bankruptcy litigation roundtable · a tort cause of action partially because fiduciary duty claims...

Bankruptcy Litigation Roundtable New York City – March 14, 2012

Hosted by the Institutional Investor Educational Foundation (IIEF)

Moderator: Judge Arthur Joseph Gonzalez

Executive Summary

(Read the Full Discussion Summary on Page 3) The March 2012 Bankruptcy Litigation Roundtable was attended by 30 people chosen for their diverse, high level involvement in restructuring and bankruptcy litigation. They included prominent restructuring advisors, institutional investors, creditor committee attorneys, trustees, bankruptcy litigators, academicians and board members. Judge Gonzalez not only moderated the discussion but also provided a valuable perspective as a judge who has presided over many major bankruptcy cases. The discussion topics included:

Can Gheewalla and Lemington be reconciled? Are deepening insolvency claims still a concern? Should they be?

Do professionals now have a free pass? The ever-strengthening in pari delicto defense

Have LP’s lost their fiduciary rights? Has the law failed to protect investors or can sophisticated investors protect themselves?

Are trustee clawbacks v. LBO shareholder sellers an abuse of innocent investors?

Are fraudulent conveyance actions v. LBO sponsors an abuse of innocent PE firms?

Does Liberty Media show the way to strip the cupboard and leave bondholders high and dry?

Everyone agreed that bankruptcy law is rapidly evolving, with current cases in circuit courts throughout the nation continuing to affect the options available to shareholders, creditors and debtors to recoup their losses – and the degree to which board members can be held accountable for their decisions. The evolving legal landscape continues to create uncertainty in the marketplace. The first 45 minutes of discussion focused on Lemington and its ramifications for deepening insolvency claims. The discussion was lively, with participants often (but respectfully) disagreeing with one another. Some, including Judge Gonzalez, questioned why deepening insolvency should be a separate cause of action, while others believed creditors deserve a direct cause of action because the breach of fiduciary action in Delaware is a dead end for them.

03/14/2012 Bankruptcy Litigation Roundtable iief.org

Roundtable Discussion Executive Summary—Continued

There was a lot of discussion about deepening insolvency as a theory of damages – as well as discussion about the potential for lenders to be targeted as defendants in a deepening insolvency tort. The conversation about in pari delicto was particularly animated, with participants discussing cases in which they have been directly involved. There was widespread agreement that forum shopping is a big consideration. If you call it a tort, that opens up a lot of potential forums for in pari delicto cases. The question of whether clawbacks v. shareholder sellers are an abuse of innocent investors led to a heated discussion about the responsibility of directors to simultaneously maximize equity value while mini-mizing tail-end risk. The participants generally agreed that recent clawback cases have been disruptive to the market. The potential for clawback has created an additional layer of risk and uncertainty for boards, and the distribution of clawback proceeds is not always clear or predictable. The Liberty Media case has likewise created uncertainty in the marketplace. Bondholders are naturally worried about being left with bad assets by companies that engage in a prolonged disaggregation strategy. The lack of a bright-line test makes it hard for them to evaluate these transactions. The discussion concluded with a topic that was not on the official agenda: Stern v. Marshall and various rules affecting bankruptcy courts and the appeals process. The Stern v. Marshall ruling has led to a variety of strategies for avoiding bankruptcy court.

We encourage you to read the full discussion summary (beginning on Page 3),

which captures each participant’s contributions.



Discussion Topics:

Moderator Judge Gonzalez explained that Chatham House Rules would be followed for the roundtable discussion. Therefore, only the moderator is identified by name in the following summary.

Can Gheewalla and Lemington be reconciled? Are deepening insolvency claims still a concern? Should they be?

Do professionals now have a free pass? The ever-strengthening in pari delicto defense

Have LP’s lost their fiduciary rights? Has the law failed to protect investors or can sophisticated investors protect themselves?

Are trustee clawbacks v. LBO shareholder sellers an abuse of innocent investors?

Are fraudulent conveyance actions v. LBO sponsors an abuse of innocent PE firms?

Does Liberty Media show the way to strip the cupboard and leave bondholders high and dry?

Judge Gonzalez: Let’s begin with the topic, “Is there really anything left in deepening insolvency?” Creditor Counsel: The 2007 Gheewalla decision out of Delaware made it fairly clear that creditors do not have direct claims against corporations for deepening insolvency. The Lemington decision does suggest that the deepening insolvency claim is alive and well, at least in Pennsylvania. The case ruled that where directors and officers have not utilized due care and due faith in undertaking their corporate responsibilities, they can't rely on the business judgment rule, and that the deepening insolvency claim might exist where there's an element of fraud.

Institutional Investor: Do you think that a Delaware bankruptcy court would have found the same as the Pennsylvania court? Creditor-side Counsel: The reasoning in Lemington was solid and discussed on a nationwide basis, so I believe that the same results might be obtained in different jurisdictions in cases with a similar fact pattern. In Lemington, the directors relied on reports from part-time managers and didn't exercise due diligence and care.

“Why should deepening insolvency exist as a separate cause of action in the first place?”

Judge Gonzalez: Why isn't it just a breach of fiduciary duty? Major Creditor Committee Counsel: It's an attempt to import British rules into our system. In the UK, they have this concept of not trading while insolvent. If what you're saying is that there is no such cause of action, but that the directors and officers can be liable through general breach of fiduciary, then I have no problems with that. Chief Restructuring Officer: But liable to whom is the real question. I sit on NYSE company boards and our focus is on what will help the corporation. Sometimes you can’t tell. Are we talking about 1) deepening insolvency - dragging the company down after you know the company ought to be in bankruptcy, 2) the zone of insolvency, or 3) after the company has filed for bankruptcy? It’s really three different things. Gheewalla ignores the question of deepening insolvency because it doesn't believe it exists under Delaware law. I look at Lemington and all I see is breach of fiduciary duty.

