Your client has been providing products to a customer for years. The client is not paid directly by its customer, but by the customer’s parent company as part of a cash-management system (CMS), what the customer describes as an enterprise-wide pooled account. After a couple of turbulent months with irregular payments, the customer files for bankruptcy. The client asks about its outstanding receivable and preference exposure but there is more at risk than just the last 90-days of payments.
Cash-Management Systems
Almost all multi-entity companies employ a centralized CMS. Although these systems can be incredibly complex, especially in larger international companies, they are in essence nothing more than pooled accounts, or a system of pooled accounts. A parent company and its subsidiaries share one or more bank accounts for receipts and disbursements, which allows the corporate entity to make payments and receive funds without keeping separate bank accounts for each individual subsidiary. This reduces or eliminates the need for intercompany transfers and permits a free flow of cash among related corporate entities. Through this system, funds become much more fluid, permitting quick and easy of access by each entity. The pooling of funds also allows the corporate enterprise to more economically invest excess cash and easily track cash availability and needs across the corporate enterprise. Although the entities that participate in the CMS share a bank account, each entity retains its separate corporate existence — with its own distinct assets and liabilities, which can create big problems for creditors if one or more of these entities become insolvent.
Hypothetical Simple CMS
As an example, a simple CMS in which the parent, Holdco, is a nonoperating holding company with two operating subsidiaries, Rich Inc. and Poor Inc. The receivables of both subsidiaries are “up-streamed” to an account held and controlled by Holdco. Holdco pays the bills for Rich and Poor from this central account, as well as makes payments for management expenses, finance charges, legal fees and various other costs. Poor is burning cash rapidly, depleting the funds in the cash-management account and requiring Holdco to make further draws on its line of credit. Rich is profitable, but cannot make money nearly as fast as Poor is losing it. Poor, which has long been insolvent on a balance sheet test, eventually loses so much money that the entire corporate enterprise becomes insolvent. Since Rich is a co-obligor on Holdco’s line of credit, it also becomes insolvent even though it remains operationally profitable.
Eventually, the three entities file for chapter 11. The assets of Rich are sold as a going concern, but after the sale, the cases are converted to chapter 7 and the assets of Poor and Holdco are liquidated. A panel trustee is appointed[1] and files avoidance actions against all of the creditors that were paid from the single cash-management account, alleging receipt of preferential transfers under § 547 of the Bankruptcy Code, and alternative counts alleging receipt of constructive fraudulent transfers under § 548 and applicable state law fraudulent transfer provisions as permitted by § 544(b).
Based on the above scenario, we can expect three different outcomes for creditors of the three entities; each creditor’s exposure will depend on which entity the creditor supplied.
The Trustee May Recover Preferential Transfers from Holdco Creditors
The simplest analysis is for creditors of Holdco, which received payments from a bank account controlled by Holdco for debts owed by Holdco. Payments received within 90 days before the bankruptcy, or one year for insiders, are preferences under § 547,[2] subject to the defenses available under § 547(c).
Under § 547, a transfer can be avoided as only a preference if it is a transfer of the debtor’s interest in the property. An enterprising lawyer might argue that these payments cannot be preferences because Holdco itself never generated any revenue: Holdco only held the revenue that was generated by its subsidiaries. Thus, only the subsidiaries, not Holdco, owned the transferred funds.
Courts faced with similar arguments have held that an account is property of the entity that holds the legal title to the account and has the right to control payments from the account. In the above hypothetical CMS, as is typical, control is exercised by the parent company and, accordingly, the payments are transfers of an interest in Holdco’s property even though the funds were originally generated by the subsidiaries.[3]
The Trustee Likely Cannot Recover Payments to Rich’s Creditors
The trustee’s preference claims against the creditors of Rich Inc. will be met by a similar argument: The payments were a transfer of an interest in a property that was held by Holdco, not property belonging to Rich. Thus, a preference case on behalf of the estate of Holdco fails because Holdco owed no antecedent debt to the creditor.[4] A preference case on Rich’s behalf also fails because Rich held no interest in the property that was transferred.[5]
Accordingly, the trustee will turn to the alternative constructive fraudulent transfer count. Under § 548 and most state law fraudulent transfer statutes, applicable under § 544(b), the trustee must prove that the debtor (1) was insolvent[6] when the transfer was made and (2) received less than reasonable equivalent value in exchange for the transfer. Reasonably equivalent value includes satisfaction of an antecedent debt.
The initial reaction might be that the payments satisfied antecedent debts, which counts as reasonably equivalent. However, under both § 548 and state law, the payment is avoidable if the debtor received less than the reasonably equivalent value. The creditor received payment from the cash-management account that was owned and controlled by Holdco. However, the creditor provided its goods or services to Rich, not Holdco. Holdco received no direct value in exchange for its payment.
