Friday, September 18, 2009

Tangled Financial Web Allows Assets to Escape Trustee's Reach

A recent opinion by Bankruptcy Judge Craig Gargotta demonstrates the problems arising from the use of cash management systems and also provides an object lesson in why lawyers should have more than a passing knowledge of accounting concepts. In Ingalls v. SMTC Corporation, No. 06-1283 (Bankr. W.D. Tex. 9/11/09), the bankruptcy trustee sought to recover millions of dollars in inter-corporate transfers. After a two week trial, the court issued a 94 page opinion denying all relief.

The case was precipitated when SMTC Manufacturing of Texas filed a chapter 7 petition after divesting its assets. While the debtor paid all of its current trade debt, it also made numerous transfers to insiders leaving it unable to pay a sizeable debt on its lease.

The transfers challenged by the trustee fell into four categories:

1) Payments to the parent company’s affiliates in North Carolina and Mexico;

2) Expense reallocations which increased the Texas company’s share of expenses;

3) Approximately $41 million transferred to the holding company through a cash management system; and

4) Transfer of the debtor’s fixed assets to affiliates.

The Corporate Structure and Cash Management System

To understand the case, it is necessary to understand the relationship between the debtor and its affiliated companies, their cash management system and the companies’ secured debt.

The corporate structure consisted of a parent company, SMTC Corporation, which owned a holding company, HTM Holdings, Inc. HTM owned the operating companies, including SMTC Manufacturing of Texas.

The companies used a cash management system which centralized their funds. Prior to March 2002, the operating companies would deposit funds into their operating accounts which would be swept into a zero balance account maintained by the holding company. The funds in the zero balance account would be applied to the holding company’s debt to Lehman Brothers. As funds were needed by the operating companies, they could either be paid from funds deposited into the operating account that day or funds advanced from the Lehman Brothers loan. Beginning in March 2002, Lehman Brothers required that all funds be deposited into a lockbox account so that the only funds available for operations came from the Lehman Brothers loan.

Lehman Brothers provided a revolving credit line to the holding company which was used to fund the operating companies. The parties kept track of how much money was paid to and paid from each of the operating companies. This number was their portion of the debt. However, each of the operating companies guaranteed the entire debt and pledged their assets. To the extent that any operating company paid more than its individual balance on the loan, it had a right of contribution against the other operating companies.

While the Texas company initially enjoyed a period of rapid growth, it ran into trouble in 2002. In mid-2002, SMTC Texas laid off about half of its employees and moved its manufacturing operations to Mexico. The cost of labor in Mexico was $3.00 per hour compared to $19.00 in Texas. However, even this was not enough to allow the debtor to meet Dell’s pricing demands so that it eventually dropped (or disengaged from) Dell as a customer. After that, it lost Alcatel as a customer and corporate decided that it was time to close the doors. The debtor surrendered its leased facilities in May 2003 and filed chapter 7 in December 2004. Significantly, the other affiliated companies continued to operate and did not file bankruptcy. The chapter 7 trustee looked at all of the transfers out of SMTC and cried foul, leading to a fraudulent transfer complaint.

Was There A Transfer?

The first major issue which the court had to consider was whether there had been any “transfers” at all. Under the Texas Uniform Fraudulent Transfer Act (TUFTA), the definition of a transfer excludes “property to the extent it is encumbered by a valid lien.” The defendants argued that no “transfers” occurred because:

1) Each individual asset transferred was worth less than the amount of the total debt: and

2) Because the debtor was liable for the entire Lehman debt, its collective assets had no equity.

The court ruled against the asset by asset approach. It found that if there was equity in the debtor’s collective assets that transfer of individual assets from that pool would be deemed to be made from the unencumbered portion of the assets rather than the encumbered ones.