Bankruptcy Litigation Roundtable New York City – March 14, 2012

Hosted by the Institutional Investor Educational Foundation (IIEF)

Moderator: Judge Arthur Joseph Gonzalez

Full Discussion Summary


“My reading of the Lemington case is that it was all about fraud”

Middle Market Restructuring Consultant: If anything, the deepening insolvency issue was more of a calculation of damages issue. Chief Restructuring Officer: But who gets to bring cause? I don't think that creditors should be able to bring a direct cause of action against directors. Private Equity/Distressed Investor: How do you align incentives in that case? I agree that if you're on the Board of Directors, you're serving the shareholders. We saw this in Lehman Brothers when the board stayed on post bankruptcy. Whose interests were they protecting? Chief Restructuring Officer: The corporation. Private Equity/Distressed Investor: The people they were appointed by were the old shareholders. People end up being beholden to whoever appoints them. Chief Restructuring Officer: I disagree. Every member of every board I sit on believes that they have a very strong obligation to the corporation. Private Equity/Distressed Investor: What does that mean in the context of insolvency? Chief Restructuring Officer: It should mean the same thing. If you're bringing value to the corporation, whoever receives the benefit is the beneficiary of the corporation and that's the whole point. Bankruptcy Partner, Corporate Law Firm: In the Lemington case, creditors ended up having the right to bring a claim. If you draw an artificial line when a fact finder decides that you're in the phase of deepening insolvency, is it fair to restrict the creditors’ committee from bringing a claim?

Judge Gonzalez: Who does the recovery belong to? Should it be the entity? When you have a corporate entity where (because of insolvency) the creditors are effectively the owners, why aren't you still using the same structure to articulate and enforce whatever rights that entity has to recoup the damages that it has suffered? Why do you move out of that structure and suddenly create these direct causes of action by creditors? It just seems to upset the entire corporate structure. Bankruptcy Commentator & Law Professor: To be the provocateur academic, the distinction here is between a fiduciary duty claim and a tort claim. You're trying to create a tort cause of action partially because fiduciary duty claims in Delaware are especially hard to bring. Judge Gonzalez: Is that a real legal justification for a separate cause of action?

“Deepening insolvency is the simple prolongation of the corporation’s existence when it's insolvent

and knows it’s in trouble“

Prominent Litigation Trustee: Lemington was very unusual because it actually went out of business and then continued having essentially a fake business while insolvency increased. The other part of the question is what does “deepening insolvency” as a damage theory mean? The two concepts are confused in the case law. Is it just the incurrence of additional liabilities by debt financing or is it something different? There's a famous article by Sabin Willett on the theoretical question, “What is a deepening insolvency cause of action?” and “What does deepening insolvency damages mean?” He believes the concept makes no sense. I think this is going to continue to be litigated throughout the country because states like Delaware do not give the creditors a breach of duty claim. The duties are owed to the shareholders.

“I can understand why creditors want to create a direct cause of action because the breach of fiduciary action in Delaware is a dead end for them.”

- Bankruptcy Commentator & Law Professor


Chief Restructuring Officer: Creditors have tons of options and most of them start to take them if they think there's a problem. They're not dumb. Partner, Major Corporate Law Firm: If the cause of action belongs to the creditors, then how can the damage be the money the corporation lost or the additional insolvency? The damage to the creditor is the amount the creditor didn't recover on their claim, which is totally independent of what the corporation lost. If it’s a corporate cause of action, then why should the creditor get the direct recovery? When you analyze deepening insolvency either as a measure of damages or as a cause of action belonging to creditors, it just doesn't hold together. Prominent Litigation Trustee: The Lemington cause of action is on behalf of the committee or the debtor or trustee standing in their shoes. It’s not a direct or private creditor claim. I believe the important issue here is whether the corporate enterprise was harmed by the deepening insolvency damage. Partner, Major Corporate Law Firm: As the chancellor said in Gheewalla, the corporation is equally harmed by shallowing profitability. If the directors make a bonehead decision and the corporation survives but loses profitability, there’s no cause of action for that. Why, when it crosses over the insolvency line, does that create a cause of action?

“When the corporate entity is harmed, it's proper

for the debtor committee or trustee to bring a cause of action.”

Prominent Litigation Trustee: The corporate enterprise at that point has been harmed, and there may be no separate creditor right. When the corporate entity is harmed, it's proper for the debtor committee or trustee to bring a cause of action. Counsel for a Major Secured Creditor Firm: The corporation is harmed whenever directors make boneheaded decisions.

Bankruptcy Commentator & Law Professor: Should we supplement the duty of care with a tort cause of action? Law Professor and Restructuring Consultant: If you provide a direct cause of action to the creditors, you’re endowing the creditors with a right that even the shareholders don't have. Prominent Litigation Trustee: I'm not suggesting the creditors have a direct cause of action. I think the Lemington case and its predecessors in Pennsylvania say that the cause of action is on behalf of the debtor and his successors - the committee or the trustee.

“Damage models are usually very difficult for trial lawyers to understand”

Law Professor and Restructuring Consultant: On the measuring damages issue, damage models are usually very difficult for trial lawyers to understand. Deepening insolvency is an elegant way to describe the situation that tends to resonate with them. Chief Restructuring Officer: Let’s say the directors are doing all the right things, they've done their due diligence, they make a “Hail Mary” pass and it doesn't work. Is that a good way to describe damages? We all have to make business decisions and sometimes those decisions don't work. Once I had to close down an entire manufacturing operation in a company I was running, and someone asked me how I could take such a risk. I said it was less risky than not making payroll the next week. My “Hail Mary” pass happened to work in that case, but sometimes it doesn't. Private Equity/Distressed Investor: Was the company insolvent when you did that? If the company is insolvent, that's exactly what you're supposed to do. Chief Restructuring Officer: Yes, it was solvent, but I would have made that “Hail Mary” pass even if the company were not. Deepening insolvency means that things are getting worse.

“If directors make a bonehead decision and the corporation loses profitability, there’s no cause of action for that. Why, when it crosses over the insolvency

line, does that create a cause of action?” - Partner, Corporate Law Firm


Private Equity/Distressed Investor: It’s one thing if the company has equity value and as a director you're making a net present value type of decision. But if the company is nearly insolvent, then that net present value decision is totally different because you may take value out of your creditors. In fact, you should be looking towards your creditors. Well-Known Restructuring Advisor: We've all been involved in cases where an investor has written a letter to the board of directors, putting them on notice that they may be acting imprudently because the company is insolvent or in the zone of insolvency. Is that a letter that could still be written in this context? It seems to me that it’s a breach of fiduciary duty if the board is continuing to operate imprudently and no longer using reasonable business judgment. At what point will creditors have standing to assert that claim?

