George Miller, the Chapter 7 trustee of former streaming on demand video and television services provider Chicken Soup for the Soul Entertainment (CSSE), recently sued several of the company’s former officers and directors for alleged breaches of fiduciary duty in connection with a pre-bankruptcy merger with Redbox Entertainment that saddled the company with an insurmountable amount of debt and led to its bankruptcy filing in 2024. He also brought claims to recover certain dividend and insider payments. In particular, Miller accuses William Rouhana, the company’s former CEO, board chairman and controlling shareholder, of treating the company like his “personal piggybank.”

One notable feature of the trustee’s complaint is that he seeks the avoidance, as a fraudulent conveyance, of releases issued to the company’s former management in connection with the merger. He argues that because the releases are avoidable, they don’t provide a defense to his claims. In this article, the Debtwire legal analyst team provides an overview of the litigation and discusses how management can still face litigation risks even if they think they may be protected by releases.

The 2022 merger with Redbox and insider transactions

According to Miller, CSSE was “floundering” by early 2022. The company reported annual net losses of USD 59.4m and USD 44.6m in 2021 and 2020 respectively. Its share price also dropped steeply, falling to USD 8 in March 2022 from USD 40 in May 2021.

Notwithstanding these troubles, in March 2022 CSSE began to explore the acquisition of Redbox Entertainment, which offered DVD and Blue-Ray rentals from a network of 32,000 self-service kiosks. It did so even though Redbox was in a “free fall” due to an outdated business model, competition from streaming services, and the effects of the COVID-19 pandemic. From 2018 to 2021, Redbox’s revenues fell from more than USD 1bn to USD 289m. Adjusted EBITDA correspondingly dropped from USD 292m in 2018 to negative 17m in 2021.

There were other indicia of concern. In March 2022, Redbox failed to timely file its 10-K. The next month, it publicly announced that it was assessing its viability as a going concern. At that time, the company’s board made contingent preparations for bankruptcy if it could not improve its liquidity situation or consummate a transaction with CSSE.

To assist with the Redbox transaction, CSSE hired Guggenheim Securities as financial advisor. According to the complaint, Rouhana and the management team “directed” Guggenheim to make presentations to the company’s board reflecting management’s “rosy projections” instead of the investment bank’s independent judgment. Miller says that there is “no indication” in CSSE’s board minutes that the board sought out information that would have allowed it to test the reasonableness of the assumptions made by CSSE management. Instead, the board allowed management to direct Guggenheim to conclude that “two independently dying businesses” would become “exceedingly profitable.” According to Miller, the company’s other officers and directors were “conflicted, beholden to Rouhana, [and] supine” and failed to exercise independent judgment or act in the company’s best interests.

Miller says that based on management’s guidance, Guggenheim represented to the board that, notwithstanding Redbox’s recent sharp revenue decline, in 2023 the company would see revenues grow to more than USD 500m and adjusted EBITDA to more than USD 64m. The reality was different – as it turned out that year Redbox reported revenues of only USD 151m and a net loss of USD 454m. Guggenheim also projected that after the merger, CSSE’s stand-alone revenue would grow more than 30% annually and adjusted EBITDA almost 50% annually. Guggenheim further estimated that by 2026 the combined company would generate over USD 1bn in revenues and have adjusted EBITDA of USD 258m. In actuality, in 2023 the combined company generated USD 409m in revenues and had a net loss of over USD 287m.

In the complaint, the trustee also accuses the defendants of turning a blind eye to insider transactions that benefited Rouhana. According to the complaint, regardless of its financial condition, CSSE funneled approximately 10% of its net revenues under management services and intellectual property license agreements to an indirect parent that was allegedly controlled by Rouhana. Between 2020 and 2024, CSSE paid approximately USD 55.6m under this arrangement. In addition, in the four years before the bankruptcy filing, the company paid more than USD 55m in dividends to preferred shareholders, even though it was allegedly insolvent. Miller also accuses the company of failing to pay employee wages and benefits during this time, as well as over USD 15.5m in payroll withholding taxes

CSSE’s officers and directors receive releases in connection with the merger

In connection with the merger, the CSSE’s directors and officers entered into a mutual release agreement with CSSE and other parties, including the company’s lender, HPS Investment Partners LLC. The release provided that, effective as of the date of the merger, the parties released and discharged each other from all “past and present claims” that the parties “ever had” that related to, among other things (i) the “CSSE Group Parties (including the management, ownership, activities, failure to act or operation or activities thereof),” (ii) “indebtedness incurred by, or equity interests in, any of the CSSE Group Parties, or any merger, asset sale, equity issuance or other transaction involving any of the CSSE Group Parties,” and (iii) the merger agreement.” Miller says that the directors and offers “had a personal interest” in making sure that the company consummated the merger because the releases only would be effective if the merger happened. According to the complaint, none of the company’s officers and directors provided any consideration in exchange for the releases.

