by Lisa G. Beckerman, Robert J. Stark
In a simple form leveraged buyout, a company (Target) is
sold pursuant to a financial arrangement whereby the Target borrows all, or a
significant portion, of the purchase price and mortgages its assets to secure
the loans for the purchase price. In more complicated LBOs, a shell corporation
is formed, which borrows a large portion of the purchase price (the Target
gives liens on its assets to
secure repayment of bank loans
and/or bond debt) and, following a tender offer
for the Target’s shares, merges into the Target.
Regardless of the form of the LBO, borrowed money is paid to the Target’s
former shareholders in exchange for their shares—arguably, worthless pieces of
paper. The new owner receives control of the Target, sometimes for relatively
little or no new capital. If the Target collapses under its new debt
obligations, unsecured creditors may look hard at whether the LBO constituted a
constructive fraudulent conveyance and may be avoided through a civil
Their theory: through the LBO, former shareholders (defendants) received
transfers (cash payments) from the Target for less than reasonably equivalent
value (stock) and the transaction rendered the Target either insolvent or with
unreasonably small capital (in light of the Target’s significant debt
obligations). See 11 U.S.C. § 548(a)(1)(B) and Norton Bankr. L. & Prac. 2d @
Initial Third Circuit Ruling
Fourteen years ago, the Third Circuit Court of Appeals,
in U.S. v. Tabor Court Realty Corp., 803 F.2d 1288 (3d Cir. 1986),
cert. denied, McClellan Realty Co. v. U.S
., 483 U.S. 1005, 107 S.Ct. 3229, 97 L. Ed. 2d 735 (1987), ruled that,
under certain circumstances a trustee in bankruptcy may prosecute fraudulent
conveyance claims against parties that orchestrated a pre-petition leveraged
buyout of the debtor.
This was a watershed ruling for several reasons. First,
the case involved the first significant application of the Uniform Fraudulent
Conveyance Act to failed LBOs. Id. at 1290. Second, the court rejected
weighty academic commentary arguing that fraudulent conveyance law should not be
applied to leveraged buyout transactions. See, e.g., Douglas G. Baird
& Thomas H. Jackson, Fraudulent Conveyance Law and its Proper
Domain, 38 Vand. L. Rev. 829, 852 (1985)("A firm that incurs obligations in
the course of a buyout does not seem at all like the Elizabethan deadbeat who
sells his sheep to his brother for a pittance.") Third, the opinion established
widely accepted precedent: "courts now uniformly hold that fraudulent conveyance
laws apply to LBOs," MFS/Sun Life Trust v. Van Dusen Airport Services
Co., 910 F. Supp. 913, 933 (S.D.N.Y. 1995), even though some courts were
initially swayed by the legal commentary arguing for the opposite ruling,
see, e.g., Kupetz v. Wolf, 845 F.2d 842 (9th Cir. 1988); Credit
Mgrs. Ass’n. v. Federal Co.,
629 F. Supp. 175, 179 (C.D. Cal. 1985). Consequently, it
can be said that the expansive body of case law applying fraudulent conveyance
principles to leveraged buyouts emanates from the Third Circuit.
This past summer, however, the Third Circuit made an
abrupt and surprising about-face. In Lowenschuss v. Resorts International,
Inc. (In re Resorts International, Inc.), 181 F.3d 505 (3d Cir.), cert.
120 S. Ct. 531, L. Ed. 2d (1999), the court held that a trustee in bankruptcy
cannot pursue fraudulent conveyance claims against a former shareholder who tendered his/her shares for cash as
part of a leveraged buyout of the debtor, if such
payments were made by the debtor to a stockbroker or financial institution (such
as a bank), as go-between, to be delivered to the former shareholder. In reaching this
holding, the court construed the "plain meaning" of Section 546(e)
as divesting the trustee of avoiding powers with respect to the former shareholder because the
shareholder received "a settlement…made by or to a…stockbroker [or] financial institution… before the commencement
of the case." 11 U.S.C. § 546(e) Since it is typical for
stockholders to receive corporate distributions through a broker or request that payments
be made directly to a bank account, the court’s holding would appear
to protect most former shareholders who would otherwise be targets of
a fraudulent conveyance attack by the bankruptcy estate.
