Restructuring News. Court-Authorized Post-Petition Payments by a Debtor of a Prepetition Debt May Not Reduce the Transferee s New Value Defense

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1 In This Issue Restructuring News 1 Court-Authorized Post-Petition Payments by a Debtor of a Prepetition Debt May Not Reduce the Transferee s New Value Defense 3 Delaware Supreme Court Curtails Rights of Creditors to Bring Derivative Suits Against Insolvent Delaware LLCs 5 Amendments to Rule 2019: To Join or Not to Join 8 Delaware Supreme Court Affirms Decision on Funds Legally Available for Redemption February 2012 Court-Authorized Post-Petition Payments by a Debtor of a Prepetition Debt May Not Reduce the Transferee s New Value Defense By Joseph N. Argentina, Jr. (215) Joseph.Argentina@dbr.com Many experienced business people are now familiar with the process by which their valid and successful debt collection efforts result in liability under the preference provisions of the Bankruptcy Code. As a result, once a company with which a vendor has been conducting business files for bankruptcy, one of the first questions becomes, How will actions from this point forward impact my liability for the payments I ve already received? Based on a recent decision from the Bankruptcy Court for the District of Delaware, the postpetition payment of pre-petition debts will not impact the creditor s ability to raise the new value defense to a preference claim. Under Sections 547 and 550 of the Bankruptcy Code, a Trustee may avoid certain transfers made to creditors in the 90 days leading up the filing of the debtor s bankruptcy petition. Section 547 sets forth the six elements to the Trustee s prima facie case (1) the debtor must make a transfer; (2) the transfer must be on account of an antecedent debt; (3) the transfer must be to or for the benefit of the creditor; (4) the transfer must have been made while the debtor was insolvent; (5) the transfer must have been within 90 days of the filing of the petition; (6) as a result of the transfer, the creditor must have received more than it would have received if the transfer had not been made and the creditor had asserted a claim in a hypothetical liquidation of the debtor s estate under Chapter 7 of the Bankruptcy Code. If the Trustee can prove its prima facie case, the Bankruptcy Code provides the creditor with several defenses. One such defense is found in Section 547(c) (4), the so-called new value defense. The new value defense provides that a creditor s liability for preferential transfers is reduced by the amount of goods or services delivered to the debtor subsequent to the preferential transfer. Specifically, Section 547(c)(4) provides: (c) The trustee may not avoid under this section a transfer (4) to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor (A) not secured by an otherwise unavoidable security interest; and Corporate Restructuring Practice Group 1

2 (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor 11 U.S.C. 547(c)(4). Like many provisions of the Bankruptcy Code, the new value defense is designed to create an incentive for creditors to continue to do business with a troubled company. Trade partners are encouraged to provide additional value to the debtor rather than cut their losses and discontinue the relationship, thereby putting additional strain on an already troubled enterprise and potentially hastening the debtor s slide into bankruptcy. As experienced preference defendants know, application of subsequent new value is often the first step in the analysis of the creditor s preference exposure. Trustees will often acknowledge the new value offset without dispute once both sides agree on the accuracy of the amounts delivered. Therefore, it may be in the creditor s best interest to continue to make deliveries to the troubled company, even as bankruptcy looms on the horizon. Courts do not agree as to the effect of post-petition payment of those deliveries. Under Section 547(c)(4)(B), a creditor is not entitled to new value if the debtor later paid for it with an otherwise unavoidable transfer. If a debtor, without court authorization, pays a prepetition debt after filing its bankruptcy petition, it is likely the transfer would be avoidable under Section 549 of the Bankruptcy Code, which prohibits unauthorized postpetition transactions. See Wallach v. Vulcan Steam Forging Co., Inc. (In re D.J. Management Group, Inc.), 164 B.R. 831, 836 (Bankr. W.D.N.Y. 1994) (noting that such a postpetition preference would be avoidable and therefore creditor would be entitled to credit for the new value the transfer repaid). However, courts often authorize debtors-in-possession to pay creditors for prepetition debts in order to preserve the business during the bankruptcy. For example, prepetition creditors are often paid pursuant to a critical vendor order. Such post-payments are therefore unavoidable. Several courts have concluded that post-petition unavoidable payments made by a debtor reduce the amount of new value that a creditor payee can claim. See Wallach, 164 B.R. at 836; MMR Holding Corp. v. C&C Consultants, Inc. (In re MMR Holding Corp.), 203 B.R. 605, 609 (Bankr. M.D. La. 1996); Moglia v. Amer. Psychological Assoc. (In re Login Bros. Book Co., Inc.), 294 B.R. 297, (Bankr. N.D. Ill. 2003). These courts reason that the plain text of the Bankruptcy Code reduces the amount of a creditor s new value setoff to the extent the new value was paid with an unavoidable transfer, regardless of the timing of the transfer. Furthermore, one of the policies behind the new value exception is the replenishment of the estate by the creditor s delivery of the new value. That policy, some courts contend, would be defeated if the creditor were allowed to keep the original preferential payment of its debt on account of the subsequent new value contribution to the estate and also receive repayment of that contribution. Moglia, 294 B.R. at 301; MMR Holding, 203 B.R. at 609. Other courts have held that the new