Fraudulent Transfer Analysis Turns Sour

Significance of Ruling

The $500 million proceeds of the VFI bank borrowings went to Campbell, VFI's sole shareholder, but VFI received in exchange something of questionable value ' the Division. In view of the Third Circuit's previously articulated 'totality of the circumstances test,' In re R.M.L., Inc., 92 F.3d 139, 153 (3d Cir. 1996) (' … in assessing the reasonable equivalent issue,' courts consider 'a variety of factors, including the fair market value compared to the actual price paid and the arm's length nature of the transaction.'), the VFB ruling is stunning. First, the Spin was hardly an arms-length transaction. Campbell's heavy-handed self-dealing in the transaction was undisputed. Indeed, VFI's pre-Spin Board of Directors ' which approved the transaction ' consisted of Campbell officers who did neither due diligence nor anything else to protect VFI's interests, and understood their role to be merely approving the Spin and resigning. And, most significant, the businesses Campbell sold to VFI probably had a true economic value of many million dollars less than the $500 million purchase price paid to Campbell. The declining state of the Division's businesses, saddled with a $500 million debt load due in five (5) years, also confirmed VFI's inadequate capitalization.

The Third Circuit, like the District Court, rejected VFB's fraudulent transfer claims, glossed over the overwhelming evidence and relied almost exclusively on VFI's market capitalization, a number that VFB alleged had been manipulated or distorted by certain accounting techniques employed by Division managers in the years preceding the Spin. Even more significant, the court ignored the debtor's actual operating results that evidenced the true value of the Division's assets.

VFI's earnings quickly declined after the March, 1998 Spin, as did its sales. By January 1999, VFI had to sell three of its nine businesses. VFI was later forced to file a Chapter 11 petition on Jan. 29, 2001. By May of that year, VFI had sold all of the businesses for a total net discounted value of $38 million, at least $115 million less than what it had paid Campbell in the Spin transaction three years earlier.

VFB sued under New Jersey's version of the Uniform Fraudulent Transfer Act ('UFTA'), adopted by approximately 40 states and substantively identical to the fraudulent transfer provision of the Bankruptcy Code (' 548). Asserting both a constructively and actually fraudulent transfer, VFB alleged that 'Campbell engineered a fraudulent transfer from [the debtor] to Campbell of more than $600 million in cash and assumed liabilities ” VFB, LLC v. Campbell Soup Co., 2005 WL 2234606, at *1 (3d Cir. 9/13/05). As the District Court noted, a finding of constructive fraudulent transfer requires: 1) that a debtor make a transfer and not receive 'reasonably equivalent value'; and 2) that, at the time of the transfer, the debtor was either 'inadequately capitalized' or became insolvent as a result of the transfer. Id. at *20. As for the debtor's 'actual intent to hinder, delay, or defraud' its present and future creditors, the District Court summarily rejected VFB's claim, Id. at *31, and the Court of Appeals ignored it. The District Court also rejected VFB's inadequate capitalization claim because 'the professionals involved in the Spin-off [plus] independent third parties that purchased VFI's stock and, [six (6) months] later, its bonds, believed that VFI's assets were adequate to operate the businesses ” Id.

Was the Division worth roughly the $500 million paid by the debtor? According to the District Court and the Third Circuit, the debtor got at least roughly the value it gave. '[I]n light of [the debtor's] $1.1 billion market capitalization nine months after the spin, the Division businesses were worth indeed far more than $500 million.' 2007 WL 942360, at*6. Although neither New Jersey law nor the Bankruptcy Code provides 'a universal definition of 'reasonably equivalent value,'… a party receives reasonably equivalent value for what it gives up if it gets 'roughly the value it gave.” Id. at *5, citing In re Fruehauf Trailer Corp., 444 F.3d 203, 213 (3d Cir. 2006).

The court rejected VFB's attack on the District Court's use of a market capitalization approach. 'Equity markets allow participants to voluntarily take on or transfer among themselves the risk that their projections will be inaccurate; fraudulent transfer law cannot rationally be invoked to undermine that function ' Market capitalization is a classic example of ' an anchored projection [based on actual performance], as it reflects all the information that is publicly available about a company at the relevant time of valuation ' A company's actual subsequent performance is something to consider when determining ex post the reasonableness of a valuation, ' but it is not, by definition, the basis of a substitute benchmark.' Id. at *6.

