Bankruptcy Decisions You Should Know

Posted on October 23, 2012 by Timothy G. Dietrich

Every now and then, a few cases that are clearly critical to commercial lending and loan recoveries float to the surface of the flood of bankruptcy court opinions. This is the first in a series of short synopses of cases that you should factor into your strategies.

Upstream Subsidiary Guaranty As A Fraudulent Conveyance

The case of In re TOUSA has been widely followed on appeal and is among the most significant in the country. Simply stated, the U.S. Bankruptcy Court for the Southern District of Florida found (1) that the granting of a guaranty by subsidiary corporations to secure more than $420,000,000 of new loans extended to the parent corporation, secured by liens on the corporate assets of the subsidiaries, was an avoidable fraudulent conveyance. The new lender provided funding for a compromise and settlement of prior secured debts, which rendered the parent company, in the opinion of the Court, the "most highly - leveraged company in the industry". TOUSA, Inc. was a large residential builder. Six months later, the parent company and all of its subsidiaries filed a Chapter 11 case. The fraudulent conveyance claim was advanced against the original lenders who received the compromise and settlement payment and they were ordered to return the $420,000,000 payment.

The Bankruptcy Code provides, in Section 548, that a trustee may avoid as fraudulent any transfer of an interest of the debtor (such as a lien) if the debtor received less than reasonably equivalent value in exchange for the transfer and the debtor was insolvent at the time or rendered insolvent as a result of the transfer. Obviously, to the extent that a transfer is avoided under Section 548 of the Bankruptcy Code, the trustee may recover the property transferred, either from the initial transferee or from an entity which benefited from the transfer.

The Bankruptcy Court found that the subsidiaries were, in fact, insolvent at the time that the guaranty and new collateral were granted and that the subsidiaries did not receive reasonably equivalent value for the guaranty and liens. The Court found that the subsidiaries received indirect and minimal benefits from the transaction and rejected the contention that avoidance of contingent claims, avoidance of litigation or avoidance of imminent bankruptcy were sufficient consideration.

On appeal, the U.S. District Court reversed the decision of the Bankruptcy Court.(2) On further appeal to the U.S. Court of Appeals for the Eleventh Circuit, the District Court was reversed and the Eleventh Circuit essentially overruled the District Court and supported the original trial court decision. (3)

The Bankruptcy Court also discounted the viability of insolvency "savings clauses" in the subsidiary guaranty, which are not unusual in these transactions and purport to have the effect of reducing the amount of the guaranty by a sum sufficient to assure that the subsidiary remains solvent, thereby preventing a fraudulent conveyance claim. Neither the District Court nor the Eleventh Circuit ruled on the validity or effect of the savings clause.

The TOUSA decision may ultimately be little more than an obvious response to a refinancing occurring six months before a bankruptcy filing and the court’s judgment about the lenders’ due diligence. Nevertheless, the case raises several points that should be considered by both lenders and workout officers. For example:

(a) Due diligence on the financial condition and solvency of the subsidiary providing a guaranty must be thoroughly conducted and the creation of contemporary evidence of solvency at the time of the transaction is essential to the enforcement of the upstream guaranty.

(b) Incidental and intangible benefits to the subsidiary providing the guaranty, particularly in a setting where the companies are already stressed or in trouble, is unlikely to win the day in defending against a fraudulent conveyance claim. More concrete benefits must be identified - and documented. Some lenders resort to a "co-borrower" structure to work around the benefits/consideration problem. We urge caution in a co-borrower structure where there is ample evidence that the parties have no expectation that the subsidiary will borrow under the credit facility.

(c) The degree of foreseeability of subsequent financial difficulty must be assessed and a lack of credible evidence supporting the lender’s or recipient’s contention that they could not anticipate subsequent insolvency will be problematic.

(d) Credit underwriting decisions which rely upon the value of subsidiary assets and upstream guaranties have been common in the past, with the lender often arguing that the subsidiary received "indirect value", even though it did not receive loan proceeds. The TOUSA decision indicates that the possible prevention of an immediate bankruptcy filing is not "reasonably equivalent value", in and of itself. Upstream guarantys should be discounted as a credit support in the credit underwriting process, unless the lender can identify either (1) that the subsidiary will receive a direct and demonstrable benefit from the transaction or (2) the subsidiary was clearly, as shown by evidence, solvent at the time of the transaction.

(e) Receiving payoff proceeds from a transaction involving other funding sources, which include an upstream guaranty, may subject the recipient of the payoff to a fraudulent conveyance claim and to a refund of the payoff. Again, due diligence is necessary in any material payoff or settlement situation.

(f) Continue using "savings clauses" in upstream guaranties. Their protective value has not yet been finally determined.
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(1) Official Committee of Unsecured Creditors of TOUSA, Inc. v. Citicorp N. Am. Inc. (In re TOUSA Inc.), 422 B.R. 783 (Bankr. S.D. Fla. 2009).
(2) 3V Capital Master Fund Ltd. v. Official Committee of Unsecured Creditors of TOUSA Inc. (In re TOUSA Inc.), 444 B.R. 613 (S.D. Fla. 2011).
(3) Senior Transeastern Lenders v.  Official Committee of Unsecured Creditors (In re TOUSA Inc.), 680 F.3d 1298 (11th Cir. 2012).

