Leveraged Buyout Transactions Under Heightened Scrutiny in Bankruptcy Withstanding Creditor Challenges to Fraudulent Transfer Claims

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1 presents Leveraged Buyout Transactions Under Heightened Scrutiny in Bankruptcy Withstanding Creditor Challenges to Fraudulent Transfer Claims A Live 90-Minute Teleconference/Webinar with Interactive Q&A Today's panel features: Douglas S. Mintz, Special Counsel, Cadwalader Wickersham & Taft, Washington, D.C. Steven T. Bobo, Partner, Reed Smith, Chicago Wednesday, May 26, 2010 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific You can access the audio portion of the conference on the telephone or by using your computer's speakers. Please refer to the dial in/ log in instructions ed to registrations.

2 The Seventh Circuit s Recent Opinion in Boyer v. Crown Stock Distributing, Inc. Lessons From A Failed Leveraged Asset Sale The Seventh Circuit Court of Appeals recently upheld the avoidance of a leveraged buyout transaction in Boyer v. Crown Stock Distributing, Inc., F. 3d (7 th Cir. November 18, 2009), and its opinion presents some interesting twists on fraudulent conveyance issues. The case involved the purchase of all of the assets, but not the stock, of Crown Unlimited Machine, Inc. ( Old Crown ), which was a designer and manufacturer of machinery for cutting and bending tubes. The $6 million purchase price was paid with a combination of $3.1 million in cash and a $2.9 million promissory note. The cash was funded by a bank loan obtained by the purchaser that was secured by a senior lien on all the assets being acquired. The promissory note given to Old Crown was secured by a subordinate lien on the assets, and the note terms provided that the purchaser would have to pay a reduced amount of only $100,000 per year unless future sales exceeded a specified threshold. The purchaser was a newly-formed company ( New Crown ) that took the name of the seller after the closing. The principal of New Crown had worked for Old Crown for a while prior to the sale, and he contributed only $500 of his own money towards capitalizing New Crown. There were several more significant features of the transaction. Just prior to the closing, Old Crown distributed over $590,000 of its available cash to its shareholders in the form of a dividend. Trade creditors and other unsecured creditors were not informed either of the sale or that they were dealing with a different entity after the closing. Creditors had no way of discovering the sale on their own since New Crown had adopted Old Crown s corporate name and continued operating the same business with the assets it acquired.

3 Following the closing, New Crown s business struggled, and it filed bankruptcy about three and one-half years later. In New Crown s bankruptcy proceeding, its assets were sold for $3.7 million to a newly-formed entity (of which the principal of New Crown became the president). Although the sale proceeds were sufficient to repay New Crown s bank loan, not much was available to distribute to unsecured creditors. The bankruptcy trustee initiated litigation to avoid the purchase transaction and recover the purchase price paid to Old Crown and the dividend received by Old Crown s shareholders, utilizing the four year reach back period available under the Indiana Uniform Fraudulent Transfer Act and Section 544 of the Bankruptcy Code. 1. The Bankruptcy Court s Decision Was a Split Decision In the proceedings before the Bankruptcy Court, New Crown was found to have paid the $6 million purchase price without receiving reasonably equivalent value in return. Consequently, New Crown had begun its operations with assets that were unreasonably small in relation to the business. The Bankruptcy Court believed that the assets acquired by New Crown had been worth no more than $4 million as of the closing and that New Crown had been so depleted by the debt that it had taken on that it had been on life support from its inception. Therefore, the Bankruptcy Court ruled that the buyout transaction should be avoided; with the result that Old Crown could neither enforce its $2.9 million promissory note nor retain the $3.1 million in cash received at closing and the two interest payments of $100,000 received on the promissory note. However, the Bankruptcy Court refused to allow the trustee to recover the $590,000 dividend that Old Crown paid to its shareholders shortly before the closing. It ruled -2-

4 that the dividend was legitimate because it had been paid from cash that belonged to Old Crown rather than to New Crown. The court rejected the trustee s argument that the purchase of Old Crown s assets had been a leveraged buy out and refused to collapse the transactions and recharacterize them as a sale by the shareholders of Old Crown, so that the dividend would be seen as an asset of the New Crown s bankruptcy estate. Thereafter, both sides appealed. Old Crown and its shareholders sought to overturn the judgment avoiding the sale of assets, and the trustee sought to reverse the holding that the $590,000 dividend payment could not be recovered. 2. The Seventh Circuit Sides With the Trustee On appeal, the Seventh Circuit took a fresh look at the situation and sided with the trustee. It had no difficulty finding that the transaction should be avoided as a fraudulent conveyance despite the reluctance of some other courts and various commentators to characterize leveraged buyout transactions as fraudulent conveyances. The defendants argued that this transaction was neither a conventional leveraged buyout nor a fraudulent conveyance because it was an asset sale, not a sale of the company s stock, and also because New Crown had limped along for three and a half years before collapsing into the arms of the bankruptcy court. (Id. at 9). The Seventh Circuit rejected the defendants first point as being of no conceivable significance, because leveraged buyouts can take the form of asset acquisitions, citing to In re OODC, LLC, 321 B.R. 128 (Bankr. D. Del. 2005), and In re Aluminum Mills Corp., 132 B.R. 869 (Bankr. N.D. Ill. 1991). According to the Seventh Circuit s view of the situation, although the transaction was nominally a purchase of Old Crown s assets, it was actually a transfer of the ownership of the company because Old Crown distributed the money it received in the sale to its -3-

