Chapter VIII Modern Issues

• Jurisdiction: United States

Chapter VIII Modern Issues

A. Leveraged Transactions

1. Leveraged Transactions Generally

As the availability of credit in the capital markets ebbs and flows, so do the number and size of leveraged transactions. During times of abundant credit availability, opportunistic investors, corporate raiders, significant equity-holders, self-interested managers and yield-seeking boards of directors will often pursue, negotiate and consummate leveraged transactions with varying degrees of success. These transactions take various forms, from leveraged acquisitions to leveraged buyouts and leveraged spinoffs. No matter what form these transactions take, they all involve borrowing money to finance the deal while radically altering the capital structure, frequently leaving pre-existing creditors structurally and/or contractually subordinated to substantial new indebtedness.

A common type of leveraged transaction is a leveraged buyout (LBO), whereby an acquirer borrows money and uses such borrowed funds to purchase a target company by cashing out shareholders. As part of the acquisition financing, the assets of the acquired company (and sometimes the assets of the acquiring company) are pledged as collateral for the borrowed money. The acquirer usually contributes very little equity capital, while the former shareholders usually receive an amount of cash that is a premium to the then-current trading price of the equity being cashed out. The creditors of the acquired and/or the acquiring enterprise often find themselves materially worse off, with a weaker borrower liable for significant new indebtedness while sitting at a lower priority behind the secured financing lenders.

Similarly, in a leveraged spinoff, a parent company uses borrowed funds, sometimes secured by the assets of a particular business or asset, and distributes the loan proceeds (or other consideration) as a dividend to the parent company or to its shareholders. In these instances, the parent company may cause an existing subsidiary (or a new subsidiary created to hold the spun-off business) to borrow money to finance the acquisition or to capitalize itself. These transactions are sometimes used by a parent company to jettison a poorly performing business line or a business subject to substantial legacy liabilities (such as environmental, asbestos and/ or pension liabilities). Inversely, these transactions can be used to spin off a healthy and mature business or a business with growth potential while leaving behind the existing capital structure, with substantial liabilities attached to the remaining enterprise.

While the closing of a leveraged transaction is often greeted by excitement from the directors, officers, sponsors and shareholders, some of whom have a direct financial stake in the closing of the transaction, post-closing cracks often appear and threaten the viability of the enterprise, resulting in bankruptcy. Sometimes these cracks become glaring soon after the closing, as the business labors under the weight of substantial new indebtedness, while other businesses are able to hold on to and sustain their operations, as they are buoyed by relaxed lending terms and access to the capital markets.

Ultimately, as the business sours and the financial health of the borrower becomes dire, such leveraged transactions are fertile ground for fraudulent transfer litigation as unsecured creditors seek redress and attempt to recover more in a litigation than the value available to them in the new, highly leveraged capital structure.

This is particularly acute where a healthy borrower is solvent prior to the leveraged transaction, but is insolvent or left with insufficient capital following the leveraged transaction, diminishing the recovery available to unsecured creditors absent litigation.

2. Common Participants in Fraudulent Transfer Litigation Arising from Leveraged Transactions

Typical plaintiffs commencing fraudulent transfer litigation arising out of leveraged transactions include (1) the borrower/transferor, (2) in instances where the borrower/transferor has filed for bankruptcy protection, a chapter 11 trustee,⁷³¹ a chapter 7 trustee,⁷³² a creditors' committee of the debtor,⁷³³ a trustee or plan administrator,⁷³⁴ and/or (3) individual creditors pursuing remedies under state fraudulent transfer law.

Typical defendants include the following: (1) lenders who provided financing in connection with the leveraged transaction; (2) former shareholders whose shares are redeemed in an LBO; (3) the parent corporation in a leveraged spinoff; (4) equity sponsors of the transaction; (5) current and former directors and officers; and (6) company and board advisors.