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Series LLC: What is it?

Posted on June 16, 2012 by Troy B. Rider
A series limited liability company, commonly known as a series LLC, is a special form of a limited liability company that provides liability protection across multiple “series” or “cells” each of which is protected from liabilities arising from the other series if certain requirements of state law are followed. In overall structure, the series LLC is comparable to a corporation with several subsidiaries. Although each cell of a series LLC can own distinct assets, incur separate liabilities, and have different managers and members, a series LLC usually pays one filing fee to be formed under state law, thereby decreasing costs.  
 
Delaware was the first state to introduce the series LLC but a few other states have followed suit. Currently, Delaware, Iowa, Oklahoma, Nevada, Illinois, Tennessee, Utah, Wisconsin and Texas enacted some form of Series LLC legislation. 
 
One of the primary benefits of a series LLC is that it permits the operation of multiple separate business activities within a single legal entity. A series LLC also permits the reduction of administrative burdens and costs compared to the alternative of forming multiple companies. In Delaware, for example, the fees required to form a series LLC and the annual tax payable by a series LLC are the same as those imposed on a non-series LLC. 
 
Series LLCs do have some drawbacks. Since they are relatively “new”, there is a lack of case law on interstate recognition. For example, how will a series LLC formed in Delaware will be treated in a non-series LLC state such as Pennsylvania. In addition, there is uncertainty in the tax treatment of a series LLC and utilizing a series LLC in a secured transaction. Due to each “series” having separate assets and liabilities, it may be unclear whether the debtor is the individual series or the series LLC.
 
Despite being relatively unproven, series LLCs have frequently been used by investment funds since, under applicable securities laws, a series LLC may be the sole registrant but may register interests in all the series of the series LLC. This can dramatically reduce the costs and burdens of filing multiple registration statements. In addition, series LLCs could be considered an ideal entity under any of the following scenarios:

 
  • Holding multiple parcels of real property in liability-segregated cells.  


 

  • Facilitating an equity compensation program in a business with multiple divisions. With each division segregated into a separate series, the series LLC can give the key employees of each series some sort of equity interest tied to that series only rather than equity interests in the entity as a whole. Such structure rewards employees in productive divisions and protects them from the potential downside of other divisions.
     
     
  • Facilitating a business combination. For example, rather than undertaking a traditional merger, two companies wishing to join forces might form a series LLC, with each company contributing its assets to a separate series, or with the owners of each company contributing their ownership interests to a separate series.  Even though series LLC’s are a “new” player to the entity selection game, they may be advantageous in certain circumstances.  Accordingly, you should consult an experienced advisor before deciding to utilize a series LLC.
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Consider Converting Your C Corporation Now (and Save Income Taxes!) While Asset Values and Tax Rates are Low

Posted on June 5, 2012 by Alex E. Snyder
If your business is currently operating as a C corporation and you do not know the reason why (other than because it has always operated as a C corporation), this article is directed at you.  
 
For federal tax purposes, corporations are classified as either subchapter C or subchapter S corporations. While there are many differences between the treatment of C corporations and other types of entities, perhaps the most notable is that C corporations are subject to two levels of taxation. The corporation is taxed on its income, and the corporation’s shareholders also pay taxes when distributions are made. Both an S corporation and a Limited Liability Company (LLC) do not pay tax at the corporate level (thereby eliminating the double tax), which could save your business and its shareholders federal income taxes presently and upon an eventual sale. 
 
Now is a great time to consider converting your C corporation to an S corporation or an LLC. As most business owners are aware, asset values are currently deflated, which would decrease any taxable gain realized as a result of conversion. In addition, Congress continues to discuss increasing income tax rates on capital gains and dividends, which would increase the income tax implications of a conversion at a later date. 
 
Conversion from a C corporation to an S corporation is as easy as making an election with the IRS to be treated as an S corporation (a so-called “S election”). However, only certain businesses may file an S election. An S corporation may have no more than 100 shareholders (though certain family members are considered to be a single shareholder for purposes of this requirement). Further, generally only individuals, non-profit entities and certain kinds of trusts can qualify as shareholders. 
 
Historically, business owners of a C corporation often viewed the “built-in gains tax” as a reason not to make an S election. The built-in gains tax is a tax upon the sale of assets owned by an S corporation if those assets are sold within 10 years of the S election to the extent the assets were appreciated when the C corporation made its S election. Even if the built-in gains tax is a concern, with the current environment of deflated asset values, the potential built-in gains tax liability on a C to S conversion is likely to be relatively low. 
 
