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When worlds collide: failed LBOs and the Bankruptcy Code.

When Worlds Collide: Failed LBOs and the Bankruptcy Code


On December 1, 1988, the financial press announced to the world that Kohlberg Kravis Roberts & Company had succeeded in its leveraged buyout bid to purchase RJR Nabisco, Inc. for the staggering sum of over $25 billion [16]. The RJR Nabisco transaction represents the pinnacle of leveraged buyouts (LBOs), being more than quadruple the size of the next largest LBO on record, that of Beatrice Companies for over $6 billion. Indeed, it was a fitting climax to a year that witnessed LBO acquisitions totalling an astronomical $60 billion in value.

Yet, while the mavens of Wall Street reveled in the glory of this megadeal, that same day a federal court in Illinois issued a decision representing the latest in a series of judicial opinions dealing with a force even greater than the behemoth LBOs - the Bankruptcy Code, particularly its laws on fraudulent conveyances, as applied to LBOs of companies which subsequently become bankrupt.

LBOs Under Attack

Almost by definition, an LBO acquisition is a financial mechanism preordained to collide headon with the common law and statutes relating to creditors' rights that trace their roots back to the 16th century. A leveraged buyout typically consists of the purchase of a corporation, the "target," from its shareholders by an investment entity, known as the "acquiror." The acquiror finances the purchase with proceeds of a loan secured by the target's assets and a small equity investment by the acquiror. Hence the term "leveraged," as the essence of the deal is the use of all or most of the target's assets to secure the borrowing, typically massive in comparison to the equity put in by the acquiror [6].

The direct economic effect of the LBO on the acquired company is clear - after the LBO, the sum total of its assets are now heavily mortgaged. A huge debt must be serviced, but the loan proceeds were transferred not to the target, but to its former shareholders. In the eyes of creditors, the target has been substantially weakened in terms of its credit worthiness. The general creditors now are confronted with a greatly diminished asset pool to look to for a recovery should the company fail. In addition, they will have a lower priority than the secured LBO lenders in any forced distribution. Obviously, the foregoing represents a scenario no general creditor desires to be caught up in.

Consequently, when an LBO target is unable to meet its increased financial burdens and succumbs to bankruptcy, the injured creditors seek redress under the Bankruptcy Code and the long-standing law of fraudulent conveyances. These laws permit a bankruptcy trustee (or a debtor in possession of its business, if no trustee is appointed) to set aside any transfer of assets made with the actual intent to defraud creditors [12]. More importantly in this context, a transfer can also be set aside as a fraudulent conveyance, if it constitutes a "constructive" fraud on creditors. Constructive fraud would include a transfer of assets for less than fair consideration, which leaves the transferor either insolvent with an unreasonably small amount of capital, or unable to pay its debts when they become due [9]. It is primarily on these points that aggrieved creditors have moved to attack failed LBOs as fraudulent conveyances.

The Wieboldt Case

The case decided on that first day of December 1988 was Wieboldt Stores, Inc. v. Schottenstein [5]. Wieboldt was a Chicago-based retail concern in declining financial health. In January 1985, unable to pay current obligations, Wieboldt agreed to be acquired via a tender offer made by WSI Acquisition Corporation. WSI intended to finance its leveraged buyout by selling or pledging substantially all of Wieboldt's assets, particularly its real property, which was already serving as collateral for obligations upon which Wieboldt was at least partially in default at the time. When the sale of Wieboldt's major piece of real estate did not generate sufficient funds to discharge its pre-LBO obligations, WSI sold the company's customer charge accounts, pledged all accounts receivable, and subjected the remaining real estate holdings to first or second mortgages.

By the time of the buyout, the LBO lenders had full knowledge of the loan or credit commitments of WSI to each of them. Moreover, the board of directors of Wieboldt understood WSI intended to pledge substantially all of Wieboldt's assets to fund the transactions, without using any of its own funds. The board also knew the proceeds from the LBO lenders would not increase working capital. Nevertheless, the tender offer was approved, and by the end of 1985, WSI had acquired ownership of 99 percent of Wieboldt's stock.

The following September, certain of Wieboldt's aggrieved creditors commenced an involuntary liquidation proceeding against the company. On September 26, 1986, Wieboldt filed a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code. Acting as a debtor-in-possession, without a trustee, Wieboldt filed its lawsuit, alleging the LBO worked a fraud upon its unsecured creditors.