Loaded with merger debt, CSSE files for bankruptcy and Miller brings suit

The merger, which was completed on 10 May 2022, loaded CSSE with debt. Prior to the merger, at year-end 2021, the company’s total debt was approximately USD 56.7m. However, by the end of 2023 its total gross debt had grown to approximately USD 562.4m. Debt service expenses exploded to USD 76m, or 16 times the company’s pre-merger expenses, and the company had no unrestricted cash. The following table summarizes the company’s debt at the time of its Chapter 11 filing.

According to the complaint, the ability to service this debt was predicated on a post-COVID increase in the demand for kiosk rentals that never happened. And as a result of the lack of liquidity, the company didn’t have the funds to obtain content for the kiosks.[1]

Out of cash and facing termination notices from content suppliers, CSSE ended up filing for Chapter 11 on 28 June 2024. Less than two weeks later, on 10 July, the company’s primary lender, HPS Partners, withdrew its offer to provide DIP financing, and the bankruptcy court converted the debtors’ cases to Chapter 7 upon the debtors’ oral motion.

In his complaint, Miller asserts a variety of claims against Rouhana and the debtors’ former officers and directors, and several non-debtor entities that are direct or indirect parents of CSSE and are allegedly controlled by Rouhana. He asserts that the defendants breached their fiduciary duties of loyalty for causing the company to enter into the merger, for allowing the company to operate under the insider management services agreements and make preferred dividend payments, and for failing to pay wages, benefits, and taxes. He also seeks recovery of the management services payments and preferred dividends as constructive fraudulent transfers because they were made while the company was allegedly insolvent. Finally, he seeks recovery from the defendants of the unmade payments for wages, benefits and taxes.

Miller asserts that the releases issued to CSSE’s officers and directors in connection with the merger are “no bar to the claims asserted in [the] Complaint.” According to Miller, the releases issued by CSSE were constructively fraudulent transfers that can be avoided, that is, annulled, under both federal and state law because they were not exchanged for “reasonably equivalent value.” It is unsurprising that Miller takes this position, given that the releases cover not only the breach of fiduciary duty claims in connection with the merger but also arguably some of the allegedly fraudulent transfers that took place before the merger.

Any causes of action that CSSE has against the officers and directors vested in the debtors’ bankruptcy estates as of the filing of the bankruptcy petition, which created bankruptcy estates consisting of all property of the debtors. Miller, as the representative of those estates, can only assert the claims possessed by the debtors’ bankruptcy estates. Thus, he cannot bring any claims against the officers and directors that CSSE has released, unless the release is avoided.[2]

The intersection of releases and fraudulent conveyance actions

When one thinks of avoidable transfers, the first thing that usually comes to mind is the transfer and recovery of money. However, the Bankruptcy Code provides the trustee with broader recovery powers. Section 548(a)(1)(B) of the Code authorizes a trustee to avoid as constructively fraudulent the transfer of any “interest of the debtor in property.” Section 544(b), which allows the trustee to bring actions under state law fraudulent conveyance statutes that may have longer lookback periods than the two years provided by section 548, has the same language. Courts have held that this language is broad enough to capture any of the debtor’s rights to sue on causes of action.[3]

To avoid a transfer of an interest in the debtor’s property under section 548(a)(1)(B), two conditions must exist. First, the debtor must have “received less than a reasonably equivalent value in exchange for such transfer” and must have either (i) been insolvent on the date of the transfer or became insolvent due to the transfer, (ii) been engaged or been about to engage in a business or transaction for which it had unreasonably small capital, (iii) intended to incur or believed that it would incur debts beyond its ability to pay as they came due.[4]

One court has said that “reasonably equivalent value is determined by applying a totality of the circumstances test designed to establish whether the value received by a debtor in a given transaction is ‘reasonably equivalent’ to what debtor gave up.”[5] Thus, to succeed with his avoidance claim, the trustee would have to show that the value of any of the claims that the officers and directors had against CSSE were “reasonably equivalent” to the value of any of the claims that CSSE had against the officers. As alleged by Miller, those claims are valued in the tens of millions of dollars.

Finally, there is the question of what can be recovered if the release is avoided. The Bankruptcy Code addresses recovery in section 550, which provides that a trustee may recover “the property transferred” or “the value of such property.”[6] Here, the property transferred was the released claims, including the claims for breach of fiduciary duty claims and to recover the insider payments and dividend payments that are arguably covered by the release. Thus, if the releases are avoided, the consequences for the defendants could be severe, potentially exposing them to tens of millions of dollars in claims.