value analysis freezes as of the petition date. Consequently, payments made by the debtor post-petition, even though they are unavoidable, will not reduce a creditor s new value defense. Most recently, in Friedman s Inc. v. Roth Staffing Co., L.P. (In re Freidman s), Judge Christopher Sontchi held that post-petition payment of new value does not affect the preference analysis, even if the debtor completely compensates the creditor for its pre-petition claim. Adv. No (CSS) slip op. (Bankr. D. Del. Nov. 30, 2011). In Friedman s, Roth Staffing Co. ( Roth ) provided staffing personnel to Friedman s Inc. ( Friedman s ). Prior to the petition date, Friedman s had paid $81, to Roth. Subsequent to those payments but prior to the petition date, Roth provided additional staffing services in the amount of $100, which remained unpaid as of the petition date. On or about the petition date, Friedman s moved the court to pay Roth s employees in order to preserve the business during the bankruptcy. Otherwise, Roth s personnel would have either walked off the job or created an unacceptable morale problem. Friedman s paid $72, post-petition to Roth pursuant to a bankruptcy court order. Friedman s later sued Roth, seeking to recover $81, as a preference. Roth asserted a new value defense to the suit. Friedman s filed a motion for partial summary judgment, seeking to have Roth s new value defense reduced by the amount of the post-petition transfer. After reviewing preference actions, the new value defense, and post-petition payments generally, the court noted that both parties relied on plain meaning arguments which were fundamentally flawed. Roth argued the term debtor in Section 547 referred exclusively to Corporate Restructuring Practice Group 2

3 the prepetition entity. Therefore, according to Roth, since new value must be to or for the benefit of the debtor, and the new value cannot be paid by a debtor with an otherwise unavoidable transfer, the preference calculation is fixed on the petition date at which point a debtor ceases to exist. Similarly, Friedman s argued that Section 101 of the Bankruptcy Code defines debtor as a person or municipality concerning which a case under this title [11] has been commenced. Therefore, according to Friedman s, a debtor does not exist until the case has been commenced. The court rejected both of these arguments by concluding that a debtor and a debtor-in-possession are not separate legal entities. According to the opinion, a debtor is a corporate entity that exists both pre- and post-petition. However, the court noted that the Third U.S. Circuit Court of Appeals in New York City Shoes, Inc. v. Bentley Int l Inc., 880 F.2d 679 (3d Cir. 1989), had held that the subsequent new value defense under section 547(c)(4) has three elements: (1) the creditor must have received a transfer that is otherwise voidable as a preference under section 547(b); (2) after receiving the preferential transfer, the preferred creditor must advance new value to the debtor on an unsecured basis; and (3) the debtor must not have fully compensated the creditor for the new value as of the date that it filed its bankruptcy petition. Id at *10 (emphasis in original). Therefore, the court concluded that the new value defense is frozen as of the petition date. Subsequent transfers of new value, as well as subsequent repayment of prepetition new value, do not affect a creditor s liability. In conclusion, a creditor who has provided subsequent new value to a debtor prior to the petition date faces the possibility that post-petition payments can reduce its new value defense. The decision by the Delaware bankruptcy court is one of the few opinions to squarely address this problem and provides some comfort and ammunition to creditors that payments received post-petition might not impact the new value defense. Delaware Supreme Court Curtails Rights of Creditors to Bring Derivative Suits Against Insolvent Delaware LLCs By Michael Pompeo (212) Michael.Pompeo@dbr.com If you are a creditor of a Delaware limited liability company and wish to pursue derivative claims on behalf of an insolvent company against the company s present or former managers based on breaches of fiduciary duties, you may be out of luck. The Delaware Supreme Court recently decided in CML V LLC v. Bax, 2011 Del. LEXIS 480 (Sept. 2, 2011), that creditors rights against limited liability companies differ from those against corporations. According to the Court in Bax, creditors of Delaware limited liability companies lack standing to pursue derivative claims under the Delaware Limited Liability Company Act (the LLC Act ) and specifically 6 Del. C and This may come as a surprise to many litigators and advisors because it is well settled that creditors of a Delaware corporation may pursue derivative claims against officers and directors of an insolvent corporation. See, N. Am. Catholic Educ. Programming Fund, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007). In Bax, CML V LLC ( CML ) was a junior secured creditor of JetDirect Aviation Holdings, LLC, a Delaware limited liability company. JetDirect was a private jet management and charter company. Beginning in 2005, JetDirect began acquiring small and midsized competitor charter and service companies. In 2006, JetDirector s board of managers became aware of deficiencies in its accounting systems and internal controls. A year later, its auditors declined to complete their audit because they could not rely on the company s internal books and records. To compound problems, JetDirect s board of managers decided in 2007 to consolidate its billing, accounting and other operations. This action exacerbated the internal control deficiencies and impaired management s ability to prepare current operating and financial reports. Despite these accounting and control deficiencies, the board of managers approved four major acquisitions in late Also in 2007, CML loaned JetDirect in excess of $34 million on a junior secured basis. The acquisitions caused JetDirect to be highly leveraged and subject to volatile swings in cash flow. By Corporate Restructuring Practice Group 3