5 shareholders and thereafter existed only as a shell. In addition, New Crown concealed the transactions from its creditors, which would be normal if the stock of a corporation were sold, rather than its assets; but in a sale of its assets, the seller s creditors would expect to be notified that they would henceforth be dealing with a different firm. (Id. at 10). On the defendant s second argument, the Court pointed out that although New Crown had been able to survive for several years, it lacked adequate capital and this was sufficient for fraudulent transfer purposes. Because all of New Crown s assets were encumbered (both by the bank and by the secured note owed to Old Crown), the sale reduced its ability to borrow on favorable terms as it had no collateral to offer to new lenders. The transaction also depleted most of the company s cash, since Old Crown had pulled out $590,000 as a shareholder dividend and New Crown had obligated itself to pay at least $595,000 in debt service on its loans, without receiving anything in return except its principal s $500 capital contribution. New Crown ran up additional debt on unfavorable terms. Seven months before it declared bankruptcy, it had $8.3 million in debt and its assets were worth only half that amount. As the Seventh Circuit characterized New Crown s situation, It was naked to any financial storms that might assail it. (Id. at 13). Therefore, the Seventh Circuit affirmed the Bankruptcy Court s rulings that New Crown had not received reasonably equivalent value in the sale and the transaction to New Crown was a fraudulent conveyance. The Court went on to take a fresh look at the shareholder dividend that Old Crown paid just prior to the sale. Even though the trustee had failed to present evidence concerning Old Crown s dividend policy, the Court determined that the dividend was inherently suspect. It pointed out that family-owned companies rarely pay dividends but instead channel distributions of profits as salary in order to avoid double taxation. There was evidence in the record showing -4-

6 that four of the Old Crown shareholders were officers and that the dividend represented 50 percent of Old Crown s profits for the prior year, which the Court believed to be unreasonably high given the cash needs of the business. It concluded that these were sufficient indications that the dividend was part of the fraudulent transfer rather than a normal distribution of previously earned profits. This caused the burden to shift to the defendants to produce evidence that it was a bona fide dividend, which they failed to meet. Therefore the Court concluded that the dividend was part of the fraudulent conveyance and could also be avoided by the Trustee. 3. All of the Avoided Transfers Could Be Recovered Even Though They Exceeded Creditor Claims The Seventh Circuit then turned its discussion to the basis of recovering the funds that the defendants had received under Section 550 of the Bankruptcy Code. If the asset sale were collapsed and recharacterized as a sale of Old Crown by its shareholders, as is implicit in the Court s characterization of the sale as a leveraged buyout, then the Court viewed the Old Crown shareholders to have been the initial transferees of the funds. In that case, the dividend that Old Crown paid to the shareholders would be an adjustment to the purchase price. On the other hand, if the overall transaction was not collapsed, the initial transferee of the cash paid by New Crown was Old Crown, and its shareholders were subsequent transferees of the initial transferee of the funds. Since the shareholders gave no value in return for the payments, they were therefore not protected by Section 550(b)(2) of the Bankruptcy Code, which precludes recovery from a subsequent transferee that took for value and in good faith and without knowledge of the voidability of the transfer avoided. -5-

7 The defendants contended that having to return any of the $3.3 million (plus the dividend) that they received would provide an unfair windfall for the trustee. New Crown had sold the assets for $3.7 million in its bankruptcy, and if Old Crown had to return all of the payments it received plus the dividend, then the debtor s estate will have received over $7.6 million. This is far more than was needed to pay total estate obligations of only about $5.3 million plus administrative expenses. The Court made clear that there would be no windfall because any excess funds after creditors are repaid in full would go back to the debtor and would be ultimately distributed according to state law, but as far as it could tell the only parties entitled to any residual would be the shareholders of Old Crown. Therefore it affirmed the Bankruptcy Court s determination that the full purchase price could be recovered by the trustee. It reversed the determination that the $590,000 dividend could not be avoided, and pronounced that any funds remaining after satisfying creditor claims and costs of administration must be returned to the defendants. 4. Noteworthy Aspects of the Decision The Court s opinion is worthy of discussion in several respects. It had no difficulty characterizing the sale of assets as a leveraged buyout and applying fraudulent conveyance concepts to the transaction. However, its analysis of the basis for treating a sale of assets as tantamount to a sale of ownership of a company is unsatisfying. The Court s treatment of the dividend that Old Crown paid to its shareholders is more unusual. The limited facts set forth in the opinion indicate that the $590,000 was some but apparently not all of the company s cash and New Crown had permitted the dividend payment prior to closing with the amount of the dividend determined by the performance of the business during the period leading up to the closing. The Court also indicated that the dividend represented half of Old Crown s profits for -6-

