Second Circuit Adopts “Control Test” For Imputation Of Fraudulent Intent In Bankruptcy Avoidance Litigation – Insolvency/Bankruptcy/Re-structuring


Second Circuit Adopts “Control Test” For Imputation Of Fraudulent Intent In Bankruptcy Avoidance Litigation – Insolvency/Bankruptcy/Re-structuring

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In yet another chapter in the tortured saga of the fallout from
the failed 2007 leveraged buyout (“LBO”) of media giant
The Tribune Co. (“Tribune”) in a transaction orchestrated
by real-estate mogul Sam Zell, the U.S. Court of Appeals for the
Second Circuit largely upheld lower court dismissals of claims
asserted by Tribune’s chapter 11 liquidation trustee against
various shareholders, officers, directors, employees, and financial
advisors for, among other things, avoidance and recovery of
fraudulent and preferential transfers, breach of fiduciary duties,
and professional malpractice. In In re Trib. Co. Fraudulent
Conv. Litig.
, 10 F.4th 147 (2d Cir. 2021), reh’g en
banc denied
, No. 19-3049 (2d Cir. Oct. 7, 2021), the Second
Circuit affirmed four district court rulings dismissing the
liquidating trustee’s claims against all of the defendants
except two financial advisors alleged to have received fraudulent
transfers in the form of fees paid in connection with the LBO. In
so ruling, the Second Circuit adopted the “control test”
for determining whether the fraudulent intent of a company’s
officers can be imputed to its directors for the purpose of
avoidance litigation.

Tribune

In 2007, Tribune, owner of WGN America, The Chicago
Tribune
, and the Los Angeles Times, was the target of
a two-stage LBO conceived by Zell that ultimately paid
Tribune’s shareholders more than $8 billion in exchange for
their shares in the company. Prior to the LBO, Tribune’s board
of directors created a special committee to evaluate the LBO. The
special committee included seven independent directors that served
on the board.

Tribune had previously hired two financial advisors, Merrill,
Lynch, Pierce, Fenner, and Smith, Inc. (“Merrill”) and
Citigroup Global Markets, Inc. (“Citigroup”), to conduct
a strategic review and recommend possible courses of action. Both
were also permitted to play a role in potential LBO financing, and
each was contractually entitled to a $12.5 million “success
fee” if a “strategic transaction” was completed. In
addition, the special committee engaged Morgan Stanley & Co.
LLC (“Morgan Stanley”) to serve as its independent
financial advisor.

There were two separate steps to the LBO. First, Tribune
borrowed approximately $7 billion and purchased approximately 50%
of its outstanding shares in a tender offer. Second, six months
later, the company bought its remaining shares and borrowed an
additional $3.7 billion in a go-private merger with a newly formed
Tribune entity. The board engaged Duff & Phelps to provide a
solvency opinion for both steps.

Duff & Phelps was also engaged to provide a solvency opinion
by GreatBanc Trust Co. (“GreatBanc”), which served as the
trustee for Tribune’s employee stock ownership plan
(“ESOP”). As part of the first step of the LBO, GreatBanc
purchased $250 million in unregistered stock from Tribune on behalf
of the ESOP. After the conclusion of the second step, the ESOP was
the majority owner of Tribune.

Duff & Phelps never issued a solvency opinion to
Tribune’s board. Instead, for a fee of $750,000, Duff &
Phelps delivered a “viability opinion” to GreatBanc in
which it concluded that, considering potential tax savings, Tribune
would be able to pay its debts as they became due after the LBO.
The viability opinion took into account the tax savings expected to
be realized from ESOP ownership and “expressly
disclaimed” that it was a solvency opinion.

The same day, Morgan Stanley and Merrill issued “fairness
opinions” that the price to be paid for Tribune’s stock
was fair. The special committee then unanimously voted to recommend
the LBO, after which a majority of Tribune’s board, including
six of the independent directors, voted in favor of it. The board
retained Valuation Research Company (“VRC”) to render
solvency opinions concerning both parts of the transaction, which
it delivered shortly before the completion of each part of the LBO
in exchange for a fee of $1.5 million.