Wieboldt filed a complaint seeking to avoid the transfer of assets made in the LBO and to recover damages against 119 defendants alleging, among other things, that its leveraged buyout by the specially formed acquisition corporation in 1985 constituted a fraudulent conveyance. Specifically, Wieboldt contended the LBO reduced the assets available to its creditors, increased its debt burden by million of dollars, and left Wieboldt insolvent and without sufficient unencumbered assets to sustain its business and ensure the payment of unsecured creditors.

The defendants were grouped into three non-exclusive categories: (1) controlling shareholders, officers, and directors of Wieboldt (the "controlling shareholders"); (2) the lenders who funded the leveraged buyout (the "LBO lenders"); and (3) other shareholders who owned more than 1,000 shares of Wieboldt and tendered their shares in the LBO. The instant matter came before the court on numerous motions by these defendants to have the complaint dismissed.

In deciding this case, Federal District Judge Holderman rejected the assertion of the defendants that the law of fraudulent conveyance does not apply to leveraged buyouts. First, the court found the language of the Bankruptcy Code itself "in no way limits [its] application so as to exclude LBOs." The Code's definition of a "transfer" of property and the statute invalidating a fraudulent transfer are both very broad and present no basis for finding an exemption for leveraged buyouts. Second, the judge looked to the rulings of other courts and found that "those courts which have addressed this issue have concluded that LBOs in some circumstances may constitute a fraudulent conveyance."

Having thus decided a leveraged buyout can be a fraudulent conveyance, the court turned to the Wieboldt buyout. The defendants claimed that this LBO was composed of "a series of interrelated but independent transactions," and that they were the transferees of the property of the acquiror, WSI, not transferees of the debtor. Wieboldt, in turn, urged the court to consider WSI as a mere conduit of its property and to collapse the LBO as one aggregate transfer to the defendants. It was the latter view that this court adopted.

Crucial here was the court's holding that the complaint alleged sufficient facts to demonstrate that the controlling shareholders entered into the transaction with full knowledge that WSI was not using any of its own funds, that the leveraged buyout would result in the further encumbrance of already encumbered assets, and that Wieboldt was insolvent at the time of the transfer. The LBO lenders were likewise implicated, said the court, because they had the same knowledge as the controlling shareholders and "were well aware of each other's loan or credit commitments to WSI," which had financed the LBO. Furthermore, the court agreed, WSI served "merely as a conduit" for the transfer of Wieboldt assets to the controlling shareholders and the LBO lenders.

Applying the principle espoused by other courts that "a court should focus not on the formal structure of the transaction, but rather on the knowledge or intent of the parties involved," the court decided to collapse the LBO into one unified transaction. "In sum," ruled the judge, "the formal structure of the transaction ... cannot shield the LBO lenders or the controlling ... shareholders from Wieboldt's fraudulent conveyance claims." For these reasons, the defendants' motions to dismiss the case were denied and the fraudulent conveyance complaint was left standing for an eventual trial.

Significant Decisions and


As with any judicial opinion, the court in Wieboldt examined precedent for guidance. However, the cases decided prior to Wieboldt present a mixed lot. To be sure, the courts have had difficulty in deciding which challenged LBOs constitute fraudulent conveyances and which do not, a reflection of judicial uncertainty as to how to deal with the modern dynamics of corporate finance, as represented by LBOs, when it clashes with the long established law of fraudulent conveyances as applied in bankruptcy proceedings.

In Kupetz v. Wolf, the Ninth Circuit Court of Appeals affirmed the trial court's determination that the LBO of the debtor was not a fraudulent conveyance [4]. There the acquiror, incorporated with only de minimis capital, purchased all of the debtor's shares for $3 million. The acquisition was financed with a $1.1 million loan and $1.9 million in letters of credit from Continental Illinois National Bank. The target company's assets were pledged to the bank to secure those obligations. Unable to service its debt, the company filed for bankruptcy a little over two years later. Subsequently, the bankruptcy trustee filed a complaint alleging that the underlying transactions were fraudulent conveyances. The federal district court directed a verdict denying those claims, and the trustee appealed.