4 2008, JetDirect was insolvent and began liquidating its assets to lessen its debt burden. Notwithstanding the liquidation of assets, JetDirect was unable to repay any of its obligations owed to CML. Consequently, on March 26, 2010, CML filed a Complaint in the Delaware Court of Chancery asserting, inter alia, derivative claims against JetDirect s present and former managers, arguing that the managers: 1) breached their standard of care in approving the 2007 acquisitions without adequate information concerning JetDirect s true financial condition, 2) acted in bad faith by failing to implement and maintain adequate internal controls, and 3) certain managers breached their duty of loyalty by benefitting from self-interested sales of assets as part of JetDirect s liquidation process. On May 27, 2010, JetDirect and the individual managers moved to dismiss the Complaint. The Court of Chancery granted the motion on the basis that CML, as a creditor, lacked standing to pursue derivative claims. CML appealed the Chancery Court s decision and the Supreme Court affirmed. The Supreme Court held that the Delaware LLC Act is unambiguous in limiting derivative standing to limited liability company s members or assignees. Limited liability companies came into existence in 1992 when the Delaware General Assembly passed the LLC Act. In passing the LLC Act, the General Assembly authorized the assertion of a derivative action on behalf of a limited liability company. Specifically, section of the LLC Act, entitled Right to bring action, provides: A member or an assignee of a limited liability company interest may bring an action in the Court of Chancery in the right of a limited liability company to recover a judgment in its favor if the managers or members with authority to do so have refused to bring the action or if an effort to cause those managers or members to bring the action is not likely to succeed. 6 Del. C The General Assembly also proscribed who may bring a derivative action on behalf of a limited liability company. Section of the LLC Act, entitled Proper plaintiff, provides: In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and: 1) At the time of the transaction of which the plaintiff complains; or 2) The plaintiff s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the term of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transaction. 6 Del. C In holding that creditors lack standing to bring a derivative action, the Delaware Supreme Court compared the use of the word may in section with the use of the word must in section Section provides that a member or assignee may bring an action in the right of a limited liability company, whereas section expressly limits standing to bring such an action by providing that the plaintiff must be a member or assignee. The Court found that the plain language of section was unambiguous in its limitation of derivative standing to LLC members and assignees. On appeal, CML argued that such a limitation was an unconstitutional encroachment on the Court of Chancery s equitable jurisdiction to extend standing to sue derivatively to prevent a complete failure of justice. At common law, courts of equity confer standing to stockholders of a corporation to sue on behalf of the corporation for managerial abuse. Courts recognize that management is predisposed not to pursue claims for breach of fiduciary duties and stockholders would be without a remedy in the absence of granting equitable standing. Derivative standing finds its roots in English common law and was recognized by Delaware courts long before ratification of the Delaware Constitution. See, Schoon v. Smith, 953 A.2d 196, 201 (Del. 2008). Delaware courts have extended to derivative standing to creditors of an insolvent corporation. See, N. Am. Catholic Educ. Programming Fund, Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). In Bax, the Delaware Supreme Court noted that the Delaware Constitution prohibits the General Assembly from reducing the Court of Chancery s general equity jurisdiction from what existed at the time the United States separated from England. The Court noted that corporations and corporate derivative standing pre-date Corporate Restructuring Practice Group 4

5 Delaware s General Corporate Law statutes. Neither limited liability companies nor limited liability company standing existed prior to Because the Delaware legislature created the right to sue a limited liability company derivatively, the Court held that it could interpret common law to override the LLC Act s express provisions. In reaching this conclusion, the Court opined that CML had an adequate remedy at hand which belied the need for derivative standing. The Court reasoned that CML Amendments to Rule 2019: To Join or Not to Join By Andrew E. Weissman (312) Andrew.Weissman@dbr.com could have negotiated for a right to convert its interest in the loan to that of an assignee or for control of the LLC s governing body in the event of an insolvency. The Court reasoned that the inability to negotiate such protective provisions in the loan documents did not result in an injustice. What remains to be seen is whether Delaware courts will reach a similar conclusion if a claim is brought by a trade creditor who may not enjoy the same leverage as a lender to negotiate the protections suggested by the Court. New amendments to Federal Rule of Bankruptcy Procedure 2019 were recently adopted in an attempt to clarify requirements surrounding file 2019 statements in Chapter 11 bankruptcy cases. Prior to the amendments, which were adopted Dec. 1, 2011, Rule 2019 was often applied in an inconsistent haphazard manner resulting in a great deal of uncertainty regarding who was required to file the statement and under what circumstances that statement was required to be filed. The Original Rule 2019 The old version of Rule 2019 required any entity 1 or unofficial committee