The current financial crisis is reminiscent of the long-standing parlor game of musical chairs where, until the coronavirus hit, business leaders were dancing to the music without regard to the number of chairs available, and now that the music has stopped, there are no chairs.
Over the last several years, public corporations that have been flush with cash have, to a great degree, rewarded shareholders with generous stock buybacks without significant regard to reserving cash in the event of an unusual need.
According to the New York Times on May 6, 2020, “AlphaSense combed through the filings and calculated that 135 big companies (with a market cap of at least $5 billion) spent more than $40 billion on buybacks in March alone.” This means that after the business shutdowns began and the pandemic had been declared, public entities were transferring cash to shareholders without regard to the potential revenue shortfalls that were on the horizon. Now, many of these companies are seeking emergency loans and cash infusions because of their lack of liquidity.
As is the case in many Chapter 11 reorganizations, because of the extent of secured debt, many times the only assets available to pay unsecured creditors come from what is called “avoidance actions” brought by a post-confirmation trustee or a Chapter 11 trustee, whereby preferential payments and fraudulent transfers made by or from the debtor are clawed back into the estate for a pro-rata distribution to creditors.
While there is familiarity with the well-publicized recovery actions by the bankruptcy trustee in the Bernie Madoff case in New York, such recoveries are not limited to Ponzi schemes or situations involving financial improprieties. These clawback recoveries are the mainstay of Chapter 11 reorganizations and Chapter 7 liquidations.
Creditors who have been recipients of payments within the 90 days prior to the filing of a bankruptcy proceeding are all-too-familiar with the attempts by trustees to recover those payments by deeming them to be preferential under bankruptcy law. However, a less utilized provision of the bankruptcy law allows trustees to recover what are deemed to be “fraudulent transfers” that have been made within two years prior to the bankruptcy filing (and in some cases, this can extend back to four years prior to the bankruptcy filing). The Bankruptcy Code’s fraudulent transfer provisions are virtually identical to the statutes in every state by the enactment of what is known as the Uniform Fraudulent Transfer Act.
While the name of the statute may lead one to believe that actual fraud needs to be proven in order to permit a recovery, that is not the case. The law provides that in addition to actual fraud, recoveries can be made by a trustee if there is what is known as constructive fraud. Constructive fraud can be found under the bankruptcy law where the debtor entity “received less than a reasonable equivalent value in exchange for” a transfer (such as cash) and where the business that became the bankruptcy debtor “was engaged in business… or was about to engage in business… for which any property remaining with the debtor was an unreasonably small capital.”
While this part of the fraudulent transfer language in the Bankruptcy Code has been little utilized except in leveraged buyout situations where courts have ordered clawback payments in connection with LBO transactions, an analysis of case law shows that the same fraudulent transfer provisions of the Bankruptcy Code may be utilized to recover payments to shareholders as a result of stock buybacks.
In a stock buyback situation, the corporate entity takes what is perceived to be excess cash and buys back its own stock from its shareholders. The price is usually inflated due to the prosperity of the corporate entity that led to the excess cash, but in return for the payment to shareholders, the entity only receives back the repurchased shares. Receiving the shares does not benefit the corporate entity’s balance sheet, and the only benefit may be for the remaining shareholders. Thus, courts have held that stock buybacks may not constitute reasonably equivalent value which triggers a fraudulent transfer action.
In 2016, the US Court of Appeals for the Second Circuit (which includes New York) held in a case involving the bankrupt Adelphia Communications Corp. that while the fraudulent transfer analysis is factually dependent on each case, as a matter of law, transfers of cash for stock buybacks may be clawed back as fraudulent transfers.
Usually, companies that are having financial difficulties are cash poor, and management, as well as members of boards of directors, are not considering stock buybacks. However, in these unprecedented times, public entities that were flush with cash at the beginning of 2020 continued to disburse the cash to shareholders after the possible consequences of the economic slowdown due to the coronavirus became apparent.
The results of all of this create a precarious position not only for corporate shareholders that received cash in exchange for the stock buybacks but also for members of boards of directors that have authorized the stock buybacks. If these entities were to need to seek bankruptcy court protection, the shareholders who were the recipients of stock buyback cash which left the corporate entities cash-poor once the economic slowdown hit can easily become the targets of clawback actions to recover the cash paid for the stock buybacks.
Additionally, non-bankruptcy courts have held that members of boards of directors have certain fiduciary duties to shareholders and creditors. It remains to be seen whether, in light of the economic slowdown created by the pandemic crisis, members of boards of directors who authorized stock buybacks will be held to have breached their fiduciary duty in authorizing the stock buybacks. If this is the case, it could lead to a proliferation of D and O claims against the directors and their insurers.
Needless to say, there is a great degree of uncertainty in all of this, but those shareholders that received cash from stock buybacks should be on notice that if the corporate entities that repurchased the stock were to seek bankruptcy court relief, a huge amount of cash clawback efforts may be on the horizon.
Charles Tatelbaum is the creditors’ rights and bankruptcy practice group leader at the Ft. Lauderdale law firm of Tripp Scott PA. Christina Paradowski and Brittany Hynes contributed to the research for this article.