Murphy v. Meritor Savings Bank (In Re O'Day Corp.)

MEMORANDUM

I. PROCEDURAL HISTORY

On April 27, 1989, an involuntary petition for relief under Chapter 7 of the Bankruptcy Code was filed by three creditors against The O’Day Corporation (“O’Day” or the “Debtor”), a manufacturer of fiberglass sailboats located at 848 Airport Road, Fall River, Massachusetts. No responsive pleading was filed by the alleged Debtor, which had ceased all operations prior to the filing. Accordingly, on May 23, 1989, an Order for Relief was entered. Two days later, Harold B. Murphy (the “Trustee”) was appointed interim trustee.

On June 1, 1989, Meritor Savings Bank (“Meritor” or the “Bank”) filed a Motion for Relief from the Automatic Stay imposed by the Bankruptcy Code. On June 19, 1989, it filed an Amended Motion in which it asserted a perfected security interest in all of O’Day’s machinery, equipment, furniture, fixtures, accounts receivable, general intangibles, and other tangible and intangible assets, as well as a mortgage lien on and security interest in the real property and improvements owned by O’Day and located in Fall River. Meritor asserted that the amount of its debt exceeded $8 million.

On June 26, 1989, the Trustee filed an opposition to the Bank’s motion. He supplemented his opposition nearly one month later, raising questions about the amount, validity, enforceability, and priority of the Bank’s lien based upon his preliminary investigation of the 1987 leveraged buyout (“LBO”) that generated the Bank’s claim.

Despite the portents of litigation, Meritor and the Trustee recognized that the expeditious disposal of the real and personal property was mutually advantageous. Consequently, on August 22, 1989, they entered into a stipulation, which was approved by the Court on September 9, 1989, that provided for the sale of the real and personal property at public auction. On August 27, 1989, the Trustee filed a Notice of Intended Sale by Public Auction to which an objection was filed by C. Raymond Hunt & Associates. By order dated September 22, 1989, and after notice and a hearing, the Court overruled the Hunt objection and authorized the Trustee to sell all the Debt- or’s assets.

On September 26 and 27, 1989, the Court appointed auctioneer, Wm. F. Comly & Sons, Inc., conducted the auction sale. The proceeds from the sale were approximately $1.9 million. The intangible assets, including the molds, designs, name and goodwill of O’Day, were sold for $620,000. The real estate was not sold. The proceeds from the sale were placed in an escrow account pending further order of the Court.

On March 19, 1990, two days before the commencement of the evidentiary hearing on Meritor’s Amended Motion for Relief from Stay, the Trustee filed a six count, Verified Complaint under the Uniform Fraudulent Conveyance Act (“UFCA”) and sections 510 and 548 of the Bankruptcy Code. In brief, the Trustee, through Count I, sought to avoid Meritor’s security interests in the collateral, pursuant to section 7 of the UFCA, based upon actual intent to hinder, delay or defraud creditors. Through Counts II and III, the Trustee sought to avoid the Bank’s liens, pursuant to sections 4 and 5 of the UFCA, based upon allegations that the LBO rendered O’Day insolvent and left it with insufficient *373 working capital. Through each of the first three Counts, the Trustee sought to avoid Meritor’s liens in their entirety. Through Counts IY and V, the Trustee sought to avoid Meritor’s mortgage lien under the UFCA and the Bankruptcy Code, respectively. Finally, through Count VI, the Trustee, pursuant to section 510 of the Bankruptcy Code, sought to equitably subordinate Meritor’s claim to that of the unsecured creditors.

With his Verified Complaint, the Trustee also filed a Motion for Temporary Restraining Order and Permanent Injunction, seeking to enjoin the Bank from foreclosing on the real property and the funds escrowed from the sale of the personal property, until the Court ruled on the merits of the complaint.

On March 21,1990, the Trustee and Meritor executed a second stipulation in which they agreed 1) that the Bank’s security interest in the personal property was properly recorded; 2) that a mortgage on the real property of O’Day was recorded on June 16, 1988 to secure Meritor’s 1987 loans; 3) that for purposes of the hearing the fair market value of the real estate in Fall River did not exceed $5 million; 4) that the debt owed Meritor as of April 28, 1989 was $8,275,156.02; 5) that for purposes of the hearing the total available proceeds from the sale of assets were projected to be $7 million; 6) that the collateral was not necessary for an effective reorganization; and 7) that there was no equity in the collateral for creditors other than Meritor.

On April 20,1990, in conjunction with the Trustee’s motion for injunctive relief, Meritor and the Trustee filed a third stipulation in which they agreed to the following:

1) that the Trustee would suffer irreparable harm in the event the Court ordered the turnover of any funds or any assets of the estate pending final adjudication of Meritor’s Amended Motion for Relief from the Automatic Stay or the claims raised in the Trustee’s Verified Complaint;

2) that the harm suffered by the Trustee in the event the injunction did not issue would outweigh any harm suffered by Meritor in the event the injunction did issue; and

3)that the requested injunctive relief was in the public interest.