This made it necessary to determine whether there was equity in the debtor’s collective assets, raising some difficult accounting issues. The difficulty arose because of the interplay between the following facts:

1) The debtor’s assets were greater than its share of the Lehman Brothers loan at some points in time;

2) The debtor had guaranteed the entire Lehman Brothers loan, which far exceeded its assets; and

3) The SMTC family of companies was making all of their payments n the Lehman Brothers loan, although there were some covenant defaults.

This raised the question of what portion of the Lehman Brothers debt should be accounted for on the debtor’s balance sheet. The trustee argued that the debtor’s obligation on the Lehman Brothers debt was a contingent obligation which did not belong on the balance sheet because of the low probability that the debtor would be called upon to perform. The defendants argued that the entire amount should be included because the debtor was unconditionally liable.

The court agreed that the debt was a contingent liability. However, whether a contingent liability should be stated on the debtor’s balance sheet depended on the likelihood that the contingency would occur and that it would affect the debtor’s balance sheet. A contingent liability could be shown on the balance sheet if the contingency was likely to occur, could be referenced in a footnote or could be omitted entirely if the contingency was unlikely to occur.

The court found that the appropriate way to measure the contingent liability was to apply a percentage to the likelihood that the guaranty would be called upon and multiply that percentage by the amount of the debt. The trustee argued that the appropriate percentage was 0% based on the fact that the SMTC companies had not defaulted upon the debt and that the debt was later paid off. The court rejected this argument because the SMTC companies had defaulted under their loan covenants and that the debt was only paid off through a restructuring in which Lehman Brothers accepted stock in partial satisfaction. Because the possibility that the debtor would be called upon to satisfy the guaranty was greater than 0% and the trustee did not advance an alternate number, the court refused to exclude the debt as a contingent liability.

However, that was not the end of the inquiry. Even though the debtor could be called upon to pay the entire debt, it had a right to contribution from its co-debtors. This was an asset which needed to be added to the balance sheet. The court assumed that the value of the right of contribution was equal to the portion of the debt which exceeded the debtor’s individual account. This may have been a leap of faith, since the court did not analyze the ability of the other companies to pay their portions. However, given that the debt was retired without payment from SMTC Texas, it may have been a reasonable conclusion. The net result was that for determining the debtor’s equity in its assets, the court examined the value of the debtor’s assets minus the amount of the debtor’s portion of the Lehman Brothers loan. The result of this analysis was that the debtor had equity in its assets until March 2003. Once the debtor reached the no equity stage, it could transfer its assets away without risk because they had no net value and were not “transfers” under TUFTA.
The effect of the court’s ruling was to exclude the transfer of the fixed assets and $3.9 million of the cash transferred through the cash management system.

Note that the result would not be the same in an action brought under 11 U.S.C. §548. The definition of “transfer” under the Bankruptcy Code does not exclude encumbered property. 11 U.S.C. §101(54). Thus, it is possible to bring a fraudulent conveyance action to recover a fully encumbered piece of property under the Bankruptcy Code, while the same transfer would not be covered under the Texas statute.

Fraudulent Conveyance Analysis

Under the Texas statute, like the Bankruptcy Code, a transfer can be avoided as a fraudulent conveyance if it is made “with actual intent to hinder, delay or defraud any creditor” or if it was made for less than reasonably equivalent value while insolvent. Actual intent can be shown through direct evidence or through badges of fraud. TUFTA, unlike the Bankruptcy Code, legislatively defines eleven badges of fraud. The badges of fraud are:

1. The transfer was to an insider;

2. The debtor retained possession or control of the property transferred after the transfer;

3. The transfer or obligation was concealed;

4. Before the transfer was made or obligation incurred, the debtor had been sued or threatened with suit;

5. The transfer was of substantially all the debtor’s assets;

6. The debtor absconded;

7. The debtor removed or concealed assets;

8. The value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred;

9. The debtor was insolvent or became insolvent shortly after a substantial debt was incurred;

10. The transfer occurred shortly before or after a substantial debt was incurred; and

11. The debtor transferred the essential elements of the business to a lienor who transferred the assets to an insider of the debtor.

