My friend Thomas Lifson of the American Thinker invites me to comment on the recent organizational shake-up at left-liberal radio talk show network Air America. As reported in today's WSJ (available free here), Air America is in deep financial trouble:
Many of Air America's investors and executives say they thought the network had raised more than $30 million, based on assurances from its owners, Guam-based entrepreneurs Evan M. Cohen and Rex Sorensen. In fact, Air America had raised only $6 million, Mr. Cohen concedes. Within six weeks of the launch, those funds had been spent and the company owed creditors more than $2 million.
When the problems came to light, "we realized that we had all been duped," says David Goodfriend, the company's acting chief operating officer.Indeed, if the facts turn out to be as the article reports, there is a very high probability that investors will be able to sue Cohen and Sorensen for securities fraud. But let's set that issue aside.
Instead, Thomas asks me to focus on the creditors. As Thomas points out:
The assets of Air America are reported to be sold to a new corporate entity, leaving creditors of its existing corporate parents, Progress Media and Radio Free America, high and dry. According to the Chicago Tribune article, the new owner will be an outfit called Piquant, LLC, controlled by the original founders of the mini-net, Sheldon and Anita Drobney. Supposedly, millions are owed by the current corporate parents.The planners of this transaction had a number of options for how they could have structured the deal; they could, for example, have merged the old entities into the new one. In choosing the form by which to effect a reorganization of a business, the planner takes into account a host of considerations. As I point out in my book Mergers & Acquisitions, successor liability can be a critical factor in the choice between a merger and a sale of assets:
In a merger, the surviving company succeeds to all liabilities of each constituent corporation. In an asset sale, subject to some emerging exceptions in tort law, the purchaser does not take the liabilities of the selling company unless there has been a written assumption of liabilities.This result follows because corporate law typically elevates form over substance, which is generally a good thing because it thereby provides necessary predictability and certainty for transaction planners. (I offer some further observations on this point in my post Some Thoughts on how Lawyers Add Value to Transactions.)
In an asset sale, as a matter of form, the selling corporations remain in existence and, as such, remain liable for the debts they have incurred (the debts are obligations of the entity). The creditors could have taken this risk into account ex ante either by tying their loan to particular assets (in other words, by taking a security interest in specific assets) or through appropriate provisions in the loan documents requiring an assignment of the debt to the purchaser of the assets.
There is an old saying: "God helps those who help themselves." Corporate law similarly takes a "you made your bed, now you must lie in it" attitude in many cases. If the creditors failed to protect themselves ex ante, they may well be SOL.
Yet, on facts like this, the creditors do have a couple of cards to play. They can attack the transaction as a fraudulent transfer.
Basically, a Fraudulent Transfer (a/k/a "Fraudulent Conveyance") is a transfer which a debtor makes for the purpose of defeating a creditor's collection efforts against the debtor. This typically happens when, say, a debtor attempts to "sell" everything to his wife, cousin or business partner for $5 to keep his stuff out of the hands of his creditors. If the court figures out that the transaction is a sham to defeat the creditor, the court will set aside the transaction and make the person holding the assets give them to the creditor.As Thomas notes, this transaction smacks of an effort to hinder Air America's creditors, which is decidedly not a good thing. Since it appears likely, based on the WSJ article, moreover, that the selling entities were de facto insolvent at the time of the transfer, the probability that a court would find a fraudulent transfer goes up significantly. The sellers will have to show that the selling entities received fair value and that the transaction had economic substance above and beyond merely stiffing their creditors.
Another option for the creditors would be to seek to pierce the corporate veil of the selling entities to hold their owners liable. Since the purchasing entity was owned by most of the same investors as the selling entities (another factor that will weigh in favor of finding a fraudulent transfer, by the way), the creditors may be able to recover from the individual investors. As I explain in Chapter 4 of my book Corporation Law and Economics, the precise phrasing of the test for veil piercing varies from jurisdiction to jurisdiction. Under a common phrasing, the creditors would have to show that:
(1) the corporation was the controlling shareholder's alter ego; and (2) adherence to the limited liability rule would "sanction a fraud or promote injustice." Under this standard, the prospect of an unsatisfied claim is not enough to meet the latter prong of the test. After all, why would a plaintiff invoke the doctrine if the corporation had enough assets to satisfy the claim? If an unsatisfied claim sufficed, the veil would be pierced in every case. ... Instead, there must be some element of unjust enrichment.If they could show that the investors allowed the selling entities to continue borrowing even while the investors were planning the reorganization, for example, the requisite fraud or injustice could be found.
Note that I am discussing here the prospect of civil liabilities, rather than criminal charges. The securities fraud claims by investors in Air America could lead to criminal charges by the Justice Department if Cohen and/or Sorensen willfully misrepresented material facts or omitted material facts they had a duty to disclose. The creditor claims of fraudulent transfer and/or veil piercing, however, would be purely a question of civil liability by which the creditors would be able to recover their losses either from the purchasing entity or the owners of the selling entities. Note also that I assuming that there are in fact unsecured creditors of the selling entities whose claims have not been assigned to the purchasing entity.