Because the Trustee and Meritor stipulated to the elements of section 362(d)(2) of the Bankruptcy Code, and because they stipulated to three of the four elements that the Trustee must establish to obtain injunctive relief, the only issue before the Court is whether the Trustee has demonstrated a likelihood of success on the merits of his six count complaint.

On March 21, March 22, April 23, April 24, May 24, June 27 and June 28, 1990, the Court conducted an evidentiary hearing with respect to Meritor’s Amended Motion for Relief from Stay and the Trustee’s request for injunctive relief. Six witnesses testified and approximately 175 exhibits were introduced into evidence.

II. FACTS

A. Pre-LBO Events

George M. O’Day was an outstanding boating enthusiast who started building O’Day “Day Sailers” in Massachusetts in 1959. Because of the quality and workmanship of the Day Sailers, as well as additional models, the O’Day name developed a premier reputation.

In 1966, Bangor Punta Corporation acquired all the assets of the original O’Day company. Several years later, in 1969, it acquired the CAL sailboat line, another prominent name in the sailboat industry. Operating under the name Bangor Punta Marine, Bangor Punta Corporation manufactured and distributed O’Day and CAL auxiliary powered fiberglass sailboats (those with motors) and non-auxiliary powered fiberglass sailboats (those without motors, such as the O’Day Day Sailer).

In 1984, Lear Siegler, Inc. (“LSI”), a publicly held corporation, acquired the O’Day and CAL lines of boats, as well as the Prindle line of day sailing and racing catamarans. The O’Day/Cal sailboats and Prindle catamarans were then manufactured by Lear Siegler Marine, a division of the Lear Siegler Industrial/Recreation *374 Group at plants in Fall River, Massachusetts, and Santa Ana, California.

Nearly three years later, in February of 1987, an investor group led by the investment banking firm of Forstmann Little & Co. (“Forstmann”) acquired all the stock of LSI. The multi-billion .dollar transaction was a leveraged buyout through which LSI was “taken private.”

In connection with the transaction, Forst-mann created a new company called Lear Siegler Holdings Corp. to acquire the stock of LSI. It also formed other corporate entities to acquire the assets of the companies or divisions formerly owned by LSI, including Lear Siegler Marine. Specifically, on January 13, 1987, Forstmann created three Delaware corporations: B.P. Acquisition Corp. No. 13 (B.P. 13), B.P. Acquisition Corp. No. 14 (B.P. 14), and B.P. Acquisition Corp. No. 15 (B.P. 15). B.P. 13 held all the stock of both B.P. 14 and B.P. 15. B.P. 14 thereafter acquired the assets of the Prin-dle division, and, similarly, B.P. 15 acquired the assets of the O’Day/Cal division of LSI. On February 10, 1987, all three entities, B.P. 13, B.P. 14, and B.P. 15, changed their names to Bangor Punta Marine Products Corp., Prindle Boats Corp. (“Prindle”), and O’Day/Cal Sail Boats Corp. (“O’Day/Cal”), respectively.

In conjunction with its acquisition of LSI, Forstmann contemplated divestiture of various divisions, including Lear Siegler Marine. Consequently, the transactions outlined above, as well as the marketing of O’Day/Cal and Prindle, were engineered with the assistance of Deloitte Haskins & Sells, as auditors and tax planners for LSI, and Goldman, Sachs & Co. (“Goldman Sachs”), as investment bankers for Lear Siegler Holdings Corp., not to mention various law firms.

In furtherance of the divestiture plan, on February 12, 1987, Winston W. Hutchins, as Corporate Vice-President, executed notes on behalf of O’Day/Cal and Prindle in the principal amounts of $12,916,425 and $1,357,720, respectively. The notes (collectively the “Intercompany Notes”) were payable to an entity known as LS Acquisition Corp. (Tr. Ex. 44, Tabs 27, 28). 1

From February 1987 to June 30, 1987, Forstmann operated O’Day/Cal and Prin-dle. Simultaneously, Goldman Sachs prepared a private offering memorandum, dated February 1987, and began marketing O’Day/Cal and Prindle.

The Confidential Offering Memorandum (the “Offering Memo”) (M. Ex. 1) produced by Goldman Sachs was a 24 page document with numerous attachments that detailed, among other things, the historical and projected financial performance of Lear Siegler Marine. Specifically, an unaudited schedule of operations revealed the following:

EBIT 5 Income Before Allocations 342 1,315 2,481 (353) 2,243 2,674 Year 2 1982 1983 1984 1985 1986 Sales 3 20,992 21,149 26,402 19,760 22,566 1987 (estimated) 24,200 Gross Profit 4 Margin 16.19 19.18 21.71 15.08 21.84 22.11 J>D JnO J>0 'bi "co cn 'b* ^ a? g g ^ ^ cn

*375 The gross profit margins for the years 1982-1986 averaged 18.80 percent. If the year 1985 is excluded, the average was 19.75 percent. For the six months ending December 31, 1986, the Offering Memo showed the company to have had net sales of $10,154,000 and gross profits of $1,953,-000 resulting in a gross profit margin of 19.23 percent.