Shortly after the second stage of the LBO was completed in
December 2007, Tribune experienced financial difficulties due to
declining advertising revenues and failed to meet projections. The
company filed for chapter 11 protection in December 2008 in the
District of Delaware.

A flurry of litigation ensued, with suits filed in 21 states as
well as the Connecticut bankruptcy"}” data-sheets-userformat=”{"2":513,"3":{"1":0},"12":0}”>Connecticut bankruptcy court alleging, among other things,
fraudulent payments to Tribune shareholders, breaches of fiduciary
duties, Delaware corporate law violations, and professional
malpractice.

In Neil v. Zell, 753 F. Supp. 2d 724 (N.D. Ill. 2010),
the U.S. District Court for the Northern District of Illinois ruled
that GreatBanc breached its fiduciary duties to Tribune’s
employees by allowing the ESOP to purchase unregistered stock
during the LBO that did not qualify for an exemption under federal
law, instead of buying common stock on the open market. The court
later certified a class action in the litigation, which was settled
in 2012 for an amount exceeding $17 million.

In December 2011, the U.S. Judicial Panel on Multidistrict
Litigation consolidated the Tribune lawsuits in the U.S. District
Court for the Southern District of New York.

The U.S. Bankruptcy Court for the District of Delaware confirmed
Tribune’s chapter 11 plan in July 2012. The plan assigned the
estate’s causes of action to a litigation trust. The litigation
trustee (“trustee”) then became the successor plaintiff
in the multidistrict litigation.

Prior Tribune Court Rulings on Trustee’s
Claims

In In re Trib. Co. Fraudulent Conv. Litig., 2017 WL
82391 (S.D.N.Y. Jan. 6, 2017) (“Tribune 1“), the
district court dismissed claims that the payments to Tribune’s
former shareholders as part of the LBO could be avoided and
recovered under sections 548 and 550 of the Connecticut Bankruptcy Code as
actual fraudulent transfers.

When considering whether a debtor had the actual intent to
hinder, delay, or defraud its creditors within the meaning of
section 548(a)(1)(A), the court explained, “courts focus on
the intent of the transferor, not the intent of the
transferee.” Id. at *5. However, if the transferor is
a corporation, courts assessing intent in this context look to the
intent of the corporate agents who effectuated the transaction on
behalf of the corporation. Under certain circumstances, the court
noted, the intent of such corporate actors to defraud can be
imputed to the corporation.

The district court acknowledged that the Second Circuit had at
that time not yet articulated a test for determining when an
officer’s intent should be imputed to a corporation in actual
fraudulent transfer litigation. However, the district court agreed
with decisions from other courts that the intent of a debtor’s
officers may be imputed to the debtor if the officers were in a
position to control the disposition of the transferor’s
property and, exercising that control, effectuated the fraudulent
transfer. Id. at *6.

The court rejected the argument that only the directors’
intent is relevant in assessing the corporation’s intent
because “it is too restrictive and ‘effectively disregards
any influence on the Board that [officers] may have
exercised.'” Id. at *7 (citation omitted). At the
same time, the court also rejected the argument that an
officer’s intent is always attributable to the
corporation in actual fraud cases.

Instead, the court held that, for the purpose of imputing fraud
in this context, if a party that does not own a majority of a
corporation’s shares is alleged to control the corporation, 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.” Id. (quoting In
re Morton’s Rest. Grp., Inc. Shareholders Litig.
, 74 A.3d
656, 665 (Del. Ch. 2013)).

The district court concluded, however, that Tribune’s
officers had neither voting power nor managerial control of
Tribune.