8 the prior year, a level which was unreasonably high given the cash needs of the business. (Id. at 15). But the opinion fails to explain the basis for this conclusion. Although the Court points out that the trustee failed to present any evidence concerning Old Crown s dividend policy, it also concluded that the form of the payment was suspect because such companies rarely pay dividends but typically are motivated by tax considerations to distribute earnings as salary. Although the opinion does not articulate what evidence was in the record on this point, the Court relied on these several indications alone to conclude that the trustee had met his burden of showing that dividend was an integral part of the fraudulent transfer rather than a normal distribution of a portion of previously-earned profits, or as the opinion describes it, the withdrawal of an asset vital to the acquiring firm. (Id. at 15). Unfortunately, the opinion is murky in terms of explaining whether and how the Court determined what amount of Old Crown s funds constituted the ordinary working capital needs of the business and what portion was earnings above that level. Therefore, it is difficult to ascertain its basis for declaring that the distribution of half of the prior-year s profits by way of a dividend to shareholders was unreasonable. The language of the opinion implies that if Old Crown had paid the $590,000 as additional salary or bonus payments to its officers instead of as dividends, those payments would have had a better chance of avoiding recovery. But this is unlikely to be a meaningful distinction since the form of payments should not dictate whether they were fraudulent conveyances, and it seems doubtful that such a difference in form would not have changed the outcome here. Consequently, it is difficult to determine how the Court defined when such payments would be insulated from avoidance in context of a leveraged sale of a company s assets. -7-

9 It is also unusual that the dividend was recovered from the Old Crown shareholders solely to help ensure that the creditors of New Crown were paid. After all, three and a half years had passed between the transaction and the bankruptcy, and the opinion does not indicate that any creditors of Old Crown remained unpaid. It also did not appear that the trustee needed to recover the dividend in order to ensure that all New Crown creditors were paid in full and all administrative expenses were satisfied. The creditor claims totaled $5.3 million, whereas the proceeds of the bankruptcy sale plus the avoided amount paid by New Crown to Old Crown totaled $7 million, without considering the dividend payment.. When viewed from a distance, the core of the Seventh Circuit s opinion relating to the dividend seems less about fraudulent conveyance issues and more focused on considerations of alter ego, or the liability of one entity for the indebtedness of another. The court mentions several times that the sale of assets and the change of entities had been concealed from the creditors. In the eyes of both the creditors and the Court, New Crown and Old Crown were essentially the same company, and there were strong equitable reasons to collapse the transaction and make the dividend subject to the claims of creditors of New Crown. The opinion s language and analysis focused on fraudulent conveyance issues because that was the way the case reached the Seventh Circuit, but the result is best understood through an alter ego lens instead. 5. Lessons For Structuring Similar Transactions The takeaway lessons are several. First, a highly leveraged transaction such as the Crown one is susceptible to being unwound as a fraudulent conveyance whether structured as a stock sale or an asset sale. Even the facts that a portion of the purchase price was in the form of a soft note and the purchaser survived for three and a half years before going into bankruptcy did not -8-

10 insulate the transaction from avoidance. Second, if the selling company has excess cash above working capital needs that is to stay with the owners of the seller, the form and timing of the transfer of those funds to the owners should be carefully considered. An extraordinary distribution of a large portion of the seller s cash on the eve of a highly leveraged sale clearly troubled the Seventh Circuit here. However, a distribution of earnings that can be shown to have been in excess of the working capital needs of the business (including a cushion above budgeted needs and funding projected growth) should not be inherently suspect. In the case of a subchapter S corporation or a limited liability company, making such a distribution through additional salary or performance bonus payments might bother a court somewhat less than an extraordinary dividend, although the basis for such a distinction seems unconvincing. Perhaps the most important lesson to avoid similar consequences is to not conceal the transaction from creditors. Although the Seventh Circuit did not explicitly analyze the issues from an alter ego perspective, it justified collapsing the dividend payment into the purchase transaction because the parties had clearly treated New Crown as the successor to Old Crown. Not only did the buyer take the identical corporate name, it appears that New Crown continued to operate essentially the same business from the same premises and with the same employees. New Crown continued to deal with Old Crown s customers and suppliers but failed to notify them that they were dealing with a different entity. There was also partial continuity between the management of the seller and the purchaser. All of these are factors in whether a purchaser should be deemed a mere continuation of the seller and liable for its debts. Accordingly, there was a strong basis to hold Old Crown liable for the debts of New Crown, allowing for recovery of the dividend to the extent necessary to ensure that creditors were fully paid. -9-

11 Although New Crown may have insisted that the transaction be made invisible to third parties in order to maximize the transfer of Old Crown s goodwill, this and the other circumstances created substantial risks to Old Crown s shareholders. Had existing and new creditors been advised of the transaction and the fact that they now were dealing with a separate entity, the defendants would have been in a stronger position to protect at least the dividend from recovery in the event of the purchaser s failure. Stephen T.Bobo Reed Smith, LLP 10 S. Wacker Drive, 40 th Floor Chicago, IL (312) sbobo@reedsmith.com -10-