“One of the most interesting measures of damages is the increase in the liquidation

deficit...which is a very complicated calculation.“

Middle Market Restructuring Advisor: As an expert witness, I have ten of these cases going right now and the issue of quantifying damages is quite complex. A variety of theories are being discussed in the marketplace, including new borrowings, wasted expenses, saved expenses, increase in the book value of the deficit between measurement dates. One of the most interesting measures of damages is the increase in the liquidation deficit, which says, “This is what the deficit would've been in one situation and what it would have been in another.” The increase in the deficit is one way in which to assess the impact of additional borrowing. That’s a very complicated calculation because you have many moving parts and you may also have more than one measurement date. Significant Restructuring Consultant: It's even more complicated than that because you then have to factor in the damages that would have occurred if the board had taken no action at all.

Prominent Litigation Trustee: But even if you can define the dates, the problem is that there is no collective waiver for the creditors to recover - as opposed to the claim being by the debtor or the debtor’s successor, where the money is brought in and then paid out. It's just not appropriate for the creditor, even though the creditor may have been harmed. Chief Restructuring Officer: How do you determine that the damages are X to Y when actions that ultimately harmed the company may have been taken with all the information, care and loyalty - and with the proper outside assistance? I don't think that's the way damages should be determined. Partner, Major Corporate Law Firm: Does that not get back to the basic legal question: Is there a cause of action of deepening insolvency? You could argue that there really isn’t; it’s all about the fraud.

“The easiest cases are those that have more dirt and mud and where maybe there was a

fraud or insider dealings.” Middle Market Restructuring Advisor: Having been both a plaintiff and a defense expert witness many times, the easiest cases are those that have more dirt and mud and where maybe there was a fraud or insider dealings. No matter where you are on the law, those facts make it easier for the expert to hold the case together. When there aren’t a lot of bad acts, there are a lot of excellent attorneys in this room who will drag you into a discussion about reasonable decision making versus just the mathematical result. Private Equity/Distressed Investor: It's not a strict liability model. When you’re a director making a decision, and you're looking at the net present value of a project, an investment or a growth strategy, it makes a difference whether you’re looking at that from the perspective of solvency or insolvency.

“It makes my hair hurt to imagine preparing testimony to defend a deepening insolvency claim, knowing what the other side could bring up as possibly

mitigating the claim.” - Significant Restructuring Consultant


Private Equity/Distressed Investor: If you’re insolvent, the analysis is the same but the net present value calculation is to your creditors. So, if the net present value investment is good for the creditors, then that’s a good decision. What I worry about as an investor is a “Hail Mary” pass that could possibly add value to out-of-the-money equity. If there’s no way that it would benefit the creditors, to me that's a bad decision. Partner, Major Corporate Law Firm: It doesn't accrue to the benefit of the equity unless the creditors get paid off in full, so if you're insolvent and the creditors are under water, there will be value accruing to the creditors before it goes to the equity. Private Equity/Distressed Investor: Let's say you have a company that has $100 million in cash, $100 million in debt. They can potentially invest that money and potentially make the company worth $1,000, and there’s a 2% chance of that happening. To me that makes no sense. Leading Restructuring Advisor: That goes to having an appropriate discount rate reflecting the risk of those decisions. And that's not always clear-cut. These are complex decisions. Leading Restructuring Officer: This comes up in the board room, where they ask their advisors, “What are the practical things that we can do to avoid what happened in Lemington?” I've been in board meetings where directors are told that (because of Delaware) they don't have to pay attention to creditors.

“Placing obligations on the directors, moving toward the British system, would greatly stall

innovation here.” Middle Market Restructuring Consultant: Current funding in every development stage company only goes so far, and at any point in time funding could just stop dead. If the board has that hanging over their head, we get nowhere.

Leading Restructuring Officer: The board in your hypothetical company should be able to make risk adjusted decisions. If they have information that the product is a dog and they expect to burn through $500 million in the next 5 months, then they should be considering the $500 million. Chief Restructuring Officer: Does anybody here believe that directors don't think about the debt they borrowed?

“Board members are not always altruistic.“ Leading Restructuring Officer: I'm sure you could make the argument that everybody had just gone to church and somehow “something just happened,” but it’s dangerous to assume that board members are 1) well-informed and 2) necessarily acting with the correct intentions. Chief Restructuring Officer: Most independent board members learn what they know from management, so how can they be independent? Lots of companies can get into trouble through no fault of their own – but as a result of outside forces. Look at the gas companies right now and the oil and gas industry in the early 80’s. When evaluating investments or a sale, we look at what value it will bring to the company. We don’t just think about how much money we can put in shareholders’ pockets. Major Creditor Committee Counsel: No, but we’re talking about a situation where the company is clearly insolvent and the board is merely continuing the company's existence by refinancing because the finance markets are hot. Leading Restructuring Advisor: This goes to reasonable intentions balancing the risk. There is a lot of capital in this market because we have the world's greatest and most transparent financial system. We also have the world's greatest insolvency system where these things are balanced. Capital formation is the backbone of the engine of value creation for our nation. As seen in other countries, when money stops flowing, the cost to the aggregate society is immeasurable.

“What I worry about as an investor is a ‘Hail Mary’ pass that could possibly add value to out-of-the-money equity. If there’s no way that it would benefit

the creditors, to me that's a bad decision.” - Restructuring Consultant


Leading Restructuring Advisor: In Japan, there is no venture capital market of note, high yield systems are essentially nonexistent or limited, and the market is illiquid. A system that encourages capital formation inherently has risks. At the same time, the standard should be, “Was the board well-informed? Did it take reasonable risks?” Major Distressed Investor: We’ve been talking about this in the context of board liability and whether they're protected by the business judgment rule. I'm curious to hear people's comments on the propriety of targeting people outside the board - and lenders in particular. We've considered extending loans, rescue financing, in the midst of allegations of deepening insolvency. It’s not like an LBO analysis, where the money goes to the corporation, you collapse it, and then it goes to shareholders. The funds often go to the company for general corporate purposes so that they have a shot at growing. From a lender’s perspective, you’ve created a liability but you’ve also created an asset of equal value.