With respect to the O’Day and Cal product lines, in particular, the Offering Memo revealed the following about the dollar value of sales and the number of units sold:

O’Day ■ CAL

Year Dollars Units Dollars Units

1982 16,858 1,301 4,134 123

1983 15,149 1,023 6,000 177

1984 21,037 1,420 5,370 200

1985 15,149 922 2,716 106

1986 14,882 952 5,438 184

Although the Offering Memo noted a “general softness in the sailboat industry” in 1986, it emphasized the company’s growth and success in its primary market segment, namely powered sailboats ranging from 27 feet to 40 feet in length. The Offering Memo also boasted of the company’s increasing market share and unit sales, its product design capabilities and innovations, its excellent dealer network, seasoned management team, and “experienced and stable” employee base. However, the Offering Memo did note the existence of problems in 1985, including the shutdown of the company’s plant in Tampa, Florida that resulted in a temporary loss of capacity; high interest rates; and high energy prices. These problems together caused a 25% decline in sales and a reduction in margins in fiscal 1985.

In early 1987, Meritor became aware of Forstmann’s desire to sell O’Day/Cal and Prindle as a result of its involvement in financing Forstmann’s acquisition of LSI. Due to its relationship with Lance T. Fun-ston (“Funston”), Meritor also was aware that Funston was engaged in the business of acquiring corporations. 6 Indeed, Kenneth E. Jones (“Jones”), a senior lending officer at Meritor, who testified he had been involved in approximately 10-15 LBO deals in 1986, contacted Funston to inform him about the sale of O’Day/Cal and Prin-dle stock. Funston arranged to receive a copy of the Goldman Sachs Offering Memo. Shortly afterwards, on February 27, 1987, L.T. Funston & Co., Inc. provided Goldman Sachs with a letter of interest. (M. Ex. 5).

As a result of the letter of interest, Fun-ston and his company were given full access to the books and records of O’Day/Cal and Prindle. He or one of his associates interviewed management and toured the facility in Fall River. In short, he had the opportunity to conduct a thorough investigation of all aspects of the company, financial and otherwise. Funston then began negotiating with Meritor about financing the stock acquisition.

*376 At Jones’ request, Funston prepared projections or sensitivity analyses, based upon the historical operating information supplied by Goldman Sachs as modified by estimates of the company’s performance. These projections were attached to a Credit Memorandum (the “Credit Memo”), dated April 24, 1987, that Jones prepared and submitted to Meritor’s Senior Loan Committee (M. Ex. 36). Like Funston, Meritor’s personnel had full access to the company’s books and records. Meritor’s personnel also communicated with management and toured the physical plant.

According to Jones, the April 24, 1987 Credit Memo was based upon interviews with management, the Goldman Sachs Offering Memo, industry sources, and general economic data. Jones sought approval for the following loans:

1. $2,500,000 Asset-Based, seven year Revolving Credit with advances not to exceed 80% of eligible receivables and 50% of eligible inventory, with some level of inventory cap;

2. $7,200,000 Term Loan to mature seven years from Closing;

3. $400,000 Six month Bridge Loan, pending the sale of the Prindle division;

4. $500,000 Subordinated Debt.

Jones anticipated that the collateral to secure the loan would be “[a]ll the assets of the Company, including real estate, inventory, receivables, trademarks, and patents.” He estimated the “market value” of the various assets at closing as follows:

Loan Value Value

' $ 640 Accounts Receivable $ 800 oo o

$1,750 Inventory $3,500 cn o

200 Machinery and Equipment Minimal

$4,400 Real Estate $5,500 oo o

During the trial he testified more precisely that the loan values represented orderly liquidation values. (Trans. Vol. I, p. 159). Jones’ Credit Memo was predicated upon the sale of the Prindle line which was unprofitable. Jones anticipated a sales price between $400,000 and ,$800,000 for that division.

Jones discussed two distinct market trends in his Credit Memo: 1) an overall decline in unit sales; and 2) a shift in demand from smaller boats to larger, more expensive ones. He noted that Lear Sie-gler Marine had maintained its sales levels in a tough market, despite adverse trends. In addition, based upon conversations with industry experts, he opined that “the industry has hit bottom and should remain stable over the foreseeable future.” He concluded that Lear Siegler Marine would generate adequate sales volume due to improved market conditions, product positioning, new products, reputation, and consistency.

