Tronox: The Weed that Choked a Flower – Lessons for Buyers on Remedies

by Stinson Leonard Street

As we noted in Parts 1 and 2 of this series, any buyer of assets from a company in any degree of financial stress should be concerned about the transaction being attacked as a fraudulent transfer. Officers and directors of a selling entity also have concerns about this risk due to potential personal liability. Such an attack can result in the transaction being “undone” (with the parties being returned to their positions prior to the transaction) or, since it is often difficult to return the parties to their prior positions, such an attack can result in a judgment against the buyer and selling officers and directors for the difference between what the buyer paid and what the court determines the buyer should have paid. Most parties mitigate this risk by getting certain information prior to closing their transaction. But the adequacy of that information is debatable until litigation is pursued.

On December 12, 2013, after 34 trial days involving 68 witnesses (including 14 expert witnesses) and over 6,000 exhibits, the U.S. Bankruptcy Court for the Southern District of New York entered a 166 page memorandum opinion holding that certain affiliates of Anadarko Petroleum owed Tronox somewhere between $5 billion and $14 billion as damages for a fraudulent transfer that began in 2002 and was completed in 2006. In re Tronox Inc., 503 B.R. 239 (Bankr. S.D.N.Y. 2013). Several months later, the parties settled for about $5 billion.

The ruling addresses many issues, each of which was hotly contested. A complete discussion of all these issues is beyond the scope of this post. Part 1 of this series discussed the facts in Tronox, the typical methods used to minimize fraudulent transfer liability, and the first lesson from Tronox – the relevant statute of limitations. Part 2 of this series discussed the second lesson from Tronox – disproving actual intent to “hinder, delay, or defraud” the seller’s creditors. Part 3 of this series discusses a third lesson from Tronox – proving the transferor was solvent at the time of the transfer. This article discusses a complex, open issue raised but not decided in Tronox – what are the remedies available against a buyer who is determined to have received a fraudulent transfer?

Background on Fraudulent Transfer Remedies
To help highlight the problem, consider three fraudulent conveyance scenarios. In the first, the debtor is unequivocally insolvent, with assets of $1 billion and liabilities of $3 billion. The debtor then transfers its $1 billion in assets to an independent third party for less than fair value – say $400 million. Most courts and commentators, and even the parties in the Tronox case, would agree that the debtor could recover a judgment against the third party transferee for $600 million, the difference between the value of the assets ($1 billion) and the amount paid ($400 million), based on Section 548(c) of the Bankruptcy Code and a similar provision in the Uniform Fraudulent Transfer Act in effect in most states.

Now consider the same scenario, except the assets are worth $5 billion. Again, most courts and commentators, and even the parties in the Tronox case, would agree that the debtor could recover a judgment against the third party transferee for $4.6 billion, the difference between the value of the assets ($5 billion) and the amount paid ($400 million). However, note that only $3 billion of the recovery is needed to pay liabilities in full – the remaining $1.6 billion of the recovery in essence belongs to the equity owner(s) of the debtor.

Finally, consider scenario two, except the $1 billion in assets are “spun off” to the equity owner(s) of the debtor in return for $400 million. Based on the plain language of the Bankruptcy Code and UFTA, many parties would argue that the debtor could recover a judgment against the equity owner(s) for $4.6 billion. But that makeks no economic sense if the debtor’s liabilities are $3 billion, and the remaining $1.6 billion owed by the transferee parties essentially belongs to the same parties who are the equity owner(s) of the debtor. This third scenario is what was at issue in Tronox.

Further complicating this issue is two key Bankruptcy Code provisions. The first provision is Section 550(a) which states “to the extent that a transfer is avoided [under sections that include fraudulent transfers], the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property…” (emphasis added). The issue under Section 550(a) is whether the phrase “benefit of the estate” limits the amount recoverable to just the amount necessary to pay the estate creditors in full.

The second Bankruptcy Code provision that complicates the fraudulent conveyance remedy discussion is Section 502(h) of the Bankrutpcy Code, which states “[a]claim arising from the recovery of property under section … 550 … shall be determined, and shall be allowed … or disallowed … the same as if the claim had arisen before the date of the filing of the petition.” This provision is most often used by preference defendants to “reinstate” their debt that was otherwise paid by an avoided preference amount. Thus, for example, a creditor who is owed $10,000 from a debtor, and is paid $4,000 by the debtor in a transfer that ends up being recovered as a preference, can then assert a general unsecured claim against a debtor for the $4,000 that was recovered as a preference. The issue in Tronox was whether the defendants who received a fraudulent transfer could then assert a general unsecured claim against the debtor for the amount of the fraudulent transfer judgment.

