Judge Gerber, a bankruptcy judge sitting in the Southern District of New York, recently issued an opinion denying in part and granting in part motions to dismiss filed by fraudulent transfer defendants in three separate adversary proceedings. The actions were initiated for the purpose of avoiding, as intentional or constructive fraudulent transfers, payments made to the Debtors’ former shareholders in connection with a prepetition leveraged buyout. In the course of the litigation and the underlying opinions (an opinion issued in 2014 dealt with an initial round of motions to dismiss), several interesting questions have been addressed for fraudulent transfer purposes, including: (i) whether the intent of a controlling person on a board of directors is the critical consideration rather than the board’s intent; (ii) which, if any, actual intent standard applied in the context of a board of directors; and (iii) if applicable, what kinds of allegations provided the predicate for a finding of a board’s actual intent.
In the instant opinion, the Court found that the plaintiff-trustee failed to satisfactorily plead factual allegations demonstrating an actual intent to hinder, delay or defraud creditors by a critical mass of Lyondell’s board of directors. As such, the claims for intentional fraudulent transfers were dismissed. While Judge Gerber permitted state law constructive fraudulent transfer claims to survive the motions to dismiss, this post will focus on the actual fraudulent transfer analysis, as the former claims largely pertained to standing and plan-related issues not germane to the blog’s central focus.
The LBO, the Bankruptcy, and the Genesis of the Adversary Proceedings
In December 2007, Basell AF S.C.A. (“Basell”) acquired Lyondell Chemical Company (“Lyondell”, or the “Debtor”) by means of a leveraged buyout (the “LBO”), forming a new company after a merger (“Merger”). The LBO was 100% financed by debt secured by the assets of Lyondell. Lyondell took on approximately $21 billion of secured indebtedness in the LBO, of which $12.5 billion was paid out to Lyondell stockholders.
In January 2009, Lyondell, along with 78 affiliates, filed a petition for Chapter 11 relief in the Southern District of New York. Lyondell’s unsecured creditors then found themselves behind that $21 billion in secured debt, with Lyondell’s assets having been depleted by payments of $12.5 billion in loan payments to stockholders. This led to the filing of three adversary complaints (the “Complaints”) by the trustee (the “Trustee”) of two trusts formed to pursue claims on behalf of Lyondell and its creditors, with each action brought against shareholder recipients (collectively, the “Defendants”) of the $12.5 billion. The Trustee brought constructive fraudulent transfer claims in two of the actions, and intentional fraudulent transfer claims in all three.
In 2014, the Court dismissed the Complaints’ claims for intentional fraudulent transfers for failing to allege facts sufficient to support the requisite intent on the part of Lyondell’s board of directors (the “Board”), but with leave to replead (the “First 12(b)(6) Decision”). This led to the revised Complaints (the “Revised Complaints”) at issue in the Court’s latest opinion. The Defendants sought again to dismiss the intentional fraudulent transfer claims on the basis that the deficiencies identified in the First 12(b)(6) Decision were not cured; they likewise sought dismissal of the state law constructive fraudulent transfer claims.
The Board’s Governance and the First 12(b)(6) Decision
According to the Revised Complaints, the Board consisted of 10 elected outside directors – who served for periods of less than one year up to twelve years – and one additional director, Dan Smith (“Smith”), Lyondell’s CEO. The Trustee alleged that the Smith utilized his longtime status as CEO and sole management member of the Board to regularly dominate Board decisions, although the Court dismissed this as conclusory; in any event, the Court found the duration of the outsiders’ tenure to be irrelevant.
Notwithstanding the Trustee’s contentions to the contrary, the First 12(b)(6) Decision had rejected his contention that the Court should rely on any intent of Smith alone for actual fraudulent transfer purposes, concluding that the appropriate standard was the First Circuit’s In re Roco Corp. – e.g., whether the individual whose intent is to be imputed “was in a position to control the disposition of [the transferor’s] property.” Consistent with the Delaware law principle that corporations can merge only with the approval of their boards of directors, the LBO transaction was approved by the Board. Thus, the Court found that it was the Board’s intent that was critical – meaning that the Trustee had to establish that enough Board members had the requisite intent on their own, or that Smith or another could cause that number of Board members to form the requisite intent.*
*The Court notes in an interesting footnote digression, that its rulings have been in the context of a corporation with a functioning board of directors, as contrasted to a closely held corporation with little or no board decision-making; in the latter case, the Court postulated that the requisite intent based on the intent of the company’s principals could be easier to find.
The Revised Complaint and the New Allegations
The Revised Complaints allege that the Board knew of the “dire” consequences of approving the LBO transaction, pointing to its (1) turning a blind eye to alleged gross overstatements of future earnings; (2) receiving a collective windfall of over $19 million in Merger-related consideration; (3) awareness of the direct relationship between the cyclicality of the industries in which the company operated and the need to limit leverage in order to ensure financial flexibility; (4) understanding that every dollar to the Lyondell shareholders would be funded with leveraged debt; and (5) knowledge that the transaction would leave Lyondell inadequately capitalized. In sum, the Board allegedly knew that the projections were inflated and unreasonable and that they were putting Lyondell’s creditors at risk.
Furthermore, the Revised Complaints bolster allegations against Smith, specifically that (1) he dominated the Board’s decisions by manufacturing “bogus” projections; (2) he alone had pre-negotiated the price per share with Basell’s controller; and (3) that members of senior management collaborated with Smith in presenting the false projections.
Which Analytical Standard(s) Apply?
