You are probably familiar with the Bankruptcy Code’s fraudulent transfer provisions, which allow a trustee to recover cash or assets that a debtor transferred away with actual intent to hinder, delay, or defraud its creditors. This can be a powerful tool in the hands of a trustee or creditors’ committee. See 11 U.S.C. Sec. 548(a)(1)(A).
But you may not have spent a lot of time thinking about how to prove intent when the debtor is a company. A company is a legal fiction; by itself, it can’t intend anything. And companies are typically made up of a lot of different people, including board members, officers, and employees. When it comes to fraudulent transfer litigation, who knew what, and who intended what, can be critical to creditor recoveries.
A recent decision by the New York district court provides a good example of how this works and how it can impact you.
In re Lyondell Chem. Co
Roughly one year before Lyondell Chemical Company (a Delaware corporation) collapsed into bankruptcy, its former shareholders had received $6.3 billion in distributions through a LBO. This included $100 million paid to its CEO through various stocks and options. The trustee alleged that Lyondell’s CEO had intended to defraud the company’s creditors by stripping it of assets to enrich himself and other shareholders, and that he accomplished this by knowingly presenting false financial projections to the company’s board of directors when the board considered approval of the LBO. The trustee asserted that the financials were inflated, unreasonable, and unachievable, and that consequently the LBO left the company inadequately capitalized and put creditors at great risk of a bankruptcy that could wipe out their claims.
The trustee’s lawsuit to avoid and recover these payments as actual fraudulent transfers hinged on whose intent would be imputed to the debtor. Would it be the scheming CEO? Or the duped board members?
Round One: The Bankruptcy Court Looks at the Board’s Intent
The bankruptcy court held that it was the intent of the board of directors that matters, and so it dismissed the trustee’s claim. Why? Under Delaware law, a corporation’s board of directors must approve a LBO. The court therefore felt that it was the intent of the company’s board, or a “critical mass” of the board members, which was essential to determining whether the company intended to defraud anyone.
Round Two: The District Court Imputes the CEO’s Intent to the Debtor
The New York district court disagreed and found that it was the CEO’s intent that mattered. Why? Because Delaware courts adhere to the “general rule of imputation.”
This means that Delaware corporations are held responsible for the acts and knowledge of their officers and directors acting within the scope of their authority… even when they act fraudulently. (The rule may seem harsh, but it is designed to incentivize corporations to create strong information systems and controls).
Similarly, when an employee acts within the scope of employment or has a duty to disclose information to his employer, the law assumes that the employer was aware of that information… even if the employee failed to disclose it.
Based on these two legal principles, the district court found that the CEO’s knowledge and intent could be imputed to Lyondell even though the CEO did not control the board and it was the board, not the CEO, that approved the LBO and the resuling shareholder payments.
The court went on to find that there were enough facts to create a strong inference that the CEO acted with actual intent to hinder, delay, and defraud Lyondell’s creditors. Because that intent could be imputed to the debtor, the court held that the trustee’s complaint would survive a motion to dismiss and that the litigation could continue.
Hey… What about Steve Bartman?
The district court also examined what “actual intent” means. The trustee had argued that debtors are presumed to intend the “natural consequences” of their actions, and that he would not need to prove the debtor actually wanted to, or believed it would, cause harm. The trustee lost this argument, and he could therefore have won the battle while ultimately loosing the war. The district court held that the standard for finding “actual intent” to defraud is higher, and that the trustee would need to prove more. He would need to establish as an additional element, actual intent and an awareness of the consequences, not just an awareness of the facts from which the consequences would arise.
What does that mean, exactly? Let’s say you’re Steve Bartman. You’re sitting at Wrigley Field drinking a beer and watching the Cubs play. You reach to catch a foul ball. A natural consequence of reaching for that ball is that you could disrupt the game. But to establish that you actually intended to cause the Cubs to lose requires more. Chicagoans would have to prove that you weren’t just foolish, but you actually intended to cost the Cubs the National League pennant.
So the trustee was arguing that he would only need to show that, by inflating financials and paying out huge sums to himself and other shareholders, a natrual consequence would be the creditors would be hindered, delayed, or defrauded in their recoveries. He may not have cared on whit about what happened to those creditors one way or another, as long as his actions, as a natural cosequence, hindered them. The district court held that the trustee would need to prove more. He would need to prove that the CEO actually thought about the creditors and intended to harm them or was conscious that he was harming them. (Legal geeks, you can curl up with the Yale Law Journal’s Intent to Defraud, published in 1915, to delve into these nuances.)