Side-Stepping Exposure to Bankruptcy Litigation: Fraudulent Transfers and Centralized Cash Management Systems

Account managers may consider receiving payments from a customer as an unequivocal victory, but they might want to take a closer look at who is actually making the payment before celebrating too much. A careful analysis may avoid being drawn in to what is a growing trend in large Chapter 11 bankruptcy cases: fraudulent transfer claims related to centralized cash management systems. By receiving payments from an entity different from the one it contracted with, a vendor may be exposing itself to fraudulent transfer liability. While courts are still sorting through these issues, creditors can try to avoid this headache by understanding the issues involved and taking certain preventative measures.

Fraudulent Transfer Actions: What Are They?

A debtor can try to recover certain transfers of assets it made shortly before filing for bankruptcy, including those deemed a "fraudulent transfer." Of the two kinds of fraudulent transfers-"actually fraudulent" and "constructively fraudulent"-corporate debtors more often pursue transfers under the theory that they are constructively fraudulent. Constructive fraud is found where the debtor received less than "reasonably equivalent value" in exchange for the transfer and the debtor:

(1) was rendered insolvent as a result of the transfer;

(2) was engaged in or about to engage in a business or transaction for which the debtor's remaining assets after the transfer were unreasonably small in relation to its business; or

(3) believed or should have reasonably believed that after the transfer it would incur debts beyond its ability to pay them as they became due.

For example, if a company transfers its only asset, a piece of land worth $50 million, to a creditor to satisfy a debt of $500,000 and the company soon files for bankruptcy, the debtor may recover the land on the basis that it did not receive reasonably equivalent value.

A debtor can recover fraudulent transfers that occurred two years before filing for bankruptcy, and sometimes longer depending on the relevant state's fraudulent transfer law.

Centralized Cash Management Systems and How They Relate to Fraudulent Transfers

Though not exclusively, most centralized cash management systems (CMS) are used by complex corporate entities that have multiple divisions and subsidiaries, and are generally structured with a parent holding company and operating subsidiaries. While the exact arrangements may vary, the basic concept is simple: the operating subsidiaries do not maintain individual bank accounts, but rather "upstream" cash to the parent corporation. The parent corporation pools cash from all of its operating subsidiaries and uses those pooled funds to pay expenses for the operating subsidiaries, including payments to third-party vendors that contract with the subsidiary rather than the parent, and provide goods and services directly to the subsidiary and not to the parent. Even though the cash is generated by the subsidiary, once a subsidiary upstreams its cash to the parent, that money belongs to the parent. The parent may not be legally obligated to pay the subsidiaries' expenses, but the system benefits the parent and the subsidiaries by reducing administrative costs and providing the parent flexibility by allowing it to allocate cash where needed.

For example, Vendor V may have a contract with Subsidiary S to provide S software for S's operations. S is a wholly owned subsidiary of Parent P and all of S's cash is upstreamed to P, which is simply a holding company with no independent operations. P is not a party to the software agreement between S and V, and P is not obligated to pay S's bills, but it does so for its own administrative ease. P cuts a check to V to pay for the software it provided to S even though: (1) P does not use the software V provided; and (2) P was not obligated to pay S's software expenses.

Under this scenario, if P were insolvent or rendered insolvent by the transfer, P arguably made a fraudulent transfer because P did not receive any direct benefit from the software provided by V, but still paid V for the service. That is to say, P did not receive reasonably equivalent value-here, software-in exchange for the payment it made to V.

Additionally, if S is insolvent, then P can make another argument that the transfer was constructively fraudulent. Remember that S is a wholly owned subsidiary of P, so P holds all of S's equity. S's equity is of no value, therefore paying for services that benefit S does not render S's equity more valuable. S is still insolvent and its equity is worth nothing.

Possible Defenses to CMS-Related Fraudulent Transfer Claims

Though the fraudulent transfers/CMS theory has been pursued in several large Chapter 11 cases, including those of defunct energy trading company Enron Corp. and shuttered title insurance company LandAmerica Financial Group, Inc., many of these fraudulent transfer cases have been resolved through settlements rather than litigation where a court issues a decision. As a result, a vendor's attorney generally cannot point to a case supporting the argument that the debtor did in fact receive reasonably equivalent value in exchange for the transfer the debtor is trying to recover.

