Ex ante review of leveraged buyouts.

• Author: Femino, Laura

INTRODUCTION

1. OVERVIEW OF LEVERAGED BUYOUTS AND FRAUDULENT TRANSFER LAW II. PROBLEMS WITH THE CURRENT REGIME A. The Impact of FTL on the LBO Market B. The Problem of Free Insurance C. Reduced Monitoring Incentives D. Difficult Post-Hoc Valuations E. Hindsight Bias F. Litigation Costs G. Inadequate Remedy H. Ex Ante Uncertainty III. PROPOSAL FOR EX ANTE REVIEW A. Implementation B. Procedural Details IV. ADVANTAGES OF EX ANTE REVIEW A. Hindsight Bias B. Improved Valuation C. Discrimination Between LBOs that Will Fail the Standards of Financial Distress and LBOs that Will Pass Them D. Sharing the Benefits of an LBO: Turning Kaldor-Hicks-Optimal Buyouts into Pareto-Optimal Buyouts E. Risk Sharing and Monitoring Incentives F. Remedy and Costs G. Assimilation of Fraudulent Transfer Law into Fraud Tort Law V. POTENTIAL CRITICISMS OF EX ANTE REVIEW A. Why Don't Creditors Just Protect Themselves? B. Type I Errors in Ex Ante Review C. Information and Transaction Costs D. Restricting Market Forces E. Bad Faith Objections and Disclosure Timing F. Risk Externalities and Imperfect Adjusters CONCLUSION INTRODUCTION

   In 1989, Kohlberg Kravis bought RJR Nabisco for $24 billion, using $19 billion in debt guaranteed by RJR Nabisco. (1) At the time, it was the largest leveraged buyout (LBO) in history. (2) After struggling to meet its debt burden for a decade, (3) RJR Nabisco was eventually broken up, and a large piece was sold off in 1999. (4) In 2003, it announced it would cut forty percent of its workforce and reduce its scope to just two brands. (5)

   The financial community generally agrees that the massive debt load incurred in the LBO precipitated or at least accelerated the failure of RJR Nabisco. (6) Under current bankruptcy law, LBOs that eventually lead to bankruptcy may later be challenged and partially unwound as fraudulent transfers (sometimes called "fraudulent conveyances"). Such ex post review of buyouts seeks to determine whether, at the time of the transaction, the buyout left the target meeting any one of three standards of financial distress. (7) In short, ex post review asks whether the buyout was doomed to fail from the start.

   Reviewing the LBO months or years after the transaction entails a number of problems, including hindsight bias, free insurance for creditors, misaligned monitoring incentives, and heavy litigation costs. This Note proposes a new solution: review LBOs for potential problems before the buyout takes place, rather than after the damage has already been done. I propose that LBOs be analyzed in much the same way and by the same standards of financial distress used in the current regime, but only at an earlier time. This would substantially ameliorate many of the problems with the current fraudulent transfer law (FTL) regime.

   This Note will begin with an overview of current FTL and how it applies to LBOs. It will then explore some of the problems with this current regime before proposing a new regime of ex ante review and detailing its implementation and procedure. Finally, it will detail some of the benefits of ex ante review and explore some possible criticisms of the proposed regime.

1. OVERVIEW OF LEVERAGED BUYOUTS AND FRAUDULENT TRANSFER LAW

   An LBO is the acquisition of a target company financed by debt that is secured by the assets of the target company and paid with the target's future cash flows. (8) Put more simply: The acquiring company borrows money from the lending bank to purchase the target company. That loan is secured by the target's assets and future cash flows. The acquirer might also use some of its own capital for the purchase along with the borrowed funds. (9) The acquirer then uses these funds to buy the target from the target's current shareholders, often at a large premium, and the acquirer becomes the new owner.

   The transaction leaves the target with a highly leveraged (or debt-heavy) capital structure, often close to a ninety percent debt-to-equity ratio. (10) Higher leverage generally disadvantages debt holders because it increases the risk that a firm will go into bankruptcy. (11) The transaction, then, may be harmful to the existing, unsecured creditors of the target, who gained nothing from the transaction but saw the value of their debt decrease as the risk associated with that debt increased.

   The existing creditors face a real loss if the LBO is a failure and the highly leveraged target does in fact go into bankruptcy. In that case, the former shareholders lose nothing-they have already sold their interest in the company. But the unsecured creditors have to stand in line behind the secured lender in order to get their money. (12) Since the lender has a lien on all of the target's assets, there will be few (if any) unsecured assets left for the unsecured creditors to share.