Lowenschuss v. Resorts International, Inc.
The Facts And Procedural History
Lowenschuss stems from the 1988 leveraged buyout of Resorts International,
Inc. by Griffco Acquisition Corporation. Under the terms of the LBO, Griffco
agreed to purchase Resorts stock for $36 per share. Resorts sent a proxy
statement to all of its shareholders that explained the terms of the merger and
that the shareholders had the right to receive $36 per share or to seek
appraisal rights in the Delaware Chancery Court under Section 262 of the
Delaware Corporation Law.
The merger was ultimately approved by the Delaware Chancery Court and
consummated. Resorts then sent a "Notice of Merger of Griffco Acquisition Corp.
With and Into Resorts International Inc." and a "Transmittal Letter" to
shareholders, explaining that they could either tender their shares and receive
$36 per share or obtain an appraisal. Fred Lowenschuss, a shareholder, sent
Resorts a letter demanding an appraisal.
At the same time, Lowenschuss filed an appraisal action in the United States
District Court for the Eastern District of Pennsylvania. One week later, Resorts
petitioned for an appraisal in Delaware Chancery Court, identifying Lowenschuss
as a shareholder seeking appraisal. The district court dismissed Lowenschuss’
claim without prejudice, deferring to the proceedings in Delaware. The Delaware
Chancery Court issued a "Notice of Entitlement to Appraisal," explaining that
shareholders seeking appraisal must "deliver [their] stock…certificates to the
Register in Chancery within sixty (60) days of this notice [or risk] dismissal
of the appraisal proceedings as to [their] shares." Lowenschuss never delivered
his shares. Instead, he filed an amended complaint in the Eastern District of
Pennsylvania against Resorts and others, moving for reconsideration of his
request for an appraisal of the shares under his control. The district court
dismissed the action without prejudice, again because of the Delaware Chancery
Lowenschuss next filed (again in the Eastern District of Pennsylvania) a
"Petition Requiring Resorts…to Pay $36.00 Merger Price to Plaintiffs Immediately
for 105,900 Shares of Resorts Class A Stock Owned by Plaintiffs and Which Are
Hereby Being Tendered and to Complete the Record." In the petition, he stated:
"Plaintiffs are hereby tendering all of their Resorts International, Inc. Class
A shares totaling One hundred and Five thousand Nine hundred (105,900) shares
for immediate payment of the merger price of Thirty-six Dollars ($36.00) per
share plus the interest which plaintiffs may be entitled to."
Four days later, Lowenschuss tendered his shares to Merrill Lynch, his
broker, which in turn tendered them to the Chase Manhattan Bank, Resort’s
transfer agent for the merger. Chase forwarded a list of the tendering
shareholders to Resorts and asked Resorts to wire funds to the payment account.
Approximately two weeks after the tender, Resort’s treasurer authorized the
transfer of funds to Chase. Chase then delivered a check to Merrill Lynch for
$3,805,200.00, which it paid over to Lowenschuss.
When Resorts realized that it had paid Lowenschuss the merger price, it filed
a lawsuit seeking to recover the payment. Resorts subsequently filed for Chapter
11 relief with the United States Bankruptcy Court for the District of New
Jersey, and the lawsuit was removed from the Eastern District of Pennsylvania to
the bankruptcy court. Resorts sought restitution of the transferred funds on a
number of grounds, including that the payment to Lowenschuss was a fraudulent
conveyance avoidable under Section 548.
The bankruptcy court awarded Resorts full restitution. On appeal, the
district court reversed. Resorts appealed the district court’s ruling to the
Third Circuit arguing, among other things, that the transaction was avoidable as
a fraudulent conveyance.