representing more than one creditor or equity security holder in a bankruptcy proceeding, or an indenture trustee, to disclose: (1) the name and address of the creditor or equity security holder; (2) the nature and amount of the claim or interest and the time of acquisition thereof unless it is alleged to have been acquired more than one year prior to the filing of the petition; (3) a recital of the pertinent facts and circumstances in connection with the employment of the entity... ; and (4)... the amounts of claims or interests owned by the entity, the members of the committee or the indenture trustee, the times when acquired, the amounts paid therefore, and any sales or other disposition thereof. Fed. R. Bankr. P. 2019(a) (2010) (amended 2011). Official committees appointed under Section 1102 or 1114 of the Bankruptcy Code were not required to file any statement under the original rule. In practice, however, old Rule 2019 was often inconsistently applied. For example, some courts held that Rule 2019 applied to ad hoc committees of equity security holders or noteholders, thus requiring disclosure. Other bankruptcy courts have held that steering groups and ad hoc committees of noteholders were not committee and therefore were not required to make disclosures under Rule Still other courts have been inconsistent with the type and quality of information to be disclosed. For example, some courts have required only the names and addresses of the members of the disclosing group, while others demanded detailed disclosure including the amount of claims, the dates claims were acquired and information related to the formation of the committee. Amendments to Rule 2019 In response to the conflicting case law from various bankruptcy courts, the Committee on Rules of Practice and Procedure of the Judicial Conference of the United States (the Rules Committee) proposed amendments to Rule 2019 that not only attempted to standardize the disclosure requirements across all courts, but also placed much more detailed disclosure requirements on each member or a group or committee, or on creditors 1 Entity in this context generally refers to an attorney or law firm, but could also apply to a financial advisor or expert witness. Corporate Restructuring Practice Group 5

6 represented by the same entity. The amended rule, as originally proposed by the Rules Committee, would have further required every group or committee, or any entity that represents multiple creditors, to file a verified statement that sets forth all the disclosable economic interests of each creditor represented by the group, committee or entity, regardless of whether such interest was represented by the Committee. In addition to requiring the disclosure of the name of the members of the group or committee, and the nature and amount of each disclosable economic interest held in relation to the debtor, the initial draft of the proposed amendment also required entities subject to Rule 2019 to disclose sensitive economic information, including the price paid for each disclosable economic interest and the date of purchase of each disclosable economic interest. Needless to say, many groups, including those involved in banking and debt trading, objected to the breadth of the proposed disclosures, particularly the requirement that creditors disclose the price paid for their economic interest and the date of purchase. These groups argued that requiring the disclosure of the price paid for interests and the date those interests were acquired would allow the public to glean parties investment strategies and could discourage trading in the secondary debt market or at least scare off investors from participating in ad hoc committees or joint representations. In the end, the Rules Committee decided to adopt a middle ground and left out some of the more objectionable disclosure requirements, but also sought to clarify when disclosure is required. As amended, new Rule 2019 generally requires disclosure of economic interests held by creditors or equity security holders who are members of a group or committee, or who are represented by a common entity, that are acting in concert to advance their common interest. Under the rule, represent means to take a position before the court or to solicit votes regarding the confirmation of a plan on behalf of another. Disclosible economic interests are defined very broadly and include claims, interests, liens, pledges, derivatives, options, participations and any right or derivative right granting the holder an economic interest that is affected by the value, acquisition, or disposition of a claim or interest. In essence, almost every interest of a creditor who is a member of a group or committee, or who is represented by a common entity, must be disclosed if Rule 2019 is triggered, not just those interests that are represented by the group or committee. Thus, for example, if a creditor is part of an ad hoc group of bondholders, but it also separately holds an option to purchase shares of the debtor, both its interest in the debtor s bonds and its option must be disclosed. The disclosures that must be made under amended Rule 2019 also require information about the formation of the group or committee, including the name of each entity at whose instance the group or committee was formed or for whom he group or committee has agreed to act. With respect to an entity, the rule requires disclosure of the pertinent facts and circumstances concerning the employment of the entity, including the name of each creditor or equity security holder at whose instance the employment was arranged. Amended Rule 2019 further requires disclosure of information about the identities and disclosable economic interest held by three levels of participants: (i) the creditors or equity holders represented by the committee, group or entity, (ii) the members of the group or committee, and (iii) any entity representing a group or committee. When a group or committee claims to represent parties who are