In the Projected Financial Analysis section of his Credit Memo, Jones described two ways to evaluate future cash flow: flat EBIT (EBIT, as has been mentioned, is an acronym for earnings before interest and taxes) and reduced sales. With respect to the former scenario, Jones and Funston assumed a flat $2 million EBIT. Using that scenario, which Jones and Funston testified was the “most likely” scenario, Jones averred in the Credit Memo that the term loan of $7.2 million would be completely paid off in the seventh year, with the revolver at $1.8 million. With respect to the reduced sales or, as Jones and Fun-ston testified, “the worst case” scenario, they employed the 1986 average price for boats sold ($17,877) and the average number of boats sold during the five years preceding the 1986 fiscal year (1,260) to derive a sales level of $22.5 million, which they discounted by 10% “to allow for future deterioration in the industry.” Under the reduced sales scenario, EBIT for the years 1988 through 1994 was projected to be $1,975 million and the gross profit margin was projected to be 21.84 percent. *377 Jones indicated that under the reduced sales scenario, the term loan would be completely paid off in the seventh year with the revolver standing at $1.7 million. Jones stated:

The largest part of debt repayment in the first year is cash from the shrinking of working capital. This contributes about $1,000,000 during fiscal 1988. It is our experience that with spin-offs from conglomerates like Lear Siegler, these now private companies can better manage inventories, stretch payables, and accelerate receivables. O’Day is envisioning that inventory will turn three days faster; receivables will stay an already excellent 16 days (most dealers pay C.O.D. or floor-plan the boats), and stretch payables an additional 13 days to 45 days. All of these numbers are reasonable. The [sic]

All in all, the projections used to make this loan decision are reasonable and attainable. 7

Jones acknowledged negative aspects of the contemplated transaction. He identified five risks associated with the proposed loan, including a collateral coverage risk. Specifically, Jones determined that collateral coverage during the first two years after the LBO would be insufficient to repay senior bank debt. However, he noted, as mitigating factors, the value of the O’Day and CAL trademarks to other boat builders, the steadiness of Lear Siegler Marine’s cash flow which would offset the $2.7 million collateral coverage shortfall, and the sale of the Prindle line, which would garner cash. The other four risks identified by Jones were 1) an industry risk associated with the decline in the number of units sold, which decline might affect EBIT and Lear Siegler Marines’ ability to service debt; 2) a management risk since existing management was not accustomed to running a private company “where cash is king, and there is no bottomless pit to draw resources;” 3) an interest rate risk; and 4) a product liability risk. Despite the risks, Jones recommended the financing package.

Six days after the submission of the Credit Memo, L.T. Funston & Co., Inc. submitted a preemptive bid for the stock of O’Day/Cal and Prindle for $14,275,000. (M. Ex. 5). This sum, according to the April 30, 1987 proposal, “represented the purchase of [intercompany] notes ($1,357,-720 and $12,916,425) at par and purchase of the Stock for $855.” The bid also assumed an adjustment to the purchase price to the extent that operating earnings for fiscal year 1987, which were projected in the Offering Memo to be $2,650,000, were below $2.6 million. Notably, the price offered by Funston was within the $14-$17 million range that Goldman Sachs anticipated as a selling price. On May 7, 1987, Meritor issued a commitment letter to Funston (Tr. Ex. 12). .An Agreement of Purchase and Sale between Bangor Punta Marine Products Corp. and LTF Acquisition Corp. was executed on June 8, 1987. (Tr. Ex. 44, Tab 1).

Prior to the execution of the Agreement of Purchase and Sale, Goldman Sachs was in contact with several other potential purchasers. Michael Dahill (“Dahill”), the President of O’Day/Cal and Prindle headed one group of potential purchasers. Although the management group headed by Dahill had financing available, Dahill testified that the transaction contemplated by Funston involved more equity and less risk than the one he and his associates contemplated. Indeed, Dahill and two other managers, Brad Turner and William Bouchard, eventually joined forces with Funston to acquire the O’Day/Cal and Prindle stock.

The structure of the acquisition involved the formation of LTF Acquisition Corp. The acquisition price was to be $13,915,000, not the $14,275,000 set forth in the preemptive bid. The price was to be subject to certain adjustments, including a dollar-for-dollar adjustment in the event that the fourth quarter earnings before interest and taxes were less than $894,000. The provision in the purchase and sale agreement that incorporated this adjustment was known as the “Clawback.”

*378 The amount of equity invested was to be $2,450,000. Of that amount, Equus Investments I, Limited Partnership (“Equus”) was to contribute $2,250,000; Funston was to contribute $80,000; Dahill was to invest $60,000, and Turner and Bouchard each would contribute $30,000.

LTF Acquisition Corp., O’Day/Cal, and Prindle jointly and severally contemplated borrowing the balance of the acquisition price from Meritor, which amount was to be secured by a security interest in all the real and personal property owned by O’Day/Cal and Prindle. After the loan was granted, the loan proceeds plus a portion of the equity were to be wire transferred to Bangor Punta’s bank. LTF Acquisition Corp. and O’Day/Cal were to merge at that time. LTF Acquisition Corp. was to be the surviving entity and was to change its name to The O’Day Corporation. Prin-dle Boats Corp. was to become a wholly owned subsidiary of O’Day. The cancellation of the Intercompany Notes executed on February 12, 1987 also was a condition of the transaction. A closing was scheduled for June 30, 1987.

