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.
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 Delaware 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 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.
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.