“The argument’s going to be that they took out way too much value to the benefit of the lender,

not the company.” Prominent Litigation Trustee: In your hypothetical loan, the collateral package is greater than incurrence of the liability. The argument’s going to be that they took out way too much value to the benefit of the lender, not the company. Major Distressed Investor: I’m only collateralizing my own loan, so why would it be fraudulent to over-collateralize my loan, particularly if we're talking about a distressed company where I need that additional cushion? Judge Gonzalez: The only thing that might be argued to be wrongful is if the collateral were tied up in such a way that the business was harmed, but that's a nuance that’s not likely to occur. Ultimately, the bank just gets paid back. Then you’re just left with lender liability causes.

Major Distressed Investor: If the board is ultimately tagged with a deepening insolvency tort, are the lenders an appropriate defendant along with the board because their funds were used to facilitate promulgation of the company's insolvency? Law Professor and Restructuring Consultant: There are some bad cases where the lending takes place, the assets are encumbered, and then there’s a distribution or some other monetization by equity at the expense of the creditors. Then those cases can bleed over to the traditional rescue financing situation where it's not the problem of lending.

“In the cases I've been involved in, the banks are an equal defendant ”

Middle Market Restructuring Advisor: That problem is dripping over into LBO situation. In the cases I've been involved in, the banks are an equal defendant - maybe not a rightful defendant but they’re on the list. Prominent Litigation Trustee: We’re talking about Lemington as though it's the law. But all Lemington really said was that it predicted Pennsylvania was going to adopt the cause of action of deepening insolvency. It's a state law cause of action, and the reality is that there are no state Supreme Court decisions in Pennsylvania on deepening insolvency. There is a lower court case, which I brought, where the decision clearly said that there's no such thing as deepening insolvency. The judge went on to say that a company that is insolvent can't even establish any kind of damages. In my opinion, it’s a dangerous decision and it’s now on appeal to the first level of appeal in Pennsylvania. It will undoubtedly go up to the Pennsylvania Supreme Court, so this issue is floating its way through Pennsylvania despite Lemington.

“If the board is ultimately tagged with a deepening insolvency tort, are the lenders an appropriate defendant because their funds were used to facilitate

promulgation of the company's insolvency?” - Major Distressed Investor


Discussion Topic: Do professionals have a free pass in the ever-strengthening

in pari delicto defense?

Prominent Litigation Trustee: The decision of Refco v KPMG was a totally political decision. It was four to three with a very strong dissent. It was politically based, favoring the professional firms doing business in New York, and obviously they're all sitting around this table: accounting firms, investment banks - the gatekeepers. The court favored the gatekeepers over the innocent creditors and representatives of creditors. In my opinion, it’s not a principled decision. The New York Court of Appeals thumbed their nose at two other cases in very prominent courts, one in the New Jersey state court, NCP, that came out the exact opposite way on equitable principles and made an exception for in pari delicto for trustees representing innocent creditors. The Pennsylvania Supreme Court in the AHERF case created an exception if the plaintiff could prove that the gatekeeper acted in bad faith. Although New York is the worst place in the world bring up a case against a gatekeeper because of in pari delicto, the Refco case has changed 50 years of New York law, knocking out plaintiff's’ claims on behalf of the debtor on a standing ground. The Court of Appeals said that in pari delicto is an affirmative defense, which may allow some plaintiffs to get summary judgments or at least motions to dismiss. There is a case pending in the 7th Circuit in Illinois that is going to test this. It’s an open issue in Illinois, and I believe there are cases in California, Texas and Florida that are more favorable to plaintiffs.

“I believe this is a perfect example of when you forum shop”

Chief Restructuring Officer: We have a case in Tulsa, Oklahoma right now purely because it's a great place to sue. We could have gone to state or federal court and we made a conscious choice.

Major Creditor Committee Counsel: I naïvely thought that the state of incorporation of the company would control the issue of where in pari delicto would apply. Institutional Investor: When you can decide where to bring the case, besides looking at the substance of the law, you need to look at where you’re filing and what their choice of laws might be. Different states may take cases based on where the incorporation took place or where the tort took place. Creditor-side Counsel: On a related note, in the contractual agreements between the debtor and the accounting or law firm, there may be choice of law provisions that govern this to some degree. Where the tort is committed, that is where the venue can be located.

“The reason for making deepening insolvency into a tort is that you open up the possible law that could apply. Same with in pari delicto.”

Bankruptcy Commentator & Law Professor: If you call it a tort, then there is a lot of law that says where the tort occurred, choice of law doesn’t apply. Then you get out of the assumption that either Delaware or New York will be the default law. Major Creditor Committee Counsel: In one of these cases, the judge said deepening insolvency exists under Pennsylvania law, but I’m going to dismiss the action on in pari delicto. Since in pari delicto deals with the corporation, it shouldn’t in theory turn on the law of the state where the company is incorporated. Prominent Litigation Trustee: That case was the first AHERF decision in the District Court where the judge dismissed the case on in pari delicto, but said that there was a deepening insolvency. The Pennsylvania Supreme Court has made it very clear that the bad faith exception eliminates the in pari delicto defense for gatekeepers. This is a forum shopping issue.

“The Refco case has changed 50 years of New York law, knocking out plaintiffs’ claims on behalf of the debtor on a standing ground.”

- Prominent Litigation Trustee


Off-shore Restructuring Advisor/Liquidator: The issue now is the broad brush approach on the question, “What is a bad corporation?” It’s moved from the idea of having one controlling party who knew about the fraud to the idea that the entity is also liable if it was at all involved. Now it seems that if you have an entity that’s involved in the fraud, in pari delicto comes in almost automatically. Ironically, I have lost cases against my own gatekeepers, but am now able to pursue the gatekeepers for an entity in which my fund was invested. Clearly there was some involvement between our two entities in regard to hiding the fraud, but I had independent directors who were not involved in the fraud. Prominent Litigation Trustee: If you can establish a direct creditor claim, like his is now, that is not a defense. In pari delicto is only a defense when the estate, or a representative of the estate, is bringing the claim. Major Creditor Committee Counsel: It must be very hard for individual creditors to sue lawyers. What’s the claim? Prominent Litigation Trustee: Aiding and abetting fraud. Off-shore Restructuring Advisor/Liquidator: Our case only worked because we were adding on to an ongoing case. When we initially filed suit, we were told that we didn't have standing. The view of the courts here is that only the estate or trustee can make the claim, not the creditors.