The Tribune 1 court rejected the trustee’s argument
that the officers had misled VRC into issuing a flawed solvency
opinion, thereby indirectly deceiving the board and the special
committee. According to the court, “[A]llowing the
Trustee’s expansive conception of the imputation doctrine
sweeps the corporate landscape too broadly.” Id. at
*10. The district court concluded that the trustee’s
“multi-layered imputation theory” would undermine
Congress’s policy of protecting securities markets by
introducing substantial uncertainty to the law governing actual
fraudulent transfer claims. Id. at *11. “[G]iven the
ease with which one could allege that the misrepresentation of a
material fact—originating from any source—manipulated
the board’s decision making,” the court wrote, “it is
important to confine the imputation doctrine to those actors who
deliberately and directly exert control inside the boardroom.”
Id.

Thus, the Tribune 1 court ruled that, because the
officers did not exercise voting or managerial control, “the
Trustee’s attempt to impute the Officer Defendants’ intent
to the corporation is unjustified.” Id.

The district court also concluded that, because the trustee
alleged that the independent directors were “clearly” in
a position to control the outcome of the board’s vote, any
intent to defraud on their part could be imputed to Tribune for
purposes of the trustee’s fraudulent transfer claim. However,
the court ruled that the trustee failed to allege actual fraudulent
intent on the part of the independent directors under either: (i)
the “purposeful harm test,” whereby the plaintiff must
provide either direct proof of actual intent or, because fraudulent
intent is rarely susceptible to direct proof, a strong inference of
fraudulent intent by relying on certain “badges of
fraud”; or (ii) the “securities law test,” which
requires either evidence that the directors had both the motive and
the opportunity to hinder, delay, or defraud the debtor’s
creditors or strong circumstantial evidence of conscious
misbehavior or recklessness.

The district court explained that, because proving intent to
hinder, delay, or defraud creditors is very difficult, some courts
consider the following “badges of fraud” when determining
whether an inference can be made to support such a finding:

(1) the lack or inadequacy of
consideration; (2) the family, friendship or close associate
relationship between the parties; (3) the retention of possession,
benefit or use of the property in question; (4) the financial
condition of the party sought to be charged both before and after
the transaction in question; (5) the existence or cumulative effect
of a pattern or series of transactions or course of conduct after
the incurring of debt, onset of financial difficulties, or pendency
or threat of suits by creditors; and (6) the general chronology of
the events and transactions under inquiry.

Id. at *13 (quoting In re Kaiser, 722 F.2d
1574, 1582 (2d Cir. 1983)).

Among other things, the Tribune 1 court rejected the
argument that the independent directors acted with fraudulent
intent because Tribune received less than reasonably equivalent
value in connection with the LBO and because the LBO rendered
Tribune insolvent. Allowing such allegations to raise a strong
inference of fraudulent intent, the court wrote, would “turn
every constructive fraudulent conveyance claim into an actual
fraudulent conveyance claim and thereby undermine the distinction
between the two claims.” Id. at *14.

The court acknowledged that the claim that an allegedly
fraudulent transfer was made to an insider or “close
associate” can support an inference of fraudulent intent.
However, it found that the only payments the independent directors
received as part of the shareholder transfers were proceeds of the
sale of their shares in Tribune and that “any inference of
scienter that could be drawn from the Independent Directors’
receipt of a miniscule fraction of the Shareholder Transfers is
weak at best.” Id. at *13.

The district court also rejected the argument that the fifth
badge of fraud had been satisfied. It explained that LBOs, by their
nature, are transactions outside the ordinary course of business
that require the incurrence of new debt. Accepting the
trustee’s argument, the court wrote, “would mean that
every LBO that ends in a bankruptcy within two years of its
effectuation would subject transferring shareholders to an actual
fraudulent conveyance claim.” Id. at *15.

