Distressed LBOs and fraudulent conveyances:

Read the article in the Cayman Financial Review Magazine

Investment risk does not necessarily end at the sale of an equity position. For many years, former shareholders who sold their stakes in leveraged buyouts have struggled with US bankruptcy trustees attempting to claw back LBO payments as “fraudulent conveyances” that gutted companies and left creditors high and dry.

Though trustees have seldom succeeded in such actions, recent developments threaten to turn up the heat on LBO sellers.

The basic strategy arises from the creative application of a sixteenth-century anti-fraud law to the twentieth-century context of a failed leveraged buyout. In England in the 1500s, creditors complained that their rights were being undermined by debtors who divested themselves of all valuable property in order to deprive creditors of a source of recovery.

In the late sixteenth century, the English Parliament passed the landmark “fraudulent conveyance” law that gave creditors the right to sue the recipient of any transfer made by a debtor with the intent to hinder, delay or defraud creditors.

Of course, proving an antagonistic debtor’s actual fraudulent intent was a significant challenge for creditors, so eventually the statute was extended to provide recovery for constructive fraud established on a more objective basis; ie the debtor (1) did not receive “reasonably equivalent value” in exchange for the asset, and (2) the debtor was insolvent either immediately before or after the transfer.

Eventually, the US states adopted laws much like the English fraudulent conveyance statute.  In addition, the federal bankruptcy law also incorporated a provision empowering the bankruptcy trustee to pursue either actual or constructive fraudulent transfers that occurred shortly before commencement of the debtor’s bankruptcy proceedings.

In the 1980s, as LBO targets began to collapse in greater numbers, trustees in these companies’ bankruptcies attempted to apply the federal fraudulent conveyance provision to recover value from the former shareholders who had received LBO payouts. T

he old English concept fit awkwardly but effectively on the modern US transaction: The LBO target company transferred money to its then-shareholders.  The money had been borrowed or guaranteed by the LBO target, usually secured by another transfer, a security interest in all of the company’s assets. While the former shareholders, and perhaps the acquirer, stood to benefit richly from this deal, the company itself received no identifiable value in exchange for the wholesale transfer of its wealth.

Moreover, the company’s existing unsecured creditors, including “senior” note holders, were left with little recourse against an insolvent company reeling under the weight of massive new debt that enjoyed contractual priority over existing unsecured claims.

Such an LBO seemed to fit the characteristics of either an actual or at least a constructive fraudulent transfer. An orchestrated payout of former equity, leaving creditors subordinated to new debt and holding a bag destined to disintegrate, decidedly violated the principle that debt must be paid before equity, so a creative but tenuous argument could be made for actual fraud on creditors.

The argument for constructive fraud was easier, as the target company had received far less than reasonably equivalent value in exchange for the transfer of wealth to former shareholders, and an LBO soon followed by a declaration of bankruptcy must have rendered the debtor-company insolvent if it was not already insolvent.

However, also in the mid-1980s, the US Congress had enacted what would prove to be a major stumbling block for claims of constructive fraud: Section 546(e) of the US Bankruptcy Code prevents a bankruptcy trustee from recovering a “settlement payment” made either by or to a “financial institution” in a case not involving actual fraud.

This provision was designed to protect financial market intermediaries from the systemic effects of a failure of any other financial market intermediary.  Unwinding one such settlement payment would have follow-on effects for many other such payments in the web of mutual claims and obligations for settling securities trades.

But the words Congress chose were not carefully confined to intermediary-level payments implicating systemic risk. Rather, the key phrase “settlement payment” was defined generically and expansively to include any kind of money transfer “commonly used in the securities trade.” So long as the transfer concluded a securities transaction, and it was made by or to a “financial institution,” it was insulated from attack by the bankruptcy trustee.

For the past three decades, bankruptcy trustees have failed repeatedly in their attempts to claw back LBO payments.

Arguments for actual fraud are difficult to substantiate, and the “settlement payment” safe harbour eliminates recovery for constructive fraudulent transfers so long as a bank either makes the payment for the company or receives the payment for the shareholder. Trustees’ attempts to find exceptions to the safe harbour, eg for private company LBOs and transactions not involving a broker-intermediary, all but uniformly failed, as appellate courts with jurisdiction over influential venues such as New York and Delaware have endorsed an expansive reading of the “settlement payment” safe harbour.

As recently as November 2012, a Manhattan federal district court reiterated the liberal application of the safe harbour in AP Services LLP v Silva. In that case, the LBO payout had been wired directly from the acquiring company to the shareholders’ bank accounts, and the mere fact that payments to settle a sale of securities had been made “to” a bank was enough to defeat the trustee’s claim.

One ingenious tactic for attacking LBO payments remains to be evaluated by the courts. The issues have been squarely presented in the massive litigation resulting from the $8.3 billion LBO and ensuing bankruptcy of the media giant Tribune Company, publisher of the Chicago Tribune and Los Angeles Times.

Creditors like New York hedge fund Aurelius Capital Management have argued that, while a bankruptcy trustee’s federal fraudulent conveyance claim is limited by the Bankruptcy Code’s “settlement payment” safe harbour, claims by individual creditors under the fraudulent conveyance laws of states like New York, Delaware and Illinois contain no such limitation. So long as such state law claims were not adjudicated in the bankruptcy proceedings, creditors argue, they remain to be advanced by individual creditors after the bankruptcy case has closed, which the Tribune Company case did, in August 2012.

This clever work-around is hotly disputed by lawyers for former Tribune Company shareholders, who are mired in 44 fraudulent conveyance lawsuits, currently consolidated in the Southern District of New York. Can the Tribune Company and its official committee of unsecured creditors effectively abandon the value of these fraud claims back to individual creditors simply by not pursuing them in the bankruptcy case?

And would this not represent a transparent end-run around the “settlement payment” restriction in federal bankruptcy law, which might in any event trump any later state law fraudulent conveyance claims?

The bankruptcy law takes no explicit stance on these key issues, though several earlier cases have taken positions seeming to favour allowing creditors to pursue these post-bankruptcy claims. If the court adopts the simplistic “plain language” approach that has been so de rigueur in disputes surrounding both the fraudulent conveyance statutes and the settlement payment safe harbour, LBO sellers may yet find that money in hand is not as safe as it seems.

Investment risk might well extend beyond sell-off and exit from the equity register.

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Jason Kilborn

Professor Jason Kilborn teaches business and commercial law at John Marshall Law School in Chicago.  His primary focus is on the comparative analysis of insolvency systems for individuals, though his interest extends to international bankruptcy as well. He recently co-authored a book on international co-operation in cross-border insolvency cases, published by Oxford University Press.

Jason Kilborn
Professor of Law
John Marshall Law School, Chicago
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T: +1 (312) 386 2860+1 (312) 386 2860
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