Article courtesy of Maggie Parker-Yavuz (Akin Gump) and Jake Gawlak (Akin Gump)
Halperin v. Morgan Stanley Investment Mgmt. (In re Tops Holding II Corp.), Docket Nos. 18-22279, 20-08950, 2022 Bankr. LEXIS 2899 (Bankr. S.D.N.Y. Oct. 12, 2022)
Overview:
Litigation trustee for unsecured creditors of Tops Holding II Corporation in its chapter 11 bankruptcy case brought fraudulent transfer and related claims against private equity investors in and directors of Tops, alleging that their actions drove the grocery store chain into bankruptcy by causing it to pay more than $375 million in dividends to equity owners despite the company’s unfunded pension plan liabilities. The trustee’s complaint sought to avoid and recover the dividends as constructive and intentional fraudulent transfers. It also sought damages against the directors on the basis of unlawful authorization and breach of fiduciary duty in the directors’ approval of the dividends, and damages against certain of the private equity investors for aiding and abetting breach of fiduciary duty. The United States Bankruptcy Court for the Southern District of New York denied the defendants’ motions to dismiss the claims.
Full Summary:
Tops Holding II Corporation (“Tops”) owned and operated 169 supermarket stores and employed 14,000 people, including over 12,300 union members. A group of private equity investors led by Morgan Stanley Investment Management Inc. and its affiliates (“Morgan Stanley”) bought Tops’ predecessor in 2007 and, following the acquisition, appointed directors to its board. Prior to the acquisition, Tops had approximately $85 million in contingent pension plan withdrawal liabilities, which constituted a significant liability for Tops. Over the course of Morgan Stanley’s six-year ownership and control of Tops, its pension plan liabilities grew to over $515 million. During the same time period, Tops paid over $375 million in dividends, in four issuances, to its private equity investors. The dividends were funded almost entirely from the proceeds of secured loans issued by Tops and decreases in capital expenditures. Tops obtained favorable solvency opinions before the issuance of three of the four dividends. After unsuccessfully attempting to sell their equity stake to outside investors, in 2013, the private equity investors sold their stock to an entity controlled by Tops’ senior management in a transaction funded mostly by Tops itself.
In 2018, Tops filed for chapter 11 bankruptcy. As part of the chapter 11 case, Tops terminated the pension plan for which it was the main participating employer, and it settled its liability to another pension plan, leaving over $1 billion in creditor losses. The trustee for the litigation trust established for Tops’ unsecured creditors filed a complaint asserting multiple claims against the private equity investors and Tops’ directors, who the trustee argued drove Tops into bankruptcy by causing it to pay out more than $375 million in “lavish and illegal dividends” while it incurred $426 million in debt and its pension plan liabilities increased to over $515 million. The trustee sought to avoid the dividends to the private equity investors under New York’s Debtor and Creditor Law (the “DCL”), as incorporated by section 544(b) of the Bankruptcy Code, as constructive and intentional fraudulent transfers, and to recover the payments under section 550 of the Bankruptcy Code. The trustee also sought damages against Tops’ directors relating to certain of the dividends, on the basis that the directors’ approval of the dividends was an unlawful authorization and constituted a breach of their fiduciary duties, and sought damages against certain Morgan Stanley entities for aiding and abetting breach of fiduciary duty. Defendants moved for dismissal on various grounds.
The court first considered the trustee’s constructive fraudulent transfer claims against the private equity investors. Finding that the claims were not time-barred, the court examined whether the constructive fraudulent transfer claims were plausible. The court noted that, under the DCL, a transfer by a debtor is deemed constructively fraudulent if it is made without “fair consideration” and one or more additional factors apply, including: (1) the transferor is insolvent or rendered insolvent by the transfer, (2) the transferor is engaging in a business transaction for which its remaining property constitutes unreasonably small capital, or (3) the transferor believes the debt is beyond its ability to pay. The court reasoned that the transfers at issue in this case were without fair consideration since a dividend, unless it is compensation, is made with respect to an owner’s equity interest, and is therefore made without any consideration. With respect to the first additional factor, the court noted that, if, as in this case, it is undisputed that the defendant did not provide fair consideration for a transfer, under the DCL, there is a presumption of insolvency. The court considered each of the dividend issuances to the private equity investors and found plausible support for the trustee’s claim that, when the dividends were paid, Tops was insolvent or rendered insolvent, was left with unreasonably small capital and/or intended or believed it would be unable to pay its debts as they matured. In its analysis, the court examined solvency opinions provided in connection with certain of the dividends, and found that the opinions were flawed in various respects and did not render the constructive fraudulent transfer claims implausible. The court also noted that the survival of Tops for a number of years after the dividends were paid was not dispositive as to whether there was unreasonably small capital. The court ultimately held that the constructive fraudulent transfer claims were plausible, and denied the defendants’ motions to dismiss.
