LBOs can get messy. Such was the case for the Tribune Company, which, in conjunction with its private equity investor, borrowed approximately $10.7 billion in 2007 to finance its buyout. Soon after the LBO was completed, Tribune experienced financial difficulties that made it unable to service its new debt, and, in December 2008, the company filed for chapter 11 protection.
The law can get messy too. Such was the state of the law facing SDNY District Judge Richard Sullivan when he heard the Tribune shareholders’ motion to dismiss the litigation trustee’s actual fraudulent conveyance claims relating to the $8 billion paid to Tribune’s shareholders in the 2007 LBO (the “Shareholder Transfers”). On his way to granting the shareholder defendants’ motion to dismiss, Judge Sullivan waded through unsettled, and at times conflicting, law concerning the imputation of an officer’s intent to a company, as well as the standard for determining actual intent to hinder, delay, or defraud.
Actual Fraudulent Conveyances
The litigation trustee (the “Trustee”) alleged that the Shareholder Transfers constituted actual fraudulent conveyances because Tribune authorized such payments with an actual intent to hinder, delay, or defraud Tribune’s creditors in violation of §§ 548(a)(1)(A) and 550(a) of the Bankruptcy Code. Section 548(a)(l)(A) allows a trustee to avoid any transfer of property of the debtor if the debtor made the transfer (1) in the two years preceding a bankruptcy filing and (2) “with an actual intent to hinder, delay, or defraud” the debtor’s creditors. Section 550(a) allows a trustee to recover the value of any property that was transferred in violation of § 548(a).
Given that it was agreed that the Shareholder Transfers occurred in the two years preceding Tribune’s bankruptcy filing, the sole issue in dispute was whether the Trustee “alleged sufficient facts to support a strong inference that Tribune, as the transferor, acted with an actual intent to hinder, delay, or defraud its creditors.” Judge Sullivan began his analysis by noting that “where the transferor in an alleged fraudulent conveyance is a corporation, as opposed to a real person, determining the transferor’s actual intent becomes more difficult to discern.” The Trustee alleged that two groups of actors possessed fraudulent intent: (i) Tribune’s officers and (ii) Tribune’s board of directors. Judge Sullivan encountered conflicting precedents when analyzing each set of actors.
The Trustee’s first argument was that Tribune’s officers possessed the requisite fraudulent intent and that such intent should be imputed to Tribune. The parties disputed the level of control an officer must have in order for such officer’s intent to be imputed to the corporation, as the Second Circuit Court of Appeals had not yet articulated a test for determining when an officer’s intent should be imputed to a corporation. The Trustee pointed to Judge Denise Cote’s July 2016 opinion in In re Lyondell Chem. Co., which applied the Delaware corporate law principle that “the knowledge and actions of [a] corporation’s officers and directors, acting within the scope of their authority, are imputed to the corporation itself,” and concluded that “to impute [CEO’s] knowledge and intent to [corporation], the Trustee need not plead that [CEO] had the power to effectuate the merger or dominated the Board.”
With no Second Circuit precedent to bind him, Judge Sullivan applied the test articulated by the First Circuit in Roco Corp., and utilized by Judge Gerber in his Lyondell bankruptcy court opinion, which Judge Conte overturned, pursuant to which “an officer’s wrongful intent may be imputed to the corporation ‘by establishing that [the officer], by reason of the ability to control’ members of the board, ‘caused the critical mass’ to form ‘an actual intent to hinder, delay or defraud creditors.’ In contrast to Judge Cote who stated that power to effectuate the transaction was not required to impute an officer’s intent to the corporation, Judge Sullivan emphasized that “imputation [is] barred unless the trustee can prove that an officer exercised ‘control’ over the transaction.”