In late June, prior to the closing, Arthur Andersen & Co. (“Arthur Andersen”) submitted to Funston unaudited financial information, which reflected actual financial results of operations for O’Day/Cal and Prindle through March 31, 1987. (M. Ex. 25). Arthur Andersen’s review of the combined balance sheets of O’Day/Cal and Prindle, and the related combined statement of income for the nine months ending March 31, 1987, however, was not the equivalent of an audit conducted in accordance with generally accepted auditing standards. Nevertheless, the balance sheet as of March 31, 1987 revealed the following:

Assets

CURRENT ASSETS:

Accounts receivable, net of allowances for bad debts of $106 and $95 at March 31, 1987 and June 30, 1986, respectively $1,706

Inventories 3,830

Other current assets 147

Total $5,683

PROPERTY, PLANT AND EQUIPMENT $5,802

Less — Accumulated depreciation 3,129

Net property, plant and equipment $2,673

NOTE RECEIVABLE $ 200

OTHER ASSETS 247

$8,803

Liabilities and Equity

CURRENT LIABILITIES:

Current maturities of long-term debt $ 78

Accounts payable 1,490

Accrued liabilities 1,250

Total $2,818

LONG-TERM DEBT, net of current maturities $ 224

EQUITY $5,761

$8,803

*379 $8,803

Notably, the balance sheet did not include any reference to the February 12, 1987 Intercompany Notes executed by O’Day/Cal and Prindle in favor of LS Acquisition Corp. Likewise, the balance sheets, dated March 31, 1987 and April 30, 1987, which were transmitted to Funston on May 16, 1987 by Goldman Sachs (M. Ex. 21) did not reveal the Intercompany Notes. However, in a separate letter dated April 24, 1987 (M. Ex. 8), in a telecopy dated April 28, 1987 (M. Ex. 20) and in a fax dated June 2, 1987 (M. Ex. 23), Funston received a March 31, 1987 balance sheet showing the Intercompany Notes. In particular, the balance sheet contained in the April 28, 1987 telecopy showed long term debt of $14,498,000. It also included, as an asset, an item designated “Excess Purchase Cost to be Allocated” in the amount of $16,461,000.

The unaudited combined statement of income for the nine months ending March 31, 1987 (M. Ex. 25) revealed the following:

NET SALES $16,898

COST OF SALES 13,709

Gross profit $3,189

OPERATING EXPENSES: Sales and advertising $ 1,113

General and administrative 730

Total $ 1,843

Operating income $ 1,346

OTHER INCOME, net 15

Income $ 1,361

EQUITY, June 30, 1986 4,664

UNLOCATED DIFFERENCE (264)

EQUITY, March 31, 1987 $ 5,761

This income statement for the period ending March 31, 1987 showed a decline in the gross profit margin from the 19.23 percent for the period ending December 31, 1986 (M. Ex. 1) to 18.87 percent for the third quarter of the 1987 fiscal year.

In performing their review of the proposed LBO, both Funston and Jones testified that they relied heavily upon the financial projections included in the Offering Memo and the third quarter interim finan-cials, which were prepared by Deloitte Has-kins & Sells and reviewed by Arthur Andersen. However, in addition to the balance sheets, statements of operation and projections available from Goldman Sachs, there was information available to Funston and the Bank in the files of the company, including Controller’s Letters and long range planning materials (Tr. Ex. 1 and M. Ex. 50), all of which highlight the general cyclical nature of the industry and the company’s earnings. For example, in a document summarizing the business environment of Lear Siegler Marine, the company projected low growth and continued consolidation for the industry. The company further identified economic cyclicality, foreign competition, and the value of the U.S. dollar as industry risks. Indeed, that document states that “[t]he major risks for the sailboating industry and Lear Siegler Marine are economic. Sailboats are part of

*380 the global leisure industry, and, therefore, are affected by economic cycles.” In a similar vein, a statement, which prefaced a document captioned “Long Range Planning 1987-1989,” characterized the business environment as follows:

Fiberglass sailboats virtually do not wear out, so to remain competitive and successful, new and more innovative products must be developed in order to entice the customer to buy. The used market continues to see a serious price erosion which is a very recent phenomenon.

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Entry costs and returns have been historically low, but financial pressures, increased marketing costs, and the recent decline of product-life cycles will continue to force consolidations and elimination of many companies.

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Participation in sailing has been on the increase since the 1950’s ... Conversely, since 1982 the industry data shows a serious unit sales decline, with the worst erosion in the history of the industry occurring since the spring of 1984.

In summarizing the long term outlook, the plan stated that “[t]he current downward trend being experienced by the sailboat industry during a positive economic period makes it difficult to look into the future with confidence.” Additionally, the company, in a “Market Business Audit” dated January 1986 that was attached to the long range planning materials, identified the following threats: “inadequate understanding of market and how to significantly effect [sic] it;” and a “higher area employment rate and factory working conditions have reduced available labor pool.”

Not only was the boating industry linked to large economic cycles, the company experienced annual cycles with respect to cash flow as well. Specifically, the company experienced a need for cash during the fall and winter months since the vast majority of sales took place in the spring and summer months.