The court next considered the trustee’s intentional fraudulent transfer claims against the private equity investors. To allege fraudulent intent, one must allege facts that (1) show the defendant had motive and opportunity to commit fraud or (2) constitute strong circumstantial evidence of conscious misbehavior or recklessness. The court noted that, in a claim to avoid an intentionally fraudulent transfer, a plaintiff may rely on one or more so-called “badges of fraud”, which include a close relationship between the parties, a questionable transfer outside the ordinary course of business, or inadequate consideration and retention of control of the property by the transferor. The court clarified prior case law and stated that, under the DCL, a plaintiff must plead only the transferor’s fraudulent intent, not that of the transferee as well. The Court found that, in this case, intentional fraud was adequately pleaded because the complaint pleaded direct evidence of intent to defraud by alleging that Tops and certain of the defendants manipulated third party valuations used to support the dividends, and alleged several badges of fraud for each dividend. The court acknowledged that it is a regular business practice to pay dividends to shareholders, but stated that “it would turn fraudulent transfer law on its head to determine that a transfer to insiders for no consideration while the transferor was or was rendered insolvent could nonetheless not be intentionally in fraud of creditors simply because it was a dividend.”
The court next considered whether three of the four dividends were excepted from avoidance under the safe harbor provisions of section 546(e) of the Bankruptcy Code. Under section 546(e), a bankruptcy trustee may not avoid a transfer that is a margin payment or settlement payment made to a financial institution or other specified types of recipients in connection with a securities contract, commodity contract or forward contract. Three of the four dividends at issue in this case were funded in part from issuances of notes. The defendants argued that, because the dividends were made in connection with note offerings under “securities contracts” and involved transfers through a financial institution (i.e., the payments were made from Tops’ bank to the private equity investors’ banks), they fell within the safe harbor. In responding to this argument, the court cited Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018), in which the Supreme Court determined that, where there is a string of related transactions, the only relevant transfer for purposes of the safe harbor is the one the trustee seeks to avoid. The court reasoned that since the trustee was seeking to avoid the dividends, not the note offerings, the dividends were not “safe harbored”. The court further noted that the dividends were one-way payments and therefore did not constitute “settlement payments” under section 546(e), and the banks involved in the dividend payments were not qualifying recipients for purposes of section 546(e) because they were not acting in the capacity of agent or custodian to Tops or the private equity investors.
With respect to the unlawful dividend claims against the Tops directors, the court found that New York law does not require that a director have breached a fiduciary duty in order to be liable for authorization of an unlawful dividend. The court then considered whether the breach of fiduciary duty claims against certain of the directors should be dismissed on the basis that (1) they are exculpated from claims for breach of the fiduciary duty of due care and (2) the claims for breach of fiduciary duty of loyalty / duty to act in good faith are conclusory or not plausible. The court found that the directors were exculpated from breaches of the duty of care based on the exculpation provision in Tops’ certificate of incorporation. The court then considered whether the other, non-exculpated fiduciary duty claims for breach of duty of loyalty / good faith were adequately pleaded, examining whether the complaint pleaded that the directors (a) furthered a material self-interest, (b) lacked independence, or (c) acted in bad faith. The court found that payments received by the directors in connection with the dividends did not make the directors improperly “interested” in the dividends because they received the payments on the same terms as any other shareholder. The court also found that the complaint’s allegations of personal friendships, and that the directors were “beholden” to Morgan Stanley, were insufficient to raise a reasonable doubt about the directors’ independence. Lastly, the court determined that the complaint did not allege, except in a conclusory way, that the directors intentionally disregarded their fiduciary obligations, and failed to allege the necessary scienter to show bad faith. The court granted the motions to dismiss the breach of fiduciary duty claims against the directors.
With respect to the complaint’s allegation that certain Morgan Stanley entities aided and abetted in breach of fiduciary duty, the court found that the complaint failed to sufficiently allege that the relevant entities engaged in activities supporting the claim, and granted the motions to dismiss.