If Rich Inc. was solvent, payment from Holdco’s cash-management account would create no problems. Payments from Holdco reduce Rich’s liabilities, thereby increasing the value of Holdco’s equity interest in Rich. However, reducing the liabilities of an insolvent subsidiary creates little or no value for the parent; the subsidiary merely becomes somewhat less insolvent and the equity interest is not substantially increased.[7] Thus, value provided to an insolvent subsidiary cannot be presumed to benefit the parent.
Although the parent does not receive a direct benefit from a transfer on behalf of an insolvent subsidiary, the parent might indirectly receive reasonably equivalent value. Examples of indirect value include the potential for the subsidiary to regain solvency or for a sale of the subsidiary for more than its outstanding liabilities. In addition, control of the subsidiary might confer other benefits on the parent, most notably, the receipt of the subsidiary’s receivables.[8]
Indirect value must be fairly concrete and tangible.[9] The indirect benefits must cause the debtor’s creditors to be “no worse off because the debtor, and consequently the estate, has received an amount reasonably equivalent” to the payments.[10] Most courts require the recipient of a transfer to prove indirect value if the trustee is able to make a prima facie case that the debtor directly received less reasonably equivalent value.[11]
In the hypothetical, it would appear likely that a creditor of Rich would be able to show sufficient indirect value to defeat the trustee’s claim.[12] However, whether Rich could hope to return to solvency or find a buyer offering a return on equity to Holdco would likely be hotly litigated questions of fact. However, what is clear from the scenario is that Rich regularly contributed more money to the cash-management account than it received.
Based on this fact alone, a court would be justified in finding that Rich’s participation in the CMS provided substantial benefits to Holdco. By paying Rich’s debts, Holdco enabled Rich to remain in business. Thus, Rich was able to continue making money, which was deposited in Holdco’s cash-management account. The value of Holdco’s estate was enhanced by the continuation of Rich’s participation in the CMS. Therefore, Holdco indirectly received substantial value in exchange for its payments to Rich’s creditors and should be able to prove that this value is at least reasonably equivalent to the amount of the payments creditors received from the cash management account.
The Trustee Likely Can Recover Payments to Creditors of Poor
The same analysis applies to creditors of Poor, but with the opposite result. Poor took substantially more funds than it contributed to the cash-management account and depleted Holdco’s cash-management account. Accordingly, Poor’s participation in the CMS was detrimental to Holdco and Holdco did not receive reasonably equivalent value in exchange for its payments to Poor’s creditors. In fact, Holdco would have been substantially better off had Poor filed for bankruptcy or ceased operations much earlier.[13]
Creditors of money-losing subsidiaries such as Poor might be able to make fact-specific arguments, such as an enterprise business model that would collapse if Poor ceased business,[14] or that Poor’s operations represented a potentially lucrative opportunity that management reasonably pursued although it ultimately proved unsuccessful.[15] Since the creditors receiving the payments bear the burden of proof on indirect benefits, these arguments would require intensive factual development for Poor’s creditors to have a chance of success.
What about Rich’s Customers?
It would be theoretically consistent for the trustee of Rich’s bankruptcy estate to also sue Rich’s customers. In the debtors’ CMS, Rich’s customers make payments directly into Holdco’s cash-management account,[16] so Rich itself never receives payment. While a portion of this money is used to pay Rich’s bills, a larger percentage is diverted to fund Holdco and Poor. Rich receives less than reasonably equivalent value.
While the author has not seen any attempt by a trustee to avoid transfers to customers, it is difficult to see why a payment to a cash-management account could not be analyzed in the same manner as a payment from a cash-management account. However, such an action would cast in even starker relief that the problems created when an entity using a CMS becomes insolvent.
Conclusion
All parties paid by or paying to centralized cash-management accounts should be aware of the risk. When dealing with a corporate group using a CMS that may be insolvent, it is not enough to simply counsel clients on how to be protected from preference exposure. All payments from the CMS may also be subject to avoidance as a constructive fraudulent transfer. If a fraudulent transfer count is alleged in a recovery action, creditors should undertake extensive investigation and discovery to build a case that the transferring debtor received substantial indirect value as part of their defense strategy.
[1] The effect is substantially the same if a liquidating trustee is appointed after a liquidating plan or even a reorganization plan is confirmed in a chapter 11 case, assuming that the debtors are not substantively consolidated and the plan properly preserves all causes of action. A chapter 7 liquidation is used in this scenario for the sake of simplicity.
[2] This is assuming that the typical unsecured credit transaction in which payment is on account of an antecedent debt. 11 U.S.C. § 547(b).
