A Roadmap For Escaping Divesting Backlash

A company confronting significant liabilities – whether they be mass tort, environmental, securities, or a host of others – faces myriad dilemmas. Among the most significant are whether it can restructure, divest assets, or even pay regular dividends without running afoul of the prohibition against fraudulent conveyances. Meanwhile, a buyer of assets from a company facing significant liabilities must determine whether it can complete the deal without being found a fraudulent transferee of the assets, or otherwise becoming the unwilling successor to the seller’s liabilities. In the case of Lippe v. Bairnco Corp., a recent decision by the U.S. Court of Appeals for the Second Circuit proves that it is possible for a company to navigate this minefield intact. In that case, the Second Circuit confirmed that a company facing significant liabilities can divest, and a third party can purchase, assets without running afoul of fraudulent conveyance laws. Surprisingly, this is true even if the transaction is between related companies and even if one of the purposes of the transaction is to shield the assets being transferred from liabilities. Stated simply, assets can be divested without fraudulent conveyance consequences as long as the deals do not harm the divesting company’s creditors. In Lippe v. Bairnco, The Keene Creditors Trust, an entity representing asbestos creditors of the now-bankrupt Keene Corp., sued three former subsidiaries of Keene and Keene’s former CEO, claiming that several transactions engaged in by Keene during the 1980s were fraudulent. In particular, the trust claimed that Keene engaged in fraud when it sold certain business assets – for cash – to some of its subs. As a manufacturer of products containing asbestos, Keene had been among the first companies sued by plaintiffs seeking compensation for asbestos-related diseases. Its first lawsuit alleging asbestos claims was filed in the mid-1970s. During the 1970s and 1980s, Keene analyzed its asbestos liabilities on a yearly basis. Throughout that time, Keene and its counsel concluded that it had sufficient assets, including hundreds of millions of dollars in insurance coverage, to pay the claims against it and Keene received “clean” opinions from its outside auditors each year. Nevertheless, the number and magnitude of the asbestos cases filed against Keene were greater than anyone inside or outside of the company could have anticipated. Keene was forced to file for bankruptcy in December 1993. Meanwhile, in 1981, Keene executed a complex restructuring, partly in response to changes in the marketplace and partly in response to its asbestos liabilities. Keene created a new subsidiary, Bairnco Corp., and “flipped” their relationship, with Keene becoming a subsidiary of Bairnco. There were several stated reasons for this reorganization, although the primary reason was the need to “deconglomerate” Keene. The restructuring also was intended to protect new acquisitions made by Bairnco or other Bairnco subsidiaries from the adverse effects of Keene’s asbestos liabilities. Between 1981 and 1989, Keene and Bairnco both bought and sold various businesses. In particular, in five separate transactions, Keene sold certain businesses to other Bairnco subsidiaries. All five of these deals were asset sales for cash paid to Keene. Once the sale price was set in each transaction, it was reviewed by an independent investment banking firm, which opined that the buyer was paying “fair value” for the assets. Keene received $273.6 million in cash, which it used to run its other businesses, acquire several new businesses, and pay its debts. The Keene Creditors Trust, which was created as part of Keene’s bankruptcy, challenged the five sales to subsidiaries as fraudulent conveyances. The trust also challenged as fraudulent Keene’s payment of dividends to its sole shareholder, Bairnco. The trust claimed that the five sales and the payments of dividends were made with an actual intent to hinder, delay, or defraud Keene’s creditors, including the existing and possible future claimants who would be seeking compensation for asbestos-related diseases. Underlying this theory was the notion that Keene knew or should have known in the early 1980s that its asbestos liabilities eventually would overwhelm it and force it to declare bankruptcy, and, therefore, it transferred certain businesses to keep them from the asbestos plaintiffs. The trust also argued that the transactions were constructively fraudulent because Keene was insolvent at the time of the deals. Even though Keene was an operating, profitable entity for many years prior to filing for bankruptcy, the trust claimed that the company was insolvent from the early 1980s on because its potential future asbestos liabilities constituted current “debts” at the time of the asset transfers. The case was initially heard in the federal court for the Southern District of New York, in Manhattan. In March 2003, that court granted summary judgment in favor of all defendants. In essence, the court found that the trust was unable to state a sufficiently valid claim to go to trial. The ruling rested on several grounds. First, and most important, the trust presented no proof that any of Keene’s creditors were harmed by the transactions. Harm to creditors is a necessary element of a fraudulent conveyance claim. The trust’s sole theory of harm to creditors was that Keene had received far less than the fair value of its businesses sold to its subs. However, the trust was unable