The appellate court expressed its discomfiture with the issue from the outset, opining that "LBOs pose difficult issues when the purchased corporation becomes bankrupt ... As some of the acquired companies have failed, creditors have begun to assert that LBOs are fraudulent." On that point, the panel pointed out that the application of fraudulent conveyance law to LBOs gives creditors the ability to "whipsaw" companies, taking advantage of successful LBOs and commencing a fraudulent conveyance lawsuit if the LBO fails.

With this possibility in mind, the court declined to apply the fraudulent conveyance laws in this context. First, the court held that there was no evidence of any intentional fraud worked by the selling shareholder on the target's creditors. Second, these shareholders did not know the acquiror intended to finance his buyout via an LBO. Third, the trustee was not representing the interest of pre-LBO creditors who lacked a full opportunity to evaluate the effect of the leveraged buyout on the target's credit worthiness. Lastly, the formal structure of the LBO bore the indicia of a "straight" sale of stock to an entity other than the target itself.

The court looked to various underlying facts in support of these holdings. The judges found that the seller shareholders acted in good faith throughout the transaction. They sold their stock at a fair price. The acquiror, albeit thinly capitalized, was backed by the substantial personal assets of its principal and his relationship with a major bank.

Most interesting was the court's recognition that a lack of fraudulent intent does not necessarily bar a fraudulent conveyance claim, because of the "constructive" fraud provisions permitting the finding of a fraudulent conveyance if, among other things, the transfer lacks fair consideration or renders the transferor insolvent. However, the tribunal backed away from that point, stating "we hesitate to utilize constructive intent to frustrate the purposes intended to be served by what appears to us to be a legitimate LBO." Furthermore, the court struck a cautionary note in noting "[n]or do we think it appropriate to utilize constructive intent to brand most, if not all, LBOs as illegitimate. We cannot believe that virtually all LBOs are designed to `hinder, delay, or defraud creditors'."

A sharp contrast to the preceding case is found in United States v. Tabor Court Realty Corp [3]. There the Court of Appeals for the Third Circuit was compelled to examine a very intricate leveraged buyout and to decide whether mortgages given in that transaction were fraudulent conveyances within the meaning of the constructive and actual fraud provisions of the Pennsylvania Uniform Fraudulent Conveyances Act ("UFCA"). The panel noted this was "the first significant application of the UFCA to leveraged buyout financing."

Here the court was greatly troubled by the nature of the LBO. The panel looked to the facts that: (1) the acquiror borrowed heavily at an extremely high rate of interest to purchase the target's stock; (2) the assets of its subsidiaries were mortgaged to secure those borrowings; (3) the acquiring company was a seemingly empty shell, able to achieve the LBO only on the strength of the massive loan; (4) "secret partners" were principals in the acquiror; and (5) there were multimillion dollar liabilities on the books of the target. Indeed, the court found this LBO "anything but unsuspicious." The severe economic distress the target was put in, without a concomitant benefit, and the lack of fair consideration suggested this was not a transaction made in the ordinary course of business.

On the basis of the foregoing circumstances, the court determined that the LBO was indeed a fraudulent conveyance, because it rendered the target insolvent, as neither the target nor any of its subsidiaries received consideration in the transaction. In so finding, the Third Circuit explicitly found that the law of fraudulent conveyances applied to this LBO. The "broad sweep" of that body of law, held the court, does not justify the exclusion of LBOs simply because they are innovative and complex. Any exemption for leveraged buyouts should be carved out by the legislature, not by the judiciary.

It is clear that leveraged buyouts are susceptible to attack under the Bankruptcy Code as fraudulent conveyances. Yet, there is doubt as to whether LBOs should be subject to fraudulent conveyance laws. Considering the tentative and somewhat confusing state of the decisional law today, the one thing which is apparent is that the courts have not, as of yet, established a clear direction in which they shall proceed on this issue. At present, no tribunal seems willing to except LBOs from that law. That is not to say that the possibility for an exemption is completely foreclosed.

At least two leading professors have staunchly advocated a more restrictive reading of the fraudulent conveyance law as applied to LBOs in light of the modern financial world's degree of sophistication in both the legal and economic aspects of the debtor-creditor relationship [1]. They believe that LBOs are undeserving of attack under the historical concepts of fraudulent conveyances. "It is not clear that permitting the debtor to engage in a leveraged buyout ... is against the long term interests of the creditors as a group." Indeed, the buyout may bring about a more streamlined and effective organization, better able to service its debt. Among other things, a privately held entity makes immediate savings by doing away with the necessity of complying with federal securities reporting requirements. To be sure, today's LBO is far different from the old Elizabethan deadbeat who sells his sheep to his brother for a pittance. In their view, the typical LBO simply lacks the element of genuine fraud that the laws of fraudulent conveyances were designed to protect creditors from.

