Second Circuit Adopts "Control Test" For Imputation Of Fraudulent Intent In Bankruptcy Avoidance Litigation

• Published date: 16 November 2021
• Subject Matter: Corporate/Commercial Law, Criminal Law, Insolvency/Bankruptcy/Re-structuring, Corporate and Company Law, Directors and Officers, Insolvency/Bankruptcy, White Collar Crime, Anti-Corruption & Fraud, Shareholders
• Law Firm: Jones Day
• Author: Mr Daniel Merrett and Mark Douglas

In yet another chapter in the tortured saga of the fallout from the failed 2007 leveraged buyout ("LBO") of media giant The Tribune Co. ("Tribune") in a transaction orchestrated by real-estate mogul Sam Zell, the U.S. Court of Appeals for the Second Circuit largely upheld lower court dismissals of claims asserted by Tribune's chapter 11 liquidation trustee against various shareholders, officers, directors, employees, and financial advisors for, among other things, avoidance and recovery of fraudulent and preferential transfers, breach of fiduciary duties, and professional malpractice. In In re Trib. Co. Fraudulent Conv. Litig., 10 F.4th 147 (2d Cir. 2021), reh'g en banc denied, No. 19-3049 (2d Cir. Oct. 7, 2021), the Second Circuit affirmed four district court rulings dismissing the liquidating trustee's claims against all of the defendants except two financial advisors alleged to have received fraudulent transfers in the form of fees paid in connection with the LBO. In so ruling, the Second Circuit adopted the "control test" for determining whether the fraudulent intent of a company's officers can be imputed to its directors for the purpose of avoidance litigation.

Tribune

In 2007, Tribune, owner of WGN America, The Chicago Tribune, and the Los Angeles Times, was the target of a two-stage LBO conceived by Zell that ultimately paid Tribune's shareholders more than $8 billion in exchange for their shares in the company. Prior to the LBO, Tribune's board of directors created a special committee to evaluate the LBO. The special committee included seven independent directors that served on the board.

Tribune had previously hired two financial advisors, Merrill, Lynch, Pierce, Fenner, and Smith, Inc. ("Merrill") and Citigroup Global Markets, Inc. ("Citigroup"), to conduct a strategic review and recommend possible courses of action. Both were also permitted to play a role in potential LBO financing, and each was contractually entitled to a $12.5 million "success fee" if a "strategic transaction" was completed. In addition, the special committee engaged Morgan Stanley & Co. LLC ("Morgan Stanley") to serve as its independent financial advisor.

There were two separate steps to the LBO. First, Tribune borrowed approximately $7 billion and purchased approximately 50% of its outstanding shares in a tender offer. Second, six months later, the company bought its remaining shares and borrowed an additional $3.7 billion in a go-private merger with a newly formed Tribune entity. The board engaged Duff & Phelps to provide a solvency opinion for both steps.

Duff & Phelps was also engaged to provide a solvency opinion by GreatBanc Trust Co. ("GreatBanc"), which served as the trustee for Tribune's employee stock ownership plan ("ESOP"). As part of the first step of the LBO, GreatBanc purchased $250 million in unregistered stock from Tribune on behalf of the ESOP. After the conclusion of the second step, the ESOP was the majority owner of Tribune.

Duff & Phelps never issued a solvency opinion to Tribune's board. Instead, for a fee of $750,000, Duff & Phelps delivered a "viability opinion" to GreatBanc in which it concluded that, considering potential tax savings, Tribune would be able to pay its debts as they became due after the LBO. The viability opinion took into account the tax savings expected to be realized from ESOP ownership and "expressly disclaimed" that it was a solvency opinion.

The same day, Morgan Stanley and Merrill issued "fairness opinions" that the price to be paid for Tribune's stock was fair. The special committee then unanimously voted to recommend the LBO, after which a majority of Tribune's board, including six of the independent directors, voted in favor of it. The board retained Valuation Research Company ("VRC") to render solvency opinions concerning both parts of the transaction, which it delivered shortly before the completion of each part of the LBO in exchange for a fee of $1.5 million.

Shortly after the second stage of the LBO was completed in December 2007, Tribune experienced financial difficulties due to declining advertising revenues and failed to meet projections. The company filed for chapter 11 protection in December 2008 in the District of Delaware.

A flurry of litigation ensued, with suits filed in 21 states as well as the Delaware bankruptcy court alleging, among other things, fraudulent payments to Tribune shareholders, breaches of fiduciary duties, Delaware corporate law violations, and professional malpractice.

In Neil v. Zell, 753 F. Supp. 2d 724 (N.D. Ill. 2010), the U.S. District Court for the Northern District of Illinois ruled that GreatBanc breached its fiduciary duties to Tribune's employees by allowing the ESOP to purchase unregistered stock during the LBO that did not qualify for an exemption under federal law, instead of buying common stock on the open market. The court later certified a class action in the litigation, which was settled in 2012 for an amount exceeding $17 million.

In December 2011, the U.S. Judicial Panel on Multidistrict Litigation consolidated the Tribune lawsuits in the U.S. District Court for the Southern District of New York.

The U.S. Bankruptcy Court for the District of Delaware confirmed Tribune's chapter 11 plan in July 2012. The plan assigned the estate's causes of action to a litigation trust. The litigation trustee ("trustee") then became the successor plaintiff in the multidistrict litigation.

Prior Tribune Court Rulings on...