The Tronox Issues Regarding Remedies
The Tronox opinion clearly holds that the “diminution in value” of Tronox (i.e. – net difference between FMV of assets transferred out and consideration received) as a result of the spinoff of its assets was $14.459 billion. Id. at 331. However, the defendants made several arguments to try to reduce this amount to the smallest number possible.

First, the defendants argued that the aggregate unpaid liabilities of Tronox were only about $4 billion, and the “benefit of the estate” language in Section 550(a), discussed above, limited the judgment to the amount necessary to pay 100% of Tronox’s liabilities. However, the court held that it had rejected this argument in a prior opinion, although it left open the possibility of the defendants asserting this argument on other grounds. Id. at 328-329.

Second, the defendants argued that Section 502(h) of the Bankrutpcy Code, discussed above, gives the defendants a general unsecured claim against Tronox equal to the alleged fraudulent transfer amount of $14.459 billion. This argument caused the court to make some comments and request more briefs. Briefs were filed, but the case was settled (for $5 billion) before the court issued a ruling on this issue. Nevertheless, the comments by the court and the briefs by the parties highlight some key remedy issues that any potential fraudulent transfer defendant should consider.

The Tronox Discussion About Section 502(h)
Although not entirely clear, the opinion in Tronox appears to agree that it is possible to assert a claim under Section 502(h) for a fraudulent transfer judgment. This arguable conclusion is not based on the plain language of Section 502(h), but instead is based mostly on cases decided under the former Bankruptcy Act, and one case under the current Bankruptcy Code. Moreover, the opinion appears to suggest that the amount of the 502(h) claim should be “the value of the [assets transferred to the defendants]to which [the defendants]would have been entitled [as former owners of the equity interests in Tronox]after payment of the [Tronox] liabilities.” Id. at 330-331. This appears to create essentially the same net economic effect as limiting the damages under Section 550(a), discussed above.

However, the court in Tronox did not make a final decision about the amount of a possible claim under Section 502(h). Instead, the court made certain “provisional findings” based in large part on some agreements among the parties in the confirmed plan and other pleadings. According to the court, those agreements included the following:
1. Plaintiffs reserved all rights to object to defendants asserting any claim under Section 502(h)
2. Plaintiffs also reserved all rights to object to the amount of any claim under Section 502(h)
3. If, however, the court allowed any claim under Section 502(h), it could be offset against the judgment – dollar-for-dollar.

The provisional findings suggested that, under one interpretation of the confirmed plan and related agreements, the allowed 502(h) claim of the deendants should be about $9.3 billion, resulting in a net judgment against the defendants of about $5.1 billion. Id. at 336. And the provisional findings further suggested that, under another interpretation of the confirmed plan and related agreements, the allowed 502(h) claim of the defendants should be only about $292 million, resulting in a net judgment against the defendants of about $14.1 billion. Id.

Both interpretations of the confirmed plan and related agreements involved treating the allowed 502(h) claims as general unsecured claims pari passu with other general unsecured claims (the “GUCs”) and allowing as an offset only the percentage of the 502(h) claim that would have been paid under the confirmed plan. However, under the first interpretation, the 502(h) claims would be paid the same percentage as the other GUCs per the estimates and calculations in the approved disclosure statement, regardless of the dilution created by adding the 502(h) claim to the GUCs’ claims. And, under the second interpretation, the 502(h) claims would be added to the GUCs and then split the consideration paid under the confirmed plan, thereby diluting the percentage distribution paid to all general unsecured creditors.

Either way, the court started the analysis by allowing the defendants a claim under 502(h) for $10.4 billion, calculated as the gross fraudulent transfer ($14.4 billion noted above) less the unpaid liabilities at the time of the transfer ($4 billion). In essence, the court held that there is a “cap” on fraudulent transfer liability equal to the unpaid liabilities of the transferee debtor.

Lessons for Buyers Learned From Tronox About Potential Remedies
First, Tronox suggests there is a ceiling on a buyer’s fraudulent transfer liability equal to whatever is determined to be the outstanding liabilities of the debtor at the time of the transfer. Second, if the debtor ends up filing bankruptcy and confirming a plan before the fraudulent transfer litigation is completed, the buyer should be sure to preserve a potential 502(h) claim as part of the confirmed plan. Moreover, the existence of a potential 502(h) claim should be used by a buyer in any settlement discussions. In this regard, note that the existence of a 502(h) claim does not hinge on paying all liabilities in full – it can be asserted for any potential fraudulent transfer liability.

As noted throughout this series, the Tronox opinion highlights many key arguments and evidence in dealing with fraudulent transfers. These articles only summarize some of the highlights. Parties are encouraged to carefully read the opinion and related pleadings for more details on the various points.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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