12 Sixth Circuit Affirms That Buyout Payments for Privately-held Stock Were Protected as Settlement Payments In a decision with potentially broad implications, the United States Court of Appeals for the Sixth Circuit has recently determined that payments made to former shareholders of a privately-held company in a leveraged buy-out transaction are protected as settlement payments pursuant to Section 546(e) of the Bankruptcy Code. In In re: QSI Holdings Inc., No , 2009 WL (6 th Cir. July 6, 2009), the court found that the payments to shareholders could not be recovered in a subsequent bankruptcy proceeding because they constituted settlement payments under the plain language of Section 546(e) and that this provision was not limited to transactions involving publicly traded securities but also extended to privately held securities transactions. The case arose from the leveraged buy-out of Quality Stores, Inc. ( QSI ), a privately held company, through a merger with Central Tractor Farm and Country, Inc. Under the transaction, QSI s 170 shareholders were paid in either cash or stock in the surviving entity, with the total value exchanged exceeding $200 million. The transactions were accomplished through HSBC Bank USA acting as exchange agent to collect the stock from individual shareholders and distribute cash payments or new stock to them in return. Some of QSI s stock had been held in an Employee Stock Ownership Trust ( ESOT ). For these shares, the settlement process also involved the ESOT trustee, LaSalle Bank. Two years after the merger, the surviving entity, which had changed its name to Quality Stores, Inc., fell on hard times. Creditors filed an involuntary bankruptcy against it in late 2001, and QSI ended up in a Chapter 11 proceeding. In its capacity as debtor in possession, QSI thereafter filed a fraudulent conveyance action against the former shareholders alleging that the

13 stock they tendered for cash payments represented less than reasonably equivalent value in return and that the LBO transaction left the company with unreasonably small capital and caused it to incur debts greater than its ability to pay. In response, the former shareholders filed a motion for summary judgment on the basis that the cash they received constituted settlement payments made by a financial institution and were therefore exempt from avoidance. The bankruptcy court agreed, concluding that these payments fell within the Section 546(e) exemption. On appeal, the district court affirmed the bankruptcy court s decision. The debtor further appealed to the Sixth Circuit, contending that this exemption is limited to transactions involving publicly-traded securities. It argued that Congress did not intend for the exemption to extend to transactions involving a leveraged buyout of privately-held stock because this type of payment is not commonly used in the securities trade, as defined in Section 741(8) of the Bankruptcy Code. The debtor contended that the court should follow more the restrictive views of certain other courts construing the scope of this exemption. The Sixth Circuit rejected these arguments and joined a number of other courts that recognize that the definition of settlement payment is extremely broad, although somewhat circular. The court focused on the final phrase in the Section 741(8) definition: the payment must be one commonly used in the securities trade. Id. at 549. It rejected the debtor s suggestion that the lower courts had failed to consider whether the buyout of QSI contained the hallmarks of a payment made in the securities trade. The court s brief review of the legislative history revealed that purpose of this provision was to ensure expanded protection that would include margin and settlement payments to and from brokers, clearing organizations, and financial institutions. Again, Congress s purpose was to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those - 2 -

14 industries., id. at , quoting from Kaiser Steel Corp. v. Charles Schwab & Co., Inc., 913 F.2d 846, 849 (9 th Cir. 1990). Although it had ruled upon a buyout of publicly-traded securities, the Kaiser Steel court had concluded that the transfer of consideration in an LBO is consistent with the way settlement is defined in the securities industry. Id. at 550. The Sixth Circuit determined that the logic of the Kaiser Steel decision extends to privately held securities. It relied upon the recent decision in Contemporary Indus. Corp. v. Frost, 564 F. 3d 981 (8 th Cir. 2009), in which the Eighth Circuit had faced the same issue and found there was no indication of any intent to exclude such payments from the definition of settlement payments merely because the stock was privately held. The Eighth Circuit decision had interpreted the phrase commonly used in the securities trade as a catchall phrase intended to underscore the breadth of the 546(e) exemption. Id. at 986. The Sixth Circuit adopted this conclusion. Id. at 550. The QSI court acknowledged that other courts have reached a different conclusion on the issue because of their focus on a perceived purpose of Section 546(e) to protect publicly traded securities from market volatility resulting from a bankruptcy, citing In re Norstan Apparel Shops, Inc., 367 B.R. 68 (Bankr. E.D.N.Y. 2007). Norstan arose from the leveraged buy out of all of the company stock, which was owned directly and indirectly by the two principal officers. The proceeds of the loans made to finance the stock purchase flowed directly from the lender to the shareholders, rather than to the company. Id. at 73. The Sixth Circuit distinguished the Norstan case on the basis that it involved the two sole shareholders of a closely held Subchapter S corporation, did not implicate public securities markets, and lacked many of the indicia of transactions commonly used in the securities trade. By contrast, the QSI situation involved a transaction with the characteristics of a common leveraged buyout involving the merger of - 3 -

15 nearly equal companies,.[t]he value of the securities at issue is substantial and there is no reason to think that unwinding that settlement would have any less of an impact on financial markets than publicly traded securities. Therefore the Sixth Circuit concluded that nothing in the text of Section 546(e) precluded its application to settlement payments involving privately held securities. Id. at 550. The debtor also contended that an element of Section 546 (e) had not been satisfied because there had been no transfer made by or to a financial institution. The debtor argued that the intermediary bank never had dominion or control over the funds but instead had acted merely as a conduit, relying on a decision by the Eleventh Circuit in In re Munford, Inc., 98 F.3d 604, 610 (11 th Cir. 1996). According to this argument, the bank could not have received a transfer of the debtor s property if it never had a beneficial interest in either the funds or the shares exchanged for those funds. The Sixth Circuit rejected this position, following instead decisions from several other Courts of Appeal that found that the plain language of Section 546(e) nowhere requires a financial institution to have a beneficial interest in the transferred funds, relying on In re Resorts International, Inc., 181 F.3d 505, 516 (3 rd Cir. 1999), and Contemporary Indus., 564 F.3d According to the Sixth Circuit, the role played by HSBC Bank in the QSI buyout was sufficient to satisfy the requirement that the transfer was made to a financial institution. Id. at 551. The Sixth Circuit s analysis and careful use of language suggests limits to the settlement payments exception through the use of an intermediary financial institution in buyout transactions. In particular, its contrast between the Norstan Apparel decision and the QSI situation provides insight. In the view of the Sixth Circuit, Norstan Apparel merely involved the two sole shareholders of a Subchapter S corporation (who were paid directly by the LBO lender - 4 -

