Restructuring

Contributed by Jessica Diab

TGIF, right?!  Before kick starting your weekend — here’s what you need to know about the recent decision from the United States Court of Appeals for the Third Circuit in the chapter 11 cases of SemCrude L.P. and its debtor affiliates.
FACTS
SemGroup, L.P., a “midstream” energy company provided transportation, storage, and distribution of oil and gas products to oil producers and refiners.  From 2005 through to July 2008, when SemGroup filed for chapter 11, SemGroup had a significant line of credit from a syndicate of over 100 different lenders.  Despite prohibitions in its credit agreement, SemGroup participated in certain types of high risk trading activity unbeknownst to the lenders.  Due to the erratic price of oil between July 2007 and February 2008, SemGroup posted large margin deposits, incurred significant borrowings, and ultimately defaulted under its credit facility (it does not appear that the default declared by the lenders was based upon the trading strategy).  Shortly thereafter, SemGroup commenced a case under chapter 11 of the Bankruptcy Code.  SemGroup’s chapter 11 plan was confirmed on November 20, 2009, pursuant to which a litigation trust, vested with the claims held by the SemGroup estate, was created.
The trustee under the litigation trust commenced two adversary proceedings against SemGroup’s equity holders, seeking to avoid equity distributions made in August 2007 and February 2008 on the basis that such distributions constituted constructively fraudulent transfers because (i) SemGroup was left with unreasonably small capital after the equity distributions and (ii) SemGroup was insolvent at the time of the 2008 distribution.  In particular, the trustee asserted, among other things, that (1) both the 2007 and 2008 equity distributions were fraudulent transfers pursuant to section 548(a)(1)(B)(ii)(II) of the Bankruptcy Code and (2) the 2008 equity distribution was constructively fraudulent pursuant to section 548(a)(1)(B)(ii)(I) of the Bankruptcy Code.  The Bankruptcy Court entered an adverse judgment on these claims which was affirmed by the District Court and, as you know, an appeal to Third Circuit followed.  We’ll address the Third Circuit’s analysis with respect to each claim in turn.
ANALYSIS
Section 548(a)(1)(B)(ii)(II)
Under section 548(a)(1)(B)(ii)(II) of the Bankruptcy Code, a transfer of property by a debtor may be set aside as constructively fraudulent if it can be shown that the debtor (i) received less than reasonably equivalent value in exchange for such transfer and (ii) following the transfer, any property remaining with the debtor was unreasonably small capital.  The parties agreed that the first requirement was satisfied as the equity holders provided no value in exchange for the distributions.  Accordingly, the only issue with respect to this claim was whether, following either of the two equity distributions, SemGroup was left with unreasonably small capital.
When considering whether a debtor was left with unreasonably small capital following a transfer of the debtor’s property, courts look to whether it was “reasonably foreseeable” that the company would fail due to a lack of capital.  As mentioned, SemGroup had access to a significant credit facility which was available after each of the equity distributions, which suggested that it was adequately capitalized.  The trustee argued, however, that on these facts, simply having access to the credit facility was not enough to establish that the debtor was adequately capitalized.  According to the trustee, because SemGroup was in violation of its credit agreement due to its trading strategy, there were at least material questions of fact as to whether it was reasonably foreseeable that the lenders would have cut off the credit facility and, if they did, whether SemGroup would have been adequately capitalized.
The lower courts both reasoned that the trustee’s argument rested “upon conjecture biased by hindsight” and that “hindsight should not be used to answer the question of unreasonably small capital.”  Indeed, as stated by the Bankruptcy Court, to rely on hindsight would “improperly expand fraudulent conveyance law far beyond its proper borders.”  The Third Circuit agreed, pointing out that to accept the trustee’s theory, one would need to “engage in multiple levels of forecasting” regarding (1) lenders’ reaction to discovering the conduct, and then (2) the consequences of that reaction (in other words, that the only option available to the lenders would be to foreclose access to all credit), which (3) had reasonably foreseeable consequences of bankruptcy.  The Third Circuit was simply dubious of the proposition that the “line would have simply been pulled” had the lenders been aware of the trading strategy.  According to the Third Circuit, there was a range of options that the lenders could have taken upon becoming aware of the improper trading many of which would have preserved SemGroup’s adequate capitalization.
For these reasons, the Third Circuit agreed with the lower courts, holding that “[a]bsent the bias of hindsight, it simply cannot be said that SemGroup was likely to be denied access to a credit facility” and, with such access, SemGroup was adequately capitalized after each of the two equity distributions.
Section 548(a)(1)(B)(ii)(I)
As noted, the trustee also challenged the 2008 equity distribution as constructively fraudulent under 548(a)(1)(B)(ii)(I).  To successfully challenge a transfer as constructively fraudulent under 548(a)(1)(B)(ii)(I), the trustee had to demonstrate that SemGroup received (i) less than reasonably equivalent value in exchange for the transfer or obligation and (ii) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation.
On this claim, the parties once again agreed that no reasonably equivalent value was provided for the second equity distribution.  Accordingly, the Bankruptcy Court focused exclusively on whether SemGroup was insolvent at the time of the equity distribution or became insolvent as a result of such distribution.  Based on testimony by an expert who relied on a valuation report prepared by Goldman Sachs, the Bankruptcy Court found that SemGroup was not insolvent following the 2008 equity distribution.
On appeal, the trustee challenged the reliability of the testimony arguing that the expert adopted the valuation report “wholesale” and did not base his opinion on his own beliefs.  In considering the reliability of expert testimony, the Third Circuit stated, that in some circumstances, an expert might be able to rely on the estimates of others so long as the expert explains why he relied on such estimates and why he believes such estimates are reliable.  In this case, the expert previously worked at Goldman Sachs and, as a result, was aware of the methodologies used to create the report.  In addition, the report was contemporaneously prepared in anticipation of a contemplated securities offering which served to enhance its reliability.  More importantly, perhaps, was that the expert used his own analysis and judgment to adjust the report to account for SemGroup’s speculative derivative trading.  Accordingly, the Third Circuit found no basis to conclude that the Bankruptcy Court abused its discretion in relying on such expert testimony.
CONCLUSION
Before embarking on your weekend, remember — hindsight, friend of regret and remorse, is rarely the bearer of good news and, as the United States Court of Appeals for the Third Circuit recently confirmed, it should not be considered when determining whether a debtor has unreasonably small capital for the purposes of a fraudulent transfer claim.
Jessica Diab is an Associate at Weil Gotshal & Manges, LLP in New York.