In re Tronox: Spin-off Ridding Assets of Massive Legacy Liabilities Avoided as Fraudulent Transfer

Practical Law Legal Update 2-553-2686 (Approx. 9 pages)

In re Tronox: Spin-off Ridding Assets of Massive Legacy Liabilities Avoided as Fraudulent Transfer

by Practical Law Finance and Practical Law Bankruptcy & Restructuring

Background

Kerr-McGee Corporation (Old KM) was an energy and chemical company with massive environmental, tort and other liabilities. To make itself a more attractive merger candidate, in 2002 it began to internally reorganize to separate its profitable oil and gas exploration business (E&P Business) from its relatively small chemical business. The chemical business was left with all of Old KM's current and pre-existing environmental and tort liabilities except those directly related to the current operations of the E&P Business. Specifically, in a series of 11 transactions occurring from 2002 to 2005, Old KM created a new parent company (NKM), to which it transferred the equity of the subsidiaries that owned the valuable E&P Business. Old KM, renamed Tronox, retained the chemical business and responsibility for 85 years of environmental, tort and retiree liabilities. In 2005, this separation of the E&P Business and the chemical business was formalized in a series of agreements.

Later in 2005, Tronox incurred more than $500 million in debt, consisting of secured bank debt and unsecured bonds, and issued equity in an initial public offering (IPO). Tronox transferred almost all of the proceeds of the financing (about $800 million) to NKM, which remained a majority shareholder of Tronox. In March 2006, NKM distributed the remaining shares of Tronox stock to NKM's shareholders, leaving Tronox a free-standing public company. However, Tronox had poor cash flow and almost immediately after the spin-off, struggled to fund the legacy liabilities inherited from Old KM. In June 2006, Anadarko Petroleum Corporation (Anadarko) acquired NKM for about $18 billion in cash.

Tronox and fourteen of its affiliates (Debtors) filed for Chapter 11 relief on January 12, 2009. In May 2009, they sued Anadarko and NKM, now a subsidiary of Anadarko (Defendants), for over $15 billion in damages, alleging that the corporate reorganization and the transfer of the E&P Business should be avoided as fraudulent transfers. Specifically, the Debtors filed a complaint setting forth 11 claims for relief, including:

Actual fraudulent transfers under the Oklahoma Uniform Fraudulent Transfer Act (Oklahoma UFTA).
Constructive fraudulent transfers under the Oklahoma UFTA.
Fraudulent transfers under section 548(a) and section 550(a) of the Bankruptcy Code.

On November 30, 2010, the Court confirmed the Debtors' plan of reorganization which, among other things, created a litigation trust (Plaintiffs) to pursue these claims for the benefit of environmental and tort creditors, who agreed to accept the proceeds, if any, of the pending litigation as their plan distribution. The plan also provided that the amount of any damage award would be reduced by the value of any claim the Defendants might have under section 502(h) of the Bankruptcy Code, which entitles an entity that is forced to disgorge property to the debtor a prepetition claim against the estate.

For more information on fraudulent transfers, see Practice Note, Fraudulent Conveyances in Bankruptcy: Overview.

Outcome

The Court ruled that the Defendants were liable for both actual and constructive fraudulent transfer, and that the Plaintiffs were entitled to recover damages. However, the Court did not make a final determination on the amount of damages.