not members of the group or committee, amended Rule 2019 requires that the members also reveal the year and quarter in which they acquired their economic interests (unless acquired more than a year before the commencement of the bankruptcy case). Supplemental disclosures are required for material changes in the disclosed facts when any entity or group takes a position before the court or solicits votes on a plan. The rule allows the court to impose penalties in the event of noncompliance, including by refusing to hear, or invalidating acceptances and rejections given by, the entity, group or committee. Although the rule gives the court discretion to grant other appropriate relief, it is notable that the enumerated penalties apply to entities, groups and committees, rather than to the individual interest holders represented by them. Of note, amended Rule 2019 specifically excludes indenture trustees, agents under agreements for the extensions of credit, class action representatives and governmental units from the Rule s disclosure requirements unless a court orders otherwise. These entities were likely excluded for two reasons. First, the purpose of indenture trustees and class action representatives is to represent a class or group of creditors. That group of creditors represented by an indenture trustee or class action representative could include hundreds or thousands of interest holders, many of whom are anonymous. Second, these entities represent creditors or equity holders under formal legal arrangements of trust and contract law that govern and limit their role, such as an indenture governing Corporate Restructuring Practice Group 6

7 the responsibilities of an indenture trustee, or a credit agreement governing the role and responsibility of an agent bank. Another significant departure from the old version of Rule 2019 is that official committees are no longer excluded from the disclosure requirements. The information required to be submitted by official committees under amended Rule 2019, however, is more limited than it is for other parties. Generally, official committees must disclose the names, addresses, claim amounts and other economic interests of each member of the committee, but need not disclose the circumstances of the committee s formation, for whom the committee has agreed to act and about the economic interests held by the creditors that the committee represents. Also, unlike ad hoc committee members or other groups subject to Rule 2019, the members of an official committee are able to claim to represent entities outside the committee without being subject to the additional requirement that each member provide information about the date that they acquired their claims. Indeed the purpose of committee appointed under the Bankruptcy Code is to represent the interests of other creditors or equity holders. Implications of the Amended Rule 2019 Clearly, any creditor that is considering joining with other creditors to form an ad hoc committee or group must consider the disclosure requirements of Rule 2019 before agreeing to be part of such committee or group. Likewise, investors considering a purchase of a claim or other interest in a debtor through the secondary market should consider what level of involvement is necessary for the investor to protect its interest. If joining with one or more other creditors is necessary, than the investor may be subject to the disclosure requirements of Rule While the rule is now clear in most instances when a 2019 statement will need to be filed, there remain several unanswered questions. First, it appears that the rule does not apply to a situation where one attorney represents several different creditors with different claims and interests. For example, it is common for many trade creditors or landlords to hire the same attorney to represent them in a particular bankruptcy case because of that attorney s familiarity with the case and economies of scale created by the representation of multiple creditors in the same case. In those instances, so long as the attorney is not taking a position before the court on behalf of several creditors, but is only appearing individually for each client, then disclosure is likely not required. However, similarly situated clients, like trade creditors or landlords, may be concerned about the same issues in a bankruptcy case. At what point do separate creditors represented by the same attorney with some of the same issues start acting in concert to advance their common interests? Where an attorney takes the same position before the court on behalf of several creditors, or files a pleading on behalf of multiple creditors, then the disclosure requirements will likely be triggered. Still, the exact confines of what constitutes acting in concert remains an open issue. Second, while a creditor must disclose all of its own disclosible economic interests, must it disclose the interests of its affiliates or subsidiaries? If a subsidiary takes a position in a bankruptcy case or solicits votes regarding confirmation, is it acting in concert with its parent? Third, do parties to a lock-up agreement supporting a plan or strategy in a bankruptcy case constitute a group that must file a 2019 Statement? What about lenders who act in concert to credit bid for a debtor s assets? Fourth, what about defendants subject to a joint defense agreement, such as defendants who have banded together to defend common issues, such as preferences or fraudulent conveyances. Is that type of group subject to Rule 2019? These questions and many more will likely remain unanswered until they are tested in court. As such, creditors and other parties in interest will need to carefully consider how they will protect their interests in bankruptcy cases and whether active participation is preferable to acting as a more passive observer. Each party-in-interest will need to determine if it is best served by: (1) joining a group or committee that is represented in the proceedings, thus becoming subject to amended Rule 2019 disclosure requirements, (2) securing separate and independent counsel while incurring the expense of its own representation in the bankruptcy process, or (3) remaining a passive player in the bankruptcy process without any formal representation. As always, businesses and individuals should seek the advice of experienced bankruptcy counsel before making an uniformed decision that could leave them subject to disclosure requirements or otherwise prejudiced in the bankruptcy case. Corporate Restructuring Practice Group 7

