Posting for

Tuesday, September 1, 1998

by: Bert Rush

brush@firstam.com

CREDITORS' RIGHTS/FRAUDULENT CONVEYANCES/BANKRUPTCY

Last week, at the ALTA Reinsurance Committee meeting in Lake Tahoe, Alan Pedlar of the L.A. firm of Stutman, Treister and Glatt gave a very interesting presentation on fraudulent conveyances.

In commercial transactions we are frequently asked to remove the creditors' rights exclusion, and told that our competitors would be all too happy to do so and replace us in the transaction. This has been fueled lately, at least somewhat, by Joe Bonita's article, "An Elizabethan Legacy: Creditors' Rights and Title Insurance," published in the May/June issue of the ABA's Probate & Property magazine. Joe, if you didn't know, is S.V.P. and Chief Underwriting Counsel for Chicago Title, as well as Chair of the ALTA Forms and Practices Committee. His article makes the exclusion sound positively dispensable.

After listening to Joe "defend himself" (Paul Hammann's words), Alan showed us a brief filed in an adversary proceeding in the bankruptcy of Foxmeyer Corporation, now pending in Delaware.

Seems that Foxmeyer Corporation, through its operating company Foxmeyer Drug, was until recently the fourth largest distributor of pharmaceuticals and health care products in the U.S. It had more than 2,000 employees, and had operated for more than 90 years. Its business relied heavily on trade credit--unsecured--extended by such suppliers as Eli Lilly, Bristol-Meyers, etc., running in the neighborhood of tens of millions of dollars at any given time.

Foxmeyer Drug had an unsecured loan from Citicorp with a balance of about $100 million. Since at least 1995, its parent company (now known as Avatex) considered various ways to transfer assets out of Foxmeyer Drug and pay a dividend to Avatex. Two problems were that Foxmeyer's credit facility with Citicorp (as well as agreements with other creditors) did not permit such a loss of value, and the Foxmeyer companies were financially stressed.

The solution came as "asset-based financing" provided by GECC. The Foxmeyer companies borrowed $300 million, using $100 million to pay off Citicorp and $200 million to pay a dividend to Avatex.

Alan's point was that he believed that if this transaction had been presented to any of the major title underwriters with a request to delete the creditors' rights exclusion, most--or at least some--would have been willing to do it.

Now the rest of the story: 69 days after the loan closed the Foxmeyer companies filed a voluntary Chapter 7 bankruptcy. A trustee in bankruptcy has filed the aforementioned adversary proceeding to set aside the GECC lien against Foxmeyer assets. The trustee claims the entire transaction was a fraudulent conveyance, which may be set aside under Bankruptcy Code section 548 and applicable state laws. The trustee's court-approved budget to litigate against GECC is $10 million.

The $200 million paid to Avatex was a "red flag," since the Foxmeyer companies got nothing for it--no "reasonably equivalent value" in the language of BK Code section 548.

And, according to Alan, even the $100 million paid to retire unsecured debt to Citicorp will be tough to defend. Authoritative case law holds that trading unsecured debt for secured debt can be a fraudulent conveyance--where other "non-preferred" unsecured creditors get left out. (Dean v. Davis, 242 U.S. 438, 37 S.Ct. 130, 61 L.Ed. 419 [1917].)

This is a challenging subject to include in training--but let's consider it a "must" for employees and agents who have hands-on responsibility for a significant volume of commercial transactions.

Forbes magazine carried a cover story last March 9 titled "LBO Madness! The Hocus-Pocus Behind Those Fancy Deals." A very interesting article about too much investment money now being made available for too few good deals. It's clearly not a time for us to allow our underwriting standards to drop just to match "the competition."

Questions, comment, argument? Just press the "reply" button and send your thoughts to LandSakes.

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Following Tuesday's posting James Karela (Bolingbrook, IL) writes:

Following the money is one way to analyze some creditors' rights issues, but one theory is that if all excess funds are returned to the borrowing entity (and we have no actual knowledge that funds are being later sent upstream etc.) that we as insurer are protected in some way. "Don't ask; don't tell" seems to be the theory. I'm not sure how this helps us in insuring a lender (unless they have actual knowledge that the money will later be sent upstream); but that is the theory.

Any ideas about what our level of inquiry should be when funds are being funded back to the borrower and not to pay off a pre-existing lien?

How much comfort can we take when we have a SPE borrower (bankruptcy remote) set up at the behest of the lender?

Reply: If we're asked to remove the creditors' rights exclusion we'll want to ask a lot of questions before deciding. "Don't ask/don't tell?"--fahgetaboutit!!! We will want to know where the money is going and, if we're given false or misleading information, we might later deny or rescind coverage.

Commercial transactions in which we're asked to remove the exclusion typically involve millions or tens of millions of dollars in liability, so our level of inquiry will be "high." We will want complete details on unpaid liens and unsecured debt of the borrower --as well as contingent liabilities such as pending or threatened litigation.

At the ALTA meeting last week, Joe Bonita waxed eloquent about unsecured and trade debt typically encountered with various types of business. Shopping malls typically have little unsecured debt because they pass most expenses on to tenants. Retailers, on the other hand, should be expected to carry heavy trade debt--money owed to suppliers. Joe reeled off a list of businesses along with their typical debt profiles--very impressive. But anyone who's read Dobie Gillis knows about the logical fallacy of "generalization." We wouldn't want to underwrite the creditors' rights risk by merely putting borrowers in categories and guessing at their most likely debt picture--we need details in reliable form to make these underwriting decisions--and we need to know what questions to ask.