“The problem of in pari delicto as a defense is that they knock you out on a motion to dismiss - before you get discovery and before you get to

causation and damages.” Prominent Litigation Trustee: Proximate cause is another defense. Even if you establish the primary elements of the cause of action, you have to show proximate cause and damages and those are very difficult issues. The problem of in pari delicto as a defense is that they knock you out on a motion to dismiss - before you get discovery and before you get to causation and damages.

Off-shore Restructuring Advisor/Liquidator: There is a way to get around the exception to in pari delicto - which is adverse interest. But that is difficult to show. If you had your money in a bank account and it earned interest, then there's no adverse interest. Prominent Litigation Trustee: Outside New York, adversity is a fat question, good faith/not good faith is a fat question. Parmalat lost on in pari delicto in the lower court in New Jersey, and the case is working its way up through the appeal process to the New Jersey Supreme Court. The issue is also coming up in the 9th and 7th Circuits. In pari delicto, like Lemington, is still very much out there as an issue, but it's evolving. Partner, Major Corporate Law Firm: This may mitigate in favor of assigning individual creditor claims to a trustee. Prominent Litigation Trustee: Yes. To protect the best of both worlds, the creditors formed a creditors’ trust to bring suit simultaneously with the estate’s claim, on the hope that if one theory got knocked out, the other plaintiff group would be successful. Partner, Major Corporate Law Firm: In this case, there was an actual assignment where the creditors signed a document saying, “I’m appointing you to pursue my own claims.” Judge Gonzalez: When you get those claims assigned, how do you deal with the reliance issue? Reliance on the fraudulent financial statements, etc. Prominent Litigation Trustee: It would affect the direct claims as to whether the creditors relied. The issue is whether any creditor ever read the financial statements, so reliance is definitely an issue. Judge Gonzalez: When you get to trial, if you represent 100 creditors, some attorney is going to want to cross examine all 100 creditors to find out if they relied. You may get a settlement before you get there.

“Now it seems that if you have an entity that’s involved in the fraud, in pari delicto comes in almost automatically. ”

- Off-shore Restructuring Advisor/Liquidator


Discussion Topic: Have LPs lost their fiduciary rights?

Judge Gonzalez: This question deals with Paige. Has the law failed to protect investors or can sophisticated investors protect themselves? Creditor-side Counsel: The basic facts of the case: Paige Hedge Fund set up and needed seed capital. They had a general partnership agreement, as well as the seed funding agreement. They got the Lerner fund to contribute $40 million into the fund and Lerner entered both the partnership agreement and the seed money agreement. There were some conflicts in the terms under which Lerner could withdraw the funds. Under the seed capital agreement, it could withdraw at any time, but there would be a very heavy penalty for withdrawing early. Under the general partnership agreement, there was essentially the ability to withdraw any time, but the fund manager could close the gate if withdrawals ever exceeded 20% in any quarter. The partnership agreement did allow for the parties to enter into side agreements that would modify the partnership agreement. In 2007-8 the fund had not made any investments, but was just sitting on the cash. Lerner decided to pull out and agreed to pay the management fees the fund would have been entitled to for the remainder of its time. The fund refused to release the funds. Finally Lerner submitted its redemption request and the fund threw up a gate, arguing that the $40 million (99.9% of the fund’s assets) exceeded the 20% threshold. They were permitted to do that under the partnership agreement but Lerner nonetheless challenged it. Lerner brought suit on the grounds that it was an abuse of the fund manager’s discretion to throw up the gate in this circumstance, since there were no other investors (other than the fund manager). It was only in the fund managers self-interest to throw up the gate and continue to collect management fees.

Vice Chancellor Strine determined that when a fund manager is acting only in self-interest and acting only to line its own pockets, then it's an abuse of discretion. Off-shore Restructuring Advisor/Liquidator: Clearly it was pretty easy in this case to demonstrate that the general partner was acting solely in self-interest. That doesn't happen in most scenarios. LPs have a tough time being able to assert their rights in those types of vehicles. And not just in this country. That problem arises in many other jurisdictions where investors have even fewer rights. Creditor-side Counsel: A lot of the commentary I read talks about both Paige in the U.S. and the Weavering decision out of the Caymans.

“In the Weavering case, the non-executive directors were found liable for effectively

deepening the insolvency damage” Offshore Restructuring/Litigation Counsel: In the Weavering case, it was the executive director who was the wrongdoer. He started disguising losses for the fund by creating fictitious swap agreements with a shell company. The issue was whether the non executive directors should have spotted his wrongdoing. The judge found that they should. They had a responsibility to supervise, and they had clearly had failed to fulfill that duty. Even though they were not the wrongdoer, they were found liable for effectively deepening the insolvency type damage. The judge held that there was a certain time when the directors should have discovered the fraud was going on and that they were effectively responsible for the increased loss that incurred between the time that they should have discovered the fraud and the time that they did. The plaintiffs were awarded $111 million in damages. The plaintiffs asked the judge to assess damages based on the redemptions made from the fund from the time when the fraud should have been discovered, arguing that those redemptions were irrecoverable.

“We all know the general law in Delaware whereby for alternative entities, LPs and LLC's, the fiduciary rights can be essentially contracted away.”

- Creditor-side Counsel


Discussion Topic: Are trustee clawback vs. LBO shareholder sellers an abuse of

innocent investors? Judge Gonzalez: Let’s turn now to the Tribune case. How do people view trustees seeking clawbacks? Is it unfair? Prominent Litigation Trustee: If there’s a bankruptcy cause of action for fraudulent conveyance, what difference does it make who the defendant is - whether it's an LBO sponsor or shareholder? It's certainly not unfair or illegal; there's a cause of action. Judge Gonzalez: But what does it do to the marketplace? Prominent Litigation Trustee: If you're getting into the 546(e) issue, the history of that was to try to actually protect the securities markets in closing out derivatives trades. Your Honor wrote on that very eloquently; unfortunately the Second Circuit didn't agree with you. I don't believe an LBO payout to shareholders as a result of an LBO interferes with the market. This is not what Congress was trying to address years ago when they were talking about derivatives and the protection of broker-dealers and dealers throughout the world in a potential meltdown in a derivatives situation. I think the Second Circuit ruling reversing your decision is very dangerous for causes of action by estates, creditors committees and trustees.

“The threat of clawbacks would depress the equity value in certain companies.”