Each month, Victor Gonsalves (“Gon-salves”), the company’s Controller, prepared monthly Controller’s Letters. Each Letter contained financial data and observations presented in the following format: statistical highlights for month and year to date, net sales analysis by product line, analysis of net earning by product line, reconciliation of actual pre-tax earnings to forecast, analysis of operating expense, analysis of income tax provision, analysis of accounts receivable, analysis of inventories, analysis of days payable outstanding, analysis of cash flow, analysis of short term forecast, and analysis of number of employees.

In the January Controller’s Letter (Tr. Ex. 27), Gonsalves reported net sales of $2,003,000, $142,000 above the forecast for the month; net earnings of $43,000, $26,-000 below the forecast for the month; days payable outstanding of 23 and a negative cash flow of $204,000. He noted that “lower direct labor efficiency (due to new labor) continues to effect overhead applied and the unfavorable D.L. [direct labor] variance. Higher material prices over standard, on a few high volume components, contributed to the unfavorable purchase price variance.” He also pointed out that the company had made an effort to take all 2% cash discounts, which reduced payables.

Gonsalves, in his February Controller’s Letter (Tr. Ex. 28), reported net sales of $1,656,000, $380,000 less than forecasted for the month; net earnings of $57,000, $17,000 below the forecasted amount for the month; days payable outstanding of 18, and a negative cash flow of $105,000. Gon-salves attributed the unfavorable variance in earnings to the decrease in sales and an unfavorable overhead variance. He noted higher prices for lead and cushions, as well as lower direct labor efficiency due to new labor and new product.

In the March 1987 Controller’s Letter (Tr. Ex. 29), Gonsalves reported net sales of $3,085,000, $215,000 better than the forecast, net earnings of $154,000, $55,000 below forecast; days payable outstanding of 21; and a positive cash flow of $887,000. Gonsalves complained, however, that high manufacturing variances continued to be a *381 major problem. He also observed that higher prices for cushions, lead and sails continued to affect purchase price variance.

On May 6, 1987, Gonsalves prepared the April Controller’s Letter. (Tr. Ex. 30). He reported net sales of $2,297,000, $237,000 below forecast; net earnings of $128,000, $60,000 below the forecast for the month, days payable outstanding of 25; and a positive cash flow of $998,000. Gonsalves observed that the retention and training of new employees continued to be a problem, creating unfavorable labor and overhead variances. He also stated that prices on major components were continuing to rise, citing the increase in the cost of lead by five cents per pound during the month.

Because Gonsalves prepared the June Controller’s Letter on July 13, 1987, the last Controller’s Letter that would have been available to Funston or Jones was the May Letter dated June 5, 1987. (Tr. Ex. 31). In that Letter, Gonsalves reported net sales of $2,019,000, $291,000 below the forecast; net earnings of $83,000, $55,000 below the forecast; days payable outstanding of 26; and a positive cash flow of $621,000, well above the forecast. Gon-salves stated that “[mjanufacturing delays due to lack of skilled manpower had a major impact on shipment of product from Fall River.” He also stated that “[ojver the past month, we have seen raw material prices increase substantially, ranging from 4% to 52% on major commodities (resin 20%, fiberglass 5%, engines 11% to 38%, lead 52%). Echoing Gonslaves’ report, in a statement of operations addressed to the corporate headquarters, the Senior Vice-President and General Manager of Lear Siegler Marine, Bernard Gleason, noted that “[tjhere has been a distinct lack of interest at the retail level on all brands of sailboats, and the dealer network can see no reason for the apparent lack of consumer demand.” He then reported that due to significant increases in the prices of raw materials, the company would be forced into a major price increase on August 1, 1987.

Notwithstanding the availability of current information about the company’s financial performance, neither Funston nor Meritor took steps to revise the reduced sales scenario projections, which implicitly assumed a gross profit margin of 21.84 percent. The projections were not modified even though the Controller’s Letters, the four and five year average gross profit margins (i.e., 19.73 percent and 18.80 percent, respectively), and the March 31, 1987 operating results documented a general financial decline, as well as a decline in the gross profit margin from 19.23 percent to 18.87 percent.

•B. The LBO

The closing of the acquisition occurred on schedule on June 30,1987. On that day, LS Acquisition Corp. assigned the Inter-company Notes to O’Day/Cal and Prindle. The Intercompany Notes, in turn, were can-celled by O’Day/Cal and Prindle. (Tr. Ex. 44, Tabs 27, 28). Additionally, Meritor provided the following credit facilities:

1. A term loan secured by all assets in the amount of $7,200,000 payable in incremental quarterly installments ranging from $87,500 to $250,000 with a final installment of $1,450,000 in June 1994, plus interest payable monthly at 4.5% above a specified treasury securities yield rate, and deferred interest payable on June 30, 1994 at 1.01% of the company’s annual sales beginning with the fiscal year ended July 1, 1989;

2. A revolving line of credit secured by all assets in the amount of $2,500,000 with availability based upon 80% of eligible accounts receivable and 50% of acceptable inventory (up to a maximum of $2,000,000), due on June 30, 1994, with interest payable monthly at 2.75% above Meritor’s base rate ($1,871,411.10 was advanced at the closing);

3. A deferred interest acquisition loan secured by all assets in the amount of $500,000 due on June 30, 1994, plus interest payable monthly at 13% and deferred interest payable on June 30, 1994 at 0.87% of the company’s annual sales beginning with the fiscal year ended July 1, 1989;

4. An irrevocable letter of credit in the amount of $400,000, which reduced the amount available under the line of credit *382 to secure a potential tax liability of the selling shareholders.