Nor did the court accept VFB's argument that Campbell's manipulation of the Division's sales and earnings prior to the Spin had distorted the District Court's market capitalization valuation. According to the court, 'Campbell's sales and earnings manipulation could [not] have seriously misled the public markets about the Division's prospects' because of later publicity and disclosure and because 'it would be easy for interested observers to take the effect of this behavior into account when evaluating Campbell's reports and projections.' Id. at *6, n.4. Moreover, reasoned the Third Circuit, the District Court 'explicitly chose not to rely on [the debtor's] market capitalization at the time of the Spin, precisely because of Campbell's manipulation, and instead looked at market capitalization several months later, when the truth of [the debtor's] situation had become clear '.

'Consequently, if [the debtor's later] September 1998 market capitalization reflected a value for the Division businesses of at least $500 million, despite no longer being affected by Campbell's pre-Spin operations, then the Division must have been worth more than $500 million at the time of the spin ' [T]he market's valuation of [the debtor] as solvent in FY 1999 was strong evidence that [the debtor] was solvent at the time of the [March, 1998] Spin, and therefore received reasonably equivalent value for its $500 million.' Id. at *7.

Accepting the District Court's dismissal of competing expert witness testimony, the court stressed that 'the market price is 'a more reliable measure of the stock's value than the subjective estimates of one or two expert witnesses.” Id. at *8, quoting In re Prince, 85 F.3d 314, 320 (7th Cir. 1996). Because VFB had not shown clear error in the District Court's fact-findings and because the District Court 'meticulously and accurately' considered the relevant facts in determining that VFI had received reasonably equivalent value, the Third Circuit found them to be ”largely immune from attack on appeal.” Id., citing In re R.M.L., Inc., 92 F.3d 139,154 (3d Cir. 1996). Accordingly, it declined to 'discuss the fine distinctions between balance-sheet insolvency, equitable insolvency and unreasonable under-capitalization.' Id. at *9.

The court also rejected VFB's assertion that the Spin had rendered the debtor insolvent. '[The debtor's] pre-spin balance sheet contained nothing; its post-spin balance sheet contained $500 million in debt and the Specialty Foods Division. As noted above, the District Court did not clearly err in valuing the division at well over $500 million, meaning that [the debtor's] assets were easily greater than its debts '. In June 1999, well after the markets were aware of all information that might have been concealed about [the debtor's] condition at the time of the spin, [the debtor] was able to sell $200 million in unsecured debt. That debt continued to sell at par value until January of 2000, indicating that until that point … creditors believed that [the debtor] would pay its unsecured debt as it came due.' Id. at *10.

Rejecting VFB's claim that Campbell aided and abetted a breach of the debtor's directors' duty of loyalty when it entered into the Spin transaction, the court found no breach because of the debtor's solvency at the time of the Spin (i.e., because VFI was solvent, its directors' duties were to its shareholder, Campbell, not to the corporation). 'The ' directors looked out only for Campbell's interest because, substantively, that was their duty; whether they thought they were acting in the interest of [the debtor] or Campbell 'seems inconsequential.” Id. at *9. Moreover, 'it makes no sense to impose a duty on the director of a solvent, wholly-owned subsidiary to be loyal to the subsidiary as against the parent company [its sole shareholder].' Id. at *10.

Comments

The facts in the record of this case are eye-popping. A bankruptcy judge easily could have ruled differently. See, e.g., In re Paragon Trade Brands, Inc., 324 B.R. 829 (Bankr. N. D. Ga. 2005) (Chapter 11 estate of former subsidiary prevailed against former parent for breach of warranty after transfer of business to subsidiary).

The Third Circuit seemed reluctant to go behind the District Court's findings, heavily relying on the 'clearly erroneous' standard for appellate review contained in Fed. R. Civ. P. 52 (a) ('Findings of fact, whether based on oral or documentary evidence, shall not be set aside unless clearly erroneous, and due regard shall be given to the opportunity of the trial court to judge the credibility of the witnesses.').

