such as section 548 (governing fraudulent transfers).  It states: “The term ‘transfer’ means . . .  each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property.”

The Code thereby instructs bankruptcy courts to conclude that a transfer has occurred for each “mode . . . of disposing of . . . property . . . .”  A divisive merger under Texas law is surely a “mode . . . of disposing of . . . property. . . .”  As a result, for bankruptcy purposes a Texas two-step is a transfer, whatever the Texas authorities decide to call it.  And, therefore, the Texas Two-Step should have no import in bankruptcy for determining whether there’s been a transfer for bankruptcy purposes.  Property has been disposed of. Thus, for Code purposes there is a “transfer.”  The first statutory predicate to considering whether there has been a fraudulent transfer has been satisfied and the court could then go on to the other, meaty fraudulent transfer issues. The Texas Two-Step is a transfer because the Bankruptcy Code says it is.

While we reach an identical conclusion to that of Judge Whitley, and we do not fault his reasoning from the bench, our analytic path is better in the long run for bankruptcy decisionmaking. The court’s reliance upon the best way to interpret the potential contradictions of the Texas Business Organizations Code is a precarious foundation for the ruling. One could imagine another bankruptcy court, faced with the Texas statute’s contradictions (“it’s not a transfer” vs. “it’s not in derogation of any other right”), interpreting and concluding differently.2 Another judge might not consider such a result as absurd as Judge Whitley and we do. And yet another bankruptcy court could feel compelled to certify questions to the Texas Supreme Court on how to interpret the Texas divisive merger statute and its impact.

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The new mass tort bankruptcies present major issues of policy and statutory construction for which answers will not be assured and apparent. But the question of whether there is a transfer for bankruptcy purposes is clear. A divisive merger is a disposition of property and, hence, the Code says it’s a transfer, thereby triggering the opening prerequisite to there being a fraudulent transfer.

The Code says so. Plainly.

1: A recording of the hearing is embedded in the linked PDF, which PDF may need to be downloaded in order to access the recording; the relevant portion of the hearing begins around 20:15 in the recording.

2: See Curtis W. Huff, The New Texas Business Corporation Act Merger Provisions, 21 St. Mary’s L.J. 109, 122-25 (1989).

 

 

Critical Vendor Order Insufficient to Protect Critical Vendors Against Preference Claims

By Nicholas A. Koffroth (Fox Rothschild)

Nicholas A. Koffroth

In Insys Liquidation Trust v. MeKesson Corporation (In re Insys Therapeutics, Inc.), No. 21-50176 (JTD), No. 21-50176, 2021 WL 3083325 (Bankr. D. Del. July 21, 2021), the United States Bankruptcy Court for the District of Delaware reminded practitioners to exercise caution when analyzing the scope of protections offered by critical vendor orders.  The order at issue in Insys Therapeutics provided that “[t]he Debtors are authorized, but not directed . . . to maintain and administer the Customer Programs” and that “[n]othing contained . . . in this Final Order is intended to be or shall be construed as . . . (c) a waiver of any claims or causes of action that may exist against any creditor or interest holder.”  These common provisions proved critical in the Court’s holding that “something more is required” to insulate critical vendors from preference liability.

In the opinion, the Court denied a motion to dismiss the complaint brought by a group of critical vendors for three reasons.  First, the Court held that preferential payments that occur before the entry of a critical vendor order cannot be protected by a subsequent authorization to pay outstanding prepetition claims unless specifically provided in the order.  Second, the permissive language of the critical vendor order did not support the vendors’ claim that the prepetition payments would necessarily have been authorized had they been made postpetition.  Third, the critical vendor order expressly preserved the estates’ claims against critical vendors.  Additionally, the Court analyzed and rejected application of the limited “critical vendor defense.”

The article discusses the Court’s holding in greater detail and offers practical considerations for practitioners. The full article is available here.

Another Court Adopts Majority View in Approving Bankruptcy Trustee’s Use of Tax Code: Look-Back Period in Avoidance Actions

By Daniel J. Merrett (Jones Day) and Mark G. Douglas (Jones Day)

Daniel J. Merrett
Mark G. Douglas

The ability of a bankruptcy trustee or chapter 11 debtor-in-possession (“DIP”) to avoid fraudulent transfers is an important tool promoting the bankruptcy policies of equality of distribution among creditors and maximizing the property included in the estate. One limitation on this avoidance power is the statutory “look-back” period during which an allegedly fraudulent transfer can be avoided—two years for fraudulent transfer avoidance actions under section 548 of the Bankruptcy Code and, as generally understood, three to six years if the trustee or DIP seeks to avoid a fraudulent transfer under section 544(b) and state law by stepping into the shoes of a “triggering” creditor plaintiff.