Addressing the securities law test, the Tribune 1 court
acknowledged that the independent directors had the motive and
opportunity to hinder, delay, or defraud Tribune’s creditors
because the independent directors would receive consideration in
exchange for their shares only if the LBO was consummated. However,
the court concluded, “the mere fact that the Independent
Directors received Shareholder Transfers in connection with the LBO
fails to support a strong inference of scienter, since a corporate
director’s desire to realize personal benefits in connection
with a merger is a motive shared by every corporate director in
America.” Id. at *16 (citation and internal quotation
marks omitted).

The district court rejected the trustee’s argument that the
independent directors had acted recklessly when they approved the
LBO. Because the special committee hired its own advisor and worked
with the board’s advisors, the court explained, the special
committee did not “blindly” accept the projections of
Tribune’s management. Id. at *17. Moreover, the court
noted, failure to conduct more rigorous downside testing of the LBO
would support a finding of negligence, not conscious misbehavior or
recklessness.

The court also determined that, although the independent
directors considered negative trends in the newspaper industry and
concluded that the trends weighed in favor of the LBO, the
trustee’s argument amounted to “little more than a
meatless assertion that the Independent Directors should have known
better,” which was not enough to establish fraudulent intent.
Id. at *19.

On the basis of these findings, the court ruled that the trustee
had also failed to plead facts sufficient to allege that the
independent directors possessed actual intent to hinder, delay, or
defraud Tribune’s creditors through the LBO.

In In re Trib. Co. Fraudulent Conv. Litig., 2018 WL
6329139 (S.D.N.Y. Nov. 30, 2018) (“Tribune 2“),
the district court granted motions to dismiss the trustee’s
claims against certain officers, directors, and shareholder
defendants for breach of fiduciary duties to Tribune or its
subsidiaries, aiding and abetting such fiduciary duty infractions,
unjust enrichment, and violations of Delaware corporate law in
connection with the LBO. According to the court, the trustee failed
to allege that the defendants owed fiduciary duties to Tribune
following closure of the first step of the LBO, that the defendants
ever owed fiduciary duties to Tribune’s creditors, that they
took actions that rendered Tribune insolvent as part of the first
step, or that Tribune mistakenly transferred assets to any of the
defendants.

The court also dismissed claims to avoid severance payments made
to certain employees after the LBO as actual and constructively
fraudulent and preferential transfers based on: (i) its previous
determination in Tribune 1 that the LBO could not be
avoided as an actual fraudulent transfer; (ii) its finding that the
severance payments could not be avoided as constructive fraudulent
transfers because Tribune received value in exchange for the
payments; and (iii) its finding that the payments were made more
than 90 days prior to Tribune’s bankruptcy filing to
non-insider creditors.

In In re Trib. Co. Fraudulent Conv. Litig., 2019 WL
294807 (S.D.N.Y. Jan. 23, 2019) (“Tribune 3“),
the district court denied in part and granted in part motions to
dismiss claims against the independent directors for breach of
fiduciary duty, violations of Delaware corporate law, unjust
enrichment, equitable subordination, and avoidance of
indemnification obligations. Among other things, the court found
that: (i) the trustee adequately alleged violations of the duty of
loyalty, rendering exculpatory provisions immaterial; (ii) because
the second step of the LBO was structured as a merger, rather than
a purchase or redemption of stock, the Delaware corporate law claim
was barred by the doctrine of “independent legal
significance”; (iii) to support his equitable subordination
claim, the trustee plausibly alleged that the independent directors
violated their fiduciary duties to Tribune; and (iv) Tribune’s
indemnification obligations to the independent directors could not
be avoided as fraudulent transfers because Tribune incurred those
obligations more than two years before filing for bankruptcy.

In Tribune 3, the district court also dismissed in part
and granted in part motions to dismiss the trustee’s claims
against an independent director (who did not join Tribune’s
board until after step one of the LBO) and certain related entities
for breach of fiduciary duty, avoidance of fraudulent and
preferential transfers and obligations, alter ego liability, unjust
enrichment, and equitable subordination.

