Companies that have valuable assets but also face significant liabilities will sometimes engage in restructurings to isolate, or “ring-fence,” the good assets from the liabilities. Often the companies are able to accomplish their shuffling of assets without judicial interference, especially if they proceed over a period of years and justify the transactions with analyses from independent professionals and industry observers.
But every once in a while, a court will put a stop to such actions if they harm creditors, especially when the companies proceeded quickly and without creditor involvement. In December 2013, in Tronox Inc. v. Anadarko Petroleum Corp. (In re Tronox Inc.), 503 B.R. 239 (Bankr. S.D.N.Y. 2013), Judge Allan Gropper, a bankruptcy judge in the influential United States Bankruptcy Court for the Southern District of New York, issued a lengthy opinion that avoided billions of dollars of transfers involving such “ring-fencing” efforts. Judge Gropper made preliminary findings of a range of net damages of at least $5.15 billion. The parties subsequently settled, meaning that the decision will not undergo appellate review. Nevertheless, the opinion may have a wide-ranging impact on what steps companies with long-term liabilities can take to preserve value for shareholders by separating valuable assets from such liabilities, and may open the floodgates for bankruptcy estates and unsecured creditors to challenge transactions that occurred years earlier.
Among the interesting rulings in Tronox are the court’s decision to reach back to avoid transfers that occurred nearly a decade before the companies filed for bankruptcy, its heavy criticism of defendants’ use of market data to justify the transfers, and its decision to permit avoidance of transfers even where the value of the avoided transfers exceeded what was necessary to pay creditors in full. The decision discusses a number of issues important to insolvency practitioners, investors in distressed debt, and private equity sponsors. For companies like Ceasar’s and Sears and their equity sponsors—which recently have engaged in arguably analogous transactions to unlock value for equity security holders in the face of substantial debt—Tronox could be worrisome because it gives hedge funds, distressed debt traders, and bankruptcy counsel roadmaps on how to challenge transactions that most industry professionals previously would have viewed as untouchable. Tronox is also important for companies seeking to restructure their long-term environmental and tort remediation liabilities.
To set the stage for his rulings, Judge Gropper reviewed a lengthy chronology of the transactions of Kerr-McGee Corporation from 2000 to 2006. Kerr-McGee had “enormous legacy environmental and tort liabilities” from 2,700 environmental sites (including at least seven “Superfund” sites). Beginning in 2000, the company, with input from financial and legal professionals, started developing a plan to separate certain of its valuable businesses from its legacy liabilities to make the businesses more attractive to investors and acquirers. Over a six-year period, the company engaged in numerous transactions that resulted in its valuable businesses being separated from the entities liable for the legacy environmental and tort liabilities. These included an initial public offering for Tronox, Inc., entry into a secured credit facility, and an issuance of unsecured notes.
In 2002 the most valuable business was transferred to a new entity, the so-called “New” Kerr-McGee, leaving a chemical business and legacy liabilities with “Old” Kerr-McGee, which was renamed Tronox Worldwide LLC. Three years later, in 2005, Tronox incurred approximately $450 million in secured bank debt and issued unsecured notes of $350 million. All but $40 million of the proceeds from these transactions were paid to New Kerr-McGee. Later in 2005, Tronox was taken public in an initial public offering, resulting in $225 million in proceeds that were also paid over to New Kerr-McGee. Finally, in March 2006, New Kerr-McGee distributed the Tronox stock to its shareholders, completing the spin-off of the Tronox assets (and liabilities) and establishing Tronox as an independent company. Within a few weeks of the last transaction, Anadarko acquired New Kerr-McGee for $18 billion in an all-cash transaction.
Even though it had interim financial difficulties, Tronox did not file for bankruptcy until January 2009. A few months later, the bankruptcy estate filed a complaint in the bankruptcy court against Anadarko and other beneficiaries of the transfers, alleging actual and constructive fraudulent transfers and a variety of common law claims. The complaint sought billions in compensatory and punitive damages, attorneys’ fees, and interest.
