Vincent J. Roldan ’98
Vandenberg & Feliu, LLP
On December 12, 2013, the United States Bankruptcy Court for the Southern District of New York in Tronox Inc. v. Kerr-McGee Corp.1 issued an important opinion on fraudulent conveyance liability that may affect how large companies address long term environmental and tort remediation obligations. In Tronox, the court ruled that the spin-off of a successful energy business from a troubled chemical business was an actual fraudulent transfer designed to separate the valuable assets from the significant liabilities. The court awarded the creditors up to $14.5 billion in damages, which is apparently the largest environmental bankruptcy award ever.2 The 112-page opinion was the result of a 34-day trial involving 28 witnesses (including 14 expert witnesses) and 6,100 exhibits. As discussed below, the decision provides an indication of how courts will weigh evidence (or lack thereof) when analyzing a possible fraudulent transfer. Despite substantial documentation in support of their defense, the defendants were unable to prove whether there was any good faith belief that debtor would be able to support environmental and other legacy liabilities that had been imposed upon it. This article explores this issue as well as other certain key issues that participants in transactions with substantial legacy liabilities should consider.
The Facts: An M&A Solution to Significant Environmental Exposure
Kerr-McGee Corporation (“Kerr-McGee”) was an energy and chemical company that had operated since 1929. Among other things, Kerr-McGee had a profitable oil and gas exploration and production business (the “E&P Business”) and a chemical business (the “Chemical Business”). By 2000, Kerr-McGee faced billions in substantial environmental and tort exposure related to its Chemical Business. Attempts to sell all or part of the company were unsuccessful, in large part due to the substantial environmental risk related to the Chemical Business. One of the rejecting suitors was Anadarko Petroleum Corporation (“Anadarko”), who purportedly passed on the transaction because the future environmental liability was “$BILLIONS” with “no end in sight for at least 30 more years.”
In response to the rejections by potential acquirers, in 2002 Kerr-McGee began to implement an out-of-court corporate restructuring that was completed in 2005. There were several components to the restructuring, each of which was designed to allow Kerr-McGee to separate the valuable E&P Business from the Chemical Business. In 2002, Kerr-McGee transferred the assets relating to the valuable E&P Business to a new parent company (“New Kerr-McGee”). The Chemical Business assets and the concomitant legacy liabilities were left behind at Kerr-McGee, which was later renamed Tronox Worldwide LLC (“Tronox”).
In 2005, Tronox incurred approximately $450 million in secured bank debt and issued unsecured notes of $350 million. All but $40 million of the proceeds from these transactions were paid to New Kerr-McGee. Also in November 2005, Tronox was taken public in an initial public offering, yielding approximately $225 million in proceeds that were also paid to New Kerr-McGee. In March 2006, new Kerr-McGee distributed the Tronox stock to its shareholders, completing the spin-off of the Tronox assets (and liabilities) and establishing it as an independent company.
Just weeks after the spin-off was concluded, the former suitor, Anadarko, acquired New Kerr-McGee for $18 billion in an all-cash transaction. Tronox continued to limp along for years after being spun off, ultimately filing for bankruptcy in 2009. Tronox and related entities filed a fraudulent conveyance lawsuit against the parties involved in the prior spin off transactions, seeking to avoid the transfers of the valuable assets and over $15 billion in damages. This litigation was transferred to a litigation trust created pursuant to the Tronox plan of reorganization, which provided the environmental creditors with the proceeds of the fraudulent conveyance litigation.
The Impact: Relevant Legal Conclusions and Lessons
The Tronox decision is comprehensive and complex, addressing, among other things, fraudulent conveyance, valuation and jurisdictional issues. The lawsuit alleged that the separation of the E&P Business from the Chemical Business and subsequent sale of the E&P Business to Anadarko was an actual and constructive fraudulent conveyance. Before getting to those fraudulent conveyance issues, the court had to deal with a statute of limitations issue because Tronox filed for bankruptcy in January 2009. The applicable “claw-back” period would encompass the 2005 IPO, but not the 2002 spin-off if that transfer was treated as a separate distinct transaction.
