Losing Control: Court Rejects “Control Test” for Determining if Debtor Has Interest in Dividends it Paid

Contributed by David G. Litvack
In Michaelson v. Farmer (In re Appleseed’s Intermediate Holdings, LLC), the United States District Court for the District of Delaware recently faced an atypical argument as to why an avoidance action should be dismissed.  In Appleseed’s, the defendants in an avoidance action argued that the dividend at issue, although paid by the debtors, was not property of the debtors’ estate under section 544 of the Bankruptcy Code.  At first blush, the argument seems unconvincing, but as detailed below, the defendants put forth creative arguments as to why the debtors had no interest in the dividend.
In a series of transactions in 2007, the private equity owners of the debtors orchestrated an acquisition and dividend recapitalization that allegedly caused the debtors’ insolvency.  At the time of the transactions, the debtors were wholly owned subsidiaries of non-debtor Orchard Brands, which, in turn, was indirectly owned by certain private equity funds.  Through a series of transactions, Orchard Brands agreed to acquire an unrelated corporation pursuant to a leveraged buyout.  As part of this leveraged buyout, the private equity funds used the transaction to facilitate a dividend recapitalization whereby the debtors borrowed $710 million, secured by all of the debtors’ assets, and contemporaneously distributed a dividend of $310 million to the private equity funds.  Pursuant to the dividend recapitalization, the private equity funds realized an immediate return on their investment without having to sell their equity stake through a merger, sale, public offering, or the like.
Although it was determined that one of the debtors would pay the dividend to another debtor, which debtor, in turn, would pay the dividend to Orchard Brands, for ultimate payment to the private equity funds, in order to bypass this “administrative hassle,” the dividend was, instead, paid directly to the ultimate beneficiaries (including the private equity funds) by the lender.  On January 19, 2011, after being unable to afford the payments on the loans, the debtors filed for protection under chapter 11 of the Bankruptcy Code.
Pursuant to the debtors’ confirmed plan of reorganization, the trustee of the litigation trust brought an adversary proceeding against certain parties, including the private equity funds, seeking to, among other things, avoid the dividend payment as a fraudulent transfer pursuant to section 544(b) of the Bankruptcy Code.  Under section 544(b)(1) of the Bankruptcy Code, “the trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim . . . .”  Thereafter, the defendants moved to dismiss certain counts of the relevant complaint, including the counts alleging fraudulent transfer as to the dividend.  In addition to various other arguments, the defendants argued that because there was no “interest of the Debtors” to avoid, section 544(b)(1) of the Bankruptcy Code could not be used to avoid the dividend payments.  The defendants’ supported this position by pointing to the fact that the debtors were required under the loan documents to pay the dividend, and thus, had no control over the relevant funds.  Further, the defendants pointed to the flow of the relevant funds, none of which passed through any of the debtor entities, but instead was paid directly to the defendants.
Unconvinced by this argument, the court noted that had the debtors simply decided to not issue the dividend, the debtors would have retained the loan proceeds and such proceeds would have been property of the debtors’ estate.  Although the non-issuance of the dividend technically would have rendered the debtors in default under the loan documents, the court opined that because the non-issued dividend would have resulted in increased working capital, “any rational creditor would have forgiven default to obtain a stronger financial position for free.”  Moreover, the court rejected the defendants’ reliance on the Eleventh Circuit’s “control test” for determining if the debtors had an interest in the dividend as the Third Circuit has not adopted the control test.  The Eleventh Circuit’s control test, as articulated in 3V Capital Master Fund Ltd. V. Official Comm. of Unsecured Creditors of TOUSA, Inc. (In re TOUSA), provides that a debtor has an interest in property if: (1) the debtor retains the power to designate which party will receive the funds, and (2) the debtor retains the power to actually disburse the funds at issue to that party.  The court stated that even if it were to apply such test, the elements have been satisfied because: (1) the board of directors of the relevant subsidiary voted to approve the payment of the dividend, and (2) only the subsidiary can disburse its own dividend. The court also noted that if, as certain defendants argued, the debtors had “no choice” but to issue the dividend, then it would have been unnecessary for the board of directors of the subsidiary that issued the dividend to vote in favor of the issuance of the dividend.  Accordingly, because that board of directors voted on the dividend, some discretion was present.
The court’s patience for the defendants’ overall argument seemed to wear thin, as evidenced by the court’s conclusions on the topic:

It truly defies logic to argue that [the debtors] did not have an interest in property in the $310 million dividend [the debtor] itself issued. . . . It would be paradoxical to allow the [private equity funds] to offer Debtors’ property as collateral, abscond with the proceeds of the loan in the form of a dividend, and yet declare that the Debtors had no interest in [the] property.”

Ultimately, the court denied the motion to dismiss.  This case establishes that, at least in the Third Circuit, whether a debtor has an interest in property will be determined using a totality of the circumstances approach, rather than the “control test” articulated by the Eleventh Circuit. Courts in the Third Circuit will look to the totality of the circumstances to determine the parties’ intent, and not elevate form over substance.  As this opinion only dealt with motions to dismiss, absent a settlement, we envision many more colorful opinions as the cases moves forward.  Stay tuned for further updates.