The bankruptcy court dismissed the common law claims before trial, but permitted the case to proceed to trial in mid-2012 on the fraudulent transfer claims. Judge Gropper issued his 166-page opinion on December 12, 2013, finding that New Kerr-McGee and its subsidiaries had received actual and constructive fraudulent transfers of Old Kerr-McGee’s/Tronox’s assets. Anadarko was dismissed as a defendant, although Judge Gropper noted that it could be held liable in the future, were it found that Old Kerr-McGee/Tronox assets had been transferred to Anadarko. Within days of the ruling, Anadarko’s share price and value of its bonds dropped precipitously.
Although the opinion raises numerous important issues for bankruptcy practitioners, several of the court’s rulings easily could have chilling effects on ongoing restructuring and will give unsecured creditors more leverage in their efforts to block equity sponsors from separating good assets from bad liabilities. In particular, the court held that the transfers, made over a six-year period between 2000 and 2006, collectively constituted an actual fraudulent transfer, one made “with actual intent to hinder, delay, or defraud” creditors. Judge Gropper found “clear and convincing” evidence of actual intent to hinder or delay the legacy environmental and tort creditors. He rejected the defendants’ contentions that they believed Old Kerr-McGee/Tronox would survive, and that there were legitimate business purposes for the transaction. It is highly unusual for a bankruptcy court to hold that a multi-stage set of corporate transactions, involving sophisticated business representatives, law firms, and other professionals, constitutes an actual fraudulent transfer.
Judge Gropper also held that the transactions constituted a constructive fraudulent transfer, one that made for less than reasonably equivalent value while the debtor was (or was rendered) insolvent, undercapitalized, or unable to pay its debts as they came due. Judge Gropper found that Old Kerr-McGee/Tronox had received less than reasonably equivalent value for its valuable businesses that were separated from the entity liable for the legacy liabilities, and that it was (or was rendered) insolvent, undercapitalized, or unable to pay its debts as they came due.
In reaching his constructive fraudulent transfer conclusion, Judge Gropper found that the net value of the assets transferred from Old Kerr-McGee/Tronox to New Kerr-McGee was $14.459 billion. In exchange for this substantial net flow of value to New Kerr-McGee, Judge Gropper found that Old Kerr-McGee/Tronox did not receive reasonably equivalent value. He also rejected the defendants’ contention that value had to be measured on an entity-by-entity basis, holding that value could be netted because the debtors had always treated their financials on a consolidated basis, and fraudulent transfer laws look at substance, rather than form. Normally, courts will not ignore separate corporate structures as Judge Gropper did.
Next, Judge Gropper had to determine that, at the time of the transfers, the liabilities of Old Kerr-McGee/Tronox exceeded the value of its assets. Judge Gropper stated that the key issue on the liability side was “the amount of Tronox’s environmental and tort liabilities,” which were disputed, unliquidated, and contingent. The court observed that valuing such liabilities “is what this case is all about.” Valuing contingent liabilities as part of a solvency determination is relatively rare, although it should have been obvious to the defendants that the contingent environmental liabilities would be a critical issue. Judge Gropper characterized as a “major failure of proof” that the defendants did not provide a comprehensive environmental liability analysis.
