Two US federal appeals courts recently held that a provision of the Bankruptcy Code can protect private company sellers in the event that the company they sold later goes bankrupt and a fraudulent transfer claim is brought against them to recover the sale proceeds. The courts found that this protection applies when a financial institution is used to handle the transfer of consideration in the sale. It is especially important that sellers consider this protection in transactions involving significant leverage, because of the increased likelihood of a fraudulent transfer claim following the closing.

Background  

In re: QSI Holdings, Inc. was decided by the Sixth Circuit Court of Appeals in July. Its ruling followed that of the Eighth Circuit in Contemporary Indus. Corp., a case involving similar facts that was decided in April of this year. In the QSI Holdings transaction, Central Tractor agreed to acquire Quality Stores by way of a cash and stock merger. The transaction was an LBO, with each company’s assets pledged as collateral for a loan obtained to pay a portion of the cash consideration. Central Tractor deposited the cash portion of the consideration with a financial institution, HSBC, and the Quality shareholders deposited their shares with HSBC. At closing, HSBC delivered the Quality shares to Central Tractor and distributed the cash to Quality’s shareholders.

The combined company later experienced financial difficulties, which ultimately led it to file a voluntary petition for bankruptcy. As part of the bankruptcy proceedings, the combined company sought to recover the sellers’ sale proceeds by filing a suit against them alleging that the LBO transaction caused the company to be overleveraged and the distribution of the sale proceeds to the sellers constituted a fraudulent transfer. In response, the sellers filed – and were granted – a motion for summary judgment arguing that the sale proceeds could not be recovered because the parties had used a financial institution (HSBC) to handle the transfer of consideration, and financial institution transactions are immune from fraudulent transfer claims under the Bankruptcy Code. The plaintiffs ultimately appealed the decision to the Sixth Circuit, which ruled in favor of the sellers as described above.

Conclusion  

These recent rulings demonstrate a trend among the federal courts that payments for private securities handled through a financial institution may be protected from recovery under the Bankruptcy Code. The cost to engage a financial institution is likely to be minimal, and the arrangement could protect sellers from loss of sale proceeds and expensive, time-consuming litigation.