Tex. Bus. & Com. Code §24.005(b).

The list of badges of fraud raises several interesting issues. First, the issues of solvency and reasonably equivalent value are included in the badges of fraud. Thus, it would make sense to determine these issues first, since a positive finding on these two elements would eliminate the need to determine the other nine badges of fraud. The other implication is that since solvency and reasonably equivalent value are just two of eleven badges of fraud, a transfer can be fraudulent even though the debtor was solvent at the time or received reasonably equivalent value. The second interesting question is how many badges of fraud are enough. The meticulous Judge Gargotta noted that the presence of “many” badges of fraud “will always make out a strong case of fraud” and that four or five have been found to be sufficient in some cases. On the other hand, one badge of fraud is not enough. Once a sufficient number of badges of fraud are established, then the burden shifts to the transferee to establish some “legitimate supervening purpose.”

Analysis of Actual Intent to Hinder, Delay or Defraud

Judge Gargotta chose to do the more difficult analysis of intent to hinder, delay or defraud first. His decision on these issues effectively decided the constructive fraud issue as well.

The Judge rejected the trustee’s arguments regarding direct evidence of fraudulent intent. The Trustee contended that emails discussing the possibility of bankrupting the Texas company and “walking away” from the lease combined with failure to produce board minutes where these options were discussed was proof that the corporate parent intended to defraud the lessor. The trustee also argued that the debtor hindered the lessor when it failed to make several payments on the lease when it had the cash to do so. The court was not moved by this evidence. Discussing the option of bankrupting the company and walking away from the lease did not go one step further and establish intent to transfer the assets away. The court did not give any particular significance to failure to produce the board minutes, refusing to draw an inference that the minutes would have been harmful.

This led to a discussion of badges of fraud. As a preliminary matter, Judge Gargotta had already determined that the debtor was insolvent throughout the relevant period. As a result, one badge of fraud and half of the constructive fraud analysis had already been decided. It was not contested that the transfers were made to insiders, so that a second badge of fraud was present. However, at this point, the trustee hit a wall as the court failed to find any additional badges of fraud.

Badge 1: Transfers were made to insiders. This badge was not disputed.

Badge 2: The debtor retained possession or control of the property transferred. This badge was not present.

Badge 3: The transfer or obligation was concealed. All of the transactions were recorded on the debtor’s books. The transfers were all properly documented. As a result, this badge was not present.

Badge 4: Before the transfer was made, the debtor had been threatened with suit. The debtor was not sued until after it shut down in May 2003.

Badge 5: The transfer was of substantially all the debtor’s assets. Collectively the transfers were of substantially all the debtor’s assets. However, individually none of them were. Furthermore, because the Texas statute excluded fully encumbered assets from the definition of “transfer,” the final series of transfers were not considered. As a result, when the last transfer which could be considered to be a transfer was made, the debtor still had assets left, defeating this badge.

Badge 6: The debtor absconded. This was another badge implicated by the definition of transfer. Because the only “transfers” which could be considered were those occurring prior to March 2003, this badge did not apply because the debtor was still operating its business at this time.

Badge 7: The debtor removed or concealed assets. This badge is similar to badge 3. However, instead of concealing transactions, it relates to concealing assets. However, the result is the same. Since the debtor accounted for all of the transfers in its records, it did not conceal assets.

Badge 8: Reasonably equivalent value. I will return to this badge.

Badge 9: The debtor was insolvent or became insolvent. The court found this issue was present.

Badge 10: The transfer occurred or the obligation was incurred shortly before or shortly after a substantial debt was incurred. The only major debt which the debtor had was its lease. This was incurred on September 1, 2001. All of the disputed transfers occurred during 2002 and 2003. As a result, this badge was not present.

Badge 11: The debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor. This was not present.