3. Leveraged Transactions: Potential Avoidable Obligations and Transfers⁷³⁵

In the wake of a failed leveraged transaction, litigation may be commenced seeking to avoid obligations incurred and transfers made in connection therewith. Obliga-tions typically include both primary and guarantee claims. Transfers typically include (1) payments related to the leveraged transactions made at the closing thereof, and/or following the closing of the leveraged transaction, but related thereto; and (2) pledges of other assets and liens related thereto. Examples of transfers include:

• payments to the target corporation's former stockholders (LBOs);⁷³⁶
• payments of debt, equity and/or cash to the parent company, its creditors or its equity-holders (spinoffs);
• transfer of assets (spinoffs, leveraged acquisitions);
• payments of financing fees, costs and expenses (all leveraged transactions with debt financing);
• payments of advisor fees, costs and expenses (all leveraged transactions);
• payments of tender offer/deal manager fees (LBOs); and
• payments of success bonus payments, payments made in connection with the target's management equity incentive plan, payments to offset excise taxes, and severance payments (LBOs).

Additionally, payments made after the leveraged transaction has closed, such as principal and interest payments on leveraged transaction debt, are often subject to fraudulent transfer litigation.

4. Grounds for Avoidance of Obligations and Transactions in Leveraged Transactions

Fraudulent transfer actions related to leveraged transactions are subject to avoidance under both intentional fraudulent transfer and constructive fraudulent transfer theories. A plaintiff in a fraudulent transfer litigation may pursue avoidance of obligations and transfers as an intentional fraudulent transfer under either § 548(a) (1)(A) and/or applicable state fraudulent transfer law. A plaintiff in a fraudulent transfer litigation may also pursue avoidance of obligations and transfers as a con-structive fraudulent transfer under either § 548(a)(1)(B) and/or applicable state fraudulent transfer law.

United States v. Gleneagles Investment Co., and the Third Circuit's affirmation in United States v. Tabor Court Realty Corp., is the seminal case involving intentional and constructive fraudulent transfers in the LBO context.⁷³⁷ Tabor Court was one of the first significant applications of the UFCA to an LBO and is important because it established that LBOs are subject to fraudulent conveyance law.

In Tabor Court, Great American acquired Raymond Group using proceeds of a loan by a third party, with Raymond Group guaranteeing the loan and pledging its assets.⁷³⁸ At the time of the sale, Raymond Group was "on the brink of insolvency," with significant liabilities.⁷³⁹ Following the sale, the Raymond Group lacked funds to pay its operating expenses and taxes, and shortly thereafter shut down and ceased operations before its eventual bankruptcy.⁷⁴⁰ On appeal, the Third Circuit endorsed a finding that the mortgages given by the Raymond Group to the lender were intentional and constructive fraudulent transfers under applicable state law.⁷⁴¹ Although it was not shown that Raymond Group had intended to hinder or delay paying creditors, the Third Circuit affirmed based on the lower court's finding that "a party is deemed to have intended the natural consequences of his acts."⁷⁴²

As the decision in Tabor Court demonstrates, analysis of fraudulent conveyance issues in complex, multi-step leveraged transactions often involves consideration of the "collapsing doctrine," pursuant to which a multi-step transaction is treated as a single, integrated scheme. The collapsing doctrine, including its application in leveraged transactions, is discussed in Chapter IV.C, supra.

5. Leveraged Transactions: Common Defenses

Defendants in fraudulent transfer litigation commenced under the Bankruptcy Code's fraudulent transfer provisions avail themselves of a variety of defenses. The three most prominent defenses include (1) the statutory safe harbors under § 546; (2) the good-faith defense under § 548(c); and (3) standing and scope of avoidance at the guarantor subsidiary levels.⁷⁴³ While these defenses are not unique to leveraged transactions, case law has developed significantly in cases involving these transactions.

a. The § 546 Defenses

One of the prominent defenses to a fraudulent transfer claim arising out of a leveraged transaction is the statutory safe harbors under §§ 546(e),⁷⁴⁴ 546(f),⁷⁴⁵ 546(g)⁷⁴⁶ and 546(j).⁷⁴⁷ Section 546(e) is most commonly cited in leveraged transactions and is typically asserted by transaction lenders and cashed-out shareholders.⁷⁴⁸

i. Defense to Claims Against LBO Lenders

Although § 546(e) on its face applies to transfers and not obligations, some leveraged transaction lenders may nonetheless argue that loans provided in connection with a leveraged transaction and related transfers of security are protected under § 546(e). This argument is based on § 546(e)'s protection of transfers that are made to a financial institution in connection with a "securities contract,"⁷⁴⁹ and § 741(7), as amended under the Financial Netting Improvements Act of 2006, which defines "securities contract" to include "any extension of credit for the...