to prove this theory because the court previously ruled that the trust’s business valuation experts were not reliable enough to be permitted to testify. The defendants, moreover, had presented affirmative evidence – in the form of contemporaneous fairness opinions, witness testimony, and their own experts – showing that the prices paid for Keene’s assets were fair. Because there was no way the trust could prove an essential part of its case (namely, harm to Keene’s creditors), there was no way the trust could recover and its claims were dismissed. Second, the district court also found that no reasonable jury could conclude, based on the trust’s evidence, that the transactions or dividends were motivated by an actual intent to defraud Keene’s asbestos creditors. In no small part, this conclusion was based on the court’s acknowledgement that “Keene could not predict the future, and it had no reason to know, at the time of the transfers, that years later it would be rendered insolvent by a flood of asbestos filings.” Finally, the court rejected the argument that Keene was “insolvent” at the time of each of the transactions. Claims of “constructive fraudulent conveyance” can be brought under various theories under New York law, but almost all such theories require two things: * That the debtor be “insolvent” at the time of, or because of, the challenged asset sale, and * That the assets be sold for less than “fair value.” “Insolvency,” in turn, is defined as when “the present fair salable value of [the debtor’s] assets is less than the amount that will be required to pay his probable liability on his existing debts as they become absolute and matured.” Focusing on the phrase “probable liability,” the court ruled that a reasonable jury could only conclude that “Keene had, or believed it had, more than sufficient assets to cover its probable liabilities at the time of the transactions.” The fact that Keene failed to predict accurately the number and magnitude of asbestos suits it ultimately would face did not mean that Keene was “insolvent,” or that any of the challenged transactions was fraudulent. On appeal, the Second Circuit affirmed the lower court’s rulings in orders issued April 9 and May 17, 2004. In reaching its decision, the Second Circuit confirmed that no actual or constructive fraudulent conveyance occurs unless creditors are harmed by the transfer of assets. If anything, the appeals court noted, Keene’s transactions benefited creditors because, “[r]ather than converting its assets into a form unreachable by its creditors, Keene transformed them into a medium arguably more accessible: cash.” Moreover, Keene did not allow the cash it received from the transfers to “languish or dissipate” but used the cash to acquire several more businesses. The appeals court also agreed with the district court that Keene was not “insolvent” at the time of the transfers. Unlike the district court, the Second Circuit focused on the term “existing debts,” rather than the term “probable liability,” in the New York debtor and creditor law. Nevertheless, both courts agreed that Keene was not obligated to predict the future in assessing its solvency. Because Keene reasonably believed it was solvent at the time of the transfers, the trust could not prove that the transfers were fraudulent. “Insolvency” – In the Eye Of the Beholder? The importance of Lippe v. Bairnco for any company facing significant liabilities, or anyone seeking to buy assets from such a company, is how the decisions handled the question of solvency in the face of potentially significant future liabilities. The district court looked at whether Keene had a subjectively reasonable belief that it would be able to pay its future liabilities as they became due. The appeals court, by contrast, looked instead at the objective question of when tort claims accrue so as to constitute “existing debts.” Because it is the higher court, the analysis of the Second Circuit is controlling. However, the appeals court did not address the district court’s alternative analysis, which suggests that the lower court analysis also could be legitimate in the proper circumstances. Both approaches are extremely favorable to debtors, especially those facing potential mass tort liabilities. Under their analyses, a company is not required to predict the future. As long as a company facing mass tort liabilities undertakes a reasonable effort to estimate its existing and future liabilities and comes up solvent, the risk that an asset sale will later be deemed a “fraudulent” conveyance is greatly reduced. This debtor-friendly analysis is at odds with one of the few prior cases involving the same issue – a 2002 Delaware court decision against Sealed Air Corp. in connection with the bankruptcy proceedings of W.R. Grace & Co. The transaction challenged as fraudulent in that case was the 1998 acquisition by Sealed Air of a division of W.R. Grace. Like Keene, at the time of the transactions, W.R. Grace was facing tens of thousands of asbestos cases and was likely to face tens of thousands more in the future. Also like Keene, Grace retained outside consultants to undertake an analysis of its potential future liabilities. That analysis, when placed along Grace’s assets, showed that the company was solvent, which meant that the Grace was free to go through with the sale of its division to Sealed Air. Ultimately, that analysis proved to be wrong and Grace filed for bankruptcy only three years later. Unlike the courts in Lippe v. Bairnco, the Sealed Air court held that future