Lastly, in a point brought home by the Ninth Circuit in its "whipsaw" analogy in Kupetz, Professors Baird and Jackson warn against any law that gives general creditors too much by insuring them against any less than satisfactory transaction a debtor may enter into. Fraudulent conveyance law in the context of LBOs should be activated, they say, where there are suspicious circumstances, such as those the Third Circuit found in Tabor Court. Otherwise, the LBO is no different from any other business activity, with both the potential of risks and benefits to be borne by the company and its creditors alike.

The Future of the Conflict

In view of all of the foregoing, the "players" in the high stakes game of leveraged buyouts must now confront the potential for legal proceedings brought on by disgruntled creditors of the bankrupt target. Courts may be inclined to follow Wieboldt and take the offensive in vindicating the rights of injured general creditors by setting aside the transfers constituting the LBO transaction. Moreover, the threat of judicial action looms even larger because of the uncertainty inherent in the application of a law that has yet to find firm footing.

Particularly disconcerting is the apparent willingness of some jurists, as exemplified by Wieboldt, to disregard the form of a contested LBO. LBOs are singularly complex transactions, each one shaped by a host of disparate concerns of corporate finance, tax considerations, and so forth. Financial professionals, tax advisors, and investment bankers may find their enormous expenditures of time and effort in structuring an LBO swept aside by an unreceptive judge in a fraudulent conveyance action. Yet, commentators have thus far seen little value in modifying the structure of an LBO in an attempt to avoid legal challenges [15].

For potential LBO participants and their advisors, Wieboldt and its predecessors may signify it is time to intensify preventive measures designed to insulate them from a subsequent attack, should the target company later slip into bankruptcy. Such procedures would entail the construction of an extensive pre-LBO record, evidencing careful scrutiny of issues such as the target's solvency, capital maintenance, cash flow, and asset dispositions.

A management proposing its own leveraged buyout of the target must also be particularly mindful here of its disclosure obligations, as it has been held that because material facts concerning an LBO are within the possession of management and management's interests conflict with those of the shareholders in a management-led LBO, judicial review of disclosures and nondisclosures will be especially rigorous [13]. This of course increases the burden on management, its investment bankers, and other advisors.

Prospective LBO lenders should in particular assure that the financial information and projections relating to the target be as accurate and conservative as possible [11]. To be sure, this task is now more difficult because of the decree of the American Institute of Certified Public Accountants that accountants may not issue written assurances regarding a target's solvency or related matters to an LBO lender [5]. As pointed out by one commentator, the virtue of such diligent inquiry is that it compels prospective LBO lenders to evaluate the economic impact of the transaction and then enables them to refuse to participate if it appears the buyout will run afoul of the Bankruptcy Code and fraudulent conveyance law. Given the likelihood that the lender who finances a leveraged buyout is in a superior position to evaluate it, that party thus assumes the risk of subsequent litigation if the LBO exceeds the parameters of a sound transaction. An LBO lender would then take on risk in equal proportion to the questionable nature of the leveraged buyout, but without the imposition of the absolute liability that would, in effect, make that lender the insurer of the transaction [14].

In point of fact, in 1989 the Senate Banking Committee requested the Treasury Department, the Securities and Exchange Commission, and other regulatory agencies to conduct an analysis of, among other things, "[w]hether banks that participate in LBO loans conduct appropriate credit analysis and whether they are obtaining enough information from borrowers" [7]. At the time of this writing, the SEC, among other agencies, is actively considering legislative and rule making proposals relating to the regulation of LBOs [8]. The upshot of the foregoing is clear - what has been previously advised as a prudent course of action for potential LBO participants may well be soon required by legislative mandate.


Wieboldt and the decisions which preceded it appear to exemplify an emerging trend of judicial thought that refuses to exempt LBOs from the laws of fraudulent conveyances and subsequent attack in bankruptcy proceedings. These cases clearly demonstrate that even today's most sophisticated LBO, carefully crafted by numerous corporate and financial professionals, could very well be completely dismantled by an activist court applying centuries old fraudulent conveyance law. LBO participants, especially those in the finance area, should bear in mind that while they view the corporate form as a device to hold assets, the legal system regards the corporation as an independent entity, one which may have equal or greater obligations to its general creditors than to its own shareholders.