There'll be lots said about this at our upcoming national meetings this fall. As a rule of thumb, I would hope that any employee or agent asked to remove the creditors' rights exclusion will go to their state or regional counsel for advice. Transactions involving liability of $25 million or more should be passed upon by the Home Office senior underwriting department--but also remember our senior underwriters welcome any question you may have in this area, so don't hesitate to call.

I don't know how much comfort to have with a transaction structured to include a special purpose entity ("SPE"), or "bankruptcy remote" entity. When you get into the details of such transactions they certainly seem well-designed to avoid creditors' rights problems--and they may also be risk-rated by an organization such as Standard & Poor's. But, on reflection, it really seems unlikely there could be such a thing as an entity immune from

bankruptcy--remote ain't immune. I think this is where the thinking of our Jack Murray (Chicago) is. And, at dinner last week, I recall Alan Pedlar making the point that a director of a bankruptcy remote entity--who has promised or been charged to vote against bankruptcy if the issue should come up--has a built-in conflict of interest, because his primary obligation as a director is to do what's best for the entity--which may indicate bankruptcy.

So these deals should not be taken at "face value," they still need to be underwritten so we understand where the money is going, and who is likely to be left "out" as an unsecured creditor. I think Cliff Morgan is pretty confident that at least the senior underwriters with our competitors are still continuing to underwrite this risk in a careful manner--not relying on shortcuts or any form of "don't ask/don't tell" thinking.

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Following up on Tuesday's posting, Jack Murray (Chicago) writes:

Bert - I agree wholeheartedly with your analysis. There is truly not (despite the apparent belief in some quarters to the contrary) such a thing as a "bankruptcy proof" entity. The recent Kingston Square Associates bankruptcy case in New York (1997) emphasizes this reality. One of the specific points the court makes in this case is that, "[i]t is universally agreed that when a corporation approaches insolvency or actually becomes insolvent, directors' fiduciary duties expand to include general creditors. Nearly all states' law is in accord...."

As the court correctly notes, the duties and loyalties of directors, general partners and others in a fiduciary positon with the "bankruptcy remote" entity change dramatically when financial difficulties ensue.

The moral is that we should never be cavalier about waiving or restricting the creditors' rights exclusion solely on the basis that the borrower or purchaser is structured as a bankruptcy remote entity.

Mike Fromhold (Valley Forge/Philadelphia) writes:

I wonder to what extent our files are sufficiently papered or memorialized, by whom, etc., in these transactions, knowing that the size and or complexity of the deal often will vary. Do we obtain written backgrounds including reps from lender, borrower, or their respective counsels? Memories make for poor testimony ( speaking for myself, of course) ... and whatever we remember hearing, including our cryptic illegible notes (yes, guilty as charged) probably won't line-up with the other side of the story and we'll be left to the vagaries of he said... she said.

I know we all receive the "slam dunk" request for creditors' rights coverage (endorsed removal of the exclsion or the issuance of the 1970 policy), but what about the rest? Query, how much information is enough and is it supported by a written request, such as an "over-limits authorization" form, as would typically be required under an agency contract. Presently, I believe each Region is left to establish and follow their own procedures, except where "a creditors' rights issue is perceived to exist", and then HO approval is needed. In view of the wake left by Joe Bonita's article, is it time to have procedures set nationally in this area which are protective and workable, and at the same time not perceived as being overly intrusive to either the client or the transaction?

Reply: Currently, underwriting the creditors' rights risk is viewed by Home Office underwriters as a work in progress. We've spent the better part of this year trying to figure out what the competition is doing--because we have to compete with 'em. The not-so-secret fear has been that they were getting reckless--giving out this coverage "like candy" (as Dave Westcott would say) with minimal underwriting.

Joe Bonita's article did little to calm that fear.

But at and after the ALTA meeting last week the conventional wisdom is that senior underwriters in other companies see this as an important issue--that they want to be careful. Cliff Morgan has expressed the opinion that Bonita's article may have been his effort to get the attention of his own underwriters--and maybe set some standards or parameters for them. Joe was forthcoming in acknowledging the risks, telling a story about a creditors' rights claim they recently had at CT where they had insured a purchase money mortgage, no less, which turned out to be a part of a much larger deal. The larger deal was an LBO and the whole mess wound up in BK court, with the insured purchase money mortgage being attacked as part of a fraudulent transfer.

Absolute nonsense! Still, they looked at potential costs of defense and opted for a quick settlement--paying $3 million. (Don't quote me on this--doing it from memory.)

So, I agree, we need to re-visit this with regional and state counsel, and plan to do so at regional meetings this fall.

Meanwhile, Frank Melchior (Iselin, NJ) writes:

Although I've read Joe's article, I suspect that there are numerous recipients of LandSakes who have not read this, nor have ready access to the article. Would it be appropriate to disseminate the article as an attachment?

Reply: Good idea. We'll try to post it Thurs. or Fri. We're still working on the quality of scanned images...and the LandSakes archives...please bear with us.

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In reply to our creditors' rights posting last week, Frank Melchior suggested we scan and post Joe Bonita's controversial (?) article. So here it is (and remember, it may be easier to read when printed).