Actual Fraudulent Transfer

Under section 548(a) of the Bankruptcy Code, fraudulent transfers may be avoided only if they occurred with two years of the bankruptcy filing. However, because most of the relevant transfers occurred more than two years before the petition date, the Plaintiffs relied on section 544(b) of the Bankruptcy Code, which incorporates state fraudulent conveyance laws. This allowed the Plaintiffs to apply the four-year limitations period for fraudulent transfer claims found in the Oklahoma UFTA. Because the bankruptcy petition was filed in January 2009, this would encompass the IPO and the final spin-off of Tronox stock in 2006, but not the transactions occurring in 2002 if they were considered separate, complete transactions. However, the Court was able to "collapse" a series of transactions occurring between 2000 through 2005 into one transaction by finding they were in reality a "single integrated scheme, known to Defendants, that culminated only in the years 2005-2006." This conclusion was supported by, among other things, a board presentation in 2001 in which Old KM's legal and financial advisors indicated that a spin-off would be the best way to free the E&P Business of legacy liabilities. By collapsing the transactions in this way, all relevant transfers fit within the four-year look-back period. The Court applied this analysis to both the actual fraudulent transfer claim and the constructive fraudulent transfer claim (see Constructive Fraudulent Transfer).

An actual fraudulent transfer is a transfer made with "actual intent to hinder, delay or defraud" creditors. The Court reasoned that intent to "hinder or delay" is distinct from "intent to defraud" and that acting with intent to hinder or delay is legally sufficient for imposing fraudulent transfer liability. Further, the Court noted that according to the Restatement (Second) of Torts, "intent" is "used to denote that the actor desires to cause the consequences of his act, or that he believes that the consequences are substantially certain to result from it." In this case, the Court, finding the Defendants' testimony not credible, determined that it was clear, based on the evidence, that Old KM "acted to free substantially all of its assets - certainly its most valuable assets - from 85 years of environmental and tort liabilities." The Court also found that the "obvious consequence of this act was that the legacy creditors would not be able to claim against [the assets of the E&P Business] and with a minimal asset base against which to recover in the future, would accordingly be 'hindered or delayed' as the direct consequence of the scheme. This was the clear and intended consequence of the act, substantially certain to result from it." Therefore, the Court held that the Defendants acted with the intent required to find liability for actual fraudulent transfer.

In addition, the Court found evidence of several "badges of fraud" supporting its conclusion that there was actual intent to hinder, delay or defraud, including:

The transfer or obligation was to an insider. Here, the transfers were between affiliates, which are insiders.
The debtor retained possession or control of the transferred assets after the transfer. Here, Old KM retained complete possession and control of the property after the transfers and effectively controlled Tronox until the final spin-off in March 2006.
The transfer or obligation was concealed. Here, disclosure of the 2002 transfers was ineffective and insubstantial.
Before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit. Here, Old KM was threatened with litigation regarding environmental and tort liabilities before the 2005 IPO.
The transfer was of substantially all of the debtor's assets. Here, the property transferred in 2002 represented all or substantially all of Tronox's assets.

Next, the Court considered whether the Defendants could rebut the evidence of actual intent and show a "legitimate supervening purpose" for the transfers. The Defendants put forth the following three defenses:

They intended and believed that Tronox was and would be a successful, solvent company.
There was a "legitimate supervening purpose" for the IPO and the spinoff, which was to maximize shareholder value by "unlocking" the value in both the chemical business and the E&P Business.
They were merely attempting to limit the overall environmental liability of the corporate group.

The Court rejected the Defendants' first argument, stating that it did not matter whether the Defendants wanted or expected Tronox to succeed, but rather whether the Defendants had a "good faith belief" that Tronox would be able to support the environmental and other legacy liabilities that had been imposed on it. The Court noted that there was a complete absence of any "contemporaneous analysis" regarding Tronox's ability to support these liabilities. Therefore, the Defendants could not have had a good faith belief that Tronox would be able to survive.

Next, the Court also rejected the Defendants' second argument, explaining that even if the purpose was to unlock value, the Defendants failed to provide a legitimate supervening purpose for the "manner in which the transfer was structured," considering that most of the legacy liabilities were imposed on only a fraction of the total assets (emphasis added).

Finally, the Court rejected the Defendant's third argument, noting that transferring assets for no consideration and without any analysis of whether the remaining assets could support the liabilities left behind, is unacceptable and constitutes an actual intent to hinder or delay creditors.

