Wire Transfers May Protect Shareholders in LBOs
3d Circuit Says Payments by Financial Institutions Are Unavoidable

(TMA International Headquarters)

In its basic form, a leveraged buyout (LBO) involves a purchasing company acquiring a target company through loans made to the target company to purchase the shares of its stockholders. LBOs have for decades been questioned in whole or in part as fraudulent transfers, and attorneys have been advising their corporate clients on how to avoid LBO-related fraudulent transfer risk since LBOs became commonly used in the late 1980s.

However, new case law suggests that the shareholders of the target company in an LBO may be protected from fraudulent transfer liability if they are paid for their shares via wire transfer. This protection appears to apply regardless of whether the target company is privately or publicly held.

In In re Plassein International Corporation, 366 B.R. 318 (Bankr. Del. 2007), the Bankruptcy Court reviewed a Chapter 7 trustee’s fraudulent transfer action against shareholders of five different companies. The trustee alleged that the shareholders sold their shares to Plassein International Corporation through a series of LBOs. As part of these transactions, the targets became jointly and severally liable for the entire debt incurred to finance the transactions, and each granted a security interest in all of its assets to secure the debt. The shares in the targets were privately held.

Several years after the LBOs, Plassein and the targets filed cases under Chapter 11 that were later converted to Chapter 7 liquidations. The Chapter 7 trustee then brought fraudulent transfer actions under Bankruptcy Code Section 544 and Delaware law to recover the payments to the targets’ shareholders, alleging that the transactions were constructively fraudulent in that by acquiring the stock of the targets, the debtors were rendered insolvent and did not receive reasonably equivalent value in the acquisitions.

The shareholders argued that the transfers were protected from avoidance by Section 546(e) of the Bankruptcy Code, which states that a “trustee may not avoid a transfer that is a…settlement payment…made by or to a… financial institution.” The court looked at each requirement in turn: (1) whether the payments to shareholders were settlement payments; and (2) whether they were made by or to a financial institution.

In determining whether the payment to shareholders should be considered a settlement payment, the court held that the term encompassed any transfer of cash or securities that was made to complete a securities transaction. The court held that payment to a shareholder for shares as part of an LBO clearly qualifies as a common securities transaction and therefore met the first requirement of Section 546(e).

Next, the court examined whether the transactions at issue were made by or to a financial institution. The court held that an LBO payment qualifies as being made by a financial institution if it is made by wire transfer. Federal regulations require that a wire transfer be performed by a bank; thus, a wire transfer will always be made through a financial institution. Here, the payments to the shareholders were made by wire transfer through Fleet Bank, and, therefore, qualified for the exemption from avoidance.

Other Case Law

To bolster its position, the court looked to a recent opinion from the 3d U.S. Circuit Court of Appeals, In re Resorts International, 181 F.3d 505 (3rd Cir. 1999). In that case, Griffco Acquisition Corporation purchased the stock of Resorts International, Inc., in an LBO. Resorts then filed for protection under Chapter 11 of the Bankruptcy Code and challenged the payment to one of its shareholders as a fraudulent transfer.

The shareholder claimed that the payment could not be avoided because it was a settlement payment under Bankruptcy Code Section 546(e). The court agreed, finding that the payment qualified as a settlement payment because it had been made by wire transfer through Chase Manhattan Bank

The court stated that under a literal reading of Section 546(e), this was a settlement payment “made by…a financial institution.” It explained that there is no requirement that the financial institution obtain a beneficial interest in the funds it handles for Section 546(e) to be applicable; it was enough that the financial institution served as a middleman and issued the funds. Thus, the Plassein court followed 3d Circuit precedent in finding that leveraged purchases of securities, if made by wire transfer, are settlement payments and therefore unavoidable.

Notwithstanding the Plassein court’s adherence to Resorts, there is an important difference between the two cases. In Resorts, the target company was publicly held, whereas in Plassein, the target companies were privately held. The trustee argued that the holding in Resorts should be limited to publicly traded securities, in that Section 546(e) was enacted to protect the securities industry’s clearance and settlement system, which only operates with respect to publicly held securities. The court in Plassein found, however, that the 3d Circuit had rejected this argument in Resorts and that the defense applies to the purchase of privately held, as well as publicly held, securities.

Lesson Learned

The lynchpin of a fraudulent transfer action against redeeming shareholders in an LBO is that there is no consideration to the target for the debt it incurs to fund shareholder distributions; the company is liable for the debt, but the funds do not remain in the company for use as operating capital; and the target receives no consideration for the sale or repurchase of the shares.

Therefore, to avoid fraudulent transfer liability in a stock purchase transaction, the transfers must not be made when the target is insolvent. Nor can the company be rendered insolvent or left with an unreasonably small amount of capital as a result of the transaction. Solvency analyses of the effects of the transaction are imperative to accurately assess the fraudulent transfer risks.

Although Resorts and Plassein are not binding outside the 3d Circuit and Delaware, it seems that the lesson to be learned is simple: in an LBO, payments to shareholders of target companies should be made via wire transfer. Taking this simple step may help to protect redeeming shareholders against fraudulent conveyance actions.