The court, for example, relied heavily on the District Court's finding that VFI was able to refinance part of its bank debt by issuing bonds in June, 1999, when the facts regarding the Spin and VFI's subsequent performance had supposedly been disclosed. But all the facts had not been disclosed at that time. Six months after the bond offering, 'VFI took the $15 million charge for under-accrued trade spending' during the prior fiscal year. The 1999 bond offering disclosure materials, which failed to describe the under-accrued trade spending, presented VFI as being financially stable and having turned the corner, when, in fact, the company was actually in a continued sharp decline. When VFI finally took a $15 million charge in January, 2000, the stock market finally realized that VFI had never stabilized and had instead been in a continuous decline. This $15 million charge caused VFI to violate a covenant with its banks and led to its bankruptcy filing. According to the un-contradicted record, VFI never would have completed the offering had the trade spending under-accrual been known at the time. Indeed, the value of the bonds, so heavily relied on by the District Court, collapsed when the news of the under-accrued trade spending surfaced.

One practitioner described the VFB suit as 'a challenge years later by a disgruntled creditor constituency that largely did not exist at the time of the [1998] Spin,' noting that only VFI's landlord was a creditor at the time. Ball, supra. But the
UFTA, applicable here, enables both present and future creditors to challenge transfers by undercapitalized debtors and those made with 'actual intent to hinder, delay or defraud.' The two courts in VFB not only downplayed the facts, but they also ignored the law.

Michael L. Cook, a member of this newsletter's Board of Editors, and Lawrence V. Gelber are partners at Schulte Roth & Zabel LLP in New York.

The Third Circuit, on March 30, 2007, affirmed a district court judgment dismissing a $500 million fraudulent transfer and breach of fiduciary duty suit against Campbell Soup Co., the former parent of Vlasic Foods International ('VFI' or the 'debtor'). VFB, LLC v. Campbell Soup Co., 2007 WL 942360 (3d Cir. 3/30/07). VFI's creditors, acting through the reorganized entity, known as VFB, claimed that Campbell's March, 1998 $500 million stock sale (or 'leveraged Spin') of its Specialty Foods Division (including subsidiaries such as Vlasic (pickles) and Swanson (TV dinners)) to VFI, a newly formed, wholly owned subsidiary, was a fraudulent transfer because VFI did not receive reasonably equivalent value and because its $500 million payment rendered it insolvent and under-capitalized. [Note, the creditor body alleging injury consisted primarily of the holders of $200 million in unsecured bonds; a landlord; various former employees; and VFI's trade creditors.] The Third Circuit, however, held that the District Court had properly found the Division acquired by the debtor to be 'worth well in excess' of the $500 million purchase price, and that the debtor was solvent at the time of its 1998 purchase. Relying on the District Court's market capitalization valuation of VFI, the court thus found that the debtor had received reasonably equivalent value and that the debtor's pre-Spin directors had not breached their fiduciary duty to creditors. According to one practitioner, the court's 'reliance on the capital markets ' is a welcome development ' ' C. Ball, 'Court Relies on Markets for Proof of Spin-off's Value,' New York L. J., April 26, 2007, at 5 (hereinafter 'Ball').

To bolster its own financial performance, Campbell sold the Division to the debtor, VFI, in exchange for $500 million. VFI borrowed the purchase price from a group of banks. Campbell then promptly distributed shares of the debt-laden subsidiary to Campbell shareholders as an in-kind dividend. Campbell dictated the most significant terms of the transaction (including, among others, the assets to be transferred and purchase price), precluding any meaningful negotiation with the debtor.

By effecting the Spin, Campbell disposed of underperforming businesses and received value similar to a sale. Campbell's shareholders continued to own the same assets, but in a different corporate package. According to VFB, however, while the Spin benefited Campbell, it set the debtor up for failure (e.g., causing it to pay additional expenses and to assume additional liabilities).

Significance of Ruling

The $500 million proceeds of the VFI bank borrowings went to Campbell, VFI's sole shareholder, but VFI received in exchange something of questionable value ' the Division. In view of the Third Circuit's previously articulated 'totality of the circumstances test,' In re R.M.L., Inc., 92 F.3d 139, 153 (3d Cir. 1996) (' … in assessing the reasonable equivalent issue,' courts consider 'a variety of factors, including the fair market value compared to the actual price paid and the arm's length nature of the transaction.'), the VFB ruling is stunning. First, the Spin was hardly an arms-length transaction. Campbell's heavy-handed self-dealing in the transaction was undisputed. Indeed, VFI's pre-Spin Board of Directors ' which approved the transaction ' consisted of Campbell officers who did neither due diligence nor anything else to protect VFI's interests, and understood their role to be merely approving the Spin and resigning. And, most significant, the businesses Campbell sold to VFI probably had a true economic value of many million dollars less than the $500 million purchase price paid to Campbell. The declining state of the Division's businesses, saddled with a $500 million debt load due in five (5) years, also confirmed VFI's inadequate capitalization.