Judge Sullivan then explained that to ascribe control over a transaction to a party without majority ownership of a corporation’s shares (as was the case in Tribune), “the plaintiff must show ‘such formidable voting and managerial power that [he], as a practical matter, [is] no differently situated than if [he] had majority voting control” of the corporation’s shares. Beginning with voting power, Judge Sullivan concluded that the Trustee failed to plead sufficient allegations of control because the officers owned only 13% of Tribune’s outstanding stock, and the Trustee made no allegation that any officer had the right to appoint directors, veto board action, or remove or reduce the compensation of a director. Similarly, Judge Sullivan found insufficient managerial power, emphasizing that: (i) although the officers attend the special committee meetings which considered the LBO, the Trustee did not allege that the officers inappropriately pressured the independent directors at those meetings; (ii) the Trustee did not allege familial or other professional ties which made the directors financially or otherwise beholden to the officers; and (iii) managerial control through deception had not been established, because even if the officers had manipulated projections in connection with the LBO, the board had enlisted its own financial advisors to assess the LBO.
Judge Sullivan concluded his discussion of imputation by distinguishing Lyondell. First, unlike the Tribune board which considered the advice of multiple independent advisors, the board in Lyondell allegedly authorized the LBO based solely on the urging of its CEO, and without obtaining any meaningful independent analysis. Second, in Lyondell, one of the outside directors who voted in favor of the LBO was a senior officer of an entity that gained $326 million from the sale, “and therefore had a strong motive to approve the LBO notwithstanding its potentially adverse impact on creditors.” Judge Sullivan noted that the $6 million that the seven Tribune officers collectively received from the Shareholder Transfers, “was an utterly miniscule fraction of the nearly $11 billion transferred,” and therefore not analogous to Lyondell.
Board of Director Intent
The Tribune board of directors delegated its decision-making authority to independent directors, who constituted a seven-member majority of the board and were responsible for assessing the LBO and related alternatives. As such, Judge Sullivan found that, unlike the officers, the independent directors “were clearly in a position to control the outcome of the Board’s vote on the LBO,” and, therefore, to the extent that the independent directors had wrongful intent, “that intent may be imputed to the corporation for purposes of the Trustee’s fraudulent conveyance claim.”
Turning to the standard for establishing fraudulent intent, Judge Sullivan was again confronted with conflicting authority within his Circuit. Judge Sullivan noted how some courts in the Second Circuit had utilized an intentional harm standard while others applied a recklessness standard. Judge Sullivan chose to “not wade into this alleged conflict between authorities,” because he found that, under either approach, the Trustee had failed to adequately allege actual fraudulent intent. Nevertheless, Judge Sullivan did state that if forced to pick he would adopt the intentional harm standard “since it more closely tracks the language of the bankruptcy code, which imposes liability for ‘actual intent to hinder, delay, or defraud.’”
Judge Sullivan explained that under the intentional harm standard, the “badges of fraud” identified by the Trustee were not compelling, because, among other reasons, LBOs, by their very nature, are not performed in the ordinary course, and the Trustee had not presented any evidence of dependent relationships involving, or concealment on the part of, the independent directors. Similarly, under the recklessness or “securities law test,” Judge Sullivan concluded that the Trustee had not sufficiently alleged fraudulent intent because: (i) “a corporate director’s desire to realize personal benefits in connection with a merger is a motive shared by ‘[e]very corporate director in America;’” (ii) the directors did not blindly or recklessly accept management’s projections – they enlisted their own independent advisors; and (iii) “the Court is highly reluctant to infer scienter on the Board’s part simply because it entered a risky transaction at a time when Tribune was struggling.”
There are different types of messiness. There is messiness that lingers for a while, becomes customary, and is unlikely to soon be addressed. Judge Sullivan suggests that the competing standards for fraudulent intent perhaps fit this profile, as he lets them continue to coexist and queries “[w]hether these are truly separate tests or merely different formulations of the same standard.” There is also new, fresh messiness. The type that is more difficult to overlook or allow to linger because it is so very apparent. The Second Circuit’s test for imputing officer liability on a corporation likely fits this profile. In a six-month span, two SDNY District Judges employed starkly different legal tests to address the same issues. This is fresh, interesting messiness, the type the Second Circuit is unlikely to allow to linger.