16 and not through a separate intermediary). The transaction lacked many of the indicia of transactions commonly used in the securities trade. QSI s buyout, on the other hand, involved 170 shareholders who received over $200 million in cash and stock through HSBC Bank USA. In the view of the Sixth Circuit, this transaction had the characteristics of a common leveraged buyout and involved the merger of nearly equal companies. The potential impact of unwinding the settlement payments would be comparable to a transaction involving publicly traded securities. The wording of the actual QSI holding - that nothing in the text of 546(e) precludes its application to settlement payments involving privately held securities - also suggests that not all buyout transactions involving an intermediary financial institution may be entitled to this exemption. Transactions that do not share much in common with transactions commonly used in the securities trade or that lack the characteristics of a common leveraged buyout may not be able to rely on such protection under Section 546 (e). For example, a small buyout transaction where the use of a financial institution as exchange agent appears to have been unnecessary except to gain the protections of 546(e) could fall into what the district court below referred to as exceptional circumstances and not entitled to the exemption. Another example of exceptional circumstances would clearly be the exception contained in 546(e) for transactions sought to be avoided under Section 548(a)(1)(A), that is, for transactions involving actual fraud. The QSI decision represents increasing legal support for protection of payments for sales of stock in either a public or a private company appropriately made through a financial institution where no fraud was present. This protection extends to constructive fraudulent conveyance and preference theories. The use of a financial institution as an exchange agent or other similar intermediary to facilitate the buyout of a corporation s stock where justified by the - 5 -

17 needs of the transaction and having the indicia of transactions commonly used in the securities trade would appear to insulate the payments from avoidance should the corporation later end up in a bankruptcy proceeding. Stephen T.Bobo Reed Smith, LLP 10 S. Wacker Drive, 40 th Floor Chicago, IL (312) sbobo@reedsmith.com US_ACTIVE

18 A BNA s BANKRUPTCY LAW REPORTER! Reproduced with permission from BNA s Bankruptcy Law Reporter, 22 BBLR 693, 05/20/2010. Copyright 2010 by The Bureau of National Affairs, Inc. ( ) LBOs and Fraudulent Transfers: How Susceptible Are You to Avoidance? BY DOUGLAS MINTZ A s the economy boomed in and leverage increased to staggering levels, LBOs took a prominent place in the deal economy. During that time, investors completed 313 LBOs in the United States for approximately $630 billion. 1 Following the recent economic downturn, many of those LBOs have become sources of controversy in a number of bankruptcies and restructurings prominent examples include Tribune Co. and Lyondell Chemical Co. In many of these cases, 1 Factset, MergerMetrics, 12/30/09. Douglas S. Mintz is special counsel at Cadwalader, Wickersham & Taft s Financial Restructuring Department, Washington, D.C. He represents secured lenders, debtors, and official and ad hoc creditors committees. He can be reached at Douglas.Mintz@cwt.com. Stephen M. Johnson, in the New York office, assisted with this article. courts have considered whether ultimately unsuccessful LBOs constitute fraudulent transfers by the lenders and/or equity purchasers, although, to date, few courts have avoided pre-bankruptcy LBOs. This article provides a survey of the applicable law courts apply in analyzing alleged fraudulent transfers, and a discussion of recent case law involving actions to avoid fraudulent transfers in the context of LBOs. In addition, this article discusses the recent decision avoiding more than $700 million in liens and secured claims in the In re TOUSA Inc. bankruptcy (a non-lbo case). Although TOUSA did not concern an LBO, the court s decision is nonetheless an important addition to the spectrum of rulings regarding the avoidability of constructively fraudulent transfers. Applicable Law There are two types of fraudulent transfers: transfers involving actual fraud, and those involving constructive fraud. The ability to avoid fraudulent transfers is founded in both the Bankruptcy Code and applicable state law. Bankruptcy Code Section 548 details the standards for avoidance of fraudulent transfers. COPYRIGHT 2010 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN

19 2 Section 544 incorporates state fraudulent transfer law. Each state has its own fraudulent transfer law. Section 548(a) details the actual fraud standard and provides that a trustee may avoid any transfer of the debtor s property, or any obligation incurred by the debtor, that was made or incurred on or within two years before the debtor filed for bankruptcy, if the debtor voluntarily or involuntarily made such transfer or incurred such obligation with actual intent to hinder, delay or defraud a creditor. 2 The Uniform Fraudulent Transfer Act ( UFTA ), described in detail below, contains a nearly identical standard. 3 Subsection 548(a)(1)(B) addresses what is referred to as constructive fraud, and permits the avoidance of any transfer where the debtor received less than a reasonably equivalent value in exchange for such transfer or obligation and either: (I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation; (II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; (III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor s ability to pay as such debts matured; or (IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business. 4 Most states have enacted a version of the UFTA, although a minority of states have implemented variations of the older Uniform Fraudulent Conveyance Act ( UFCA ). The UFTA includes provisions similar to those contained in Section 548, and thus courts interpret the actual and constructive fraudulent transfer standards similarly under the Code and the UFTA. 5 The primary difference between the UFTA and the Code is in the duration of the look-back period. Under Section 548, a debtor may avoid any transfer made within two years prior to the commencement of the bankruptcy. 6 In contrast, the UFTA provides that a fraudulent transfer action must be initiated within four years after the transfer was made or the obligation was incurred U.S.C. 548(a)(1)(A). 3 See, e.g., Del Code Ann. tit. 6, 1304(a)(1) U.S.C. 548(a)(1)(B)(ii). Subsection (IV) of Section 548(a)(1)(B)(ii) was added to the Code in This new provision would render irrelevant all questions with respect to solvency and the related analysis for certain transactions with insiders. Only a handful of cases have addressed this subsection to date, and it appears this provision applies only to bonuses and compensation made pursuant to employment contracts. See, e.g., Kovacs v. Berger (In re Berger), No , 2007 Bankr. LEXIS 2884 (Bankr. N.D. Ohio Aug. 27, 2007) (finding that Section 548(a)(1)(B)(ii)(IV) was not applicable because there was no allegation or proof that the transfer was made under an employment contract ). 5 See, e.g., Pioneer Home Builders, Inc. v. Int l Bank of Commerce (In re Pioneer Home Builders, Inc.), 147 B.R. 889, 891 (Bankr. W.D. Texas 1992) (noting similarities between Texas fraudulent conveyance statute and Section 548) U.S.C. 548(a)(1). 7 See, e.g., Del. Code Ann. tit. 6, The UFTA also contains a constructive fraud provision, modeled on Section 548(a)(1)(B), setting forth similar requirements. 8 In a bankruptcy, the debtor-in-possession is charged with maximizing the value of its estate for the benefit of economic stakeholders, which may (depending upon the specific facts and circumstances) include seeking to avoid any pre-petition fraudulent transfers. Below is a summary of the legal framework applicable to the avoidance of fraudulent transfers arising from LBOs. Key Factors The concept of avoiding fraudulent transfers existed long before the first LBO was ever consummated. It was unclear at first whether fraudulent transfer law was applicable in the LBO context. That changed, however, when the Third Circuit, in United States v. Tabor Court Realty Corp., held that the provisions of the UFCA applied to LBOs just as they did to more traditional, less complex transactions. 9 In the wake of Tabor, courts have addressed fraudulent transfers in the LBO context with increasing regularity. The case law provides several factors that are critical to a court s analysis of whether an LBO is avoidable pursuant to applicable fraudulent transfer law. LBOs as Actual Fraudulent Transfers In determining whether a transfer was made with actual fraud, courts analyze the intent of the transferor, not the intent of the transferee. 10 Because actual intent to defraud is difficult to prove, courts will consider circumstantial evidence such as certain badges of fraud demonstrating actual fraudulent intent. 11 The UFTA provides similar badges of fraud. 12 Despite the clear standards, few if any courts have found the presence of actual fraud in the context of an LBO. A court would deem an LBO to constitute an actual fraudulent transfer only if it found that the lender or equity purchaser had engaged in behavior that demonstrated evidence of an intent to actually defraud the debtor or its creditors. Actual fraud is highly unlikely in a market-based LBO. LBOs as Constructively Fraudulent Transfers Courts analyzing constructively fraudulent transfers look for the presence of two key factors: (1) whether the transfer made for less than reasonably equivalent value and (2) whether the transferor financially unsound at the time of the transfer. To satisfy the second prong of this analysis, a creditor must show that the transferor was either insolvent or had unreasonably small capital at the time of the transfer, or was left in such condition following the transfer. Reasonably Equivalent Value The target of an LBO may not have received reasonably equivalent value because the target typically re- 8 See, e.g., Del. Code Ann. tit. 6, 1304(a)(2). 9 See United States v. Tabor Court Realty Corp., 803 F.2d 1288, 1297 (1986). 10 See, e.g., Silverman v. Actrade Capital Inc. (In re Actrade Fin. Techs. Ltd.), 337 B.R. 791, 808 (Bankr. S.D.N.Y. 2005) (noting that intent of transferor and not transferee that is relevant for purposes of pleading intentional fraudulent conveyance and listing cases). 11 Rosener v. Majestic Mgmt. Inc. (In re OODC LLC), 321 B.R. 128, 140 (Bankr. D. Del. 2005). 12 See, e.g., Del. Code Ann. tit. 6, 1304(b) COPYRIGHT 2010 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBLR ISSN