   The transaction looks a lot worse if the target was close to bankruptcy at the time of the LBO. The Bankruptcy Code uses an absolute priority rule to establish the order in which stakeholders receive money when a company goes bankrupt. (13) By this absolute priority rule, shareholders can get money only after creditors have been paid in full. The failed LBO described above subverts the absolute priority rule. It allows the shareholders to cash out in full-at a premium, no less-at the time of the acquisition, while the creditors get paid--if they get paid at all-months after the acquisition when the company finally enters bankruptcy.

   Certain provisions of the Bankruptcy Code protect creditors against just such a transaction. FTL provides that if shortly before bankruptcy a debtor in financial distress gives away assets and does not get reasonable value in return, creditors can have that transaction avoided by the bankruptcy court. (14) These fraudulent transfer provisions have been applied to LBOs to avoid the lien that the target gave to the lender to finance the buyout. (15) If the lien is avoided in bankruptcy, the lender must stand in line with the unsecured creditors, or in some cases behind them, to get its money back from the bankrupt target. (16)

   FTL applies to many fraudulent transactions and is not specific to LBOs. It applies to any fraudulent transaction that took place during or shortly before the debtor went into bankruptcy. Imagine an individual who, facing bankruptcy, knows her assets will soon be taken from her and divided up amongst her creditors. She might be tempted to give away some assets--to a friend or relative, perhaps with the intention of later getting them back--before she actually files bankruptcy. This hurts her creditors, because it means there will be fewer assets left to satisfy her debts after she files for bankruptcy.

   FTL prohibits such transactions made before or during bankruptcy or creditor workouts. (17) It provides for actions to avoid the fraudulent transfer and to recover the transferred property for the benefit of the debtor's estate. (18) FTL is codified in the Bankruptcy Code and in various state statutes, many of which incorporate the language of the Uniform Fraudulent Transfer Act. In defining fraudulent transfers, these statutes distinguish between actual and constructive fraudulent transfers based on the debtor's intent. (19) An actually fraudulent transfer is similar to the scenario described for the debtor above: a transfer made or obligation incurred by a debtor with actual intent to hinder, delay, or defraud its creditors. (20) A constructively fraudulent transfer hurts creditors in the same way as an actually fraudulent transfer--it reduces the assets available for distribution to creditors--but does not involve fraudulent intent on the part of the debtor. Such conveyances are defined as a transfer made or obligation incurred by the debtor without receipt of reasonably equivalent value and that either (1) leaves the debtor with unreasonably small capital, (2) creates a reasonable expectation that the debtor will be unable to pay its debts as they come due, or (3) is completed at a time when the debtor is insolvent or which leaves the debtor insolvent as a result. (21) The Bankruptcy Code includes additional provisions for fraudulent transfers to or for the benefit of insiders, which are outside the scope of this Note's analysis. (22)

   If a transaction meets the definition of actual or constructive fraudulent transfer, that transaction may be avoided under [section] 548 of the Bankruptcy Code or under state law as permitted by [section] 544, (23) and the fraudulently transferred property or the value of such property may be recovered under [section] 550. (24)

   Now I will return to the context of leveraged buyouts. The transactions involved in a failed LBO sometimes satisfy the definition of fraudulent transfer. The target is the eventually-bankrupt debtor, and the transfer we care about is the lien on the target's assets given to the lender, who is financing the LBO. In return for this lien, the lender gives capital. It lends that capital, however, not to the target, but to the acquirer, which then uses that capital to buy out the target's selling shareholders. Here's the key: the target receives nothing in return for issuing debt and granting a lien on its assets. And this is what makes a fraudulent transfer. The debtor gave away value (in the form of a lien) shortly before bankruptcy, thus hurting its creditors by reducing the assets available to satisfy its debts.

   Proving fraudulent intent in such a transaction is difficult. The existing creditors would have to show that the selling shareholders conspired with the acquiring company to defraud the target's creditors. For this reason, most fraudulent transfer claims in the context of a failed LBO allege a constructive, rather than intentional, fraudulent transfer. (25)

   To meet the definition of a constructive fraudulent transfer, the lien granted by the target to the lending bank must satisfy both prongs of constructive fraud. First, the debtor must have received less them a...