The Third Circuit, like the District Court, rejected VFB's fraudulent transfer claims, glossed over the overwhelming evidence and relied almost exclusively on VFI's market capitalization, a number that VFB alleged had been manipulated or distorted by certain accounting techniques employed by Division managers in the years preceding the Spin. Even more significant, the court ignored the debtor's actual operating results that evidenced the true value of the Division's assets.

VFI's earnings quickly declined after the March, 1998 Spin, as did its sales. By January 1999, VFI had to sell three of its nine businesses. VFI was later forced to file a Chapter 11 petition on Jan. 29, 2001. By May of that year, VFI had sold all of the businesses for a total net discounted value of $38 million, at least $115 million less than what it had paid Campbell in the Spin transaction three years earlier.

VFB sued under New Jersey's version of the Uniform Fraudulent Transfer Act ('UFTA'), adopted by approximately 40 states and substantively identical to the fraudulent transfer provision of the Bankruptcy Code (' 548). Asserting both a constructively and actually fraudulent transfer, VFB alleged that 'Campbell engineered a fraudulent transfer from [the debtor] to Campbell of more than $600 million in cash and assumed liabilities ” VFB, LLC v. Campbell Soup Co., 2005 WL 2234606, at *1 (3d Cir. 9/13/05). As the District Court noted, a finding of constructive fraudulent transfer requires: 1) that a debtor make a transfer and not receive 'reasonably equivalent value'; and 2) that, at the time of the transfer, the debtor was either 'inadequately capitalized' or became insolvent as a result of the transfer. Id. at *20. As for the debtor's 'actual intent to hinder, delay, or defraud' its present and future creditors, the District Court summarily rejected VFB's claim, Id. at *31, and the Court of Appeals ignored it. The District Court also rejected VFB's inadequate capitalization claim because 'the professionals involved in the Spin-off [plus] independent third parties that purchased VFI's stock and, [six (6) months] later, its bonds, believed that VFI's assets were adequate to operate the businesses ” Id.

Was the Division worth roughly the $500 million paid by the debtor? According to the District Court and the Third Circuit, the debtor got at least roughly the value it gave. '[I]n light of [the debtor's] $1.1 billion market capitalization nine months after the spin, the Division businesses were worth indeed far more than $500 million.' 2007 WL 942360, at*6. Although neither New Jersey law nor the Bankruptcy Code provides 'a universal definition of 'reasonably equivalent value,'… a party receives reasonably equivalent value for what it gives up if it gets 'roughly the value it gave.” Id. at *5, citing In re Fruehauf Trailer Corp., 444 F.3d 203, 213 (3d Cir. 2006).

The court rejected VFB's attack on the District Court's use of a market capitalization approach. 'Equity markets allow participants to voluntarily take on or transfer among themselves the risk that their projections will be inaccurate; fraudulent transfer law cannot rationally be invoked to undermine that function ' Market capitalization is a classic example of ' an anchored projection [based on actual performance], as it reflects all the information that is publicly available about a company at the relevant time of valuation ' A company's actual subsequent performance is something to consider when determining ex post the reasonableness of a valuation, ' but it is not, by definition, the basis of a substitute benchmark.' Id. at *6.

Nor did the court accept VFB's argument that Campbell's manipulation of the Division's sales and earnings prior to the Spin had distorted the District Court's market capitalization valuation. According to the court, 'Campbell's sales and earnings manipulation could [not] have seriously misled the public markets about the Division's prospects' because of later publicity and disclosure and because 'it would be easy for interested observers to take the effect of this behavior into account when evaluating Campbell's reports and projections.' Id. at *6, n.4. Moreover, reasoned the Third Circuit, the District Court 'explicitly chose not to rely on [the debtor's] market capitalization at the time of the Spin, precisely because of Campbell's manipulation, and instead looked at market capitalization several months later, when the truth of [the debtor's] situation had become clear '.

'Consequently, if [the debtor's later] September 1998 market capitalization reflected a value for the Division businesses of at least $500 million, despite no longer being affected by Campbell's pre-Spin operations, then the Division must have been worth more than $500 million at the time of the spin ' [T]he market's valuation of [the debtor] as solvent in FY 1999 was strong evidence that [the debtor] was solvent at the time of the [March, 1998] Spin, and therefore received reasonably equivalent value for its $500 million.' Id. at *7.