20 3 13 See, e.g., Boyer v. Crown Stock Distribution Inc., 587 F.3d 787, 792 (7th Cir. 2009) ( payment to the shareholders by the buyer of the corporation is deemed a fraudulent conveyance because in exchange for the money the shareholders received they provided no value to the corporation but merely increased its debt and by doing so pushed it over the brink ); MFS/Sun Life Trust-High Yield Series v. Van Dusen Airport Servs. Co., 910 F. Supp. 913, 937 (S.D.N.Y. 1995) ( Because the assets of the target are pledged as security for a loan that benefits the target s former owners rather than the target itself, it is unlikely that any LBO can satisfy fair consideration requirements ). 14 Bay Plastics Inc. v. BT Commercial Corp. (In re Bay Plastics Inc.), 187 B.R. 315 (Bankr. C.D. Calif. 1995). 15 See id. at Id. at See Mellon Bank NA v. Official Comm. of Unsecured Creditors of R.M.L. Inc. (In re R.M.L. Inc.), 92 F.3d 139, 152 (3d Cir. 1996). 18 See Mellon Bank NA v. Metro Commc ns Inc., 945 F.2d 635, (1991). 19 See Rubin v. Mfrs. Hanover Trust Co., 661 F.2d 979, 991 (2d Cir. 1981) (holding that transfers in an LBO, effectuated solely for the benefit of third parties, do not provide fair consideration to the debtor, though the debtor may experience indirect benefits that come through a third party). 20 Metro Commc ns, 945 F.2d at 647. ceives nothing in return for transfers it makes or obligations it incurs. 13 In a typical LBO, the target company is heavily leveraged and often pledges its assets as security for the loans, while the loan proceeds themselves are transferred to the company s former shareholders in exchange for their securities, leaving the company with significant debt obligations but no new capital. For example, in In re Bay Plastics Inc., 14 the debtor commenced a fraudulent transfer avoidance action against certain stockholders that tendered shares in an LBO almost a year and a half prior to the commencement of the debtor s bankruptcy case. In connection with the LBO, the debtor incurred a $3.95 million obligation, $3.5 million of which it used to purchase its shares from tendering stockholders. Applying California s version of the UFTA, the bankruptcy court held that the debtor could avoid the payments to the selling stockholders. 15 The court held that it is apparent that the $450,000 that [the debtor] presumably received (the $3.95 million loan less the $3.5 million paid to the selling stockholders) is not reasonably equivalent to the $3.95 million obligation that it undertook. 16 Some courts also have examined whether an LBO conferred intangible benefits upon the debtor (even if such benefits did not actually materialize 17 ). In Metro Communications, 18 the Third Circuit held that an LBO target received reasonably equivalent value because the transaction enabled it to receive a line of credit and to achieve operational synergies resulting from the business combination. Other courts have held that indirect benefits may be insufficient to support a finding that reasonably equivalent value has been exchanged. 19 The Metro Communications court did note, however, that the more common outcome with respect to LBOs transactions characterized by their high debt relative to equity interest is that [debtors] are less able to weather temporary financial storms because debt demands are less flexible than equity interest[s]. 20 In MFS/Sun Life, the holders of bonds issued by an airport services company brought an action against the company, its former management, and its LBO purchasers, alleging that the LBO rendered the company insolvent and constituted a fraudulent transfer. In determining whether the $28.5 million provided to and remaining with the company for working capital after the LBO was reasonably equivalent to the $55 million obligation the company incurred, the court held that the target/ debtor potentially could have received indirect benefits, including: (i) synergistic effects of new corporate relationships; (ii) a new management team; (iii) tax benefits; and (iv) additional post-closing credit. 21 However, the debtor failed to prove the value of these potential benefits through evidence. In the absence of evidence of value, the court could not conclude that the debtor received reasonably equivalent value. Assessing Insolvency or Unreasonably Small Capital A creditor challenging a transaction as actually or constructively fraudulent must demonstrate that the target was insolvent at the time of the transaction (or rendered insolvent by the transaction), that the transaction left the transferor with unreasonably small capital, or that the transaction left the transferor unable to pay its debts as they came due. These standards overlap substantially. The principal distinction between insolvency and unreasonably small capital in the LBO context is the difference between being bankrupt at the time of the transaction and being left with such diminished assets that bankruptcy is both likely and foreseeable. 22 Unreasonably small capital is a less technical, and perhaps less stringent, standard than is insolvency because of its subjective nature, though courts must exercise caution so as not to allow hindsight to cloud their judgment. 23 The Third Circuit s decision in Moody v. Security Pacific Business Credit Inc., 24 is instructive regarding the standards to be applied in an LBO insolvency analysis. In Moody, the Chapter 7 trustee brought fraudulent transfer claims under the Pennsylvania fraudulent transfer statute and the Bankruptcy Code against participants in the debtor s failed LBO. On appeal to the Third Circuit, the plaintiff argued that the district court should have calculated the amount the company would have received had it attempted to liquidate its PP&E on the date of the acquisition or immediately thereafter. 25 The Third Circuit rejected the liquidation methodology suggested by the plaintiff, instead adopting a going concern methodology to determine solvency because the debtor had positive cash flow at the time of the LBO and was coming off a break-even year before acquisition costs. 26 The Third Circuit then considered whether the district court properly valued the debtor s PP&E on a going-concern basis. Recognizing the probative value of the proceeds received by the debtor for PP&E in connection with the sale of certain of its subsidiaries after the LBO, the Third Circuit affirmed the district court s valuation of the debtor s PP&E MFS/Sun Life, 910 F. Supp. at Boyer v. Crown Stock Distribution Inc., 587 F.3d 787, 794 (7th Cir. 2009). 23 See id F.2d 1056 (1992). 25 Id. at See id. at Id. BANKRUPTCY LAW REPORTER ISSN BNA