The Third Circuit’s Holding And Reasoning
The Third Circuit affirmed the district court’s decision, holding that
Section 546(e) divests Resorts of its powers to avoid the transfer to
Lowenschuss. As noted above, Section 546(e) prevents the trustee from avoiding a
fraudulent conveyance that constitutes a securities "settlement payment" made by
or to, among others, a stockbroker or financial institution.
The court stated that, in Bevill, Bresler &
Shulman Asset Management Corp. v. Spencer Savings & Loan Association
, 878 F.2d 742 (3d Cir. 1989), it
adopted an "extremely broad" interpretation of "settlement payment" for purposes
of Section 546(f), reflecting what it perceived to be Congress’ intent to
protect the nation’s securities industry and its participants from financial
attack by a bankruptcy trustee in the event a member of the securities industry
filed for bankruptcy protection. The court thought application of the "extremely
broad" interpretation of "settlement payment" in Bevill would encompass Resorts’
payment to Lowenschuss.
The court noted that the only other federal court of
appeals to directly address the issue presented in this case, the Tenth Circuit
in Kaiser Steel Corp. v. Pearl Brewing Co. (In re Kaiser Steel Corp.),
952 F.2d 1230, 1239-40 (10th Cir. 1991), cert. denied, 505 U.S. 1213, 112 S. Ct. 3015, 120 L.
Ed. 2d 887 (1992), held that payments to former shareholders as part of an LBO
were "settlement payments" for the purposes of Section 546(e). See also
In re Comark, 971 F.2d 322, 325 (9th Cir.
1992)(citing Kaiser Steel approvingly for the
proposition that "a settlement is ‘the completion of a securities
transaction.’"). In the Third Circuit’s view, the general thrust of Kaiser
Steel, Bevill and Comark
was that the term "settlement payment" is a broad one
that includes almost all securities transactions.
The court acknowledged that a number of commentators have criticized Kaiser
Steel arguing that LBOs generally do not implicate Congress’ concerns about
protecting the securities industry’s clearance and settlement system. It also
conceded that a number of lower courts have held that the term "settlement
payment" does not include payments made for shares by a corporation as part of
an LBO because the system of intermediaries and guarantees involved in
traditional securities transactions is not in play in an LBO transaction. The
court, however, concluded that a payment for shares during an LBO was
"obviously" a common securities transaction, and it therefore held that it was
also a settlement payment for the purposes of Section 546(e).
A Split of Authority Among the Circuits Remains Unresolved
Resorts urged the court to follow the Eleventh Circuit’s
opinion in Munford Inc. v. Valuation Research Corp., 98 F.3d 604 (11th
Cir. 1996), cert. denied,
522 U.S. 1068, 118 S. Ct. 738, 139 L. Ed. 2d 675 (1998). The court refused.
In Munford, the Eleventh Circuit took a less
formalistic view of Section 546(e), viewing the financial institutions involved
in a leveraged buyout as nothing more than intermediaries or conduits through
which cash was transferred to former shareholders. According to the
Munford court, "[f]unds were deposited with the bank and when the bank
received the shares from the selling shareholders, it sent funds to them in
exchange. The bank never acquired a beneficial interest in either the funds or
the shares." Id
. at 610. The court
reasoned that a trustee in bankruptcy may only avoid transfers to a
"transferee," and that the bank was not a transferee because it never acquired a
beneficial interest in the funds. It concluded that the former shareholders were
the only "transferees" of the funds and that Section 546(e) offered no
protection from the trustee’s avoiding powers to shareholders. The court
therefore held Section 546(e) inapplicable.
The Third Circuit found the Munford dissent more persuasive. The dissent did
not think it appropriate to read a "beneficial interest" requirement into
Section 546(e) where such requirement was not otherwise explicit. The Third
Circuit concurred, finding no reason to disregard the section’s "plain
In the fall, Resorts filed with the United States
Supreme Court its petition for a writ of certiorari to review the
Lowenschuss opinion. This past December, the Supreme Court denied
Resorts’s petition, despite the clear conflict between the rule adopted in the
Third and Ninth Circuits, on the one hand, and the rule adopted in the Eleventh
Circuit, on the other hand. This is the third time the Supreme Court has
declined to address the issue, having previously denied petitions for writs of
certiorari in Kaiser Steel and in Munford
Some Ruminations on Lowenschuss v. Resorts Int’l, Inc.
