Shearman And Sterling

Financial Institutions Advisory & Financial Regulatory, Time and Money

December 16, 2022

Judge Drain Tackles Private Equity and Fraudulent Transfers in ‘Tops’ Decision


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On October 12, the Honorable Robert D. Drain, U.S. Bankruptcy Judge for the Southern District of New York, issued his final decision from the bench in the bankruptcy cases of supermarket chain Tops Holdings II Corporation (“Tops”). The decision came in an adversary proceeding seeking to avoid four dividend payments totaling $375 million from 2009–2013 paid to the Tops’ private equity investors (the “PE Group”) as constructive and actual fraudulent transfers and also hold the director-defendants responsible for breaching their fiduciary duties.

The Court largely denied the defendants’ motion to dismiss, in which they asserted that the dividends were safe harbored under Bankruptcy Code section 546(e) and the breach of fiduciary duty claims were time-barred, and held that the litigation trustee could proceed with the majority of the stated causes of action, most notably the constructive and actual fraudulent conveyance claims and damages against the director-defendants for unlawfully approving certain dividend payments.

In 2007, the PE Group acquired Tops for $300 million, contributing $100 million in equity and funding the balance of the purchase price with $200 million of secured debt. Initially, the PE Group offered to pay an additional $115 million, but decreased its offer because the seller declined to indemnify the PE Group against Tops’ pension plan liabilities. Tops’ pension plan liabilities increased to $515 million by 2013 while its secured debt load more than doubled to ~$650 million, with capital expenditures also materially reduced. Overleveraged and unable to pay its creditors, Tops sought chapter 11 bankruptcy protection in 2018, and after confirmation of its chapter 11 plan, the litigation trustee filed the aforementioned complaint.

Here, we outline key takeaways of the decision:

  • Fraudulent transfer claims may succeed even after the six-year lookback period has expired. The litigation trustee sought to claw back the dividends under sections 544 and 550 of the Bankruptcy Code, which utilizes state law avoidance powers and statute of limitations—in this case, New York’s six-year statute of limitations. In order to circumvent New York’s lookback period, the litigation trustee identified the IRS as the triggering unsecured creditor and relied on the nullum tempus doctrine (“no time runs against the king”). Under the nullum tempus doctrine, the United States is not bound by statutes of limitation. The litigation trustee conceded that the nullum tempus doctrine is limited by 26 U.S.C. § 6502, which establishes two separate time limits for the IRS to enforce its right to collect a tax: (i) a timely assessment (usually three years post-tax return filing) and (ii) if timely assessed, a ten-year collection/litigation period. Judge Drain noted that it is the IRS’s status as a creditor at the time of the transfer that gives it standing, not the assessment. Reading these doctrines together, the opinion concludes that the IRS “‘need not assess the tax to qualify as a triggering creditor for purposes of § 544(b),’ only that after an assessment it has ten years to commence suit.”

    Judge Drain determined that, at this stage, there could be merit to the litigation trustee’s position and was not willing to hold that trustee’s claims were time-barred.
  • Dividend payments may not be protected under the safe harbor provisions of Bankruptcy Code section 546(e). For an alleged fraudulent transfer to be subject to the safe harbor provisions of the Bankruptcy Code, the transfer must constitute a qualifying transaction that is made by a qualifying participant.

    Judge Drain found that the dividends at issue did not constitute qualifying transactions under section 546(e) because unlike the “settlement payment” in Merit Mgmt., Tops received nothing from the PE Group in exchange for the dividends.

    Moreover, no qualifying participants were party to the dividends. The PE Group argued that the transfers were made from Tops’ bank to the PE Group’s banks, which were acting as agents or custodians for their customers (i.e., the PE Group). However, the PE Group did not identify any agency or custody agreement between the banks and Tops or the PE Group. Therefore, Judge Drain held that a depositor into a bank account, without additional documentation, has only a debtor/creditor relationship with the bank.
  • The trust established a claim for actual fraudulent transfer. Fraudulent intent may be established by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness. Judge Drain upheld the trust’s claim for intentional avoidance and recovery of an actual fraudulent transfer because the trustee provided evidence that Tops and the PE Group knew (i) the solvency analyses justifying each dividend were facially and materially inconsistent with one another and internal valuations, (ii) the pension liabilities would render Tops insolvent, and (iii) the projections upon which the solvency opinions relied were unrealistic. Judge Drain noted that, although it is expected for a corporation to pay dividends to its shareholders, Tops’ actions, taken while under control of the PE Group, were not the actions that directors and officers would be expected to take under such circumstances. Judge Drain stated that “[i]t 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.”
  • Provide all information when seeking solvency opinions. Judge Drain’s decision also casts a light on material deficiencies within the solvency opinions relied on by the PE Group to defend its receipt of the contested dividends. Tops engaged multiple financial advisory firms to provide opinions on the dividends at issue, but failed to provide their advisors with material disclosures, including the existence of the pension liabilities. In fact, as part of the engagement of these firms, Tops agreed that the financial advisory firms would not “independently verify the accuracy or completeness of” the information provided to them.

    Judge Drain characterized this lack of independent verification as a “garbage in/garbage out” approach and cited these deficiencies as among the reasons why the defendants had not met their burden in support of the motion to dismiss. Both financial advisory firms and those engaging such outside experts should take careful note of Judge Drain’s critique and in future situations, ensure that all liabilities of the target company are disclosed and verified before a solvency opinion is issued.
  • Code changes to come? In a moment of reflection, Judge Drain posed the question as to “why Congress has put the courts to all this parsing and hair splitting over (a) whether a transaction is one or many and, if many, has the avoidable transaction has been properly identified, or (b) whether there is a qualifying participant that is a proper customer, agent or custodian.”

    In his view, all that truly matters is whether the dividends rendered Tops insolvent—whether the dividends are safe harbored is just a distraction. Judge Drain suggested that “Congress should act to restrict to public transactions its current overly broad free pass in section 546(e) that has informed the playbook of private loan and equity participants to loot privately held companies to the detriment of their non-insider creditors with effective impunity.”

    It remains to be seen whether Congress will heed Judge Drain’s advice and take up the scope of the application of section 546(e) as an additional item to address in any future bankruptcy reform legislation.

Authors and Contributors

Jordan Wishnew


Financial Restructuring & Insolvency

+1 212 848 7090

+1 212 848 7090

New York

Allison Selick


Financial Restructuring & Insolvency

+1 212 848 8182

+1 212 848 8182

New York