Bankruptcy Judge Kevin Gross of Delaware is back in the news with another important opinion in post-confirmation fraudulent transfer litigation involving Physiotherapy Holdings Inc. His new decision stands for the proposition that creditors who take stock in a reorganized company are entitled to recover more than the principal amount of their claims through successful post-confirmation prosecution of a fraudulent transfer action.
In June 2016, Judge Gross denied the defendants’ motion to dismiss and disagreed with Note Holders v. Large Private Beneficial Owners (In re Tribune Co.), 818 F.3d 98 (2d Cir. 2016), where the Second Circuit expansively read the safe harbor in Section 546(e) to impliedly preempt state law and bar creditors from pursuing their own fraudulent transfer claims.
In a follow-up decision on Nov. 1 in the same lawsuit, Judge Gross handed the defendants another defeat by holding that recovery on fraudulent transfer claims is not capped by the amount of creditors’ claims under a chapter 11 plan.
The Busted LBO
The Physiotherapy reorganization involved a typical leveraged buyout gone sour. Barely a year after the LBO closed, the company defaulted on $210 million in senior unsecured notes that had been sold to finance the acquisition. Although the noteholders were owed $237 million with accrued interest at the time of confirmation, the prepackaged plan gave them an allowed unsecured claim of $210 million, for which they received new common stock plus half of recoveries by a litigation trust.
The disclosure statement said that the new stock was worth about $85 million, or 40% of the noteholders’ claims.
Somewhat more than two years after confirmation, the noteholders sold their stock in the reorganized company to a third party. In return, they received $282 million. Although more than the principal amount of their claims, the sale proceeds were less than $380 million, what the claims would be worth now, or $470 million, the amount noteholders would have received by maturity.
The Fraudulent Transfer Suit
After confirmation, the trust initiated suit against the sellers in the LBO, seeking to recover about $250 million they received in selling the company and alleging that the transaction was a fraudulent transfer “with actual intent” or was constructively fraudulent. After Judge Gross rejected Tribune and denied the defendants’ motion to dismiss the complaint last year, the parties entered into mediation.
The mediation came to a roadblock over the question of whether the noteholders’ recovery was capped by the amount of their claims. If there were a cap, the noteholders might be entitled to no further recovery, and the sellers could keep what they received in the LBO even though it may have been a fraudulent transfer.
To remove the logjam and foster settlement, Judge Gross agreed at the parties’ behest to decide whether the fraudulent transfer claims are capped. Undertaking what might seem like an advisory opinion, Judge Gross assumed without deciding that the LBO did entail a fraudulent transfer.
Judge Gross said that arriving at a decision about a cap “is not as apparent as it may seem.” He cited cases from the bankruptcy court in New York and the Ninth Circuit for the proposition that there is no cap. On the other hand, the defendants argued that “fraudulent transfer laws are remedial, not punitive.” Furthermore, he said, “Windfalls and punitive damages are not bankruptcy concepts,” and creditors “are not entitled to recover more than their unpaid claims.”
Arguing for a cap, the defendants contended that a recovery should be awarded only to recover harm to the creditors and that the $250 million sought in the lawsuit exceeded the noteholders’ actual losses.
Finding no authority in the Third Circuit, where the Delaware bankruptcy court sits, Judge Gross held that there is no cap. He relied in part on Moore v. Bay, 284 U.S. 4 (1931), where Justice Oliver Wendell Holmes, Jr. held that a trustee could avoid an entire fraudulent transfer, not simply the amount to cover claims of creditors in existence at the time of the transfer.
If there were a cap, Judge Gross said, the defendants “would keep most if not all of the transferred money. The Court cannot countenance such an inequitable result if liability exists.”
The defendants relied on Section 550, governing the liability of transferees of avoided transfers. They emphasized language in Section 550(a) allowing the trustee to recover “for the benefit of the estate.”
Judge Gross said that “‘for the benefit of the estate’ does not mean for the benefit of creditors,” because “estate” means all legal and equitable interests of the debtor.
By accepting stock for their claims, Judge Gross said that the noteholders “took a risk and are entitled to the benefits of their risk-taking.” Although they ended up recovering more than the principal amount of their claims, the value of the reorganized company could have declined, and their losses could have increased.
Moreover, Judge Gross pointed out at the end of his opinion that the noteholders sustained a loss despite selling their stock for more than the principal amount of their claims. At present, the noteholders would be owed $380 million and would have taken in $470 million by maturity, in both cases less than they received for their stock in the reorganized company.
To read ABI’s discussion of Judge Gross’ decision last year, click here. To read about the Second Circuit’s Tribune opinion, click here.