[3] See, e.g., In re Southmark Corp., 49 F.3d 1111, 1116-19 (5th Cir. 1995); In re Amdura, 75 F.3d 1447, 1451 (10th Cir. 1996); but see Adelphia Recovery Trust v. Goldman, Sachs & Co., 748 F.3d 110, 115-120 (2d Cir. 2014) (applying judicial estoppel to find that cash-management account was property of subsidiary where debtors had uniformly asserted ownership in subsidiary for years until initiation of avoidance action).
[4] 11 U.S.C. § 547(b)(2).
[5] Under § 547(b), the trustee may only avoid a transfer of property of the debtor. The trustee might attempt to salvage this count by arguing that the creditor was a subsequent transferee permitting avoidance under § 550(a)(2). Putting aside tracing issues, § 550(b) provides a defense for good faith subsequent tranferees that receive the transfer in exchange for providing value to the transferee, which includes the satisfaction of an antecedent debt. While this may create litigation issues, most non-insider trade creditors will fit within this defense.
[6] Insolvency is one of four options under § 548(a)(1)(B), but because it is the most commonly alleged and for the sake of simplicity, it is the only one discussed in this article.
[7] See, e.g., Murphy v. Avianca Inc. (In re Duque Rodriguez), 77 B.R. 937 (Bankr. SD. Fla. 1987), aff’d, 895 F.2d 725 (11th Cir. 1990).
[8] See Mellon Bank v. Metro Communications Inc., 945 F.2d 635, 647 (3d Cir. 1991) (recognizing value in form of goodwill and increased ability to borrow); Telefest Inc. v. VU-TV Inc., 591 F. Supp. 1368, 1380-81 (D.N.J. 1984) (recognizing that payments protecting essential supply source provided value); In re Fairchild Aircraft Corp., 6 F.3d 1119, 1127 (5th Cir. 1993) (holding that payments to keep subsidiary in business while attempting to sell subsidiary as going concern provided value to parent, but that payments made after subsidiary ceased operations were avoidable).
[9] Official Comm. of Unsecured Creditors of TOUSA v. Citicorp N. Am. (In re TOUSA Inc.), 422 B.R. 783, 846-50 (Bankr. S.D. Fla. 2009), aff’d, 680 F.3d 1298 (11th Cir. 2012). See also Gold v. Marquette Univ. (In re Leonard), 454 B.R. 444, 456-57 (Bankr. E.D. Mich. 2011) (holding that indirect economic benefit must be “(1) an ‘economic’ benefit; (2) concrete; and (3) quantifiable”).
[10] Harman v. First Am. Bank of Maryland (In re Jeffrey Bigelow Design Group Inc.), 956 F.2d 479, 484 (4th Cir. 1992).
[11] TOUSA, 422 B.R. at 844; Gold, 454 B.R. at 457-58; Cooper v. Centar Invs. (Asia) Ltd. (In re TriGem Am. Corp.), 431 B.R. 855, 868 (Bankr. C.D. Cal. 2010).
[12] This is not intended to be an exclusive list of defenses to a fraudulent transfer claim. Defendants have attempted many defenses to similar fraudulent transfer claims, with varying results, such as tracing the funds to the specific debtor with which they dealt (Gold, 454 B.R. at 452-53), collapsing transactions (In re Best Products Co. Inc., 157 B.R. 222 (Bankr. S.D.N.Y. 1993), seeking to substantively consolidate the entities (In re Pearlman, 462 B.R. 849, 852 (Bankr. M.D. Fla. 2012)), or arguing that the accountholder was contractually obligated to make the payments (LandAmerica Fin. Group Inc. v. S. Cal Edison (In re LandAmerica Finance Group Inc.), APN 10-03819, 2014 Bankr. LEXIS 2213 *7 (May 19, 2014)).
[13] Even if cessation of business or a bankruptcy filing by Poor would have forced Holdco and Rich into bankruptcy (possibly as a result of loan guaranties), avoidance of bankruptcy is not, by itself, value for purposes of fraudulent transfer law. Senior Transeastern Lenders v. Official Comm. of Unsecured Creditors (In re TOUSA Inc.), 680 F.3d 1298, 1313 (11th Cir. Fla. 2012)
[14] Garrett V. Falkner (In re Royal Crown Bottlers Inc.), 23 B.R. 217 (Bankr. N.D. Ala. 1982).
[15] Mellon Bank NA v. Official Committee of Unsecured Creditors of RML Inc. (In re RML Inc.), 92 F.3d 139, 152 (3d Cir. 1996).
[16] This approach would probably not work if payments were made out by check to Rich and simply deposited by Rich into Holdco’s account, because in that scenario, Rich has received value. However, it is assumed for purposes of this argument that the customers paid directly to Holdco’s account, either by checks made out to Holdco or by electronic funds transfers directly into Holdco’s cash-management account.