Not counting the letter of credit, the Meritor loan facilities generated $9,571,411.10. Funston, management and Equus Investments contributed $2,450,000. From those sums, $12,066,000 was paid to Bangor Pun-ta Marine Products Corp. 8 The O’Day Corporation received $235,000 from which it paid $233,656.04 in fees (Tr. Ex. 5), as follows:

1) Meritor legal fees $ 33,000.00

2) TWT Consultants, Inc. (Re: Due Diligence Acquisition Management) $ 18,476.65

3) L.T. Funston & Co., Inc. for closing fee $ 60,000.00

4) L.T. Funston & Co., Inc. for management fee $ 80,000.00

5) L.T. Funston & Co., Inc. for expenses, including Meritor

financing commitment fee of $25,250 $ 42,179.39

$233,656.04

In the end, O’Day was left with $1,343.96 in cash, and the balance of the money, approximately $120,000, went to Meritor. (In an undated letter, John Freal (“Freal”), a Bank officer who worked with Jones, advised Funston that the amount of fees due Meritor at closing would be $119,-263.88).

Prior to, and as of the date of the LBO closing, there existed a number of claims against Lear Siegler Marine and Bangor Punta Marine, including those of Norman Silk, a tort claimant, (Tr. Ex. 44, Tab 1, Exhibit 2.09(a)), and Cannons Engineering Corp. (Tr. Ex. 44, Tab 1, Exhibit 2.10) (hazardous waste liability for two sites of which one was the Re-Solve site). (M. Ex. 71). The Silk claim, the Re-Solve claims, and the Cannons Engineering Corp. claims are still pending (Trans. Yol. II, pp. 12-15), and proofs of claims have been filed in this case by each of the claimants.

A comparison of the balance sheet of the company before and after the LBO closing made by Douglas Voiland (“Voiland”), the Trustee’s expert, a Certified Public Accountant, (Tr. Ex. 47) reveals the following:

BALANCE SHEET June 30, 1987

Internal Year End Actual AA & Co. Opening

6/30/87 6/30/87

$ 856 Cash -09 -Cl

Accounts receivable, net 615 535

Inventories FIFO 3,528 3,101

Other current assets 173 276

Total current assets 4,323 4,768

P, P & E, net 2,829 6,252

Intangibles, net 271 6,549

TOTAL ASSETS 7,423 17,569

*383 MERITOR revolver (credit line) $ 0 1,870

IRB — current 81 262

MERITOR term loan current 0 600

Accounts payable 1,344 1,259

Accounts liabilities 1,479 2,959

Total current liabilities 2,904 6,950

IRB 182 0

MERITOR letter of credit 0 0

MERITOR term loan 0 6,600

MERITOR subordinated loan _0 500

Total long-term debt 182 7,100

Deferred income taxes 1,069

Equity (capital deficiency) 4,337 2,450

TOTAL LIABILITIES AND EQUITY $7,423 $17,569

The actual internal closing balance sheet was prepared by Deloitte Haskins & Sells. It shows a healthy company with minimal long term debt, and $1,419,000 of working capital, which is defined as the difference between current assets and current liabilities. (Trans. Yol. I, p. 113).

The opening balance sheet was prepared by Voiland using the work papers generated by Arthur Andersen in connection with the preparation of audited financial statements as of July 2, 1988. The Arthur Andersen balance sheet reflects all adjustments related to the purchase price settlement (the Clawback) and the sale of the Prindle line, although O’Day did not receive either the Clawback, i.e., approximately $948,000, (Tr. Ex. 46) or proceeds from the sale of Prindle, i.e., $470,000, until April of 1988. (Tr. Ex. 46). Parenthetically, Gon-salves, in contrast, indicated in a Controller’s Letter that O’Day received $622,658 from the settlement and $400,000 from the sale of Prindle assets. (M. Ex. 28).

Meritor’s expert, Elmer Heupel (“Heu-pel”), a Certified Public Accountant and Certified Fraud Examiner, had no particular quarrel with the balance sheet prepared by Voiland from the Arthur Andersen work papers, even though that balance sheet shows a company with substantial long and short term debt and no working capital.