8 Delaware Supreme Court Affirms Decision on Funds Legally Available for Redemption By Samuel Mason (215) Summary and Facts The Delaware Supreme Court has affirmed a Chancery Court holding that a corporation s board of directors was entitled to conclude that it did not have funds legally available to redeem preferred stock within the meaning of the mandatory redemption provisions of its certificate of incorporation. The board s conclusion was predicated upon the absence of cash availability, and was supportable even assuming net assets exceeded the redemption amount as required by Delaware General Corporation Law ( DGCL ) restrictions on redemptions. In SV Investment Partners, LLC et al. v. ThoughtWorks, Inc. (Del. 2011), published by the court on November 15, 2011, SV Investment Partners and affiliated funds (SVIP) invested $26.6 million in the preferred stock of a Delaware corporation called ThoughtWorks, Inc., an information technology services firm. ThoughtWorks Certificate of Incorporation was amended to include a provision (the Redemption Provision) that on and after the fifth anniversary of the closing, SVIP would be entitled to require ThoughtWorks to redeem the preferred stock for cash out of any funds legally available therefor. Also, ThoughtWorks was required to value its assets at the highest amount permissible for purposes of calculating the amount it could legally pay under the DGCL. Starting in 2005 SVIP sent a number of demand letters exercising its redemption rights. The board of ThoughtWorks determined from time to time the amount of funds legally available and made several redemptions to that extent, totaling $4.1 million. In 2007 SVIP filed suit in the Court of Chancery seeking a declaratory judgment to establish the meaning of the phrase funds legally available. During discovery and settlement negotiations, ThoughtWorks sought financing for a potential redemption but none was consummated. In 2010 the board obtained financial advice that ThoughtWorks net asset value was in the range of $ million and its cash availability in the range of $1 3 million. The board, however, felt that cash availability was zero, taking into account certain adverse circumstances, and refused to make any further redemption at that time. In November 2010, the Court of Chancery concluded that funds legally available meant cash funds on hand in an amount not exceeding net assets, as defined in Section 154 of the DGCL, and that Thoughtworks board was entitled to deference when it determined that the company did not have sufficient cash. The Delaware Supreme Court has now affirmed this holding. Meaning of Funds Legally Available Therefor The Redemption Provision stated that redemption was to be made out of funds legally available therefor. Section 160 of the DGCL prohibits a redemption of stock when the capital of the corporation is impaired (Section 170 does the same with respect to dividends). Capital is impaired if funds used to redeem stock exceed the amount of the corporation s surplus, which is defined by Section 154 of the DGCL to mean the excess of net assets over the par value of the corporation s issued stock. Net assets are the amount by which total assets exceed total liabilities. SVIP argued that funds legally available means an amount equal to net assets as determined based on a financial valuation of the company, without regard to whether net assets consist of cash, property, plant and equipment, inventory, goodwill or some other asset. If net assets exceed the redemption amount, then the company has an obligation to pay, and if it cannot do so because of inadequate cash flow, then SVIP would be entitled to a judgment that it could attempt to enforce in the normal course, presumably in the bankruptcy arena. The Chancery Court on the other hand used Black s Law Dictionary and various other dictionaries to define funds, legally and available, and concluded that the phrase means cash that is obtainable and ready for use in conformity with applicable law. A corporation can have cash that is not legally available, or a corporation can lack cash yet have the legal capacity to make a redemption, using other corporate property, if it had a surplus. Corporate Restructuring Practice Group 8

9 Calculation of Net Assets The Chancery Court, and in reviewing the Chancery Court holding, the Supreme Court, also analyzed the definition of net assets assuming for purposes of argument that SVIP was correct when it asserted that funds legally available means that net assets exceed the redemption amount without regard to the nature of the assets. SVIP s expert used the discounted cash flow, comparable companies and comparable acquisition methods to show that ThoughtWorks net assets were in the range of $ million, well above the amount necessary to redeem the preferred stock. However, the Chancery Court said that the assets must be valued based on real economic value that the corporation may borrow against or the creditors may claim or levy upon, citing Klang v. Smith s Food & Drug Centers, Inc., 702 A.2d 150, 154 (Del. 1997). Thus the court appears to use the kind of analysis that an asset based lender might use, wishing to ensure that a loan could be paid off by sale, within a reasonable time table, of equipment, inventory, receivables, and similar salable assets. In contrast, the expert s methodologies are geared to a valuation of the company as a going concern (including goodwill). Also, the expert s testimony