The court also rejected the defendants’ heavy reliance on market data as a basis for determining that Old Kerr-McGee/Tronox was solvent, even though Old Kerr-McGee/Tronox was able to raise approximately $750 million from an IPO and financings in 2005 and had survived for several years following the spin-off. Before Tronox, courts in the leading bankruptcy forum—the Southern District of New York and the District of Delaware—had embraced market data approaches used to prove solvency. See VFB LLC v. Campbell Soup Co., 482 F.3d 624 (3d Cir. 2007); Iridium Operating LLC v. Motorola, Inc. (In re Iridium Operating LLC), 373 B.R. 283 (Bankr. S.D.N.Y. 2007); In re Old CarCo, LLC, 454 B.R. 39 (Bankr. S.D.N.Y. 2011). But Judge Gropper was not persuaded by the so-called market data. He found that investors were provided with overly optimistic financials that had unrealistic EBITDA projections and did not adequately reserve for the legacy liabilities. He also rejected the defendants’ claims that third-party investors were willing to buy Old Kerr-McGee/Tronox, finding that none of the offers was binding and that none of the investors had been willing to accept responsibility for the full amount of the legacy liabilities. It was the failure to account for contingent liabilities properly that led the court to conclude:
There is thus much evidence in the record regarding the insufficiencies of the Tronox financials used in the IPO. Nevertheless, it is not necessary for Plaintiffs to prove that the IPO financial statements were false and misleading. Plaintiffs have clearly overcome the presumption of market efficiency because this case is not about Tronox’s earning power, or its ability to maintain its position as the world’s third-largest TiO2 producer . . . . This case is about the legacy liabilities that Kerr-McGee imposed on Tronox and their impact on Tronox’s solvency.
503 B.R. at 300-01.
The opinion also involves important statute of limitations issues concerning fraudulent transfer claims, arguably expanding the time for bankruptcy estates (in bankruptcy) and creditors (outside of bankruptcy) to challenge transactions. Typically, constructive fraudulent transfer claims may be brought within four years of the subject transfer, and the Oklahoma state law the parties argued governed applied such a four-year limitations period. But Judge Gropper held that all of the transfers could be avoided, even though the largest transfers of assets out of Old Kerr-McGee/Tronox occurred in 2002 and the bankruptcy occurred in 2009.
Judge Gropper further found that transactions more than six years before the bankruptcy could be avoided because (i) the transactions could be “collapsed” into a single scheme spanning from 2000 to 2005, (ii) the federal government itself was a creditor, and thus the Federal Debt Collection Practices Act provided a six-year statute of limitations, which was further extended by a tolling agreement, and (iii) the fraudulent transfer causes of action did not accrue (and thus the four-year period did not commence) until the separation was completed and New Kerr-McGee stopped supporting Old Kerr-McGee/Tronox, and the creditors suffered injury. In making these rulings, the court emphasized the importance of elevating substance over form.
These conclusions may be surprising to equity sponsors, directors, and officers considering multi-stage “ring-fencing” transactions over a period of years. Statutes of limitations are, in one sense, arbitrary: they are the embodiment of form over substance by creating hard and fast deadlines. But Tronox injects uncertainty as to when a statute of limitations actually begins to run. Moreover, the decision is unusual given the long period of time between the first “step” and the last “step” (every case the court cited involved multi-stage transactions occurring over a far shorter period of time), and its rejection of the colorable argument that each subject transaction was not dependent on the other in order to be consummated.
Finally, Judge Gropper held that damages would not be capped at what the legacy creditors were still owed. Although not settled law, prior to Tronox a common view of fraudulent transfer claims in bankruptcy was that fraudulent transfers could be set aside to the extent necessary to pay creditors in full, but not to a greater extent to provide creditors or equity holders a windfall. For example, if a debtor owed creditors $500,000 and had fraudulently transferred $1 million in value, the transfer would be avoided only to the extent necessary to pay the $500,000 owed. But Judge Gropper held that the transfers could be avoided in their entirety, even though the value of the transfers no doubt exceeded what was necessary to pay creditor claims in full. Bankruptcy Code section 550(a) requires that recovery of an avoided transfer be “for the benefit of the estate,” but it does not require that recovery be limited to what is necessary to pay the estate’s creditors. There is no statutory prohibition on creditors receiving a “windfall” from a fraudulent transfer recovery.
Tronox creates significant risks for companies and their equity holders, directors, and officers when there are efforts to isolate valuable assets from potential liabilities. Transactions occurring over many years, with the advice of respected professionals and tested by market participants, now face the risk of avoidance. But risk for one set of interested parties presents opportunities and leverage for others. Tronox opens the door for unsecured creditors to challenge a broader array of transactions over a longer period of time by seeking to collapse transactions that are not directly linked, but that can be characterized as part of a common scheme.