Leveraged buyouts, known as LBOs, have frequently been the subject of fraudulent transfer challenges when the target company later files bankruptcy. As its name implies, the classic LBO involves the use of leverage — debt — to finance the acquisition of the target company’s stock. Often that new debt is secured by the assets of the target company. This post highlights a new article that addresses one of the hot issues in LBO fraudulent transfer litigation, but before doing that it may help to give some context to the discussion.
What Is A Fraudulent Transfer? There are two types of fraudulent transfers. The first is a transfer made with an actual intent to hinder, defraud, or delay creditors. However, transfers may be considered fraudulent, even in the absence of actual fraud, if the transfer has a similar effect on creditors. This second type of fraudulent transfer involves what is known as "constructive fraud." A court may find that a transfer involves constructive fraud if a company, at a time when it is already financially impaired or is made so by the transaction itself, does not receive "reasonably equivalent value" in return for the transfer in question. Section 548, the Bankruptcy Code’s fraudulent transfer statute, and state fraudulent transfer laws, cover both actual and constructive fraudulent transfers.
The LBO Fraudulent Transfer Lawsuit. When an LBO is followed sometime later by a bankruptcy, a fraudulent transfer lawsuit may be filed to challenge the LBO itself. Although actual fraud may be asserted, more often the case involves a constructive fraud claim.
- The argument usually made is that the use of the target company’s assets to secure loans (the leverage), the proceeds of which were then paid to selling shareholders (the buyout), rendered the company insolvent, made it otherwise unable to pay its debts when they became due, or left it with an unreasonably small capital with which to conduct its business. Since the target company does not receive anything in exchange for the payment to the selling shareholders, the lack of reasonably equivalent value element is usually present.
- The plaintiff in a fraudulent transfer lawsuit may be the company itself as Chapter 11 debtor in possession, the official committee of unsecured creditors, or a bankruptcy trustee or post-confirmation plan trustee.
- The defendants may include the new shareholders, the lenders who obtained security interests in the target company’s assets, and the shareholders who sold their stock for cash to the acquirer.
The Settlement Payment Defense. When selling shareholders are sued, they often assert a defense based on the "settlement payment" exception to certain fraudulent transfer claims found in Section 546(e) of the Bankruptcy Code. This exception was added to the Bankruptcy Code to prevent disruptions to the functioning of capital markets that might occur if long-settled trades were able to be unraveled by a fraudulent transfer action years down the road. Some courts, interpreting the term "settlement payment" to include payments made from a financial institution, have held that payments to selling shareholders, made by means of wire transfers using a bank or other financial institution, qualify as just such a "settlement payment" protected from avoidance as a fraudulent transfer under Section 546(e). Those courts, in effect, hold that the fact that a bank made wire transfers rendered an otherwise potentially fraudulent transfer immune from challenge.
Two Recent Articles Tackle This Issue. Two articles, including one published last week, take a look at how courts have been addressing the reach of the Section 546(e) defense in the context of these wire transfer payments.
- My Cooley Godward Kronish LLP Bankruptcy & Restructuring group colleagues Michael Klein and Ronald R. Sussman wrote an article for the May 2008 edition of the Turnaround Management Association’s The Journal of Corporate Renewal examining that issue. Their article is entitled "Do Wire Transfers Really Protect Shareholders in Private LBOs? Not in the 2d — and Perhaps Other — Circuits."
- An earlier article, written by Faye B. Feinstein and Lauren N. Nachinson, is entitled "Wire Transfers May Protect Shareholders in LBOs: 3d Circuit Says Payments by Financial Institutions Are Unavoidable" and focuses on Third Circuit law.
How Far Does The Defense Go? The new article discusses case law from outside of the Third Circuit. In particular, it examines a recent decision from a New York bankruptcy court that rejected the Section 546(e) defense in a situation involving an LBO of a private, rather than publicly traded, target company. The article sums up the differences this way:
The application of the settlement payment defense in the context of an LBO has been far from uniform. While courts in the 3d Circuit have utilized Section 546(e) to shield virtually all LBO payments from avoidance, even in the context of private transactions, a significant number of courts have limited the scope of this safe harbor provision.
Accordingly, the extent to which wire transfers may insulate LBO payments from attack under fraudulent transfer laws will likely be determined as much by the venue of the bankruptcy proceedings as much as the facts of the transaction at issue.
Worth Reading. Anyone involved in LBOs, including acquirers, target company directors or management, selling shareholders, and of course their professionals, will find these articles very interesting reading.