Are leveraged buyouts "safer" transactions following the
Lowenschuss decision? One might be inclined to quickly come to that
conclusion. The opinion supports the conclusion that the Bankruptcy Code
immunizes former shareholders from fraudulent conveyance attack by the
bankruptcy estate. If former shareholders are now protected, so seem to be other
LBO participants, such as the lending institutions and bond purchasers that
financed the transaction and the new owners of the company. These other
participants would likely have been pulled into an estate action against the
former shareholders to avoid the LBO. For attorneys advising a troubled company
with LBO debt obligations or any of the company’s creditors,
can be read as stripping the company’s
bankruptcy estate of a potentially valuable asset: the lawsuit against the
former shareholders. Moreover, from the perspective of firms in the business of
orchestrating leveraged buyouts, the opinion certainly is a positive development
that may help in consummating difficult transactions.
There are, however, limitations to the
Lowenschuss rule. Perhaps axiomatic,
the rule does not apply if the company does not file for bankruptcy protection.
If the elements of the cause of action are available, the company may pursue
fraudulent conveyance claims against its former shareholders outside of
bankruptcy under state fraudulent conveyance statutes (that is, presuming that
the post LBO board operates with sufficient independence from the company’s new
owners to authorize such action outside of bankruptcy oversight). The former
shareholders will not be able to rely on the "settlement payment" defense of
Section 546(e) in such a case: no comparable provision is incorporated into the
Uniform Fraudulent Transfer Act or the Uniform Fraudulent Conveyance Act.
Depending on the company’s financial situation, the company and creditors may
opt, as part of an out-of-court workout, to protect and prosecute a valuable
cause of action belonging to the company against the former shareholders rather
than immediately seeking bankruptcy protection for the company.
Second, the Lowenschuss rule applies in only
the Third and the Tenth Circuits. In light of Munford, former
shareholders may not rely on the Section 546(e) defense in the Eleventh Circuit.
Furthermore, as alluded to above, lower courts in Texas, Illinois and
Massachusetts have sided with the Eleventh Circuit and refused to follow the
Lowenschuss rule. See Jewel Recovery, L.P. v. Gordon (In re Zale
Corp.), 196 B.R. 348 (N.D. Tex. 1996); Wieboldt Stores, Inc. v.
Schottenstein, 131 B.R. 655 (N.D. Ill. 1991); Brandt v. Hicks, Muse
& Co., Inc. (In re Healthco Int’l., Inc.), 195 B.R. 971 (Bankr. D.
Mass. 1996). In the many remaining jurisdictions, the issue has not been
adjudicated and it is impossible to predict how the courts would rule. Thus,
important "forum shopping" issues that must be considered and can be used
strategically in future cases.
Moreover, no simple answer can be discerned because the
company files for bankruptcy protection in the Third Circuit. Although Delaware
has long been a jurisdiction of choice for filing complex Chapter 11 cases, a
Delaware filing by a "busted LBO" does not necessarily mean that former
shareholders can rest easy. Bankruptcy Code Section 544(b) provides a trustee in
bankruptcy or a debtor in possession with avoidance powers available "under
applicable law," implicating choice of law principles. Under federal common law
choice of law rules, the law of the jurisdiction with the "most significant
relationship" with the transaction and the parties will apply—not the law of the
jurisdiction where the Chapter 11 case is pending. See, e.g., SEC v.
Infinity Group Co., 27 F. Supp. 2d 559, 564 (E.D. Pa. 1998); In re Best
Prods. Co., 168 B.R. 35, 50 (Bankr. S.D.N.Y. 1994), aff’d, 68 F.3d
26 (2d Cir. 1995). Factors to be considered in determining the jurisdiction with
"the most significant relationship" include: the place where the transfer
occurred; the place where the LBO transaction occurred; the domicile, residence,
nationality, place of incorporation and place of business of the parties; and,
the place where the relationship, if any, between the parties is centered.
