Leveraged buy-outs (LBO’s) are a time-honored means of financing the acquisition of companies.¬† They tend to occur in waves, finding greatest popularity when credit is easy and money is cheap.
Because of their dependence on favorable credit conditions, LBO’s are also rather risky.¬† When credit markets tighten and asset values drop – as they did most recently during the “Great Recession” of 2008 – the risk is borne primarily by unsecured creditors of the acquisition target.¬†
LBO’s, popular during the “roaring 80’s” and again during the “go-go” years of the George W. Bush Administration, are once again crashing and burning in significant numbers.¬† Recent victims include household names like Chrysler, Hawaiian Telcom, Linens ‚ÄėN Things, Simmons, LyondellBasell, Capmark Financial Group Inc., and Tribune Co.¬† Others, including Clear Channel Communications, Harrah‚Äôs Entertainment, and TXU, have defaulted on their LBO debt.¬† Indeed,¬†nearly half of non-financial American companies that defaulted on Moody‚Äôs-rated debt instruments in 2009 were reportedly leveraged acquisitions of private-equity funds.
Companies with overburdened balance sheets are forced to “de-leverage” and restructure their debt, typically at the expense of these creditors.¬† Because the essence of an LBO is the use of secured debt to finance an acquisition,¬†the historical response to¬†“de-leveraging” has been for unsecured creditors to attempt to unwind the security interests encumbering the company’s assets.¬†¬†These efforts are¬†typically¬†undertaken through fraudulent transfer claims – which are reportedly on the rise in the wake of last year’s financial turmoil.
The original idea behind fraudulent transfer¬†claims – which trace their roots back nearly half a millenium in Anglo-American commercial law – was that debtors shoudln’t be able to place valuable assets beyond the reach of their creditors.¬† The idea is a simple one, but proving a debtor’s subjective intent is often far more difficult than it looks.
In light of this difficulty, courts have developed certain “objective tests” to determine whether a transaction is “construtively fraudulent.”¬† Though a number of modern variations exist, their primary theme is that transfers made (or liabilities incurred) by a debtor in a financially precarious position may be “avoided” (i.e., unwound).
A debtor is generally considered to be in a financially precarious position if¬†it receives less than ‚Äúreasonably-equivalent value‚ÄĚ in exchange for property or debt while the debtor (1) is insolvent at the time of the exchange; (2) is rendered insolvent by the exchange; (3) is left, following the exchange, with ‚Äúunreasonably small capital‚ÄĚ for the business in which it is engaged or is about to engage; or (4) intends to or believes it will incur, debts it would be unable to pay as they matured.
Where an LBO is found to have been a fraudulent transfer, the court‚Äôs order that the transfer is avoided may include: (1) stripping the lender of its liens; (2) recovery of loan payments and fees; (3) subordination or disallowance of lender‚Äôs claims in bankruptcy; and (4) recovery of fees paid to professionals in connection with a leveraged buyout.
As attractive as all this might sound for unsecured creditors, unwinding an LBO¬†as “constructively fraudulent”¬†is unfortunately only slightly less difficult than establishing subjective fraudulent intent.¬† As a result, such creditors have little recourse but to settle fraudulent transfer claims very cheaply.¬† LBO participants, on the other hand, are incentivized to take on risky acquisitions at the creditors’ [potential] expense.
That, at least, is the argument put forth by John Ginsberg in his recently-uploaded draft article entitled “Remedying Law‚Äôs Failures to Remedy Fraudulent Transfers in Leveraged Buyouts” (downloadable at SSRN).
Ginsberg, an in-house lawyer at an unnamed federal agency, focuses on the “unreasonably small capital” test (the test most commonly used in attacking an LBO) and argues that the standard for¬†meeting that test – whether¬†insolvency is¬†“reasonably foreseeable” – requires far greater certainty in order for creditors to realize the protections intended for them by fraudulent transfer law.
In essence, Mr. Ginsberg argues that rather than asking whether insolvency is “reasonably foreseeable,” courts ought to clarify “reasonable foreseeability” in probabalistic terms.¬† It should be easier to attack (or to defend) a fraudulent transfer if it can be shown, for example, that the “probability” of insolvency at the time of an LBO was 50% – or 60%, or 75%.¬† Further, courts ought to articulate what, for them, constitutes an acceptable margin of error (say, 40% risk of insolvency with a margin of error of +/- 15%).
Finally, Mr. Ginsberg argues that a “probabalistic” approach eliminates the potential confusion arising when a subsequent “insolvency triggering event” is blamed for sinking a perhaps-somewhat-risky-but-otherwise-perfectly-viable LBO: If the probability of insolvency is established ahead of such a “trigger¬†event,” it is far easier to determine whether or not that event is, in fact, a significant factor in the company’s failure.
Mr. Ginsberg’s article (a working copy of which is available on SSRN) is an interesting read – not least because it offers a succinct and accessible snapshot of recent decisions addressing fraudulent transfers and LBOs.
Mr. Ginsberg’s proposed approach is also not the only one available to those seeking a more “objective” treatment of LBO financing.¬† A number of authors have suggested that the “foreseeability of insolvency” may be best determined by reference to prevailing industry liquidity and solvency ratios.¬† These are easily accessible through research databases, and provide some objective benchmarks as to what the participants in an LBO transaction might reasonably have anticipated at the time of the transfer.
That said, even these more “objective” approaches are not without their problems.
For example, if courts in a particular jurisdiction have enunciated a 50% or greater probability as the threshold for “reasonably foreseeable” insolvency, won’t the parties engaging in an LBO simply adjust their forward-looking assumptions to be certain that the “probability” is something less than 50%?¬† And what level of probability rises to the level of “reasonably foreseeable” in the first place?¬† Ginsberg’s article acknowledges this last uncertainty, and leaves the matter open for discussion.
Ratio-based tests also have their own problems.¬† Which solvency ratios are most meaningful to a particular industry?¬† And which¬†ones is a court most likely to apply to a particular transaction?¬† Though ratios are comparatively easy to compute, their application has been a subject for juducial hand-wringing and scholarly suggestions for the better part of 8 decades.
Something to think about.