Based on the definition of transfer and facts which were not seriously contested, the most badges of fraud that could be established was three. Thus, the whole case boiled down to reasonably equivalent value.

Reasonably Equivalent Value

1. The Trustee challenged $104,646.00 in payments to SMTC Charlotte from February 2002 to June 2002 and $37 million to SMTC Mex/SMTC Chihuahua from February 2002 to February 2003.

While these transfers were substantial, the defendants established that the SMTC companies transferred their manufacturing operations from Texas to Mexico to take advantage of lower wages. However, Dell continued to place orders with SMTC Texas, which then filled them with product purchased from SMTC Mex and SMTC Chihuahua. The Debtor added a mark-up to the product purchased from Mexico before it sold it to Dell. The defendants produced invoices, bills of lading and other documents to establish that the transfers to the affiliated companies were for payment of product actually purchased which the debtor sold for a profit. Thus, this group of transfers was factually shown to be for reasonably equivalent value.

2. The Trustee challenged approximately $2 million in expense reallocations between the debtor and the corporate office.

The defendants established that the expense reallocations were based on recommendations from the companies’ accountants and were reasonable. Thus, this set of transactions was supported by reasonably equivalent value.

3. The Trustee challenged $37 million in funds which were upstreamed to the holding company by the cash management system.

This looked to be the trustee’s strongest claim. Between January 2002 and December 2003, the Debtor transferred $41 more to the holding company than it received back. This seemed to be a simple cash in cash out analysis showing a net transfer without reasonably equivalent value. However, this was a case where the complexities of the cash management system worked against the trustee. The court concluded that the trustee’s expert only considered transactions running through the debtor’s bank account and not transactions reconciled at the corporate level. Because many inter-corporate transactions were handled through reconciliations, the court found that an analysis of the bank statements only was insufficient to show whether the debtor received reasonably equivalent value.

The Court stated:

The Trustee has not provided the Court a complete picture that explains specifically why reasonably equivalent value was not received. What the ZBA Master Bank Reconciliation demonstrates is that the $41.1 million figure that was derived solely by analyzing the bank accounts does not accurately reflect the payments made to SMTC Mex or any of the other affiliates on behalf of the Debtor via intercompany transfers. The Trustee failed to account for this reconciliation in his explanation as to what effect these transactions would have on reasonably equivalent value. He therefore has not proved the absence of reasonably equivalent value by a preponderance of the evidence.

Opinion, p. 70.

With this finding, the trustee’s case was doomed.

Why It’s Hard To Be The Trustee

This was a difficult case for the trustee. He was faced with a debtor which had transferred all of its assets to affiliates (although it also paid $3.9 million to trade creditors). However, the case turned into a battle of the accountants. The trustee starts off at a disadvantage in a battle of experts because the trustee usually starts off without any cash to pay experts. In this particular case, the trustee sought to employ an accountant on a contingent fee basis. Unfortunately, this violated the disciplinary rules governing accountants in Texas and the court disqualified the expert. The trustee then had to retain another accountant to testify based on the first accountant’s compilations. The court did allow the first accountant to testify as a fact witness. Thus, the defendant had access to its own expert accountant which it retained as well as the defendants’ management, while the trustee had to start over with a new expert who was looking in from the outside.

Concluding Thoughts

SMTC illustrates the difficulties arising from inter-related companies with a common cash management system. The SMTC companies succeeded in walling off SMTC Texas and allowing it to fail. Despite the fact that many of the assets were transferred to affiliates, it was extremely difficult to unscramble the companies’ finances. The court successfully worked through the issues related to contingent liabilities and rights of contribution. However, it found that the trustee’s expert had failed to account for all of the value provided to the debtor. The result was not based on knowing the answer, but on uncertainty resulting from the inability to fully deconstruct the companies’ intertwined finances. While the defendants may have prevailed in any circumstance, the complexity of the arrangement was certainly an assisting factor for the defense.


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