Thus, to illustrate by hypothetical, it seems safe to presume that a Delaware
Chapter 11 filing will not protect former shareholders that reside in Florida
who received cash in exchange for their shares as part of an LBO orchestrated in
Florida of a company with its principle assets and businesses operating in
Florida. In such a case, the court adjudicating the fraudulent conveyance action
against the former shareholders likely will rely on Eleventh Circuit law—the
Munford rule—rather than the law that is binding in the Third Circuit.
Perhaps a more interesting issue from the perspective of
academics and legal pundits concerns the long-term implications of
Lowenschuss. As the Lowenschuss court acknowledged, the Tenth
Circuit’s 1991 Kaiser Steel opinion invoked a storm of criticism. See,
e.g., Neil M. Garfinkel, No Way Out: Section 546(e) is No Escape for the
Public Shareholder of a Failed LBO,
Colum. Bus. L. Rev. 51
1991; Gerald K. Smith & Frank
R. Kennedy, Fraudulent Transfers and Obligations:
Issues of Current Interest, 43 S.C. L. Rev. 709 (1992); William C. Rand,
In re Kaiser Steel Corporation: Does Section 546(e) of the Bankruptcy Code
Apply to a Fraudulent Conveyance Made in the Form of an LBO Payment?, 19
Fordham Urb. L.J. 87 (1991); Jane Elizabeth Kiker, Judicial Repeal of
Fraudulent Conveyance Laws; Kaiser Steel Corp. v. Charles Schwab & Co., 913
F.2d 846 (10th Cir. 1990), 14 Hamline L. Rev. 453 (1991). It seems safe to
conclude that Lowenschuss
will not sit any easier with
The commentators argued that the "settlement payment"
defense, as adopted by the Lowenschuss and Kaiser Steel
courts, embraces an overly formalistic interpretation of Section 546(e) that
disregards Congress’ intent. They noted that Section 546(e) does not, on its
face, suggest Congress intended to immunize cashed out shareholders from a
fraudulent conveyance attack. Nor does the legislative history indicate that
Congress had such intention. Rather, the section’s legislative history suggests
that the section was designed for a different purpose: to prevent disruption in
the securities industries caused by the insolvency of one commodity or security
firm leading to the insolvency of another. See H.R. Rep. No. 420 at 261 (1982)
("The commodities and securities markets operate through a complex system of
accounts and guarantees. Because of the structure of the clearing systems in
these industries and the potential volatile nature of the markets, certain
protections are necessary to prevent the insolvency of one commodity or security
firm from leading to the insolvency of other firms and possibly threatening the
collapse of the affected market.") Several courts addressing this issue after
Kaiser Steel, but before Lowenschuss, found the commentary
persuasive and refused to follow the Kaiser Steel holding. See,
e.g., Munford, 98 F.3d at 610; Jewel Recovery, 196 B.R.
348; Wieboldt Stores, 131 B.R. 655; Healthco Int’l.,
195 B.R. 971.
Lowenschuss thus raises
the following important question: has the Third Circuit revived and given
credibility to a theory of law that commentators and jurists have long reviled?
The answer remains to be seen.
 Bankruptcy Code Section 546(e) provides as
Notwithstanding sections 544, 545, 547,
548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer
that is a margin payment, as defined in section 101, 741, or 761 of this title,
or settlement payment, as defined in section 101 or 741 of this title, made by
or to a commodity broker, forward contract merchant, stockbroker, financial
institution, or securities clearing agency, that is made before the commencement
of the case, except under section 548(a)(1)(A) of this title.
11 U.S.C. § 546(e). Section 548(a)(1)(A)
authorizes a trustee in bankruptcy or debtor in possession to avoid intentional,
as opposed to constructive, fraudulent conveyances; i.e., those conveyances made
"with actual intent to hinder, delay, or defraud" creditors.