Pre-Bankruptcy LBOS As Fraudulent Transfers

Former shareholders in leveraged buyouts may be sued by the estate representative or by creditors to recover funds paid to them for their shares as fraudulent transfers under federal or state law if the debtor subsequently files for bankruptcy. The authors discuss the claims and defenses in such suits, focusing on two pending bankruptcy cases that raise, among other things, the scope of the "safe harbor" for payments made to complete a securities transaction or a securities contract.

In a bankruptcy fraudulent transfer suit, a representative of the bankruptcy estate, usually a bankruptcy trustee or a debtor-in-possession, sues individuals and business entities to unwind (or "avoid") the fraudulent transfer, and to recover the money or property that was transferred before the debtor filed for bankruptcy. If the estate representative prevails in the suit, the net proceeds of the recovery will be distributed to the debtor's creditors according to the payment priority scheme set forth in the Bankruptcy Code.

Former shareholders of a company that has gone into bankruptcy may find themselves on the receiving end of a fraudulent transfer suit, which may come as a rude awakening to those who participated in open transactions in public markets with no expectation that the company from which they received a payment or distribution was destined for bankruptcy. Nevertheless, former shareholders may be found legally obligated to return the sums of money paid to them. This article examines the implications and risks presented to shareholders for fraudulently transferred property, focusing in particular on one type of transaction that, under certain circumstances, may be avoided as a fraudulent transfer - the leveraged buyout.

In some cases, former shareholders sued for alleged fraudulent transfers have found a so-called "safe harbor" created under amendments to the Bankruptcy Code for the protection of settlement payments in the securities markets.1 Creditors' efforts to skirt that safe harbor or - depending on your point of view - to confine it within its statutory limits, are now at issue in the fraudulent transfer cases arising from two recent bankruptcies, Lyondell and Tribune Company. We discuss these cases below.

CLAWING BACK THE DEBTOR'S PROPERTY: FRAUDULENT TRANSFER LAWS

"Fraudulent transfer law originally developed in response to a very specific problem: debtors on the verge of insolvency would sometimes transfer their assets to friends or relatives for nominal consideration, leaving little or no value in their estates to satisfy the claims of other creditors."2 To curb this problem, which was thought to be widespread in sixteenth-century England, Parliament in 1571 passed the "Statute of 13 Elizabeth," making transfers made to hinder, delay, or defraud creditors illegal and void.3 The Statute of 13 Elizabeth "has been either enacted [in substance] in American statutes prohibiting such transactions or has been incorporated into American law as a part of the English common law heritage."4 Although their roots trace back hundreds of years, fraudulent transfer laws and doctrines have significant and complex implications for modern corporate transactions.

Types of Fraudulent Transfers

Generally, there are two types of fraudulent transfers. The first is an actual or intentional fraudulent transfer, which occurs when debtors transfer their property with the intent to "hinder, delay, or defraud" their creditors. For this issue generally, it is the intent of the debtor that most courts regard as relevant. The knowledge or good faith of the transferee may be relevant as to other issues. Because debtors trying to shield their property from creditors rarely admit that they have intended to do so, the law recognizes certain circumstantial evidence from which fraudulent intent may be inferred, known as the badges of fraud. A creditor can thus...