As the economy boomed in 2005-2007 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, courts have considered whether ultimately unsuccessful LBOs constitute fraudulent transfers by the lenders and/or equity purchasers, though 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.
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. Section 548 of the Bankruptcy Code details the standards for avoidance of fraudulent transfers. Section 544 of the Bankruptcy Code incorporates state fraudulent transfer law. Each state has its own fraudulent transfer law.
Section 548(a) of the Bankruptcy Code details the “actual” fraud standard and provides that a debtor 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) of the Bankruptcy Code 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 of the Bankruptcy Code, and thus courts interpret the actual and constructive fraudulent transfer standards similarly under the Bankruptcy Code and the UFTA.5 The primary difference between the UFTA and the Bankruptcy Code is in the duration of the “look-back” period. Under section 548 of the Bankruptcy Code, 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.7
The UFTA also contains a constructive fraud provision, modeled on section 548(a)(1)(B) of the Bankruptcy Code, 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 prepetition fraudulent transfers. Below is a summary of the legal framework applicable to the avoidance of fraudulent transfers arising from LBOs.
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 receives 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 materialize17). 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.27
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
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 . . . .”32 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 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.
While fraudulent transfer standards are clear, courts’ application of them can be complex. It is critical to note that few courts have avoided LBO’s as fraudulent. However, in the current unwinding of highly leveraged transactions, courts may give a closer look to these deals.