Restructuring

Contributed by Victoria Vron
It is not often that we see insolvent debtors pay dividends to shareholders.  It is even less often that we see such payment pass muster under fraudulent transfer laws.  Crumpton v. Stephens (In re Northlake Foods, Inc.) involves one such rare occurrence.  In Northlake, the United States Court of Appeals for the Eleventh Circuit Court held that the benefits to a debtor as a result of its subchapter S election constituted reasonably equivalent value for its corresponding obligation to pay a dividend to a shareholder in the amount of tax the shareholder paid as a result of the subchapter S election, thus making the payment of the dividend not avoidable as a fraudulent transfer.
The facts in Northlake are fairly straightforward.  In 1991, Northlake entered into a shareholders’ agreement with Stephens, a shareholder.  The agreement provided that if Northlake makes a subsection S election pursuant to the United States Internal Revenue Code, such that its income becomes taxable to shareholders rather than to Northlake (thereby avoiding double taxation), Northlake would pay a dividend to Stephens in an amount sufficient for Stephens to pay the taxes that resulted from the subchapter S election.  The dividend would be paid in the year following the year in which the income was passed through to Stephens.  In 2005, Northlake designated itself an S corporation.  Its federal tax return for that year reflected positive taxable income, which was passed through to Stephens and other shareholders.  The amount of Stephens’s personal income tax attributable to his share of Northlake’s taxable income for 2005 was $94,429.00.  In 2006, Northlake’s board of directors passed a resolution authorizing a cash dividend to Stephens in the amount of $94,429.00, which was subsequently paid to Stephens in accordance with the resolution.
In 2008, Northlake filed for chapter 11 protection and in 2009, a trustee was appointed in the case.  The trustee filed a complaint against Stephens seeking to avoid the 2006 payment of the dividend as a constructively fraudulent transfer under section 548 of the Bankruptcy Code and section 544 of the Bankruptcy Code (using the Georgia Uniform Fraudulent Transfer Act). Section 548 provides that a transfer that is made within 2 years prior to the commencement of the bankruptcy case is constructively fraudulent if (1) the debtor received less than a reasonably equivalent value in exchange for such transfer and (2) one of the following is satisfied: (a) the debtor was either insolvent on the date of transfer or became insolvent as a result of such transfer; (b) the debtor had unreasonably small capital; (c) the debtor intended to incur, or believed it would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or (d) the transfer was made for the benefit of an insider under an employment contract and not in the ordinary course of business.  The Georgia Uniform Fraudulent Transfer Act contains a similar test (although with a longer statute of limitations).
The parties did not dispute that Northlake was insolvent at the time the dividend was paid to Stephens.  Accordingly, the only issue for the bankruptcy court was whether Northlake received reasonably equivalent value in exchange for payment of the dividend.  Ruling on Stephens’s motion for judgment on the pleadings, the bankruptcy court held that Northlake received reasonably equivalent value for two reasons.  First, because section 548 defines “value” to include satisfaction of antecedent debt, the bankruptcy court analyzed the transaction to determine whether an antecedent debt was satisfied.  It held that Stephens’s performance under the shareholders agreement (i.e., including Northlake’s income on his personal tax return) created an antecedent debt and that the payment of the dividend was in satisfaction of that antecedent debt.  The court further found that this transaction represented reasonably equivalent exchange of value.  Second, the bankruptcy court held that Northlake also received reasonably equivalent value by virtue of the subchapter S election.  The court explained that the dividend was paid pursuant to the shareholders’ agreement to reimburse Stephens for the income taxes Stephens had to pay as a result of Northlake’s operations and that without the subchapter S designation, Northlake would have paid the income tax directly.  The district court affirmed the bankruptcy court’s decision on the ground that Northlake’s election as a subchapter S corporation constituted reasonably equivalent value for the dividend.  Because it affirmed on this ground, the district court did not address the question of whether the dividend satisfied an antecedent debt owed under the shareholders’ agreement.  Notably, the district court disagreed with the trustee’s argument that creditors must necessarily benefit from a transaction in order for it to not be a fraudulent transfer.  All that is required is that creditors not be worse off because of the transfer.  Here, because Northlake would have had to pay the taxes had it not elected subchapter S designation, creditors were no worse off because of the dividend.
The trustee appealed the district court’s decision to the Eleventh Circuit.  The Eleventh Circuit affirmed the district court’s ruling that the benefits to Northlake from the subchapter S election constituted a reasonably equivalent exchange of value for payment of the dividend.  Like the district court, the Eleventh Circuit did not address the bankruptcy court’s antecedent debt ruling.  Interestingly, the trustee urged the Eleventh Circuit to find that the bankruptcy court should have conducted a fact intensive inquiry and considered the totality of the circumstances surrounding the payment of the dividend before determining that reasonably equivalent value was exchanged.  It appears that the trustee was asking the court to determine that the dividend amount was not reasonably equivalent to the taxes Northlake would have paid had it not made the subchapter S election.  The Eleventh Circuit refused to undertake such an inquiry and held that although some cases of fraudulent transfers may warrant an inquiry into the totality of circumstances, this case did not.  Plus, a dollar-for-dollar transaction is not necessary to show an exchange of reasonably equivalent value. The Eleventh Circuit found that it was plain from the face of the complaint that a benefit was provided to Northlake from the transaction.  The shareholders’ agreement allowed Northlake to shift to subchapter S status whenever it wanted and, when it did, to get the benefit of time by having its shareholders pay income taxes in a given year and reimburse the shareholders for such taxes in the subsequent year.  The complaint contained no allegations indicating why these benefits did not constitute reasonably equivalent value.
This decision affirms the view of certain courts that “reasonably equivalent” is not synonymous with “equivalent.”  Notably, it also shows courts’ reluctance, in certain circumstances, to do a deep dive into a transaction to determine whether reasonably equivalent value was exchanged.  Although the result in this case does not appear to be inequitable, it does little to answer the question of how disparate must the value exchanged be before it is not “reasonably equivalent.”