Major Distressed Investor: Let’s take a company that’s positioned for a sale. It’s considering a strategic buyer willing to pay six times cash flow, and all of a sudden a financial sponsor comes in willing to pay seven times cash flow - but they're going to employ some leverage to do so. What is the board supposed to do? Take the higher offer and expose their shareholders to some long-term tail risk, or take the below-market offer that mitigates some of that risk?

Judge Gonzalez: Who did they have a duty to there? Do you really have a duty to protect that aspect of the shareholder’s exposure?

“If you expose your shareholders to clawback risk, have you maximized value for them?”

Major Distressed Investor: If your fiduciary duty runs to maximizing value for your shareholders, then if you expose them to clawback risk, have you maximized value for them? Chief Restructuring Officer: But how do you know you're going to expose them? You don't know that it's going to go bad. Major Distressed Investor: My hypothetical situation was a strategic buyer that was not going to employ leverage and a financial sponsor that would do it in the context of an LBO. No one has a crystal ball to know if it will fail or not, although some of the lawyers in this room will look back in hindsight and say these things are destined to fail. However, there's no question that you've increased the exposure for the shareholders in transaction B as supposed to transaction A. As a board member, are you supposed to take that into account in deciding or do you just go for the highest offer? If I'm going to be exposed down the road for the entire value I’ve received, I'm not even sure how that business model works anymore. Institutional Investor: Speaking as a representative of the innocent shareholder in a public company (we manage a couple of large index funds) there may not be anything immoral about the potential for clawback. But as a practical market matter, it’s creating a lot of disruption. Major Creditor Committee Counsel: I can see the argument when you've got thousands and thousands of shareholders. But what's really galling is when you see a transaction leveraged by a few shareholders and they're trying to hide under 546(e).

“There may not be anything immoral about it (the potential for clawback of LBO tender offer proceeds) but as a practical market matter,

it’s creating a lot of disruption.” - Institutional Investor


Judge Gonzalez: I think the Second Circuit opinion is quite broad. That was the argument of the dissent, that it opens the door to just about any transaction that you run through a financial institution. Prominent Litigation Trustee: I think the Second Circuit decision is so broad that it would wipe out the 10 shareholder LBO case. Creditor-side Counsel: We’ve also seen Rakoff use it in the Madoff situation where there is complete fraud. Partner, Major Corporate Law Firm: In the Madoff situation, there were no securities transactions, so it's not like there was a buyout for shareholders. Prominent Litigation Trustee: But Rakoff found a securities transaction and that's why it will be reversed - I hope.

“Capital markets work effectively when you have greed and fear”

Middle Market Restructuring Consultant: The threat of clawbacks keeps some of that fear in play when people make the decision about which offer to accept. Partner, Major Corporate Law Firm: Frequently clients come to me saying, “This company is insolvent and they want to pay me what they owe me. Is there a preference?” And I say, “Take the money! You may have to give it back, but take the money.” Same thing for public shareholders. The best offer is to take the money - or sell out on the eve of the LBO so that you don't actually receive the money because of the LBO. Someone mentioned index funds, which don't have a choice in these things. There is perhaps a little more unfairness to them with regard to risk. Judge Gonzalez: As a trustee, how can you say to your constituencies, “I'm not going to pursue them because it's not nice?” You have to pursue them. If Congress wants to protect them, Congress can protect them.

Chief Restructuring Officer: But you also have state law. That's why so many liquidating trusts and litigation trusts get formed and all these claims get dumped into them. Because in state law, you’re not covered by a 546(e) issue. Prominent Litigation Trustee: In some cases, the direct claims are being assigned to trustees separately to bring their private claims. Otherwise you have thousands of creditors trying to bring private claims.

“In buyouts, it's almost a casino”

Significant Restructuring Advisor: If you take the money that you're offered as a shareholder, presumably the people that are buying from you have done their due diligence. The people who are lending to you have done their due diligence and you presume that everything is okay. It is not always that way. The buyout houses don't expect every deal to be perfect. They know that a certain percentage of their deals will encounter trouble and the sellers should also realize that. Judge Gonzalez: As a shareholder, don't you always believe that once you receive the proceeds from the sale no one will touch them again? If you’re in a commercial business, it’s somewhat different. If you’re selling to a company and you know that company’s going bankrupt, you know that somewhere down the line someone may try to get the money back. At least that's the way the market understands the potential of bankruptcy. But if you're a shareholder and your shares are sold, I don't think you ever (until recently) envision someone can actually try to get the money back. Significant Restructuring Advisor: In an LBO of a closely held company, anyone whose advisor hasn’t mentioned the potential for a clawback is probably not getting the full realm of advice. In a situation with a large number of shareholders, I agree. You sell and you don't expect to hear from anybody again.

“If you're a shareholder and your shares are sold, I don't think you ever (until recently) envision someone can actually try to get the money back.”

- Judge Gonzalez


Prominent Litigation Trustee: Years before we had these giant LBOs, the same argument was made when there were hundreds and thousands of innocent trade creditors in a case. They got a payment 90 days before the bankruptcy. They thought that was just fine, but then they had debtors suing thousands of people just to recoup a couple hundred dollars. Is that unfair? No, that's what the bankruptcy law says; you have to have equality of distribution.

“In any large LBO where there is a limited number of shareholders, they ought to know there's a

possibility that they're going to have to give back some of that money if things don’t go well.”

Middle Market Restructuring Advisor: Getting back to our hypothetical company where a strategic buyer is willing to pay $300 million and a private equity or LBO buyer is willing to pay $380 million for the same company. If you're on the board evaluating which offer to take, part of the evaluation should be, “Is this going to blow up? If you think the deal’s going to blow up, what advice are you giving to shareholders? Judge Gonzalez: It's the difference between thinking it's going to blow up and handicapping the potential that it may blow up. Well-Known Restructuring Advisor: You shouldn't have to factor that in because you have a very easy way to make that determination. The board should shop the assets and ensure a robust process. If you’re going to sell to management in a management-led LBO and you haven’t shopped the asset, everyone should look at the situation and expect that it could get tested in hindsight. But if you have a robust sales process and you’ve chosen between five bids, what better test is there that you have a reasonably equivalent value? Middle Market Restructuring Consultant: I was comparing two groups of buyers, say 10 strategic buyers that all came out in a tight 5% range around $300 million – with a highly leveraged LBO transaction for $380 million.