unfiled, unknown, objectively unknowable, unaccrued, and then-unquantified future liabilities had to be taken into account when assessing W.R. Grace’s solvency. In other words, potential asbestos claimants, once they had been exposed to asbestos, had a right to payment. So their claims were considered “debts” for solvency purposes, even if neither Grace nor the claimants themselves were aware of their claims at the time. An objectively reasonable belief in a company’s solvency, the court concluded, was not enough. In essence, if a mass tort defendant ever finds itself unable to pay its liabilities, the Sealed Air court would find it “insolvent” as of the day its first claimant was first exposed to the toxic substance at issue. The differences between the pro-debtor analysis of Lippe v. Bairnco and decidedly anti-debtor approach of Sealed Air may arise, in part, from differences in the applicable state law. The Sealed Air court interpreted New Jersey’s version of the Uniform Fraudulent Transfers Act (UFTA), not the New York’s version of the Uniform Fraudulent Conveyances Act (UFCA). Unlike the New York law, the UFTA does not refer to “probably liability” or “existing debts” in determining insolvency. Instead, the UFTA takes a pure balance sheet approach: A company is insolvent when “the sum of the debtor’s debts is greater than all of the debtor’s assets at a fair valuation.” Whether the differences between the tests for insolvency explain the radically different approaches of the Lippe and the Sealed Air courts will be for a future court to decide, since Lippe was decided after Sealed Air but did not discuss the case. Falling somewhere between the draconian result of Sealed Air and the more favorable result of Lippe v. Bairnco is the 2002 decision by the federal Bankruptcy Court in Louisiana in In re Babcock & Wilcox. In that case, the plaintiffs petitioned the court to revoke Babcock & Wilcox’s corporate restructuring on the grounds that, at the time of the restructuring, asbestos liabilities had already made the company “insolvent.” Relying in part on Louisiana state law, the Bankruptcy Court agreed that future asbestos claims must be taken into account when determining a company’s solvency. Such future claims had to be assessed objectively; the company’s subjective belief about the scope of its future liabilities is irrelevant. Although this ruling might seem harsh at first glance, the court’s application was tempered by common sense. It concluded that B&W’s internal estimates of its future liabilities, even though they did not turn out to be accurate, were not “objectively unreasonable” and were made in good faith based on the information known at the time. The court said that, in determining whether B&W was solvent, it “cannot use hindsight and can only determine whether the predictions by [B&W] were reasonable under the circumstances existing at the time they were made.” For all intents and purposes, the Babcock & Wilcox court reached the same result as the Lippe v. Bairnco court. Both courts concluded that a company is not required to anticipate every contingency. Insolvency will not be assessed purely in hindsight. Internal estimates of future liabilities are necessary, and as long as they are made competently and in good faith, a company can rely on those estimates to show that it was solvent at the time of a transaction – even if the estimates later turn out to be inaccurate by a substantial margin. The differing results in Lippe, Sealed Air, and Babcock & Wilcox show that courts have not reached a consensus on whether, and to what extent, defendants now in bankruptcy should be faulted for not having predicted the future course of litigation that put them there. These cases underscore the need for a company contemplating an asset sale or restructuring to carefully analyze potential liabilities, based on all of the available information, and to ensure that the deal is done at fair value and in a form that does not diminish the transferor’s assets that are available to creditors. Lippe Lessons Aside from the solvency issue, the opinions in Lippe v. Bairnco provide much-needed guidance for companies that face potentially significant liabilities and want to continue doing business as usual. Likewise, anyone who is considering the acquisitions of assets from such a company and does not want to risk fraudulent conveyance and related liabilities should take heart. No harm, no foul The most significant lesson Lippe teaches is that a company facing potentially significant liabilities can transfer assets lawfully, even with the specific purpose of shielding those assets from creditors, as long as the transfer does not harm creditors. When a company faces potentially overwhelming liabilities, it is not condemned for eternity to hold onto all of its assets when legitimate business purposes otherwise would dictate the sale or other disposition of some or all of those assets. “Legitimate business purposes” can be wholly unrelated to the pending liabilities, such as a desire to achieve efficiencies and increase profits by combining related businesses, or can stem from the liabilities themselves, such as a desire to free up management’s time and energies from the preoccupation of the liabilities and allow them to return to running the business full time. In the words of the district court in Lippe: “Even assuming management’s concern over the asbestos cases was a motivating factor [in the sale of the businesses], there was nothing inappropriate about a company’s management looking for lawful ways