Constructive Fraudulent Transfer

To prove constructive fraudulent transfer, a plaintiff must demonstrate each of the following elements:

There was a conveyance of an interest in property or the incurrence of an obligation.
Receipt of less than reasonably equivalent value (REV).
The transferor was or was rendered by the conveyance insolvent, inadequately capitalized or unable to pay its debts as they came due.

Reasonably Equivalent Value

The Court relied on the Plaintiffs' expert testimony to find that Tronox transferred property worth $17 billion and only received $2.6 billion in return, which indicates a lack of REV. While the Defendants did not disagree with these calculations, they raised the following three objections, all of which the Court rejected:

The transfer of the E&P Business, which occurred at the end of 2002, should be excluded from the reasonably equivalent value analysis because it took place seven years before the bankruptcy and therefore was outside of the Oklahoma UFTA's four year look-back period. The Court dismissed this objection because it could collapse these transactions, as it previously found they were part of a single integrated plan (see Actual Fraudulent Transfer). Therefore, the 2002 transfers fit within the four-year look-back period.
The waiver of an intercompany claim of $378 million owed by Tronox to NKM should be valued at face amount and treated as a contribution by NKM to Tronox to be added to the REV calculation. The Court also rejected this claim, explaining that there was insufficient evidence of the intercompany claim's existence and, even if it existed, the Court would treat it as equity rather than debt.
The REV analysis should be performed on a strict entity-by-entity basis. The Court disagreed and explained that doing so would wrongly elevate form over substance because Tronox operated its businesses, handled environmental liabilities and marketed the IPO on a consolidated basis, and further, no creditor had relied on the separate identity of the Tronox entities.

Insolvency

The Defendants relied on market evidence to prove Tronox's solvency, arguing that Tronox was solvent because it was able to:

Complete a successful IPO.
Obtain an offer from a private equity firm (Apollo) to purchase the chemical business.
Issue $450 million in secured debt and $350 million in unsecured bonds.

However, the Court rejected this market defense because the Plaintiffs' expert was able to successfully demonstrate that:

The financial statements on which the market relied were false and misleading. Also, financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP) may underestimate contingent liabilities because GAAP only requires disclosure of contingent liabilities that are "probably and reasonably estimable," while a solvency analysis requires assigning a fair value to each contingent liability.
The projections on which the IPO was based were inflated, sell-side projections and that key numbers were imposed at the direction of NKM's chief financial officer.
The significance of Apollo's offer to buy the chemical business was overstated because it contained many open items, included $504 million in indemnities for environmental and tort liability and was not even brought to the attention of NKM's board. The Court also dismissed Apollo's analysis of the legacy liabilities because it was limited to known environmental sites and therefore materially underestimated NKM's total exposure for the purposes of a valid solvency analysis.

The Court also rejected the Defendants' experts' valuation of Tronox's environmental and tort liabilities, noting that they did not provide independent analysis and merely critiqued the reports of the Plaintiffs' experts. Further, their extremely low estimate of Tronox's future environmental liabilities did "not pass the common sense test" and their extremely low estimate of Tronox's future tort liability lacked credibility. The Court found the Plaintiffs' experts more credible and essentially adopted the low-end of their estimates, valuing Tronox's environmental liability at $1.5 billion and its tort liability at $257 million, as of the date of the IPO. Combining these amounts with $1.27 billion in legacy liabilities and $803 million in other undisputed liabilities, the Court valued Tronox's total liabilities at slightly more than $2 billion.

Both the Plaintiffs and Defendants' solvency experts calculated the value of Tronox's assets by performing a discounted cash flow analysis, a comparable company analysis and a comparable transaction analysis. Again, the Court found the Plaintiff's expert to be more credible, adopting his finding that Tronox's assets were about $1.03 billion as of the date of the IPO. Therefore, valuing total liabilities at $2 billion, the Court concluded that Tronox was insolvent by about $850 million as of the date of the IPO.

The Court also found that based on the Plaintiffs' expert testimony:

Tronox was undercapitalized in light of its legacy liabilities.
The Defendants reasonably should have believed that Tronox would incur debts beyond its ability to pay as the became due.