The longer look-back periods governing avoidance actions under various state laws significantly expand the universe of transactions that may be subject to fraudulent transfer avoidance. Indeed, under a ruling recently handed down by the U.S. Bankruptcy Court for the Western District of North Carolina, the look-back period in avoidance actions under section 544(b) may be much longer—10 years—in bankruptcy cases where the Internal Revenue Service (“IRS”) or another governmental entity is the triggering creditor. In Mitchell v. Zagaroli (In re Zagaroli), 2020 WL 6495156 (Bankr. W.D.N.C. Nov. 3, 2020), the court, adopting the majority approach, held that a chapter 7 trustee could effectively circumvent North Carolina’s four-year statute of limitations for fraudulent transfer actions by stepping into the shoes of the IRS, which is bound not by North Carolina law but by the 10-year statute of limitations for collecting taxes specified in the Internal Revenue Code.

Zagaroli does not break new ground on the power of a bankruptcy trustee or DIP to bring avoidance actions under section 544(b) of the Bankruptcy Code. Nevertheless, the court’s endorsement of the majority approach on the availability of a longer look-back period in cases in which the IRS is a creditor is notable. Widespread adoption of this approach could significantly augment estate avoidance action recoveries.

The full article is available here.

Tribune II: Law Firm Perspectives

By Xiao Ma (Harvard Law School)

Xiao Ma

On December 19, 2019, the Second Circuit issued its amended opinion in In re Tribune Company Fraudulent Conveyance Litigation, 2019 WL 6971499 (2d Cir. Dec. 19, 2019), which held the “safe harbor” provision in section 546(e) of the Bankruptcy Code covers Tribune Company’s payments made to public shareholders as Tribune constitutes a “financial institution” in pursuance with the Bankruptcy Code definition, and such definition includes the “customer” of a financial institution when the financial institution acts as the customer’s “agent or custodian…in connection with a securities contract”.

The Second Circuit’s opinion was controversial in light of the Supreme Court’s recent ruling in Merit Management Group, LP v. FTI Consulting, Inc., 138 S.Ct. 883 (2018) on the scope of safe harbor, with law firms perceiving it as moving away from the position of Merit by opening new room for application of safe harbor protection. Jones Day suggests that the Tribune’s reasoning “avoided the strictures of Merit”, while Nelson Mullins finds it “shifting the focus from the financial institution as a ‘mere conduit’ to an ‘agent’.” Kramer Levin comments that the decision represents a “dramatic, and perhaps unexpected, extension of the safe harbor from the position it occupied in the immediate aftermath of Merit.” Weil calls it throwing the 546(e) safe harbor a lifeline.

Firms also find the case paving a way to protect LBO payments from subsequent attacks. King & Spalding notes that the Second Circuit’s opinion provides protection for recipients involved in LBO transaction where the debtor is the “customer” of the intermediary financial institutions. Cadwalader believes that the decision may “narrow the impact” of Merit, as market participants could structure their transaction to involve a financial institution thereby bypassing the “mere conduit” carve-out. Skadden agrees on the likely trend of structured LBOs, highlights that the customer defense is “likely to continue gaining momentum” after the Second Circuit’s decision. Parties would ensure they meet the “financial institution” and “customer” criteria methodically articulated in Tribune. “An appropriately structured principal/agent relationship could continue to shelter transfers or distributions within the ambit of section 546(e) safe harbors,” says Weil, adding that the operative facts will be key to strengthen the position.

Finally, Gibson Dunn notes that Tribune is not binding on other circuits. It remains to be seen whether such holding will be extended to different circumstances by other courts. “Some courts may find (in contrast to the Second Circuit) that the Supreme Court in Merit could not possibly have intended that its narrowing of the section 546(e) safe harbor be so easily vitiated by an argument that the Court itself acknowledged in a footnote,” says Kramer Levin.

