Delaware Bankruptcy Court Recharacterizes $37B AIG Debt as Equity, Equitably Subordinates Claims in Major Win to Former Executives; Finds AIG Tortiously Swept Cash on Eve of Bankruptcy

Relevant Documents:
Opinion
Order

Judge Mary Walrath issued an opinion and order today in the first phase of trial on debtor AIG Financial Products Corp., or AIG FP’s, adversary proceeding against former executives seeking to subordinate their deferred compensation plan claims as debt subordinate in priority to a $65 billion intercompany revolving loan by parent company American International Group, or AIG Inc., to the debtors. The judge finds in favor of the executives’ counterclaims, recharacterizing the intercompany loan as equity and subordinating it to the compensation plan claims.

Judge Walrath also finds that AIG committed a tort through its unilateral set-off of $127 million of the debtor’s cash pool funds against the revolver on the eve of the debtors’ December 2022 bankruptcy filing. The judge finds that the executives’ claims for tortious interference with the compensation plan are otherwise time-barred and that AIG Inc. is not a subject to successor liability for the compensation plan claims.

Judge Walrath issued the ruling after a nine-day evidentiary hearing on Phase 1 threshold issues of recharacterization, equitable subordination, and tort and asset transfer claims. In the next phase of the proceedings Judge Walrath will consider breach of contract claims, damages due to the set-off and successor liability against AIG FP’s subsidiary Matched Funding, an entity that received the debtor’s remaining derivative contracts and related collateral in 2022.

Today’s ruling threatens the underpinnings of the debtor’s plan, which proposes to convert AIG Inc.’s $37.4 billion unsecured revolving loan claim in exchange for the parent’s retention of its existing AIG FP interests.The executives’ appeal of the bankruptcy court’s denial of their motion to dismiss the debtor’s chapter 11 case is pending before the U.S. Court of Appeals for the Third Circuit.

The group of executives includes 46 former employees of the debtor who are plaintiffs in a Connecticut state court action for deferred compensation. The dispute is about a $65 billion intercompany revolving loan extended by AIG Inc. (through nondebtor affiliate AIG Funding Inc.) to the debtor at the height of the 2008 financial crisis. The loan channeled proceeds from an $85 billion loan that AIG Inc. received from the Federal Reserve Bank of New York in 2008.

The former employees argued that the revolving credit line should be recharacterized as equity and that AIG FP is seeking to characterize the parent’s funding as debt in order to avoid paying them their deferred compensation. According to the executives, AIG FP was required to restore account balances or adopt a plan of repayment by December 2013 under the compensation plan, but instead the debtors engaged in financial maneuverings “in collusion with, and at the direction of, AIG Inc.,” in an attempt to avoid liability for the deferred compensation.

In her recharacterization analysis, Judge Walrath tests the “economic reality” of the funding transactions under the Third Circuit’s 2006 SubMicron decision. Although the document and relevant correspondence “called the advances loans,” the judge finds that AIG Inc.’s control, the parties’ conduct and the “economic reality” show that the advances were an equity infusion.

Judge Walrath notes that the transactions were not at arm’s length and are subject to particular scrutiny because AIG Inc. “totally controlled” the debtor. The judge notes that this control is “particularly evident” in the adversary proceeding,” noting that AIG Inc. relied on the AIG FP to conduct the trial and that the debtor opposed recharacterization “even though it would significantly reduce the amount of claims against the estate.”

Analyzing the parties’ conduct, Judge Walrath observes that AIG Inc. advanced billions of dollars through its funding subsidiary for over two years before the revolving loan and promissory note were executed in October 2010. The judge notes there is no evidence that the debtors’ board approved the loan, despite a documentary requirement. Further, Judge Walrath concludes that AIG Inc. “did not act as a creditor normally would,” in that although it unilaterally drafted the loan documents, the parent company failed to include “normal” credit terms, performed no due diligence or credit analysis, and “had no expectation that it would be repaid.”

Judge Walrath finds AIG Inc. “divulged its true intent” when it abandoned a plan to recapitalize the debtors in 2010. According to the opinion, AIG Inc. proposed to convert $35 billion of the loan to equity, offsetting a $18 billion against a tax receivable it owed to the debtor that would have left only a $2 billion balance on the revolver.

AIG Inc. said the recapitalization would have assisted it in repaying its obligations to the Federal Reserve and restoring the debtors’ profitability. The judge, however, says that AIG Inc. “abandoned” the recapitalization only after outside counsel warned that restoring the debtor to solvency could trigger a potential $600 million obligation to restore the former executives’ deferred compensation accounts, according to a citation to the evidentiary record.

Judge Walrath quotes an email from then-AIG CFO David Herzog stating: “I don’t care how it’s driven, we’re not paying the deferred comp.” The judge notes that AIG Inc. “finally papered the FP Revolver as debt only after abandoning the recapitalization.” At the same time, the judge says, AIG Inc. was considering a change to its intercompany loan policy that would have required it to treat the revolver as equity.

In the evaluation of the “economic reality” of the transaction, Judge Walrath observes that the conditions of the Federal Reserve’s loan prohibited AIG Inc. from making equity contributions to subsidiaries absent government consent. The judge says that given the “political climate” resulting from the 2008 financial crisis, AIG Inc. “had to call its advances to FP a loan even though it considered them an equity infusion.”

The judge says an analysis under the Sixth Circuit’s 2001 AutoStyle decision would confirm its conclusion on recharacterization.

In an alternative ruling, Judge Walrath also finds that the revolver is subject to subordination to the executive’s claims. The judge applies “rigorous scrutiny” to the transactions due to AIG Inc.’s insider status and finds that the parent company injured the executives by preventing the debtors from restoring the deferred compensation balances as required under the plan, misleading the executives by suggesting that a restoration plan could be implemented, aborting the plan to recapitalize the debtor and exercising set-off rights against the debtor’s funds.

Judge Walrath rejects the debtor’s contention that the decision to abort the recapitalization plan was a “rational financial decision” because it would allow them to avoid paying the deferred compensation claims. The judge says the owed compensation is “de minimus” compared with the over $6 billion in additional interest expense that the debtor incurred after the recapitalization plan was aborted and finds that AIG Inc.’s decision was intended to “benefit itself and harm” the debtor and the former executives.

Judge Walrath finds that the novation of 94 of the debtor’s 97 remaining derivative contracts to Matched Funding constitutes a transfer of approximately 79% or $1.1 billion of the debtor’s $1.4 billion in remaining assets and “foreclosed” the debtor’s ability to continue operations. As a result, the judge concludes that Matched Funding is a successor under the compensation plan’s transfer clause.

Judge Walrath, however, declines to find that approximately $33.9 billion in 2022 intercompany offsets or the $127 million prepetition cash sweep give rise to successor liability for AIG Inc. because the transactions did not move assets away from the debtor.

The prepetition cash sweep does, however, give rise to a prima facie tort claim against AIG Inc. According to the judge, there is “sufficient evidence” that AIG Inc. had an “improper motive” and was acting to “strip” the debtor of its assets before the bankruptcy filing to forestall a recovery by the executives.

As to the executives’ tortious interference with contract claim, the judge finds that it is barred by Delaware’s three-year statute of limitations. As detailed in the decision, the injury occurred when FP failed to restore the account balances by the plan’s Dec. 31, 2013, deadline, and was barred in 2016 before the former executives asserted the claim in the 2023 adversary proceeding.