Partner, Major Corporate Law Firm: The issue here is whether the board should take the lower offer because it's afraid that the higher offer will fail and result in bankruptcy, creating liability for the shareholders to return the money. As these causes of action are successfully pursued over the coming years, is Delaware corporate law going to develop to say that a board may take into consideration the likelihood of success of the acquisition, and that taking the lower offer is not a breach of duty? Well-Known Restructuring Advisor: But what Vlasic was all about is, if the market is giving you an indication of contemporaneous value, then hindsight is 20/20. And in a situation where the board has ensured a sufficient process to know that it’s getting value in the company under the market circumstances, it's very hard to look back. A board under those circumstances that chooses the lower value will get second-guessed a lot more. Law Professor and Restructuring Consultant: There's a leap of faith that works most of the time - equating a fair price with reasonably equivalent value. You can have a situation where the board has exercised its duties consistent with its fiduciary responsibility, but nonetheless has engaged in a constructive fraudulent transfer because of the lack of reasonably equivalent value. Partner, Major Corporate Law Firm: So may a board accept a lower offer? Chief Restructuring Officer: Yes, they absolutely can. They accept them all the time. It comes back to what’s highest and best. We get offers all the time and it’s not unusual to take a lower offer if we're concerned. Middle Market Restructuring Advisor: A straight sale is different from a leveraged recap, and I think the debt charge on the company has to be evaluated. It seems to be very possible that the board would think it better to take the lower offer rather than the LBO transaction because it could put undue stress on the company.

“A board absolutely can accept a lower (purchase) offer (and not be in breach of fiduciary duty). We get offers all the time and it’s not unusual to take a

lower offer if we're concerned.” - Chief Restructuring Officer


Judge Gonzalez: The shareholder receives cash in either scenario; but only one carries the risk that someone will want to get the cash back. Middle Market Restructuring Advisor: The question is what's better for the company vs. what's better for the shareholder. Leading Restructuring Officer: If you're on a board, you should be concerned about the shareholders. I find it troubling to see so many people not taking responsibility for making their own business decisions within their own risk profiles. They want to put the responsibility onto a board of directors, who now not only have to take care of the shareholders but also need to protect themselves against a potential clawback if they get in trouble. Leading Restructuring Advisor: What doesn't get reviewed is how many buyers approached the board, and whether there was a mini process, an open process, a private process, or an unsolicited offer that that was rejected for a variety of reasons. For example, it’s not uncommon for boards to receive unsolicited offers from strategics that just want to take out a competitor and liquidate the business. Well-Known Restructuring Advisor: The operative point is how the market is valuing, and how robust the sale process was. That’s evident in the case law in matters like Vlasic. Major Distressed Investor: If you're successful in clawing back proceeds from equity, where should they go? In our hypothetical LBO situation, presumably the liens are gone and maybe even the claims have been avoided. At that point, there is a windfall for the estate - say enough to pay off creditors. Who benefits from this windfall value if it can’t go back to the lenders because their loans have been avoided? Does the timing matter? Partner, Major Corporate Law Firm: Or does the new LBO sponsor, the equity holder, get all the money back? We’re assuming the trade gets paid.

Major Distressed Investor: If you look at the Tribune report, it suggested that you don't necessarily bring an avoidance action to the extent of making creditors whole. If you claw it all back, you have all this excess value and it seems unfair if the lenders don't participate in that. But in some scenarios you've already avoided their claim. Partner, Major Corporate Law Firm: Does this go back to the original equity holders because you avoided the transaction, so the subsequent equity holders aren’t entitled to it? Major Distressed Investor: No, you just avoided the payment; you haven't avoided the transaction.

Discussion Topic: Does Liberty Media show the way to strip the cupboard and

leave bondholders high and dry? Creditor-side Counsel: This topic stems from the recent Delaware Supreme Court affirmation of the Delaware Chancery Court decision in Liberty Media. The case raises the question of whether bondholders are at risk if a company engages in a relatively prolonged disaggregation strategy. Over the course of approximately six years, Liberty engaged in three asset spinoffs and there was a proposed fourth spinoff. While none of the parties involved viewed this as a violation of the covenants under Liberty’s previous indentures, an anonymous bondholder wrote a letter and raised the issue, arguing that these spinoffs should be viewed in the aggregate as a transfer of essentially all the assets, thus triggering that provision of the indenture. Liberty commenced an action against Bank of New York Mellon as the trustee, declaring that the series of steps did not constitute a transfer of the assets and should be viewed on a standalone basis. The Chancery Court and the Delaware Supreme Court sided with Liberty, determining that they should not be viewed in the aggregate.

“If you're successful in clawing back proceeds from equity, where should they go? Who benefits from this windfall value?”

- Major Distressed Investor


Creditor-side Counsel (continued): The Chancery Court set out a 3-step process that looked at the transfers through various prisms: 1) the end result test, which considered whether or not the transactions were prearranged parts of a single transaction designed to achieve an end result; 2) the interdependency test, whether they wouldn't work unless viewed together; and 3) the binding commitment test, whether there was a binding commitment from the outset to taking the later steps. The Supreme Court affirmed the decision but said that that 3-step test was not necessary. Private Equity/Distressed Investor: I recall that the appellate court was narrower in its application because they didn't want to necessarily have to determine the intent of the company in putting together a long term strategy. We looked at it from the bond perspective and then from the equity perspective, and determined that it would be very difficult for someone to subjectively determine what Liberty’s company strategy was because it was over a six-year period. When the lower court decision came out, we read the test and were very concerned that that kind of creation of judgment law would create issues. When the decision came out from the appellate court, they affirmed on the merits. What they came up with for a test would give companies more flexibility to create a disaggregation strategy without causing an issue with their bond indentures. Partner, Major Corporate Law Firm: The question here is whether bondholders have been left high and dry. What would the result have been if the bond indenture specifically provided for this kind of circumstance, and can't bond indentures do that going forward?

“If you want to contract a different way, go

ahead. That's how you protect yourself.” Judge Gonzalez: At the end of the opinion, the court said the boilerplate language didn't cover the situation. In that sense, the ruling was very narrow. If you want to contract a different way, go ahead. That's how you protect yourself.

Private Equity/Distressed Investor: There are bond indentures that will cover a series of transactions that potentially would include a disaggregation strategy, but that raises the question of when the series of transactions has to be measured and over what period of time. Judge Gonzalez: You could put that timeframe in the agreement as an issue to be negotiated.

