The Texas Two-Step & Fraudulent Asset Transfers
The Texas Uniform Fraudulent Transfer Act (“TUFTA”), defines a fraudulent transfer as a transfer made by a debtor (1) with actual intent to hinder, delay or defraud a creditor, or (2) without receiving a reasonably equivalent value in exchange for the transfer in proportion to the debtor’s remaining assets or ability to repay its debts. Actual intent is determined based on a series of factors, which include the party to whom the transfer was made, who retained possession or control of the transferred property, concealment, the threat of suit, the percentage of the debtor’s assets which were transferred, insolvency, and timing.
A corporate restructuring trend has recently taken off which commentators have dubbed the “Texas Two-Step,” whereby companies use divisive mergers to insulate their assets from their liabilities, and then seek to resolve the liabilities through bankruptcy. A company which has accumulated a significant amount of debt converts into two or more entities, and allocates (and separates) its assets and liabilities between them. The entity burdened with the liabilities then initiates Chapter 11 bankruptcy proceedings in an effort to resolve the claims. Divisive mergers are permitted by the Texas Business Organizations Code (“TBOC”), which alternatively defines merger as “the division of a domestic entity into two or more domestic entities or other organizations.” Under the Code, when a merger takes effect, title to the assets and liabilities passes without any legal transfer or assignment.
In practice, caselaw addressing the Texas Two-Step has been limited to mass tort liability cases, wherein a company facing a mountain of tort liability uses a divisive merger to transfer the liabilities and limited assets to a new entity created for the purpose of resolving the tort claims, which files bankruptcy in an attempt to resolve the claims at once, while a separate new entity takes on (at least) the lion’s share of the company’s assets and continues to operate the business unburdened by the liabilities. Courts have appeared to side with the transformed companies, holding that the liability-ridden company’s bankruptcy filing is permissible where the filing is based on a “valid reorganizational purpose” – like addressing present and future liabilities associated with ongoing tort claims to preserve corporate value. However, the Courts have stopped short of stating that the maneuver would be permissible under all circumstances, instead undertaking an analysis based on the totality of the circumstances to determine whether the use of a divisive merger amounts to bad faith warranting a dismissal of the bankruptcy filing. Totality of the circumstances requires consideration of litigation posture and pre-petition litigation conduct outside of the bankruptcy proceedings, the debtor’s subjective intent, the debtor’s financial distress, pressures from creditors, the extent of assets, structure and formation of the debtor, and the debtor’s reorganizational purpose and exit strategy. This approach considers whether the debtor utilized the divisive merger and bankruptcy filing for the sole purpose of hindering a creditor, which appears to mirror TUFTA’s approach to determine whether a fraudulent transfer has occurred, and suggests that in some cases, the Texas Two-Stepping debtor will still have to face the music. One court expressly recognized this possibility, finding that if a debtor used the TBOC divisive merger statute to commit a fraudulent transfer, TUFTA and the U.S. Bankruptcy Code’s fraudulent transfer provision would be available to address those actions.
In July 2021, the Nondebtor Release Prohibition Act (H.R. 4777) was introduced in the House, which would require dismissal of bankruptcy proceedings if the debtor or its predecessor was formed by divisive merger with the intent or foreseeable effect, and actual effect, of separating material assets from material liabilities in the 10-years preceding the filing of the bankruptcy petition. This bill has not advanced beyond its introduction and it remains to be seen whether this bill or one like it will become law. In the meantime, creditors are not completely without recourse. Within the bankruptcy proceedings, creditors can challenge divisive mergers as fraudulent transfers and can seek substantive consolidation of the successor entities’ liabilities and assets. In some cases, creditors may attempt to pierce the corporate veil and seek relief from officers and shareholders.
Kuiper Law Firm, PLLC understands the challenges creditors face when a debtor files bankruptcy, and the added complexity where a divisive merger is at issue; and we will continue to monitor legal developments related to the Texas Two-Step and creditors’ rights. If you have any questions about the information in this article, or how it applies to you and your business, do not hesitate to contact us.