In a prior Roundtable post, Professor Bussel noted that a plain meaning interpretation of the term “financial institution” should not include the customers of commercial banks, thus precluding a sharp change from Merit.

For Roundtable’s other posts on Tribune, see Bankruptcy Court Disagrees with Second Circuit’s Holding in Tribune, Tribune Fraudulent Conveyance Litigation Roundup. For Roundtable discussions relating to the 546(e) safe harbor, please refer to the tag #Safe Harbors.

Second Circuit Fumbles Tribune on Reconsideration

Daniel J. Bussel

By Daniel J. Bussel (UCLA School of Law)

The Second Circuit recently issued its revised opinion in Tribune Company Fraudulent Conveyance Litigation, determining that a debtor-transferor that effectuates a transfer involving a securities contract in its capacity as the customer of a commercial bank is itself a “financial institution” within the meaning of the Bankruptcy Code section 101(22)(A) and therefore the transfer is protected under section 546(e).

This ruling has critically important implications for the avoiding powers of the bankruptcy trustee. Section 546(e) insulates all transfers involving securities by or to a financial institution from avoidance except as an “actual fraud” under section 548(a)(1)(A). Virtually all transferors are customers of commercial banks and almost any transfer can be effectuated with funds transferred through the agency or in the possession of a commercial bank. The result is the virtual repeal of the avoiding powers as to any transfer involving securities that is not an actual fraud on creditors, undoing centuries of fraudulent transfer and preference law.

These considerations are powerful enough that the Second Circuit, if necessary in light of the statute’s plain language, should have striven mightily to avoid interpreting the term “financial institution” so as to include the customers of commercial banks. The Code’s avoiding power sections read as a whole make no sense if limited only to cases involving transfers by entities that are not customers of commercial banks. Moreover, such a reading of section 101(22) flies in the face of Merit Management, the recent, directly applicable, Supreme Court precedent.

The full article is available here.

For more posts on the scope of section 546(e), see Ralph Brubaker, Understanding the Scope of the § 546(e) Securities Safe Harbor Through the Concept of the “Transfer” Sought to Be Avoided.

Debate Intensifies as to Whether the Bankruptcy Code’s Avoidance Provisions Apply Extraterritorially

by Charles M. Oellermann and Mark G. Douglas (Jones Day).

The ability to avoid fraudulent or preferential transfers is a fundamental part of U.S. bankruptcy law. However, when a transfer by a U.S. entity takes place outside the U.S. to a non-U.S. transferee—as is increasingly common in the global economy—courts disagree as to whether the Bankruptcy Code’s avoidance provisions apply extraterritorially to avoid the transfer and recover the transferred assets. Several bankruptcy courts have addressed this issue in recent years, with inconsistent results.

In a recent example, in In re CIL Limited, 582 B.R. 46 (Bankr. S.D.N.Y. 2018), the U.S. Bankruptcy Court for the Southern District of New York, disagreeing with other courts both within and outside its own district, ruled that the “transfer of an equity interest in a U.K. entity to a Marshall Islands entity was a foreign transfer” and that the Bankruptcy Code’s avoidance provisions do not apply extraterritorially because “[n]othing in the language of sections 544, 548 and 550 of the Bankruptcy Code suggests that Congress intended those provisions to apply to foreign transfers.”

The decision further muddies the waters on an issue that has become increasingly prominent as the volume of cross-border bankruptcy cases continues to grow and cross-border transactions become ubiquitous. The split on this issue exists not merely between courts in different jurisdictions, but also among courts in the Southern District of New York, where the majority of cross-border bankruptcy cases have traditionally been filed.

The full article is available here.

Do Managers Strategically Change Their Disclosure Before a Debt Covenant Violation?

By Thomas Bourveau (Hong Kong University of Science and Technology), Derrald Stice (Hong Kong University of Science and Technology), and Rencheng Wang (University of Melbourne)

Little is known about how managers change their voluntary forecasting behavior as a debt covenant violation approaches. We find that management forecasts are more optimistic in the period leading up to a debt covenant violation (“DCV”), based on a sample of firms in the period before they disclose a DCV in their financial statements. Additionally, we find that managers who are most optimistic in their forecasts also take on more risk and increase dividend payouts before violations. Those managers tend to take actions consistent with last-resort efforts to delay the discovery of DCV and opportunistically engage in activities likely to be curtailed by lenders in the event of a covenant violation.

