In this past economic downturn, an increasing number of private equity sponsors have seen their portfolio company sales come under challenge on the basis of an alleged fraudulent conveyance. Many highly leveraged capital structures associated with pre-recession LBOs proved unsustainable in the down-cycle, and the ensuing restructurings and bankruptcies led creditors and debtors in possession to seek to recover payments made to selling shareholders as part of the LBO - in many cases years after the transaction closed.
The federal Bankruptcy Code empowers the debtor in possession to avoid pre-bankruptcy transfers for which transfers the debtor did not receive reasonably equivalent value and was left insolvent, unable to pay its debts or with unreasonably small capital as a result of the transaction. States also have fraudulent transfer statutes that often provide for longer time periods to bring avoidance claims than the Bankruptcy Code. In the LBO context, bankruptcy trustees often take advantage of these longer claim periods and bring fraudulent transfer claims under the relevant state law.
What can selling sponsors do to mitigate the risk of successful post-LBO fraudulent conveyance claims? Sponsors should consider at least the following when planning and structuring their sale transactions:
Due Diligence of Post-LBO Capital Structure . Selling sponsors should conduct an independent due diligence of the contemplated post-LBO capital structure of the target entity to evaluate the solvency of the target post-closing, the ability of the target to service its debt obligations and the sufficiency of the contemplated capital cushion.
Analysis of Roll-Over Liabilities . Selling sponsors should also analyze the pre-closing liabilities that will be rolled over as part of the transaction. Under the laws of certain states, the success of a fraudulent transfer claim may depend on the existence of creditors pre-dating the LBO transaction who can establish they were harmed by the transaction.
Solvency Representations, Certificates and Opinions. Although solvency representations, certificates and opinions cannot eliminate fraudulent conveyance risk, they can force the buyers to analyze the post-LBO capital structure from a solvency perspective and provide more relevant disclosure to the sellers in this regard. Solvency opinions from sophisticated third-party experts may also be persuasive for purposes of the court's factual analysis.
Settlement Payments Defense . Selling sponsors should seek to structure a sale to increase the likelihood that the transaction would receive the benefit of the so-called "settlement payments" defense, a safe harbor provision codified in Section 546(e) of the Bankruptcy Code that bars avoidance of certain transfers made by the debtor before the bankruptcy case is filed.
Section 546(e) of the Bankruptcy Code provides that the bankruptcy trustee "may not avoid a transfer that is asettlement paymentmade by or to (or for the benefit of) astockbroker, financial institution, financial participant, or securities clearing agency, that is made before the commencement of the case." The somewhat circular wording of Section 741(8) of the Bankrupcty Code defines "settlement payment," in relevant part, as a "settlement payment, or any other similar payment commonly used in the securities trade."
Federal courts have routinely held that Section 546(e) insulates payments to selling shareholders from an avoidance claim in the context of public LBOs. However, courts have been divided as to whether or not the statute should apply to private LBO transactions and on the requisite level of involvement of the financial institution in processing the payments at issue.
Public vs. Private
Relying on a literal interpretation of the statute, the Third Circuit (whose jurisdiction includes Delaware), the Sixth Circuit and the Eighth Circuit1have each held that the term "settlement payment" should be interpreted broadly to encompass transfers of money or securities made to complete a securities transaction. According to these circuit courts, payment for shares in an LBO is a "common securities transaction" and therefore a "settlement payment" for the purposes of Section 546(e). As a result, these circuit courts concluded that regardless whether the target company is privately held or publicly traded, the use of a financial institution to facilitate payment of the purchase price in the context of an LBO protects such payments from subsequent fraudulent conveyance claims under Section 546(e).
These circuit courts have rejected the reasoning employed by lower federal courts in Texas and New York,2each of which relied on the legislative history of Section 546(e) to hold that the settlement payments defense was not intended by Congress to apply to private LBOs.
While several other circuit courts (including the Second Circuit whose jurisdiction includes New York) have yet to address the applicability of the settlement payments defense in the context of a private LBO, sponsors should take comfort in the decisions from the Third, Sixth and Eighth Circuits. Notably, with a case called In re Plassein , the Third Circuit settled the law in Delaware, the jurisdiction most frequently encountered by private equity sponsors.
We note, however, that the U.S. Bankruptcy Court for the District of Delaware recently denied a motion to dismiss an adversary proceeding in a case called In re Mervyn's Holdings, LLC, et al .3and held that the settlement payments defense did not apply in an LBO transaction where a series of conveyances were deemed to form part of a single integrated scheme of transactions that the court "collapsed" into a single transaction. The Mervyn's court concluded that the plaintiff in Mervyn's alleged actual fraud (not constructive fraud as in other LBO fraudulent transfer cases) and rejected the settlement payments defense as not all of the "collapsed" conveyances constituted settlement payments (in this case, the LBO included a separate transfer of real estate assets for virtually no consideration).
Role Of The Financial Institution
These recent cases also provide guidance as to how involved a financial institution must be for the settlement payment defense to apply. In the Third Circuit's In re Plassein decision, the selling shareholders delivered their shares directly to the acquiror, and the court concluded that a bank's facilitation of a wire transfer alone was sufficient. The other courts did not go so far; rather the Sixth and Eighth Circuits concluded that the bank's role as exchange agent or escrow agent was sufficient. Importantly, each of these circuit courts expressly rejected a precedent from the Eleventh Circuit, which required a financial institution to acquire a beneficial interest in the LBO consideration to qualify under Section 546(e).
By conducting proper due diligence and negotiating and structuring the transaction with a keen eye toward the solvency of the surviving entity post-closing, selling sponsors can seek to reduce the risk of successful post-LBO fraudulent conveyance claims. Selling sponsors should also work with their counsel to seek to structure purchase price payments as "settlement payments" under the Bankruptcy Code.
Although federal courts have set forth different standards regarding the requisite role of the financial institution in an LBO transaction, selling sponsors should consider providing that a financial institution be engaged to serve as an exchange or paying agent on the transaction. It should be noted, however, that courts can reject structures that are intended to abuse the "settlement payments" safe harbor. The payment structure must be one that is commonly used in securities transactions. 1 In re Plassein Int'l Corp. (In re Plassein) , 590 F.3d 252 (3d Cir. 2009); QSI Holdings, Inc. v. Alford (In re QSI Holdings), 571 F.3d 545 (6th Cir. 2009); Contemporary Indus. Corp., 564 F.3d 981 (8th Cir. 2009).
2 Jewel Recovery, L.P. v. Gordon, 196 B.R. 348, 352-53 (N.D. Tex. 1996); Official Committee of Unsecured Creditors of Norstan Apparel Shops, Inc. v. Lattman (In re Norstan Apparel Shops, Inc.), 367 B.R. 68, 76 (Bankr. E.D.N.Y. 2007).
3 Mervyn's LLC v. Lubert-Adler Group IV, LLC, et al. (In re Mervyn's Holdings, LLC), 2010 WL 980274 (Bankr. D. Del. March 17, 2010).
Ilkka Perheentupa is a Senior Associate in the Transactions practice group of Weil Gotshal. His practice includes representing public and private companies and private equity sponsors in connection with acquisitions, dispositions, financingsand minority investments and counseling corporate or private equity clients and portfolio companies on a broad range of general corporate, securities laws and corporate governance matters. Jonathan L. Sagot is an Associate in the Private Equity and Mergers & Acquisitions practices.