While courts continue to work through these issues, vendors can raise certain arguments to support the position that the transfers they received were not constructively fraudulent. None is a sure-fire argument, but vendors may wish to consider one of these defenses if it applies to their situation:

Indirect benefit: A transfer may not be fraudulent if the parent received reasonably equivalent value by virtue of the socalled "indirect benefit rule." Under this theory, the vendor argues that the subsidiary's operations provided incidental value to the parent. Said another way, the parent received a benefit where the parent and the subsidiary are so closely related that there is an "identity of interest": what benefits one benefits the other. Therefore, if P and S are so closely related that the benefit to one constitutes a benefit to other, V could argue that its software provided a benefit to P in addition to S.

Parent received subsidiary's cash: Related to indirect benefit, another argument available to a vendor is that the parent was able to make the transfer in the first place because the subsidiary generated the upstreamed cash from which the transfer was made and that upstreamed cash itself provided reasonably equivalent value to the parent. In the S and P example, S's use of the software enabled it to carry on its operations, which in turn allowed it to generate cash that was then upstreamed to P. Under that scenario, P benefited from S using the software in the form of cash S generated as a result of having software to operate, therefore P received reasonably equivalent value in exchange for paying for S's software use.

Collapsing transactions: Finally, a vendor may argue that the parent attempting to recover a payment made on behalf of a subsidiary is improperly separating what is essentially a single transaction. The vendor supplied goods or services to the subsidiary that used those goods or services in its operations to generate cash. That cash was temporarily handed to the parent, which used that same money to pay the subsidiary's vendor. The transfer should be viewed as a single transaction rather than separate transactions as money essentially went from the subsidiary to the vendor and merely passed through the parent.

None of these theories is likely a perfect solution, and each may require hiring a financial or accounting expert to show the value of the goods or services provided, or to trace the flow of funds between the subsidiary, the parent and the vendor. However they may provide the vendor some ammunition to, if nothing else, negotiate a settlement, which may result in reduced legal expenses than if the vendor pursued the case in court.

Strategies for Minimizing CMS-Related Fraudulent Transfer Liability

Of course, the most effective protection against a fraudulent transfer claim in connection with a CMS may be to take steps to prevent a fraudulent transfer claim in the first place. Vendors may wish to consult an attorney for assistance in taking proactive measures to minimize the likelihood that they face a fraudulent transfer suit, including:

* Identify the entity making payments. Determine if the entity tendering payments is the same as the one receiving the goods or services, or if it is obligated to make payments for the services. Monitor payments to ensure that the payor remains the same, or otherwise is an entity that is obligated to make payments.

Get a guaranty. If a parent company is making payments on behalf of a subsidiary, ask that the parent guarantee payment for the goods or services the subsidiary is receiving. If the parent is obligated to pay for the services, it will receive reasonably equivalent value in exchange for the payments because the payments will reduce its liability.

Change the entity tendering payments. Ask that the payments be made directly from the entity receiving the goods or services or by an entity that is otherwise obligated to pay for the services.

Other ideas and solutions may be available depending on the circumstances. Consulting an attorney with experience in bankruptcy and creditors' rights issues may help a vendor and its customer develop an arrangement that meets all parties' needs, including protection against a fraudulent transfer claim.

Takeaway Lessons

Getting paid may seem like enough of a challenge without credit managers having to determine who is making the payment, but getting paid may not be the end of the story, particularly if the payor is a large corporation that uses a CMS. By knowing what entity is tendering payments, and what relationship it has to the entity receiving the goods and services, creditors may save themselves significant time and expense in the future. ^

A careful analysis may avoid being drawn in to what is a growing trend in large Chapter 11 bankruptcy cases: fraudulent transfer claims related to centralized cash management systems.

Even though the cash is generated by the subsidiaries, once a subsidiary upstreams its cash to the parent, that money belongs to the parent.

While courts continue to work through these issues, vendors can raise certain arguments to support the position that the transfers they received were not constructively fraudulent.

None of these theories is likely a perfect solution...However they may provide the vendor some ammunition to, if nothing else, negotiate a settlement, which may result in reduced legal expenses than if the vendor pursued the case in court.

CHRISTOPHER GIAIMO. ESQ.. DONALD WORKMAN. ESQ. AND DENA KESSLER. ESQ.

Christopher}. Giaimo, Esq. and Donald A. Workman, Esq. are partners and Dena S. Kessler, Esq. is an associate at Baker Hostetler LLP in Washington, D.C. where they practice in the firm's Bankruptcy, Restructuring, and Creditors' Rights group. They can be reached at [email protected] and 202-861-1672, [email protected] and 202-861-1602, and [email protected] and 202-861-1640.