Accepting the District Court's dismissal of competing expert witness testimony, the court stressed that 'the market price is 'a more reliable measure of the stock's value than the subjective estimates of one or two expert witnesses.” Id. at *8, quoting In re Prince, 85 F.3d 314, 320 (7th Cir. 1996). Because VFB had not shown clear error in the District Court's fact-findings and because the District Court 'meticulously and accurately' considered the relevant facts in determining that VFI had received reasonably equivalent value, the Third Circuit found them to be ”largely immune from attack on appeal.” Id., citing In re R.M.L., Inc., 92 F.3d 139,154 (3d Cir. 1996). Accordingly, it declined to 'discuss the fine distinctions between balance-sheet insolvency, equitable insolvency and unreasonable under-capitalization.' Id. at *9.

The court also rejected VFB's assertion that the Spin had rendered the debtor insolvent. '[The debtor's] pre-spin balance sheet contained nothing; its post-spin balance sheet contained $500 million in debt and the Specialty Foods Division. As noted above, the District Court did not clearly err in valuing the division at well over $500 million, meaning that [the debtor's] assets were easily greater than its debts '. In June 1999, well after the markets were aware of all information that might have been concealed about [the debtor's] condition at the time of the spin, [the debtor] was able to sell $200 million in unsecured debt. That debt continued to sell at par value until January of 2000, indicating that until that point … creditors believed that [the debtor] would pay its unsecured debt as it came due.' Id. at *10.

Rejecting VFB's claim that Campbell aided and abetted a breach of the debtor's directors' duty of loyalty when it entered into the Spin transaction, the court found no breach because of the debtor's solvency at the time of the Spin (i.e., because VFI was solvent, its directors' duties were to its shareholder, Campbell, not to the corporation). 'The ' directors looked out only for Campbell's interest because, substantively, that was their duty; whether they thought they were acting in the interest of [the debtor] or Campbell 'seems inconsequential.” Id. at *9. Moreover, 'it makes no sense to impose a duty on the director of a solvent, wholly-owned subsidiary to be loyal to the subsidiary as against the parent company [its sole shareholder].' Id. at *10.

Comments

The facts in the record of this case are eye-popping. A bankruptcy judge easily could have ruled differently. See, e.g., In re Paragon Trade Brands, Inc., 324 B.R. 829 (Bankr. N. D. Ga. 2005) (Chapter 11 estate of former subsidiary prevailed against former parent for breach of warranty after transfer of business to subsidiary).

The Third Circuit seemed reluctant to go behind the District Court's findings, heavily relying on the 'clearly erroneous' standard for appellate review contained in Fed. R. Civ. P. 52 (a) ('Findings of fact, whether based on oral or documentary evidence, shall not be set aside unless clearly erroneous, and due regard shall be given to the opportunity of the trial court to judge the credibility of the witnesses.').

The court, for example, relied heavily on the District Court's finding that VFI was able to refinance part of its bank debt by issuing bonds in June, 1999, when the facts regarding the Spin and VFI's subsequent performance had supposedly been disclosed. But all the facts had not been disclosed at that time. Six months after the bond offering, 'VFI took the $15 million charge for under-accrued trade spending' during the prior fiscal year. The 1999 bond offering disclosure materials, which failed to describe the under-accrued trade spending, presented VFI as being financially stable and having turned the corner, when, in fact, the company was actually in a continued sharp decline. When VFI finally took a $15 million charge in January, 2000, the stock market finally realized that VFI had never stabilized and had instead been in a continuous decline. This $15 million charge caused VFI to violate a covenant with its banks and led to its bankruptcy filing. According to the un-contradicted record, VFI never would have completed the offering had the trade spending under-accrual been known at the time. Indeed, the value of the bonds, so heavily relied on by the District Court, collapsed when the news of the under-accrued trade spending surfaced.

One practitioner described the VFB suit as 'a challenge years later by a disgruntled creditor constituency that largely did not exist at the time of the [1998] Spin,' noting that only VFI's landlord was a creditor at the time. Ball, supra. But the
UFTA, applicable here, enables both present and future creditors to challenge transfers by undercapitalized debtors and those made with 'actual intent to hinder, delay or defraud.' The two courts in VFB not only downplayed the facts, but they also ignored the law.

Michael L. Cook, a member of this newsletter's Board of Editors, and Lawrence V. Gelber are partners at Schulte Roth & Zabel LLP in New York.