Although both Deloitte Haskins & Sells and Arthur Andersen assigned value to the Debtor’s real property and intangibles, pri- or to, and as of the date of closing, O’Day did not own the real estate or the trademarks of O’Day, CAL and Prindle. Bangor Punta Corporation owned the trademarks of O’Day and CAL (Tr. Ex. 45, Tab 41), and Surfglas Incorporated was the owner of the Prindle patents and trademarks. (Tr. Ex. 45, Tab 42). Neither Bangor Punta Corporation nor Surfglas Incorporated was a party to the Agreement of Purchase and Sale between Bangor Punta Marine Products Corp. and LTF Acquisition Corp. (Tr. Ex. 44, Tab 1) or the Loan and Security Agreement between LTF Acquisition Corp., The O’Day Corporation, O’Day/Cal Sailboats Corp., Prindle Boats Corp. and Meritor Savings Bank. (Tr. Ex. 45, Tab 30).

By assignment dated September 23, 1987 (posi-LBO), Bangor Punta Corporation assigned to O’Day its right, title, and interest in the O’Day and CAL trademarks, together with the associated goodwill. (Tr. Ex. *384 45, Tab 41). Likewise, on October 5, 1987, Surfglas Incorporated assigned to O’Day its right, title, and interest in the Prindle patent and trademarks, together with the associated goodwill. (Tr. Ex. 45, Tab 42). Approximately one month later, on November 3, 1987, O’Day assigned the Prindle patent and trademarks to Prindle. (Tr. Ex. 45, Tab 42). These assignments were recorded at the Patent and Trademark Office on November 13,1987. (M. Ex. 64; Tr. Ex. 17).

With respect to the real estate, Meritor ultimately obtained a mortgage on two separate parcels of land: a large lot (Lot 4 on which the manufacturing plant was located) and a smaller adjacent lot (Lot 29). (M. Ex. 66). The existence of Lot 29 was not discovered by either O’Day or the Bank until months after the LBO closing (Trans. Vol. I, p. 186).

The City of Fall River owned the large parcel of real estate under an Industrial Revenue Bond (“IRB”) and leased it to The O’Day Company, a Division of Bangor Pun-ta Operations, Inc. (M. Ex. 66; Tr. Ex. 44, Tab 1, Schedule 2.06). The Lease was executed on May 1, 1970. (M. Ex. 66; Tr. Ex. 44, Tab 1, Schedule 2.06). At the time of the LBO closing on June 30, 1987, there was no entity known as The O’Day Company, a Division of Bangor Punta Operations, Inc.

Bangor Punta Operations, Inc., which merged into Bangor Punta Corporation on January 1, 1979 (Tr. Ex. 44, Tab 11), eventually transferred all of its assets to B.P. 15 which ultimately became The O’Day Corporation. (Tr. Ex. 44, Tab 18). Although LSI, the corporate successor to Bangor Punta Operations, Inc., was alleged to have transferred all of its rights under the IRB Lease to The O’Day Corporation (Tr. Ex. 44, Tab 9), the leasehold assignment was never recorded at the appropriate land court or on the Certificate of Title. Therefore, no third party received or could receive proper notice of the assignment or of any prior alleged assignments of the original leasehold interest by Bangor Punta Operations, Inc. to Bangor Punta Corporation or from Bangor Punta Corporation to LSI. (M. Ex. 66).

As a consequence, the Bank required O’Day to execute a Leasehold Mortgage (although it was not the Lessee) purporting to convey O’Day’s leasehold interest in that parcel of land subject to the lease with the City of Fall River. (Tr. Ex. 45, Tab 44). That Leasehold Mortgage, though dated July 1, 1987, was apparently executed on August 13, 1987, as evidenced by the notarization. However, the Leasehold Mortgage was never recorded at the Bristol County Land Court or Registry of Deeds as an encumbrance on the property. (M. Ex. 66).

With respect to the second smaller parcel, as of June 30, 1987, Rapistan Corporation held title to the property. (Tr. Ex. 48, 49). Rapistan transferred its right, title and interest in this parcel to O’Day in April of 1988. (Tr. Ex. 48, 49). On June 16, 1988, Meritor recorded a $10,600,000 mortgage on both parcels.

C. Post-LBO Events

Immediately following the LBO, O’Day’s availability under the revolver was approximately $80,000. (Trans. Vol. II, p. 74). Gonsalves testified that accounts payable ranged from $400-$800,000 per month; payroll was approximately $220,000 per month for hourly employees and approximately $110,000 per month for salaried employees. Gonsalves indicated that when he questioned Freal about how O’Day was going to meet these and other expenses he was told to “be creative,” a statement he interpreted to mean “hold off paying [vendors].” (Trans. Vol. II, pp. 74-80).

On July 16, 1987, Gonsalves prepared a memorandum which was sent to all of O’Day’s vendors and suppliers. (Tr. Ex. 36). In the memo, he stated:

The O’Day Corporation has entered into another phase of its life, a phase which is not new to its history. Purchased through a leveraged buyout, The O’Day Corporation stands alone as its own entity, not part of a larger corporation. With this exciting prospect comes stability and change. One change, which ef *385 fects [sic] you, our vendors, is our payment policy. We have been required by our bankers, Meritor Financial Markets of Philadelphia, to extend some of our payment schedules. This extension, we feel, will be on a temporary basis as we move into our first year of the new O’Day Corporation.

We have a seasoned management team and the back