The Wieboldt decision may be a portent of the day of reckoning for LBOs, as "critics have long complained that these deals serve little economic purpose beyond enriching management, underwriters, and lenders, and that the companies have become so prodigiously leveraged with debt that they could not withstand a financial storm "[10]. To be sure, the creation of a "safe harbor" for LBOs by way of statutory revision does not appear to be on the horizon. For these reasons, all parties contemplating involvement in a leveraged buyout, be they management, investment bankers, shareholders, and especially lenders making substantial investments of their capital, should presume significant risks are present and diligently strive to build a record to validate the transaction as legitimate, in order to fend off an attack that may come in a bankruptcy court at some future date.

In closing, the domains of leveraged buyouts and bankruptcy law already have clashed several times, with differing results on each occasion. Let the business community be forewarned and forearmed for when those worlds inevitably collide again.


[1.] Baird, D.G. and T.H. Jackson. "Fraudulent Conveyance Law and Its Proper Domain." Vanderbilt Law Review, Vol. 38, 1985, p. 829.

[2.] Bankruptcy Reporter (West). Northern District of Illinois, Vol. 94, 1988, p. 488.

[3.] Federal Reporter 2d (West). 3rd Circuit Court of Appeals, Vol. 803, 1987, p. 1288 and review denied sub nom. U.S. Supreme Court Reports (West), Vol. 483, 1987, p. 1005.

[4.] Federal Reporter 2d (West). 9th Circuit Court of Appeals, Vol. 845, 1988, p. 842.

[5.] "Interpretation of Attestation Standards: Responding to Requests for Reports on Matters Relating to Solvency." AICPA Professional Standards, May 1988.

[6.] Kirby, M.T., K.G. McGuiness, and C.N. Kandel. "Fraudulent Conveyance Concerns in Leveraged Buyout Lending." Business Lawyer, Vol.43, November 1987, p. 27.

[7.] Letter from Senator Riegle, Chairman of the Senate Committee on Banking, Housing, and Urban Affairs, to Chairman Ruder, Securities and Exchange Commission, January 6, 1989, p. 3.

[8.] Letter from Chairman Ruder, Securities and Exchange Commission, to Representative Dingell, Chairman of the House Committee on Energy and Commerce, May 1, 1989.

[9.] "Leveraged Buyouts and Fraudulent Conveyances: Lenders and Shareholders Beware, Comment." Missouri Law Review, Vol. 53, 1988, p. 761 and pp. 763-764.

[10.] Loomis, C.J. "LBOs Are Taking Their Lumps." Fortune, Vol. 116, No. 13, December 7, 1987, p. 63.

[11.] Murdoch, D.A., L.D. Sartin, and R.A. Zadek. "Leveraged Buyouts and Fraudulent Transfers: Life After Gleneagles." Business Lawyer, Vol. 43, November 1987, p. 1 and pp. 20-21.

[12.] Ohio Corrugating Co. v. DPAC, Inc. (In re Ohio Corrugating Co.), Bankruptcy Reporter (West). Bankruptcy Court, Northern District of Ohio, Vol. 91, 1988, p. 430 and p. 433, (the court authorized the official creditors committee to bring the lawsuit when the debtor-in-possession failed to take action).

[13.] Plaza Securities Co. v. Fruehauf Corp. Federal Supplement Reporter (West), Eastern District of Michigan, Vol. 643, 1986, p. 1535 and p. 1544.

[14.] Sherwin, E.L. "Creditors' Rights Against Participants In a Leveraged Buyout." Minnesota Law Review, Vol 72, 1988, p. 449 and pp. 493-496.

[15.] Smolev, R.G. "Living With Leverage: Understanding How Courts Examine Challenged LBOs." The Secured Lender, Vol. 45, No. 4, July/ August 1989, p. 6.

[16.] Wall Street Journal. December 1, 1988, p. 1, col. 2.

Anthony Michael Sabino is a always LeBoeuf, Lamb, Leiby & MacRae is New York, New York and Adjunct Assistant Professor of Business Law at St. John's University in Jamaica, New York.
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Title Annotation:leveraged buyouts
Author:Sabino, Anthony Michael
Publication:Review of Business
Date:Dec 22, 1990
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