Finally, the district court dismissed claims asserted by the
trustee against Citigroup, Merrill, Morgan Stanley, VRC, and Duff
& Phelps for aiding and abetting breaches of fiduciary duty,
professional malpractice, unjust enrichment, and avoidance of fee
payments made in connection with the LBO. Among other things, the
court determined that: (i) the trustee did not allege that Duff
& Phelps provided inaccurate or incomplete information in
connection with the LBO to Tribune or GreatBanc; (ii) the
trustee’s claims for aiding and abetting breaches of fiduciary
duties and professional malpractice were barred by the doctrine of
in pari delicto; and (iii) Tribune received reasonably
equivalent value in exchange for the financial advisors’ fees,
and the trustee made no allegations that Tribune paid the fees with
the intent to defraud creditors.

In In re Trib. Co. Fraudulent Conv. Litig., 2019 WL
1771786 (S.D.N.Y. Apr. 23, 2019) (“Tribune 4“),
the district court denied the trustee’s motion for leave to
amend his complaint to add claims for constructive fraudulent
transfers under section 548(a)(1)(B) of the Bankruptcy Code against
Tribune’s former shareholders. According to the court,
notwithstanding the U.S. Supreme Court’s ruling in Merit
Mgmt. Grp., LP v. FTI Consulting, Inc.
, 138 S. Ct. 883 (2018),
the trustee’s constructive fraudulent transfer claims were
preempted by the safe harbor for certain securities, commodity, or
forward contract payments contained in section 546(e) of the
Bankruptcy Code, and amendment of the complaint accordingly would
be futile.

All four of the district court rulings on the motions described
above were appealed to the Second Circuit, which addressed the
appeals in a single opinion.

The Second Circuit’s Ruling on Appeal

A two-judge panel of the Second Circuit (the third judge on the
panel passed away during the pendency of the appeal) affirmed in
part, vacated in part and remanded the cases below for additional
determinations.

Writing for the panel, U.S. Circuit Judge Denny Chin initially
noted that “the issue of whether a company’s officers’
intent to defraud creditors can be imputed to an independent
special committee for purposes of a fraudulent conveyance claim
under the Bankruptcy Code is a question of first impression in this
Circuit.” Tribune, 10 F.4th at 160.

Judge Chin found that the district court properly applied the
“control test” in making that determination. He wrote
that, “for an intentional fraudulent transfer claim, which
requires ‘actual intent,’ a company’s intent may be
established only through the ‘actual intent’ of the
individuals ‘in a position to control the disposition of [the
transferor’s] property.'” Id. (citing In
re Roco Corp.
, 701 F.2d 978, 984 (1st Cir. 1983); In re
Lehman Bros. Holdings, Inc.
, 541 B.R. 551, 576 (S.D.N.Y.
2015)).

In this case, Judge Chin explained, Tribune’s board, as
permitted under Delaware law, delegated its authority to approve
the LBO to the special committee. Therefore, the trustee was
required to plead allegations that gave rise to a strong inference
that the special committee had the actual intent to hinder, delay,
or defraud Tribune’s creditors, as required by section
548(a)(1)(A) of the Bankruptcy Code.

However, Judge Chin concluded that the trustee failed to
plausibly allege that the intent of Tribune’s senior management
should be imputed to the special committee because he did not
allege, among other things, that: (i) Tribune’s senior
management controlled the transfer of Tribune’s property as
part of the LBO; (ii) senior management inappropriately pressured
the independent directors to approve the LBO or dominated the
special committee; or (iii) any financial or personal ties existed
between senior management and the independent directors that could
have affected the impartiality of the special committee.

According to Judge Chin, “to impute the officers’
intent onto the Special Committee, which was working independently
with an outside financial advisor and independently reviewed
opinions provided by Duff & Phelps and VRC, would stretch the
‘actual intent’ requirement as set forth in §
548(a)(1)(A) to include the merely possible or conceivable or
hypothetical as opposed to existing in fact and reality.”
Id. at 161.