to reduce the adverse impact of asbestos litigation.” The key to lawfully transferring assets to keep them away from creditors is that the transaction cannot injure creditors. In order to sustain a fraudulent conveyance claim under either the UFCA or the UFTA, a plaintiff must prove that it was injured as a result of the conveyance. Without injury, a claim for fraudulent conveyance will not stand up. A transfer may be attacked as fraudulent only by one who is injured by it. If the transaction injures no one, then no one can bring a fraudulent conveyance claim – even if the intent of the transaction was to keep the assets out of the hands of the creditors. An extremely important caveat must be stated here. We are not suggesting, and the Lippe ruling does not say, that assets can be transferred lawfully for the purpose of hindering, delaying, or defrauding creditors. On the contrary, such transfers run afoul of the UFTA and UFCA, and nothing in Lippe changes that. Rather, Lippe confirms that transfers designed to keep particular assets away from creditors are not necessarily “for the purpose of hindering, delaying, or defrauding the creditors.” This is because, with rare exceptions, creditors are not entitled to particular assets, but only to the value of those assets and the ability to reach that value. Thus, if a company transfers individual assets or even entire business units, there is no harm to creditors as long as the company receives fair equivalent value in the form of cash or other valuable assets that are and remain as accessible to the creditors as were the businesses themselves. Again, if the creditors are not harmed, claims for actual or constructive fraudulent conveyance cannot be maintained. Buyer be wary A buyer of assets of a company that faces potentially significant liabilities can complete the deal without incurring fraudulent conveyance liability or becoming the successor to the seller’s underlying liabilities. As with the first lesson, the key here is to be certain that the transferor’s creditors will not be harmed by the deal. From the buyer’s perspective, paying cash and utilizing the services of an independent third party to confirm that the transfer involves fair equivalent value – especially if the transferor and transferee are related entities – are insurance policies well worth the premium paid. An ounce of prevention Precautions can and should be taken at the time of a deal to repel later claims that the transaction was undertaken with an actual intent to hinder, delay, or defraud creditors. Both Lippe courts noted several facts in the various Keene transfers that directly contradicted the trust’s assertion that the transactions were motivated by an intent to defraud Keene’s creditors: * The transactions were conducted openly and were disclosed in public filings; * Contemporaneous documents showed a legitimate business purpose (such as the consolidation of similar business lines to combat increased competition) for each transaction; * Keene received a fairness opinion on the price of each asset sale from an independent investment banker; * Other contemporaneous evidence showed that the parties intended that fair value be paid for the assets; * Keene received cash for the transferred assets; * Keene retained and used the cash for the ordinary operation of its businesses; * Keene retained no control over the transferred assets; * Keene continued to operate as a going concern after the transfers; * Keene management relied on the advice of its counsel concerning the structure of the transaction and specifically avoided a structure that would have increased its potential liability for fraudulent transfer; * In each year that a transaction was made, Keene had received a clean opinion from its outside auditors; and * In each year when a transaction was made, Keene management’s internal estimates indicated that it had sufficient assets and insurance coverage to pay its current and reasonably forecast asbestos liabilities. Anyone in the position of transferor or transferee in similar circumstances would be wise to follow this model in whole or substantial part. The governing law governs Which law governs the fraudulent conveyance issue is critical to the outcome. This is hardly a novel concept, but it is brought into sharp focus by the Lippe, Sealed Air, and Babcock & Wilcox decisions. Whether the UFCA or the UFTA governs could literally spell the life or death of a company facing the prospect of being named the successor to a bankrupt asbestos defendant’s liabilities. Likewise, how the relevant state law defines a “claim,” or when a cause of action “accrues,” can make a significant difference in the outcome. Unfortunately, since the parties in Lippe had stipulated to the application of New York Law, the Second Circuit offers no guidance on what law applies to these issues, and the Sealed Air and Babcock & Wilcox courts also did not address the question. In the end analysis, Lippe v. Bairnco offers a ray of hope that companies facing potentially massive liabilities can continue to conduct business as usual, can isolate their liabilities, and can divest assets without harming creditors or running afoul of the prohibition against fraudulent conveyances. Charles Rysavy is a Partner in the Newark, N.J.-based law firm of McCarter & English and Alissa Pyrich and Pranita Raghavan are Associates at the firm. McCarter & English defended the alleged fraudulent transferee Genlyte Group in Lippe v. Bairnco. Copyright 2005 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com