Tops Bankruptcy: a Lesson in Leverage

August 16, 2018 | by Robert J. Feldman

In February of this year, Tops Holding II Corporation (“Tops II”) and its operating subsidiaries (collectively the “Tops Companies”) filed Chapter 11 bankruptcy petitions in the Southern District of New York.  Tops II, owned by a local group of executives, had purchased the stock of the Tops Companies in late 2013.  In consideration, Tops II paid approximately 21 million dollars.  However, at the time of the purchase, the Tops Companies were encumbered by borrowings of over half a billion dollars, engineered by their prior owner, a Morgan Stanley private equity entity (the “Morgan Stanley Group”). During the period it owned the Tops Companies, the Morgan Stanley Group had incurred those borrowings on behalf of the Tops Companies, and had used the majority of such borrowings to make dividend distributions in excess of 340 million dollars, to itself.  The result was a company with operating profits of approximately 40 to 50 million dollars a year, but with interest payments due on the Morgan Stanley Group borrowings totally 70 to 80 million dollars a year. 

Problems emerged almost immediately following Tops II’s purchase in late 2013. Despite revenue of over 2 billion dollars, operating profits could not meet the interest due upon the outstanding debt.  In the first month of Tops II’s ownership (December of 2013), the Top Companies generated an operating profit of approximately 3.3 million dollars.  However, its interest expense during that first month under new ownership was 6.4 million dollars, resulting in a net loss of over 3 million dollars.  In fact, according to publicly available securities filings, although the Tops Companies generated an operating profit in every reporting period between the acquisition from the Morgan Stanley Group and the date of the bankruptcy filings, such operating profits were always less than the amount of interest due and owing on the debt incurred by the Morgan Stanley Group.  In short, while the Tops Companies always had an operating profit, they may have been so heavily leveraged that they were rendered unable to generate a net profit. 

In the currently pending Chapter 11 reorganization proceeding of Tops II and the Tops Companies, the Official Committee of Unsecured Creditors (the “Creditors Committee”) is seeking to investigate whether or not, under the above referenced circumstances, the dividend distributions made to the Morgan Stanley Group constituted a fraudulent transfer under either New York law or substantive bankruptcy law.

Leveraged buyouts, in which money is borrowed from an operating company to fund its acquisition, have been frequently challenged as fraudulent transfers on the theory that they leave the subject operating company insolvent, with unreasonably small capital, and/or unable to pay its debts as they come due.  The Creditors Committee is investigating whether the Tops II scenario, is an actionable variation of this fact pattern, in that the heavy borrowing by the Morgan Stanley Group occurring in the two years prior to its sale of the Tops Companies to Tops II, had the same effect: a company so heavily leveraged with debt, that it was left insolvent or with unreasonably small capital from the outset. 

The Creditors Committee is seeking a Bankruptcy Court order compelling the production of documents related to the dividend distributions made to the Morgan Stanley Group and the sale of the Tops Companies to Tops II.  In Bankruptcy Court filings, the Creditors Committee describes its reasons for requesting the documents (said request being opposed by Tops II and the Tops Companies) as follows: “[g]iven the magnitude of the dividend payments and the source of the funds used to pay those dividends, the [Creditors] Committee is investigating whether the Morgan Stanley Group dividends are subject to avoidance under applicable fraudulent transfer law.  cf. In Re Dewey and Lebouef LLP, 518 B.R. 766, 789 (Bankr. S.D.N.Y. 2014) (“equity distributions are not ordinarily considered transfers made on account of an antecedent debt, and in turn, are not connected to be made in exchange for a reasonably equivalent value”) (internal quotations omitted).”


There may also be serious issues as to whether or not the time within which to challenge the dividend distributions to the Morgan Stanley Group has elapsed.  Under Section 548 of the Bankruptcy Code, a fraudulent transfer claim can reach back to a maximum of two years prior to the filing of the bankruptcy petition.  However, Section 544 of the Bankruptcy Code allows for the borrowing of the applicable state statute of limitations on fraudulent transfers.  In New York, where the bankruptcy proceeding is venued, the statute of limitations for challenging a fraudulent transfer is six years.  A substantial portion of the dividend distributions made to the Morgan Stanley Group fall within that six year period.  However, the Morgan Stanley Group, Tops II and the Tops Companies are all Delaware corporations, leading to a potential argument that Delaware statute of limitations should apply.  Delaware’s statute of limitations to challenge fraudulent transfer claims is only four years.  All of the dividend distributions to the Morgan Stanley Group were made more than four years prior to the filing of the bankruptcy petitions. Thus, separate from substantive arguments, there may well be an issue as to whether the statute of limitations within which to challenge the dividend distributions made to the Morgan Stanley Group as fraudulent transfers has expired.

The Creditors Committee has two years from the date of the filing of the bankruptcy petition in which to bring fraudulent transfer claims.  That two year period, in this case, will expire in February of 2020.  If a fraudulent transfer claim is asserted by the Creditors Committee against the Morgan Stanley Group, it is likely to take a number of additional years for that disputed matter to be concluded.  Thus, the fate of the unsecured creditors may not be known until well into the next decade.