Collapsing Transaction Doctrine
The Tronox court ruled that the series of restructuring transactions that Kerr-McGee began in 2002 and ended in 2005 were part of a single integrated scheme, and collapsed the entire transaction for purposes of a statute of limitations analysis. The court looked to evidence, including board presentations, in 2000 and 2001 discussing the spin-off with an express purpose of limiting environmental and tort liabilities. Ultimately, the court found “overwhelming” evidence that the 2002 transaction was part of a single integrated scheme to create an E&P Business free and clear of legacy liabilities.3 This permitted the court to move beyond the 4-year statute of limitations applicable under Oklahoma state law, and include the transactions that occurred prior as part of the overall transaction.4
Actual Fraudulent Transfer
The plaintiffs alleged that the transfers of property that culminated in the spin-off were made with “actual intent to hinder, delay or defraud” a creditor within the meaning of section 548(a)(1)(A) of the Bankruptcy Code, and the equivalent Oklahoma statute. After reviewing the substantial evidence presented, the Tronox court found that the transactions were done with an actual intent to hinder or delay creditors. The court recognized that a transfer may be made without fraudulent intent even if a debtor did not intend to harm creditors, where it knew that by entering into the transaction, creditors would inevitably be hindered, delayed or defrauded. Here, there was ample evidence in the record that a principal goal of the separation of the E&P Business from the Chemical Business was to cleanse the E&P asserts of legacy liabilities, in order to make the cleansed company more attractive as an acquisition target.5 Thus, the court found that even without an analysis of “badges of fraud,”6 there was evidence of actual fraudulent intent.
For good measure, the court analyzed and found evidence establishing “badges of fraud,” including (i) the transferee was an insider, (ii) the debtor retained complete control of the property after the transfer, (iii) disclosures regarding the 2002 transaction were insubstantial and ineffective, and (iv) before the transfer was made, the debtor was involved for years in environmental and tort liability litigation.7
Among other defenses, the defendants argued that the parties believed that Tronox was viable. The Tronox court rejected several of the defendants' arguments in support. The court said that the issue is not whether Tronox was “doomed to fail,” nor whether the defendants wanted Tronox to be a “big success.”8 Instead, the court said the real issue was whether there was evidence of any good faith belief that Tronox would be able to support environmental liabilities. The court found no such evidence of any contemporaneous analysis, which the court to be “extraordinary.”9 The defendants used analyses prepared by the Kerr-McGee chief accounting officer and accountants and a cash flow analysis, but the court did not find either to be persuasive evidence of Tronox’s ability to support the legacy liabilities. For instance, the accounting analysis only opined that Tronox would be able to survive for one year, which is not necessarily evidence of Tronox’s ability to survive as a standalone entity. Similarly, the cash flow analysis was not sufficiently thorough. It predicted that environmental expenses would be zero in 2010, and “absurd” result according to the court.10
Defendants also supported submitted a solvency opinion, to show that the defendants believed Tronox was viable and creditors would not be adversely affected after the spin-off. The court rejected this defense largely because the financial advisor relied upon Company management's estimates of the environmental and tort liability, which the court found to be of no probative value in determining liability for solvency/fraudulent conveyance purposes.11
The court also rejected the defendants' claims that the spin-off was intended to create two successful standalone companies, in order to maximize shareholder value. The court pointed out that every legacy liability was imposed on Tronox, though at one time the legacy liabilities had been proposed to be allocated proportionately to the asset values of the two lines of business. The defendants did not articulate any legitimate business reason for imposing all legacy liabilities on Tronox. Accordingly, the Tronox court found sufficient evidence of intentional fraud to place the burden on the defendants to show a legitimate business purpose for the manner in which the transfer was structured. Here, the defendants failed to meet their burden.