“It’s a fallacy to assume that the bond documents are actually negotiated”

Institutional Investor: The fact is that when they’re sent to institutional investors, you have only a few hours to review before deciding to either buy or not buy. Judge Gonzalez: That's the nature of the market we’ve created and that’s too bad. Why should we make a law to protect you from not protecting yourself? Private Equity/Distressed Investor: Over the past few years, there has been an increase in third-party providers who will analyze primary issues. There actually has been a push-back by primary purchasers on covenants, but it's primarily in the high-yield space. I think this company had investment-grade covenants, where it is much more difficult, given the size of the market, to have the leverage to push back on an issuer. Leading Restructuring Advisor: The institutional investment grade market should be in a constant state of evolution because it's so liquid. I think that sophisticated institutional investors will adapt over time to account for certain anomalies like Liberty Media because certainly the law can't cover everything. Judge Gonzalez: From the secondary market standpoint, you get what you pay for. You go into this with open eyes and you assess the attendant risks.

“I think that sophisticated institutional investors will adapt over time to account for certain anomalies like Liberty Media because certainly the law

can't cover everything.”- Leading Restructuring Advisor


Creditor-side Counsel: One of the interesting postscripts in Liberty Media is that they’re planning to issue tracking stocks in January. It looks like the crown jewels will go into one, and some of the non-cash flowing assets will go into another. They’ve associated different parts of their bond debt. The long-dated converts will go with the non-cash flowing assets, and the other debt will go with QVC and Home Shopping Network – their better assets. If Liberty takes the next step and spins off these assets with their associated debts, we will have essentially an “all or substantially all” fight. The markets for convertible bonds associated with the bad assets are very nervous. Leading Restructuring Advisor: They probably have to get a solvency opinion on the levered spin, and presumably people will have a choice to sell or not sell. Private Equity/Distressed Investor: From a market perspective, at some point the leverage simply becomes too high. You need a fairness opinion to show that these two transactions are fair. If it gets to a point where the market will simply not bear the leverage, the company's only choice at that point is to refinance itself, and the only way to refinance itself is to do an exchange offer. They can't force some bondholders to go to one entity and other bondholders to the other. Creditor-side Counsel: It’s a question of “all or substantially all.” Bondholders should first go to their documents and look at what the contract says. Their primary objective is to say that, under the terms of our indentures, we should be able to go with the better assets. Fraudulent conveyance is the fall-back position if further protection is needed. Private Equity/Distressed Investor: There are other examples. When Tyco did their spinoff and split into three businesses, they were overleveraged. They tendered an exchange offer to allocate debt, but they couldn’t force their bondholders to take it. They had to offer market terms and pay people what they required to consent to that transaction. To me, that's the marketplace working.

Creditor-side Counsel: I think the market’s problem is the uncertainty hanging over everything. Liberty has been very aggressive. “All or substantially all” is not a great protection. Private Equity/Distressed Investor: The “substantially all” test does not have a bright-line itself, and that creates uncertainty. You have cases with different thresholds, which creates great uncertainty for companies looking to do shareholder-friendly transactions, and also creates uncertainty for bondholders. Having a bright-line test would give the markets more certainty in terms of being able to evaluate these transactions. Law Professor and Restructuring Consultant: What I find tantalizing from an academic perspective is the merger of Liberty with fraudulent transfer law. If you look at the step transaction doctrine, the cases that are cited are tax cases. Fraudulent transfer law also addresses transactions and steps. You can use the discussion in Liberty and the cases cited in the step transaction doctrine to bring a series of steps that may have begun eight years ago into a four year statute of limitation. You can then look at the reasonable equivalent value and solvency issues. The ultimate step in a disaggregation strategy may take place within four years of a bankruptcy filing, but the initial substantive steps may have been started 6-8 years before. If you collapse that transaction, you’ve now enhanced the potential for clawback.

Discussion Topic: Stern v. Marshall and recent rule changes

Prominent Litigation Trustee: The rule changes have been very helpful because what's been going on around the country has been a complete nightmare. One of the most significant developments pending right now is out in the Ninth Circuit in Bellingham - a tiny individual Chapter 7 case, which asks whether the bankruptcy court has the power to issue a final order ruling in a fraudulent transfer case or, if not, can write a report and recommendation.

“What I find tantalizing from an academic perspective is the merger of Liberty with fraudulent transfer law.“

- Law Professor and Restructuring Consultant


Judge Gonzalez: Moving to another topic…. In bankruptcy court, when we issue an order dismissing one count in a case, you couldn’t get to the District Court unless you met the interlocutory appeal standard. But with Rule 9033, there is no interlocutory review. So if I dismiss something – say Count One - and I do a 9033 Finding of Facts, Conclusions of Law because I couldn’t issue a final order, can that then go immediately to the District Court? The District Court certainly doesn't want to see ten 9033 applications coming up. Another issue for the District Court is that if the bankruptcy court thinks that they can enter a final order and does, and it turns out that the District Court says, “No, we’ll treat it as a Finding of Facts, Conclusion of Law,” two questions arise. 1) The District Court probably needs to give the parties an opportunity to brief it as a question of Findings of Fact, Conclusions of Law because the standard is different. 2) What happens if only one person files an appeal to the order and there are five parties in the case? If the District Court says that it's a Finding of Facts, Conclusion of Law recommendation, can the other four parties now have a new starting time? Can they now challenge it? This has left a tremendous hole that people are jumping into, mainly as a strategy for getting away from the bankruptcy court. Off-shore Restructuring Advisor/Liquidator: I have a clawback type case being argued in District Court and a similar case being argued in bankruptcy court. It will be interesting to see which court hears the case quicker, and how their case management works. There’s some potential for there to be different decisions with regard to the same sort of cases. Judge Gonzalez: My guess is that the argument will be to withdraw the reference so that it all goes before the District Court.

As promised, the Roundtable was adjourned at 10:30, although clearly the discussion could have

continued.

The 2012 Bankruptcy Roundtable Workbook materials are available to IIEF members in the Members Only area of

www.iief.org

“Rule 9033 has left a tremendous hole that people are jumping into, mainly as a strategy for getting away from the bankruptcy court.“

- Judge Gonzalez

http://www.iief.org/

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