21 4 With respect to the unreasonably small capital prong of the insolvency analysis, courts have interpreted this term in the LBO context to mean a condition in which a company bears an unreasonable risk of insolvency. 28 When determining unreasonably small capital, a court may take into account facts unrelated to an LBO that negatively affected the business, 29 such as the industry in which the debtor operates. 30 Recent Caselaw The Seventh Circuit recently opined on fraudulent transfers in an LBO context. In Boyer v. Crown Stock Distribution Inc., 31 the Seventh Circuit found that a debtor company s purchase of a competitor s assets (funded in part by seller financing), and the target company s distribution of the sale proceeds as well as its pre-sale cash reserves to its shareholders, constituted fraudulent transfers that were recoverable by the bankruptcy trustee. In so holding, the court rejected the argument that the formal characterization of the transaction as an LBO or an asset sale was critical to the case. Rather, the court stated: fraudulent conveyance doctrine... is a flexible principle that looks to substance, rather than form, and protects creditors from any transactions the debtor engages in that have the effect of impairing their rights Although the target company in this case avoided bankruptcy for more than three years after the transaction, the court found that it had been left with unreasonably small capital following the sale. The difference between insolvency and unreasonably small assets in the LBO context is the difference between being bankrupt on the day the LBO is consummated and having at that moment such meager assets that bankruptcy is a consequence both likely and foreseeable. 33 Although the case was not in the context of an LBO, the court s ruling in the high-profile bankruptcy of In re TOUSA Inc. 34 is also illustrative of the issues that arise in the context of complex avoidance actions, including those involving LBOs. In TOUSA, six months prior to filing for bankruptcy, the parent debtor borrowed $500 million to fund settlement payments in connection with litigation over a failed joint venture. As security for the loan, the parent debtor caused many of its subsidiaries, who were not liable for the settlement payments themselves, to pledge their assets to the lenders. The Creditors Committee alleged that the incurrence of the obligations, the grant of liens and security interests, and the 28 Brandt v. Hicks, Muse & Co. (In re Healthco Int l. Inc.), 208 B.R. 288, 302 (Bankr. D. Mass. 1997) (citations omitted). 29 See Moody, 971 F.2d at (increased competition rather than unreasonably small capital caused a dramatic drop in revenue following an LBO). 30 See Kendall v. Sorani (In re Richmond Produce Co.), 151 B.R. 1012, (Bankr. N.D. Calif. 1993) (finding that the debtor could no longer obtain credit because it was undercapitalized for the type of business in which it was engaged although, in another industry... the [d]ebtor might have been able to survive and even flourish ), aff d, 195 B.R. 455 (N.D. Calif. 1996) F.3d 787 (2009). 32 Id. at 793 (quoting Douglas G. Baird, Elements of Bankruptcy, (4th ed. 2006)). 33 Id. at Official Comm. of Unsecured Creditors of Tousa, Inc. v. Citicorp N. Am. Inc. (In re TOUSA Inc.), No (JKD), 2009 WL (Bankr. S.D. Fla. Oct. 30, 2009). ultimate payment of the settlement constituted fraudulent transfers. The Bankruptcy Court held that the TOUSA subsidiaries did not receive reasonably equivalent value in exchange for their incurrence of debt and payment of the settlement amounts. Specifically, the court found that the TOUSA subsidiaries received virtually no direct benefit in exchange for the transfers. 35 The court also rejected the defendants argument that the debtors had received significant indirect benefits, finding that the joint venture litigation had little effect on operations, and thus the settlement was of little value. Further, the court held that the debtors received no value from forestalling their bankruptcy filings for what proved only approximately six months. 36 Critically, the bankruptcy court found that even had the defendants demonstrated that the transfer created intangible benefits for the debtors, [n]ot a single expert or fact witness for Defendants... even attempted to quantify the value of the indirect benefits they claim were received. 37 Thus, the Bankruptcy Court found that the debtors received no reasonably equivalent value. 38 Ultimately, the court concluded that the purported benefits, even if legally cognizable, and whether considered individually or as a whole, have value (if any) that falls well short of reasonably equivalent value. 39 The TOUSA court also found that the debtor entities were insolvent both before and after the transaction. 40 Finally, the court invalidated a savings clause used in the security documents. 41 The savings clause stated that the transfer should be enforceable to the maximum extent permitted by law. 42 The bankruptcy court held this clause unenforceable for two reasons. First, because the Conveying Subsidiaries were insolvent even before the [transfers] and received no value from that transaction, the liabilities and liens cannot be enforced at all. 43 Therefore, the savings clause had no effect at all. Second, the bankruptcy court held that [t]he savings clauses are unenforceable for the additional reason that efforts to contract around the core provisions of the Bankruptcy Code are invalid as a matter of policy. 44 To date, no court has followed this ruling. Moreover, the TOUSA opinion is factually distinguishable in any LBO case as it was not an LBO. However, the ruling with respect to savings clauses in particular may be cited in future cases in an effort to void those clauses. It is not yet clear whether other courts will adopt the TOUSA court s line of reasoning. Conclusion While fraudulent transfer standards are clear, courts application of them can be complex. It is critical to note that few courts have avoided LBOs as fraudulent. However, in the current unwinding of highly leveraged transactions, courts may give a closer look to these deals. 35 Id. at * Id. at * Id. at * Id. at * Id. at * Id. at * Id. at * Id. at * Id. 44 Id. at * COPYRIGHT 2010 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBLR ISSN