was held insufficient to show that net assets were sufficient for the redemption payment, because She did not consider the amount of funds ThoughtWorks could use for redemption while continuing as a going concern She did not consider how making the redemption would affect ThoughtWorks ability to achieve the projections on which her analysis relied She did not consider how Thoughtworks might raise the funds for the redemption These criticisms might seem somewhat inconsistent with the court s purported acceptance of SVIP s position that the exercise requires only a calculation of net assets without regard to whether the assets included cash. The explanation may be that the valuation did not take the redemption into account on a pro forma basis, and doing so would have reduced the valuation. Deference Due to Board Decisions Both the lower and higher SVIP courts held that Thoughtworks board was entitled to deference in making the decision as to whether it had funds legally available, unless it acted in bad faith, relied upon unreliable methods or made a decision constituting fraud. This point is underscored by comparing the situations in SVIP and the Klang case cited in SVIP. In SVIP the board decided not to make the required redemption, and in Klang the board wanted to make the redemption as part of a larger transaction. The Klang decision permits corporations to revalue their book assets and liabilities for purposes of the DGCL Sections 154 and 160 restriction on redemptions. If a corporation has not yet realized or reflected on its balance sheet an appreciation of assets, it may do so prior to redeeming stock. In the Klang case, the corporation s investment adviser valued the assets under the market multiple approach and subtracted long term debt. The plaintiff argued that had $372 million in current liabilities been taken into account, the corporation would have had a negative net worth and would not have been able to make the redemption. The Klang court said that Section 154 simply defines net assets and does not mandate a facts and figures balancing of assets and liabilities to determine by what amount total assets exceeds total liabilities. The statute is merely definitional and does not require any particular method of calculating surplus but simply prescribes factors that any such calculation must include. So, the Klang board was permitted to make a redemption by revaluing its book net assets and going to a market multiple approach instead of a line-by-line review and adjustment of its balance sheet. For the Klang court, this was real economic value. The Chancery Court in SVIP used the phrase real economic value to require an asset-based method, and while rejecting the expert s valuation methodologies used the phrases speculative figures and highest valuation possible with a straight face even though the Redemption Provision required the SVIP Board to use the highest permissible valuation, and Klang, upon which SVIP relied, permitted a market multiple approach. The common thread here is judicial support for the determinations of the boards of directors. Corporate Restructuring Practice Group 9

10 Common Law Restriction on Redemptions Based on the SVIP court s view that that phase funds legally available means cash legally available, one might think that a different outcome might have resulted had the Redemption Provision read property legally available or simply required the redemption to be made unless contrary to Section 154 and 160. However, the Chancery Court cited a number of cases for the proposition that the common law restricts a corporation from redeeming its shares when insolvent. The court explained that the common law restriction and the DGCL restriction are separate, the DGCL does not codify the common law restriction, and a proposed redemption must be permissible under each. Even if assets exceed liabilities so that a corporation is solvent in a balance sheet sense and could make a redemption under the DGCL, a corporation may still be prohibited from a redemption unless a cash flow analysis shows that thereafter it would be able to pay its debts as they come due, which the Chancery Court said is a component of the common law restriction. Thus, in effect a corporation must have available cash to make a redemption even if that concept is not part of the document providing for mandatory redemption or if the board wishes to make the redemption in the absence of a written requirement to do so. Comparison of Redemption Restrictions and Uniform Fraudulent Transfer Act The two SVIP standards for making redemptions are similar to those embodied in the Delaware Uniform Fraudulent Transfer Act, which applies to transfers of property other than redemptions, whether made by a person or a business entity. Any transfer is voidable if made without fair consideration and if either the sum of the [transferor s] debts is greater than all of the [transferor s] assets, at a fair valuation, or the transferor intended to incur, or believed or reasonably should have believed that the [transferor] would incur, debts beyond the [transferor s ability to pay as they became due. The federal bankruptcy code also has similar provisions. Lessons Learned The basic lessons to be learned from the SVIP case, where Delaware is the controlling law, are: The funds legally available language often seen in redemption provisions means cash legally available, and even in the absence of such language a board may not authorize a redemption unless the corporation s net assets exceed the redemption amount, and the corporation will be able to pay its debts as they come due. A corporation must comply with both the DGCL and the common law. The board of directors has considerable leeway in how it calculates net assets. It may use an assetbased method if it wants to avoid a redemption, or a multiple of earnings or other valuation if it wants to justify a redemption. A valuation of net assets should take into account the effect of making the redemption. To maximize the