Judge Chin also found that the district court correctly held
that the trustee failed to plead “badges of fraud”
sufficient to raise a strong inference of actual fraudulent intent
on the part of the special committee. He agreed with the district
court that the independent directors’ profit motive in
approving the LBO did not give rise to a strong inference of actual
fraudulent intent. Judge Chin found similarly unpersuasive the
trustee’s argument that the independent directors were aware of
the risky nature of the LBO and the strong likelihood that Tribune
would be unable to service debt incurred as part of the
transaction.

The Second Circuit accordingly ruled that, in Tribune
1
, the district court did not err in dismissing with prejudice
the trustee’s fraudulent transfer claims against Tribune’s
former shareholders.

The court also found no error in the district court’s
dismissal in Tribune 2 of the trustee’s claims against
certain officer, director, employee, and shareholder defendants for
substantially the same reasons stated in Tribune 2.

Next, the Second Circuit held that, in Tribune 3, the
district court did not err in dismissing the trustee’s aiding
and abetting breach of fiduciary duty and professional malpractice
claims against financial advisors Citigroup, Merrill, and Morgan
Stanley. It also ruled that the district court properly dismissed
the trustee’s actual fraudulent transfer claims against those
defendants because the complaint did not sufficiently allege that
the transfers to them were made with the intent to hinder, delay,
or defraud Tribune’s creditors.

However, Judge Chin explained, the complaint did adequately
plead such actual intent with respect to VRC and, therefore, the
district court’s dismissal of that claim must be vacated. He
noted that the complaint alleged, among other things, that the fee
was the highest VRC had ever charged for a solvency opinion and
that the firm agreed to use a nonstandard definition of “fair
value.” Id. at 171.

Next, Judge Chin concluded that the constructive fraudulent
transfer claims against Citigroup and Merrill should not have been
dismissed, but that the constructive fraudulent transfer claims
against Morgan Stanley and VRC were properly dismissed. He
explained that, whereas Morgan Stanley and VRC, unlike Citigroup
and Merrill, had no financial stake in the LBO’s consummation
because they earned their respective fees upon delivery of their
contracted-for opinions, “the factual question of whether
Citigroup and Merrill provided reasonably equivalent value for
their success fees cannot be decided without first assessing
whether the banks satisfactorily performed their duties.”
Id. at 174. In addition, Judge Chin noted, the payments to
Morgan Stanley and VRC were in large part due before the first step
of the LBO was completed, and there was no allegation in the
trustee’s complaint that Tribune was insolvent before the first
step.

Finally, the Second Circuit affirmed the district court’s
ruling in Tribune 4 denying the trustee leave to amend his
complaint to add actual and constructive fraudulent transfer
claims.

Outlook

Relatively little remains of the twisted and tortured litigation
spanning more than a decade concerning the 2007 Tribune LBO. The
Second Circuit affirmed the dismissal of all claims except the
actual fraudulent transfer claims asserted against VRC for
avoidance of its $1.5 million fee and the constructive fraudulent
transfer against Citigroup and Merrill Lynch for avoidance of their
collective $25 million in success fees. The U.S. Supreme Court is
unlikely to agree to hear any appeal by the trustee of the Second
Circuit’s ruling. Additional appeals, however, may ensue from
the remanded litigation against the financial advisors.

Perhaps the most notable aspect of the Second Circuit’s
ruling is its adoption as a matter of first impression of the
control test, rather than a “scope-of-employment agency”
standard or a “proximate cause” standard, for imputing
intentional fraud in avoidance litigation.

The trustee filed a petition for rehearing en banc of
the Second Circuit’s decision in which he argued that the panel
applied the wrong standard for imputing fraudulent intent to
corporate actors. The Second Circuit denied the petition on October
7, 2021.

_________________

Jones Day represents certain of the defendants in the
Tribune fraudulent transfer litigation.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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