In sum, though there was plenty of evidence that Kerr-McGee’s sophisticated management gave close attention to fraudulent conveyance issues through research of failed spin-offs and discussions with outside lawyers, the defendants were only able to produce vague, conclusory generalities in support of the position that Kerr-McGee reasonably concluded that the Tronox spin-off could not be challenged on fraudulent conveyance grounds.12
Constructive Fraudulent Conveyance
The plaintiffs also charged that the defendants were liable for constructive fraudulent conveyance. To establish liability under that theory, the plaintiffs had to prove that Tronox received less than reasonably equivalent value for the assets and was insolvent (under any of the balance sheet test, adequate capitalization test or cash flow test). The court had no problem finding that Tronox did not receive reasonably equivalent value. Plaintiffs’ expert testified that Tronox transferred approximately $17 billion and received only $2.6 billion in return, which numbers were not materially disputed.13 He arrived at these figures by comparing the E&P Business to seven comparable businesses, and also compared his valuation to estimates conducted by Lehman Brothers and Salomon Smith Barney.
The more hotly contested issue was whether Tronox was insolvent as a result of the transfer. The court found that using the defendants’ most aggressive valuation of Tronox’s assets, Tronox’s environmental and tort liabilities (approximately $2 billion) far exceeded the value of its assets. The interesting part of the Tronox court's constructive fraudulent conveyance analysis was the rejection of the defendants' market evidence of solvency. The defendants argued that Tronox's successful IPO, offers to purchase the Chemical Business, and Tronox's ability to sell bonds in the market were evidence of the value of the entity at that time. The court rejected the market tests, finding that the expert testimony showed that the financial statements on which the market relied were “inflated, sell-side projections, and that key numbers were imposed” by management. Essentially, the projections relating to the IPO were unreasonable when compared with Tronox’s historical performance. In addition, the financial statements omitted certain critical contingencies and potential liabilities. There was no contention that Tronox’s financial statements discussed all legacy liabilities in any manner useful to determining solvency.
Next, the defendants offered as evidence of solvency the testimony from management that at the time of the spin-off, Tronox employees believed Tronox was solvent and not doomed to fail. This type of evidence was undermined by other evidence that others in management saw disaster on the horizon and recommended steps to address it. For instance, shortly after the spin-off, Tronox’s new head of environmental remediation advocated that Tronox sue Kerr-McGee to address the environmental liabilities. “In any event, the optimism of some of Tronox’s management is no better proof of solvency than the despair of others.”14
The Tronox case is significant for several reasons, but primarily as an example of the type of evidence that a bankruptcy court may consider in evaluating transactions designed to limit particular legacy liabilities. Courts will thoroughly review presentations from advisors to the board, comments made by management to the proposed presentations and opinions, and all available documentation to determine whether the board considered the impact of the transaction on the legacy company (and creditors). The Tronox decision will significantly impact how most financial actors evaluate fraudulent transfer risks involved in any transaction, including spin-offs, leveraged buy outs and dividend recapitalizations.
1 Tronox Inc. v. Kerr-McGee Corp., 503 B.R. 239 (Bankr. S.D.N.Y. 2013).
2 Michael Vitti, “A Cartoon And Other Takeaways From The Tronox Case,” American Bankruptcy Institute Journal (April 2014) (citation omitted).
3 Tronox, 503 B.R. at 269.
4 This portion of the Tronox decision is a reminder that potential buyers should be cognizant of the transactions that occurred prior to the applicable statute of limitation period.
5 Id. at 280.
6 “Badges of fraud” are circumstances so commonly associated with fraudulent transfers that their presence gives rise to an inference of fraudulent intent. Id. at 282-83.
7 Id. at 283-84
8 Id. at 285.
9 Id. at 285-86.
10 Id. at 286.
11 Id. at 287. These estimates were based on Tronox’s anticipated contingent liabilities stated as reserves in Tronox’s financial statements. There was no dispute that financial statements are of little use in a solvency analysis because generally accepted accounting principles (GAAP) only requires reserves for claims that are probable and reasonably estimable. Id. at 301. The court found the record to be “replete with evidence” that Kerr-McGee misapplied the standard and thereby understated its liabilities for GAAP purposes.
12 Id. at 287.
13 Id. at 295.
14 Id. at 308.
Vincent J. Roldan ’98 is a Partner at Vandenberg & Feliu, LLP in New York and specializes in corporate restructuring and Chapter 11 bankruptcy.