The Court first noted that the heightened pleading standards of Fed. R. Civ. P. Rule 9(b) apply in cases of intentional fraudulent transfers, thus meaning a plaintiff has to (i) plead, with particularity, the circumstances constituting fraud or mistake; and to (ii) establish the defendant’s mental state. Taken further, the Court had to focus on the nature of the Board’s intent as a predicate to evaluating the allegations put forward to establish that intent. For 11 U.S.C. § 548 (“Section 548”), the Uniform Fraudulent Conveyance Act (“UFCA”), and the Uniform Fraudulent Transfer Act (“UFTA”, and together with Section 548 and UFCA, the three statutes applicable in the instant case), “actual intent to hinder, delay, or defraud” must be shown. The Court found that the requisite intent must be consistent with the overall theme of intentional fraudulent transfer law: proscribing intentional actions to injure creditors, by means of placing assets out of the reach of creditors’ reach or by other intentional steps to prevent creditors from collecting on their debts or placing obstacles in creditors’ way.
In terms of the types of allegations that would permit a finding of that intent, the Court analyzed the facts under four rubrics:
Restatement (and the “Natural Consequence” Standards?)
The Court first turned to the position advocated by the Restatement of Torts (and the Defendants), which contemplates something beyond simply a bad result after the fact, or results from mere negligence: “… the actor desires to cause consequences of his act, or believes that the consequences are substantially certain to result from it.” In other words, the Trustee must put forward allegations establishing the requisite intent to achieve the consequences — impeding creditor recoveries — and not just to engage in an aggressive transaction that puts creditor recoveries at risk. In so finding, the Court declined the Trustee’s suggestion that the Restatement Standard be limited to Ponzi Scheme cases, and rejected his advocacy for the “natural consequences” standard. This latter standard stems from a 2013 Seventh Circuit decision (In re Sentinel Mgmt. Grp.), which the Court found to be too ambiguous to constitute a reliable standard, as it could be read to establish liability for consequences that are merely “foreseeable” or negligent.
Applied here, the Court can found no allegations supporting an inference that any of the Board members other than Smith and one other director had any wrongful intent of any type. Nor, for that matter, could the Court find allegations supporting the view that Smith’s satisfactorily pleaded dishonesty and greed was accompanied by an actual intent that creditors not be paid, or that they be otherwise hindered in their debt recovery efforts. The individual allegations as to the Board members do not (i) say what he or she said or heard with respect to any creditors not being paid; (ii) allege that directors other than Smith knew the projections were fraudulent; (iii) allege that there were any decisions to take steps to cause creditors not to be paid. In short, the Court found the allegations largely conclusory.
The allegations against Smith were sufficient to establish intent on his part to defraud Bassell’s controller, lenders, and others due to the merger price, but do not support an intent to hinder, delay or defraud creditors – let alone that he caused other Board members to join him in such a plan. Merely voting in favor Smith’s recommendations was insufficient to support the conclusion that he controlled them.
In sum, the Court found plenty of evidence of negligence, but no intent to do creditors harm.
Badges of Fraud
The Court noted the use of “Badges of Fraud” as circumstantial evidence of actual intent and cited the enumerations in the Texas UFTA and Section 548 as examples. According to the Court, in the typical Badges of Fraud situation, many or most of the Badges can be found, but in the instant case, nearly none of them can. The only semblance of badges the Court could find was that (i) the transfer was of substantially all of the debtors’ assets (since a large proportion of Lyondell assets were subjected to liens); (ii) the transfer was arguably to an insider (since the directors are insiders, and they received cash payments); and (iii) the debtor became insolvent shortly after the transfer was made. The Court found the silence as to the other badges of fraud to be deafening and to be determinative.
“Motive and Opportunity”
The Court found the “Motive and Opportunity” standard to require that “[g]enerally, in intentional fraudulent transfer cases as well as securities fraud cases, a strong inference of fraudulent intent may be established either (a) by alleging facts to show that defendants had both motive and opportunity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness.” Judge Gerber urged caution on that standard, however, as entities may not always act in accordance with motivation. In this context, the Court noted that generalized motives of corporate officers and directors (e.g., motives to maximize the amount received on the sale of stock or to increase executive compensation) do not support the required “strong inference” of scienter; there must be a demonstration of something out of the ordinary, such as when motive and opportunity are coupled with “something else”.
Here, the Court found that the Board had nothing more than motive and opportunity.
While the Court was willing to assume that recklessness (a securities fraud doctrine) was a potential basis for finding intent, it construed the level of recklessness in a fraudulent transfer case to require allegations of facts that give rise to a strong inference of fraudulent intent – and not, by contrast, “fraud by hindsight.” In other words, a state of mind approximating actual intent, and not merely a heightened form of negligence.
As discussed above, the Court again found evidence of negligence, but nothing beyond that; to the contrary, most of the allegations were merely conclusory, in that they fell short of alleging, for example, that the Board knew the financial projections were fraudulent. The Revised Complaints alleged that the Board accepted the projections with insufficient scrutiny.
Having found none of the four tests conclusive as to actual fraud, the Court dismissed them in their entirety, this time without leave to amend.
Notwithstanding the underlying complexity of the Lyondell proceedings, the pair of 12(b)(6) decisions Judge Gerber issued in these adversary proceedings provide important and in many ways much-needed guidance on the parameters of actual fraudulent intent in merger/LBO contexts. Most importantly, they establish who (or what) must be the source of the intent and their relation vis-à-vis the consequences of their action. For proper context, the decisions should be read in conjunction with one another.
A copy of the opinion can be found here.