Damages

The Court determined that the net value of the property fraudulently transferred was $14.459 billion. The Plaintiffs argued that they are entitled to recover this amount from the Defendants without any reduction because under section 550(a) of the Bankruptcy Code, to the extent a transfer is avoided under section 544 (among other sections), the trustee may recover, for the benefit of the estate, the property transferred or the value of the property of the property transferred.

Earlier in the case, the Court rejected the Defendants' argument that section 550 of the Bankruptcy Code caps the potential recovery on fraudulent transfer claims to the amount of unpaid creditor claims against a debtor's estate (see Legal Update, In re Tronox: SDNY Bankruptcy Court Rules That Bankruptcy Code Does Not Cap Recovery on Fraudulent Transfer Claims). However, the Defendants now argue that damages are limited by several other provisions of the Bankruptcy Code, including section 502(h), which provides that a recipient of fraudulent transfer may participate in the distribution of estate assets on the same basis as all other prepetition claims, following the recovery of the avoided transfer by the debtor. According to the terms of the confirmed plan, any allowed section 502(h) claim must be applied to directly offset any judgment against the Defendants in the fraudulent transfer litigation. The plan provides that this discount is determined by multiplying the value of the section 502(h) claim by the percentage recovery awarded to general unsecured creditors, as determined by the Court.

The Court left open a critical issue concerning how the section 502(h) claim should be calculated under the plan's provisions. Also, the plan reserved the parties' rights with respect to the dilutive effect of including the section 502(h) claim in the creditor pool when determining the percentage recovery for general unsecured creditors. The Court made provisional findings valuing the section 502(h) claim at $10.459 billion and the total offset at $9.308 billion, thereby reducing the damage award from $14.4 billion to $5.1 billion. However, it recognized that under another possible interpretation, the offset is only about $300 million, thereby reducing the damage award from $14.4 billion to $14.1 billion.

Given the lack of precedent on the application of section 502(h) and the complexity of the damage calculation, the Court declined to make a final ruling on damages and requested the parties to submit briefs on the issue.

On January 13, 2014, the Defendants submitted their brief, claiming that the offset is either $13.6 billion or $12.7 billion, making its total liability between $850 million and $1.76 billion.

Section 546(e) Safe Harbor

The Defendants argued that the transfers at issue were protected by the section 546(e) safe harbor, either as "settlement payments" or payments made by or to (or for the benefit of) a "financial participant" in connection with a "securities contract." Although the Court found that the Defendants waived these defenses by failing to raise them in a timely manner, it held that they would still fail on the merits.

First, the Court explained that the while the term "settlement payment" is broadly construed, it was not meant to protect the type of the transactions at issue, which included payments related to the internal restructuring and intercompany transfers of cash.

Second, the Court found that the 2005 agreements implementing the internal restructuring were not "contracts for the purchase, sale or loan of a security." Rather, the Court stated that these agreements just confirmed the allocation of assets and liabilities between the subsidiaries as contemplated in 2002 and that no consideration was paid for the purchase, sale or loan of a security.

For more information on the section 546(e) safe harbors, see Practice Note, Bankruptcy Code Avoidance Action Safe Harbors: Section 546(e) Safe Harbor: Stockholder's Defense.

Practical Implications

This decision represents the first time that the SDNY Bankruptcy Court has considered the application of the fraudulent transfer laws in the face of substantial environmental and tort liability. Company management and boards of directors considering undertaking similar transactions should note the manner in which the Court carefully scrutinized the company's decision-making process. This case serves as a warning and a reminder that fraudulent transfer risk should be evaluated at the start of any transaction. If the decision stands, it could have chilling effects on companies with substantial liabilities that are attempting a corporate restructuring outside of bankruptcy.

In re Tronox: Spin-off Ridding Assets of Massive Legacy Liabilities Avoided as Fraudulent Transfer | Practical Law