When dealing with customers in financial distress, the time-tested advice of “always take the money” are words to live by if you are a vendor with an open account payable. It is widely understood that such payments may be “clawed back” as preferences under § 547 of the Bankruptcy Code if the customer declares bankruptcy within 90 days of payment. Otherwise, vendors generally regard the payment as unassailable. However, given the now regular use of centralized cash management systems (CMS) by corporate enterprises consisting of multiple entities, it’s not that simple anymore. Exactly who pays matters, too.
A CMS involves a parent company pooling cash generated by its operating subsidiaries into a concentration account. The parent company then pays the subsidiaries’ obligations. But when payments are made by an entity that is not the customer obligated to pay, vendors may face clawback actions — not just for payments received during the 90-day preference period, but for all payments made up to two years before the parent’s bankruptcy filing (or longer under state law).[1] The theory of liability is simple: The entity satisfying the debt was not obligated to pay, and therefore, it did not receive sufficient value for the transfer. Unlike preferences, these claims often involve complex factual issues. Nonetheless, resolving CMS clawbacks can be facilitated by following several practical principles.
Background
A CMS is a network of bank accounts that help corporate enterprises consisting of multiple legal entities manage cash and pay expenses. In its simplest terms, funds flowing to operating subsidiaries are deposited into designated accounts, then swept into a concentration account owned by the parent company. Payments to creditors are made from this concentration account (or a similar account). Since the parent company is paying the bills of its operating subsidiaries, creditors receive payment from a different legal entity than the subsidiary. If the parent company declares bankruptcy after payment, creditors of an operating subsidiary may face a clawback action.
After commencement of a bankruptcy, a debtor in possession or trustee can seek to recover certain payments made before bankruptcy. When intentional fraud is not involved, typical clawbacks are (1) preferences and (2) constructively fraudulent conveyances (often pled alternatively to preferences).
In general terms, preferences are payments made within 90 days[2] of bankruptcy to satisfy antecedent debts owed by the payor, which results in the creditor receiving more than it would recover in a chapter 7.[3] Under the Bankruptcy Code, plaintiffs can also avoid payments, as constructively fraudulent, made within two years before bankruptcy. To prevail, plaintiffs must show that the transfer (1) was for less than reasonably equivalent value and (2) was made when the debtor (a) was insolvent (or rendered the debtor insolvent), (b) was left with an unreasonably small amount of capital or (c) believed that it would incur debts beyond its ability to pay as they matured.[4]
In CMS clawbacks, the plaintiff’s theory is straightforward: Since the parent company had no obligation to pay the subsidiary’s debts, it did not receive reasonably equivalent value for the transfer. Only a handful of recent cases have substantively addressed CMS clawback issues, including In re Enron Corp.,[5] In re Collins & Aikman Corp.[6] and In re LandAmerica Financial Group Inc.[7] These issues will remain relevant (and disputed), as debtors in most large, multi-entity chapter 11 cases now utilize a CMS.
Insights
Resolving CMS clawbacks can be streamlined by following several principles.
Utilize Public Information. Debtors in chapter 11 often seek authority to continue using a CMS and will explain the benefits of their CMS and how it CMS functions. Relevant information may also be disclosed by a public company in SEC filings. Public filings are important because (1) they offer a quick way to learn about the relevant CMS, (2) they indicate potential discovery needs and (3) defendants may use statements about the CMS to narrow disputes or seek summary judgment.[8]
Understand the Money Flow. Defendants in a CMS clawback typically argue that (1) the parent company received all the operating subsidiary’s money, the true source of the transfer, so finding liability is inequitable; (2) the transactions should be collapsed so that value received by the operating subsidiary from the creditor can be attributed to the parent company; (3) the parent company had an obligation to pay the bills because it swept all of the operating subsidiary’s cash; and (4) the parent company received reasonably equivalent value in the form of direct or indirect benefits.
Specifics about the CMS will matter. For instance, sometimes funds from operating subsidiaries flow to multiple places. Thus, assuming that the parent company received every dollar generated by an operating subsidiary may be incorrect. Moreover, when the CMS is linked to a credit facility, lenders may sweep bank accounts — material details when determining the source of payments or whether transfers should be collapsed. Finally, a defense based on benefits received by the parent may be difficult to establish, potentially requiring analysis of the specific value from each transfer. But this analysis may be unnecessary if the parent company had an express or implied obligation to pay the operating subsidiary’s debt.[9]
Know the Court. Most courts will not have opinions on CMS clawbacks, but knowing your court’s overall perspective will impact strategy. For example, some courts assess value broadly,[10] while others articulate a narrower view.[11] The court’s perspective is critical.
Get an Expert Early. Settlement requires an understanding of case merits: a fact-specific exercise with CMS clawbacks. An expert is useful during settlement negotiations for evaluating insolvency and benefits. Moreover, a testifying expert will likely be necessary if settlement proves elusive. While litigants frequently want to delay this expense, waiting can be costly.
Manage Client Expectations. Unlike preferences, which can often be settled after an analysis of relevant payment history, CMS clawbacks frequently require factual investigation and experts. Moreover, there is limited authority on CMS clawbacks, making litigated outcomes difficult to predict. The sooner both sides appreciate these realities and temper expectations appropriately, the sooner resolution can be achieved.
[1] See 11 U.S.C. §§ 544 and 548.
[2] One year for “insider” transfers.
[3] 11 U.S.C. § 547(b).
[4] 11 U.S.C. § 548(a)(1)(B)(ii)(I)-(III). Financial elements are not required under certain circumstances.
[5] Enron Corp. v. Grant Constr. Co., 2006 WL 2400369 (Bankr. S.D.N.Y. May 11, 2006) (refusing to dismiss Enron CMS clawback).
[6] Collins & Aikman Corp. v. Valeo, 401 B.R. 900 (Bankr. E.D. Mich. 2009) (denying defendants’ CMS-based summary judgment motion).
[7] LandAmerica Fin. Grp. Inc. v. S. Calif. Edison, 2014 WL 2069651 (Bankr. E.D. Va. May 19, 2014) (granting summary judgment after plaintiff conceded parent’s implied obligation to pay debt).
[8] In re Collins & Aikman, 401 B.R. at 905.
[9] In re LandAmerica, 2014 WL 2069651, at *5.
[10] Butler Aviation Int’l. Inc. v. Whyte (In re Fairchild Aircraft Corp.), 6 F.3d 1119, 1126-27 (5th Cir. 1993) (considering general benefits, not property actually realized from transfers).
[11] Balaber-Strauss v. Sixty-Five Brokers (In re Churchill Mortg. Inv. Corp.), 256 B.R. 664, 678 (Bankr. S.D.N.Y. 2000) (focusing on “quid pro quo exchange” between debtor and transferee).