In the wake of the 2008 financial crisis, many companies that were the targets of Leveraged Buyouts (LBOs) filed for bankruptcy. ((See Illka Perheentupa and Jonathan L. Sagot, Caveat Vendor – Mitigating Fraudulent Conveyance Risk, Weil Gotshal Private Equity Alert (May 2010) available at www.weil.com.)) In an LBO, creditors secure their loans against the target company’s assets, subordinating the claims of the target’s pre-LBO creditors. Thus, should the LBO fail and the target company file for bankruptcy, its pre-LBO creditors will receive little or nothing for their claims. ((Raymond J. Blackwood, Applying Fraudulent Conveyance Law to Leveraged Buyouts, 42 Duke L.J. 340, 343 (1992).)) Attacking the LBO transaction itself through fraudulent conveyance law may promise the only potential remedy for pre-LBO unsecured creditors. However, creditors seeking to apply fraudulent conveyance law to LBO transactions face significant legal uncertainty.
In its original iteration, the 1571 English “Statute of 13 Elizabeth,” fraudulent conveyance law voided all transfers by debtors whose purpose was to hinder, delay, or defraud their creditors. ((Statute of Fraudulent Conveyances, 13 Eliz., ch. 5 (1571) (quoted in id. at 344).)) For instance, an insolvent shepherd who sold a sheep to his brother for 1/100th of its value was guilty of a fraudulent conveyance. ((See Douglas G. Baird and Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829, 852 (1985) (cited in Blackwood, supra note 2, at 350).)) Under the new law, the court had the power to undo the transfer so that creditors’ claims would not be diminished by the borrower’s fraud. In its modern form, under fraudulent conveyance law, a transaction may be voided if it is made for insufficient consideration, and coincides with either 1) the insolvency of the debtor, 2) the debtor’s business being left with unreasonably small capital, or 3) the debtor’s belief or intent that it is incurring debts beyond its ability to pay them as they become due. ((Blackwood, supra note 2, at 346.))
How does fraudulent conveyance law apply to LBOs? In an LBO, a buying group (typically a private equity fund), believing that a company is undervalued or underperforming, will buy the outstanding shares of that company. Typically, buyers borrow 60-90% of the purchase price, pledging the assets of the company as collateral. ((Samir D. Parikh, Saving Fraudulent Transfer Law, 86 Am. Bankr. L.J. 305, 311 (2012).)) The LBO subordinates the existing claims of unsecured creditors to the creditors of the LBO transaction. If the LBO proves a failure and the target company files for bankruptcy, the massive claims of LBO creditors will likely leave nothing to subordinate pre-LBO creditors. ((Blackwood, supra note 2, at 343.))
If an LBO target company becomes insolvent and files for bankruptcy, pre-LBO creditors can argue that management authorized the company to overpay for its outstanding shares. ((Parikh, supra note 6, at 308.)) Simply put, they may argue that an exorbitant sum of money was paid for the shares of a company whose cash flows are insufficient to pay its debts as they become due. Like the farmer who sold a sheep for 1/100th its value, a handsome price was paid for practically worthless shares in a now bankrupt company, meeting the inadequate consideration and insolvency requirements to prove a fraudulent conveyance. ((William Curbow and Kathryn King Sudol, Simpson Thacher & Bartlett LLP, United States, Private Equity, 280 (2010) available at www.gettingthedealthrough.com.)) A showing of fraudulent conveyance has the potential to void the transfer of shares, placing shareholders at risk of having payment funds clawed back. ((Richard Houlihan and Andrew Smith, Solvency Opinions: Goals and Best Practices, 24 Com. Lending Rev. 27, 29 (2009).))
However, the U.S. Bankruptcy Code provides a safe harbor for LBOs that result in bankruptcy by preventing the unwinding of certain financial transactions. In the early 1980s, Congress amended the Bankruptcy Code to include section 546(e), the relevant part of which states that the bankruptcy trustee may not void a “settlement payment” made to or for the benefit of a financial institution, participant, or broker in connection with a securities or commodities contract. ((11 U.S.C. § 546(e) (2012).)) Congress intended section 546(e) to prevent displacement in the public commodities and securities markets in the event of a major bankruptcy. ((Gina Lynn Martin, Section 546(e): The Safest Harbor of Them All?, 10 ABI Committee News no.1, Feb. 2013, available at www.abiworld.org.)) Courts immediately began to hold that 546(e) prevented Bankruptcy Courts from unwinding LBO transactions involving the purchase of public securities. ((Parikh, supra note 6, at 339.)) However, through the 1990s, 546(e) was not held to be a protection for LBO transactions for private securities. ((Id.))
Beginning with the Third Circuit’s 1999 decision, In re Resorts International, Inc., circuit courts began to hold that the plain language of 546(e) does not distinguish between settlement payments to public shareholders and payments to private shareholders. ((Id.)) Regardless of Congressional intent, the Second, Sixth, Eighth and Tenth circuits applied the plain language of the 546(e) safe harbor to LBO transactions involving private securities in the early 2000s. ((See Martin, supra note 12.)) As of the financial crisis, when many target companies bought in LBOs went bankrupt, 546(e) appeared to be an impediment to avoiding payments in any type of LBO.
Two recent cases before the Southern District of New York have identified a potential route by which pre-LBO creditors may void fraudulent conveyances made in connection with LBOs. In In re Tribune Co. Fraudulent Conveyance Litig., and In re Lyondell Chemical Co., two different Southern District judges ruled that 546(e) bars claims brought by a bankruptcy trustee, but does not preempt state law fraudulent conveyance claims brought by individual creditors or a creditor trust. ((The Lyondell Decision and Implications for Lawsuits Seeking to Claw-Back Payments to Shareholders in LBO Transactions, Insolvency and Restructuring Update (Davis Polk, New York, N.Y.) Jan. 22, 2014, at 2.)) This holding stands in contrast to that of Whyte v. Barclays Bank PLC, in which a third Southern District of New York judge ruled that 546(e) preempts state law claims. In In re Lyondell, Judge Gerber distinguished Whyte in that a creditor trust brought both bankruptcy trustee claims as well as state law claims, but also “fundamentally disagreed” with the court’s analysis. ((Timothy J. Durken, Lawsuit Against Lyondell Shareholders For Repayment Of LBO Proceeds Survives Motion To Dismiss, Mondaq, (last updated Sept. 16, 2014), www.mondaq.com.))
As of the present, the Whyte and Tribune decisions have been appealed and will be heard in tandem by the Second Circuit later this year. The outcome of this appeal will likely decide the outcome of Lyondell. Should Tribune and Lyondell become binding law, it appears that pre-LBO creditors might avoid LBO transactions under state law if brought separately from the bankruptcy trustee claims, at least in the Second Circuit. Until the Second Circuit’s decision in Whyte and Tribune, creditors’ ability to avoid payments made to shareholders in failed LBOs remains uncertain. ((Id.))