Contrast the releases at issue in the trustee’s complaint with debtor and third-party releases that are issued in connection with Chapter 11 plans. Such releases are eagerly sought by the officers and directors of companies in bankruptcy and constitute the gold standard. This is because they receive the blessing of a bankruptcy judge who makes several findings as a condition of their approval. Typically, the judge will find that the releases are (i) issued in exchange for “good and valuable consideration,” (ii) in the best interests of the debtors, their estates and creditors, (iii) “fair, equitable, and reasonable,” (iv) made in good faith and, (v) in the case of the debtors’ release, a valid exercise of business judgment. These findings, particularly the finding that the releases are for good and valuable consideration, insulate the releases from attacks on the grounds that they constitute fraudulent conveyances.

The trustee’s complaint is a reminder that even when officers and directors receive releases in connection with a corporate transaction, their exposure may not be eliminated in a subsequent bankruptcy proceeding. This is the case where a plaintiff can colorably allege that the defendants did not exchange reasonably equivalent value for the releases. Since reasonably equivalent value is a question of fact,[7] it is likely that the trustee’s complaint would survive any defendant’s motion to dismiss, which is decided as a matter of law, not fact.

The Debtwire team is aware of at least one other case where an officer’s release was avoided. In the Chapter 11 case of Teligent, a broadband communications company, a representative appointed pursuant to the confirmed plan sued to avoid the prepetition release of a USD 12m note obligation that had been granted to the company’s former CEO in connection with his departure from the company. [8] Finding that the release was “[i]n essence . . . a $12 million gift,” the US Bankruptcy Court for the Southern District of New York avoided it under section 548. He also found that the entire amount was recoverable under section 550 and found that the representative was entitled to a judgment for that sum. More than four-and-a-half years passed between the time that the representative filed its complaint and the court issued its decision.

The Teligent decision is not binding on the Delaware Bankruptcy Court but serves as an example of the risk that directors and officers face. Even if the trustee’s lawsuit ultimately proves unsuccessful, Teligent further demonstrates that former management might find themselves having to defend a long and costly, at least for any D&O insurer, litigation.

Paul Gunther is a former practicing restructuring and litigation attorney. Prior to joining Debtwire as a Legal Analyst, Paul practiced in the New York offices of Dentons US LLP, Salans LLP and Mayer Brown LLP. He has represented various constituencies in high-profile restructurings.

This report should not be relied upon to make investment decisions. Furthermore, this report is not intended and should not be construed as legal advice. ION Analytics does not provide any legal advice, and clients should consult with their own legal counsel for matters requiring legal advice. All information is sourced from either the public domain, ION Analytics data or intelligence, and ION Analytics cannot and does not verify or guarantee the adequacy, accuracy or completeness of any source document. No representation is made that it is current, complete or accurate. The information herein is not intended to be used as a basis for investing and does not constitute an offer to buy or sell any securities or investment strategy. The information herein is for informational purposes only and ION Analytics accepts no liability whatsoever for any direct or consequential loss arising from any use of the information contained herein.

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Endnotes

[1] This also resulted in a huge write down. Of the USD 598m that the company said that it acquired in the merger, approximately USD 506m consisted of intangible assets and goodwill. However, a little later than one year after the merger the company recorded an impairment charge of approximately USD 380.8m.

[2] See In re Teligent, Inc, 380 B.R. 324, 337 (Bankr. S.D.N.Y. 2008) (“avoiding the release strips the transferee of his affirmative defense”); In re NuMed Home Health Care, Inc, 326 B.R. 859, 867 (Bankr. M.D. Fla. 2005) (stating that if the transfer is avoided, “the result would negate the Defendant’s affirmative defense that he was released from liability”).

[3] See In re Teligent, Inc, 325 B.R. 81, 86 (Bankr. S.D.N.Y. 2005) (“Generally speaking, the broad definition of ‘transfer’ is sufficiently robust to cover the release of an obligation to pay money.”); In re e2 Communications, Inc, 320 B.R. 849, 856 (Bankr. N.D. Texas 2004) (“Common sense suggests that a release of claims is a ‘transfer’ of property.”).

[4] Section 548(a)(1)(B) also allows for the recovery of transfers made “to or for the benefit of an insider” under an employment contract not in the ordinary course of business.

[5] In re Live Well Financial, Inc, 2023 WL 399590, at *14 (Bankr. D.Del. June 13, 2023) (addressing whether the exchanges of mutual releases constituted reasonably equivalent value).

[6] In re Teligent, 325 B.R. at 88 (remedy for plaintiff who successfully avoids release is limited under § 550 to the value of the transferred property).

[7] Federalpha Steel LLC Creditors’ Trust v. Federal Pipe & Steel Corp, 368 B.R. 679, 693 (Bankr. N.D. Ill. 2006) (reasonably equivalent value is a question of fact).

[8] 380 B.R. at 336-338.