In further analyses, we partition our sample and find that managers are more likely to optimistically bias their earnings forecasts when they have a higher risk of losing control rights in the event of a DCV. Managers are less likely, however, to bias forecasts if lenders have greater ability to detect bias or if managers have higher reputation concerns. Finally, we perform additional analyses to rule out potential reverse causality and omitted variable issues. Overall, our results are consistent with managers changing their disclosure behavior in order to conceal upcoming covenant violations from debtholders and to justify taking actions that are favorable to equity investors and would likely be opposed by debtholders.

The full article is available here.

The Year in Bankruptcy: 2017

by Charles M. Oellermann and Mark G. Douglas (Jones Day).

In their annual chronicle of business bankruptcy, financial, economic, and related developments in the U.S., Charles M. Oellermann and Mark G. Douglas of Jones Day review the most significant events of 2017, including business bankruptcy filing statistics and industry trends; newsworthy developments regarding sovereign and commonwealth debt; the top 10 public-company bankruptcies of the year; notable private and cross-border bankruptcy cases; significant business bankruptcy and U.S. Supreme Court bankruptcy rulings; bankruptcy-related legislative and regulatory developments; noteworthy chapter 11 plan confirmations and exits from bankruptcy; and more.

The article is available here.

Insider Status and U.S. Bank v. Village at Lakeridge

By Ronit J. Berkovich and David Li (Weil, Gotshal & Manges LLP).

The U.S. Supreme Court, in U.S. Bank Nat’l Ass’n v. Village at Lakeridge, LLC, 583 U.S. ___ (2018), offered plenty of hints on an important topic while simultaneously ruling very little about it.  In chapter 11, whether a creditor qualifies as an “insider” can have enormous implications on a range of issues, including plan confirmation, fraudulent transfer and preference analyses, and severance payment and employee incentive/retention plan (KEIP/KERP) approvals.  Lakeridge involved a dispute as to whether the bankruptcy court properly determined in confirming a plan that the sole impaired accepting creditor (the romantic partner of one of the debtor’s officers) was not a “non-statutory” insider.  If the creditor actually were such an insider, then the chapter 11 plan should not have been confirmed.

In granting cert to hear the case, the Supreme Court expressly declined the opportunity to address whether the Ninth Circuit articulated the correct legal test to determine if a person qualifies as a non-statutory insider.  Instead, the Supreme Court granted cert only to answer the narrow question of whether the Ninth Circuit applied the correct standard of review to the lower court’s determination.  Justice Kagan, writing for the Court, kept to that script by simply affirming the Ninth Circuit’s decision to apply a clear error standard of review.  Concurrences by Justices Kennedy and Sotomayor, however, each acknowledged shortcomings in the legal test the Ninth Circuit applied and each appeared to invite lower courts to consider alternative approaches.  As a whole, Lakeridge provides little binding guidance, and practitioners can expect further development in non-statutory insider law by the Courts of Appeals.

The article is available here.

Fraudulent Transfer Avoidance Recovery Not Limited to Total Amount of Creditor Claims

posted in: Avoidance, fraudulent transfer | 0

By Jane Rue Wittstein and Mark G. Douglas (Jones Day)

Courts disagree as to whether the amount that a bankruptcy trustee or chapter 11 debtor-in-possession can recover in fraudulent transfer avoidance litigation should be capped at the total amount of unsecured claims against the estate. The U.S. Bankruptcy Court for the District of Delaware recently weighed in on this issue in PAH Litigation Trust v. Water Street Healthcare Partners, L.P. (In re Physiotherapy Holdings, Inc.), 2017 WL 5054308 (Bankr. D. Del. Nov. 1, 2017). Noting the absence of any guidance on the question from the U.S. Court of Appeals for the Third Circuit, the bankruptcy court ruled that, unlike most state fraudulent transfer laws, which limit a creditor’s recovery to the amount of its unpaid claim against the transferor, section 550 of the Bankruptcy Code imposes no such limitation on the estate’s recovery. The ruling reinforces the idea that federal and state fraudulent transfer avoidance laws are intended to be remedial rather than punitive. Under state law, this understandably means that an avoidance recovery is limited to the amount necessary to make an injured creditor whole. Under federal bankruptcy law, recoveries must benefit the bankruptcy estate, which includes the interests of creditors and other stakeholders.

The article is available here.

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