If a conversion from a C corporation is of interest, and an S election is not a viable option, you may wish to consider converting to an LLC. Such a conversion is not as simple as electing S status. For federal tax purposes, upon conversion from a C corporation to an LLC, the corporation is taxed at the entity level as if it had sold all of its assets for fair market value and the shareholders are then treated as having received liquidating distributions of the proceeds. In other words, unlike converting a C corporation to an S, there are income tax consequences to converting a C corporation to an LLC. However, depressed asset values, unused net operating losses or capital loss carryovers (which can be used to offset gain) and historically low rates on distributions from the corporation to its shareholders may all help to minimize the income tax implications of converting from a C corporation to an LLC. 
 
In addition to avoiding double taxation, a benefit of converting to an LLC is that the assets of the entity will receive an increase in basis to their current fair market value. This means that if the owners later sell the LLC, the gain realized upon the sale will be less.
 
If, after reading this article, you are wondering why your business is a C corporation and whether you can reduce income taxes through conversion to an S Corporation or LLC, you should ask your tax advisor if a conversion is right for you.
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Taking a Bite out of Apple

Posted on April 24, 2007 by Eric Suter
A month or so ago, Kendra discussed the class action bar's increasing interest in options backdating.  I suggested, a bit facetiously, that the next significant backdating case may arise in connection with Apple's backdating of options granted Steve Jobs.  So much for facetious.  Bloomberg reports today that the SEC is likely to sue Apple's former General Counsel, Nancy Heinan, in connection with the backdated options:

The securities regulator will likely sue Heinen this week for allegedly backdating an Oct. 19, 2001, stock option grant to Jobs for 7.5 million shares, and an earlier grant made to Jobs' executive team members, including Heinen, on Jan. 17, 2001, her attorney Miles Ehrlich said.

The Justice Department also is investigating stock option awards at Apple, maker of the Macintosh computer and iPod music player, though ``there would be no basis for the filing of criminal charges'' against Heinen, said another defense attorney, Cristina Arguedas, of Arguedas, Cassman & Headley in Berkeley, California.

Apple, based in Cupertino, California, would be the largest company with current or former executives sued by the SEC over claims they helped fake stock-option grant dates. The company said in December that 6,428 option grants from 1997 to 2002 were backdated, including one to Jobs marked as approved at a fictional board meeting.

Heinen's attorneys (naturally) deny any wrongdoing.
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Auditing Costs under Sarbanes-Oxley

Posted on March 18, 2007 by Eric Suter
In the wake of the Enron/Worldcom/Tyco/etc. fiascos, Congress got about the work of reforming the regulation of corporate accounting and reporting practices.  The result is the now well-known Sarbanes-Oxley Act (full text .pdf) (here's a summary).  By way of example only, Sarbanes-Oxley requires:
  • [T]hat public companies evaluate and disclose the effectiveness of their internal controls as they relate to financial reporting, and that independent auditors for such companies "attest" (i.e., agree, or qualify) to such disclosure
  • Certification of financial reports by chief executive officers and chief financial officers
  • Independence, including outright bans on certain types of work for audit clients and pre-certification by the company's Audit Committee of all other non-audit work
  • [T]hat companies listed on stock exchanges have fully independent audit committees that oversee the relationship between the company and its auditor
How financially onerous are the requirements?  Well, what better way to answer that question than by resort to anecdotal evidence?  According to DealBreaker, Warren Buffet reports: 
Berkshire-Hathaway spent $24 million on auditing this year, a figure he says would have been closer to $10 million without Sarbanes-Oxley.
Based on Buffett's experience, then, Sarbanes-Oxley imposes a roughly 150% increase in auditing costs.  Granted, Berkshire Hathaway is hardly representative of most other public companies and its substantial investment operations may contribute to its enormous auditing-related compliance cost.  Nevertheless, if a public company -- no matter its size -- hasn't experienced a significant uptick in auditing costs under the Sarbanes-Oxley regime, the company might question whether it is employing best practices when it comes to the nitty gritty of compliance.  With substantial civil and criminal penalties available for violators, Sarbanes-Oxley is not to be trifled with.
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Stock Option Backdating - Under Scrutiny

Posted on February 15, 2007 by Barley Snyder LLC

Class action cases are being filed to stop the practice of stock option backdating. Backdating allows a stock option exercise price to be set using hindsight, by reporting the market price from a previous date. In most cases of backdating, a date on which the stock price was very low is chosen. Currently, there are over a dozen securities fraud cases in federal court and an unknown number of derivative actions in state courts related to the practice. It reportedly has hit hardest in the technology and telecommunications industries. Backdating is not expressly forbidden by statute but rather is being postured as a violation of SEC disclosure regs (SEC Rule 10b-5). With the recent US Supreme Court ruling in Dura Pharmaceuticals (requiring a casual connection between a company's misrepresentation and the plaintiff's economic loss), it appears that there will be proof issues in the cases that have been filed.


Eric adds™ -- Perhaps the next significant options backdating ruling will be rendered in the forthcoming U.S. v. Jobs matter.  Although I don't know about doctors, it sure doesn't look like an Apple a day repels the SEC . . .

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