chance that mandatory redemption will in fact be paid, an investor could seek to include in the redemption provision one or more of the following: (1) a requirement to raise cash by selling assets or to make the redemption by transferring specified non-cash assets (however if the assets are valued at more than the redemption obligation, such a transaction could be voided as a fraudulent conveyance), (2) a number of different valuation methodologies, requiring the board to use the one yielding the highest number, (3) the phrase property legally available, and/ or (4) a favorable methodology for a cash flow analysis. Additional strategies for the investor might include: (1) requiring a debt instrument instead of preferred stock, with a conversion feature or warrants, and (2) in the event mandatory redemption is not made when required, providing for board representation and/or issuance of additional stock. Corporate Restructuring Practice Group 10

11 Corporate Restructuring Practice Group Other Publications Timothy R. Casey (312) Howard A. Cohen (302) Maria A. Dantas (973) Andrew J. Flame (215) Kristin K. Going (202) Andrew C. Kassner (302) In the News Andrew J. Lorin (212) Robert K. Malone (973) Michael P. Pompeo (212) Frank F. Velocci (973) Steven M. Wagner (312) Sign Up Drinker Biddle s First Year Development Program Featured in the New York Times Drinker Biddle s innovative First Year Associate Development Program was featured on the front page of the New York Times Sunday, Nov. 21, The article, What They Don t Teach Law Students: Lawyering; Schools Leave Practice Training to Firms, discussed law schools emphasis on the theoretical and clients unwillingness to pay on the job practical training. The firm s First Year program was highlighted as a solution to the problem. To view the article, please click here. Kristin Going Speaks at American Bankers Association Conference Washington, D.C., Partner Kristin Going spoke in October at an American Bankers Association conference on recent case law involving indenture trustees and securitization trustees. The event, Corporate Trust 2011: Turmoil = Opportunity, was held Monday, Oct. 17, 2011, at the Mayflower in D.C. Kristin s panel, Litigation Affecting Trustees: Cases, Trends and Business Lessons explored clawback issues and trustee s obligations with regard to CDO bond issues. Andy Kassner and Joe Argentina Author Article for Legal Intelligencer Wilmington and Philadelphia partner Andy Kassner and associate Joe Argentina co-authored an article for the Legal Intelligencer titled, Fiduciary Duties of Directors and Officers Scrutinized in Bankruptcy Case. The article, published Jan. 12, 2012, discusses the case of Official Committee of Unsecured Creditors, on behalf of the Estate of Lemington Home for the Aged v. Baldwin, et al., and the myriad legal issues and exposure that may confront a corporation s directors when a non-profit finds itself in financial and management distress. In that case, the Third Circuit vacated a decision of the United States District Court for the Western District of Pennsylvania, granting summary judgment in favor of the defendant directors and officers of a debtor and dismissing the Creditors Committee s complaint that alleged causes of action for breach of fiduciary duty and deepening insolvency. The case was remanded to the District Court. The Third Circuit s decision discusses the standard for asserting causes of action against officers and directors, and when such defendants can assert the defense of in pari delicto to defeat such claims. Andy and Joe analyze the facts and the Third Circuit s opinion and conclude that the decision is a reminder that by agreeing to be an officer or director of a corporation, one assumes responsibilities that can later be the subject of intense scrutiny in litigation if the organization fails. Andrew Lorin Speaks at Life Insurance Industry Symposium New York Partner Andrew Lorin joined several members of the firm s Life Insurance & Annuities Practice Group in December as it hosted Anticipating Tomorrow: A Symposium on Emerging Legal Issues in Life Insurance in Philadelphia. Philadelphia partner Stephen Baker, leader of the firm s Life Insurance & Annuities Practice Group, co-chaired the event with Elizabeth McCrohan of Prudential Insurance Company of America. Topics included at the symposium included Ponzi Schemes and Receiverships, Unclaimed Property Issues, Emerging Fraudulent Schemes, Privacy and Social Media Issues and Equity-Indexed Life Insurance Products. Drinker Biddle Representing Largest Unsecured Creditor in American Airlines Manufacturers and Traders Trust Company ( M&T ) has tapped Kristin Going to represent it in its capacity as indenture trustee for 8 issues of municipal bonds totaling $1.4 billion of principal debt outstanding. M&T was selected by the United States Trustee as one of the nine members of the American Airlines Official Committee of Unsecured Creditors (the Committee ). Kristin and the Drinker team which includes Bob Malone, Maria Dantas and Steve Wagner are assisting M&T fulfill its fiduciary obligations to all unsecured creditors as a member of the Committee as well as address the needs and concerns of the municipal bondholders. American Airlines and its subsidiaries filed bankruptcy on November 30, 2011 in the United States Bankruptcy Court for the Southern District of New York. Corporate Restructuring Practice Group CALIFORNIA DELAWARE ILLINOIS NEW JERSEY NEW YORK PENNSYLVANIA WASHINGTON DC WISCONSIN 2012 Drinker Biddle & Reath LLP. All rights reserved. A Delaware limited liability partnership. Jonathan I. Epstein and Edward A. Gramigna, Jr., Partners in Charge of the Princeton and Florham Park, N.J., offices, respectively. This Drinker Biddle & Reath LLP communication is intended to inform our clients and friends of developments in the law and to provide information of general interest. It is not intended to constitute advice regarding any client s legal problems and should not be relied upon as such.