Geoffrey McAleenan4/19/14

The Energy Future Holdings Bankruptcy Could Lead to Clarification In Fraudulent Transfer Law

I. Energy Future Holdings Corporation: A Juggernaut Declares Bankruptcy

The largest leveraged buyout in history has declared bankruptcy.1 Unable to remain a

going-concern, Energy Future Holdings (EFH) negotiated a restructuring deal with its largest

secured creditors to shed approximately $40 billion worth of debt.2 However, the reorganization

plan still needs approval from additional, unsecured creditors, and parts of EFH’s plan require

regulatory approval from the Securities and Exchange Commission.3 Whether or not the plan

will be executed remains unanswered; particularly in the wake of a dispute that has erupted

between EFH and several of its creditors over where the bankruptcy proceedings will take place.4

Teetering on the edge of an unstructured bankruptcy, creditors’ best alternative to

recovering a portion of their capital contribution may be to avoid the leveraged buyout of EFH as

a fraudulent transfer. However, the current state of fraudulent transfer law is unclear. The United

States Court of Appeals for the Eighth, Sixth, and Third Circuits have rendered decisions

protecting payments made to former shareholders of failed leveraged buyouts under the safe

harbor provision of 11 U.S.C. § 546(e).5 Meanwhile, recent decisions in New York have held

that 546(e) does not protect payments made to shareholder defendants in LBOs.6 Complicating

matters further, the Seventh Circuit has issued a decision making it more difficult for shareholder 1John Bringardner, Looking to Shed $40B in Debt, Energy Future Holdings (TXU) Files Ch. 11, FORBES (Apr. 29, 2014, 9:39 AM) http://www.forbes.com/sites/spleverage/2014/04/29/looking-to-shed-40b-in-debt-energy-future-holdings-txu-files-ch-11/ 2 Id.3 Mike Spector, et. al, Energy Future Holdings Files for Bankruptcy, THE WALL STREET JOURNAL (Apr. 29, 2014, 3:38 PM) http://online.wsj.com/news/articles/SB10001424052702304163604579531283352498074?mod=WSJ_hp_LEFTTopStories&mg=reno64-wsj 4 Id. 5 In re Plassein Int'l Corp., 590 F.3d 252, 258 (3d Cir. 2009); In re QSI Holdings, Inc., 571 F.3d 545, 550 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 986 (8th Cir. 2009).6 In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310 (S.D.N.Y. 2013); In re MacMenamin’s Grill Ltd., 450 B.R. 414 (Bankr. S.D.N.Y. 2011).

1

Geoffrey McAleenan4/19/14

defendants to defeat fraudulent transfer claims.7 To date, the Supreme Court has not reconciled

the disagreement among the lower courts, but a bankruptcy of EFH’s magnitude could eventually

force the Court to settle the conflicting jurisprudence if fraudulent transfer claims are filed.

Fraudulent transfer claims are pervasive in bankrupt LBOs because the acquisition

mechanics require a unique capital structure, which leads to many lenders participating in the

transaction with each wanting its debts satisfied.

II. Debt Financing in Leveraged Buyouts Can Be Lucrative or Lethal

A. The Leveraged Buyout Structure’s Vulnerability to Bankruptcy

A leveraged buyout (LBO) involves substantial sums of debt secured by using the target

company’s assets as collateral. An LBO can take many forms, but the transaction commonly

involves the acquisition of the existing private or public stock of a company financed by equity

and debt with the goal of using the target’s cash flows to ultimately repay the debt.8 In private

equity, the LBO model looks something like this: a private equity firm solicits equity capital

from several institutional investors and pools that capital into a single fund, which is designated

for particular investments. Funds are typically structured as limited partnerships with investors

serving as limited partners and private equity firms acting as general partners who make the

investment decisions on behalf of the investors. The equity capital from the fund is paired with a

significantly larger amount of bank-issued debt secured by a lien on the target company’s assets.

Debt is the most important feature of an LBO. The equity contributed by investors

represents less than half of the purchase price of a target company.9 The remaining capital

required to complete the purchase is secured from bank issued debt. Private equity firms secure

7 Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787, 795-97 (7th Cir. 2009). 8 See Steven M. Davidoff, The Failure of Private Equity, 82 S. CAL. L. REV. 481, 490 (2008-2009).9 CLAUDIA SOMMER, PRIVATE EQUITY INVESTMENTS: DRIVERS AND PERFORMANCE IMPLICATIONS OF INVESTMENT CYCLES, 13 (6th ed. 2013).

2

Geoffrey McAleenan4/19/14

the majority of their funding in the form of debt because it allows them to dramatically increase

returns to investors. This is so because the target’s cash flows are devoted to repaying the interest

on the bank loans, and the excess cash is distributed to the smaller equity base, yielding higher

returns. Debt magnifies profits when the returns from the investment offset the costs of the debt.

Remunerative prospects notwithstanding, the LBO paradigm of leveraging a

corporation’s assets to purchase its equity places the target in an untenable financial position if it

fails to service the debt. To mitigate such risk, private equity buyers will select a target capable

of remaining a going concern despite being encumbered with the debt used to purchase it.

B. Selecting A Suitable Target Should Mitigate the Potential Risk of Future Bankruptcy

Selecting a stable, profitable target is paramount in avoiding bankruptcy and fraudulent

transfer claims. In an LBO, the target company subject to acquisition assumes primary

responsibility for repaying the secured and unsecured debt incurred to purchase it from the

outset. Therefore, the starting point for analyzing whether a target is a strong candidate for an

LBO is determining the cash flow available to service the target company’s future debt

obligations.10 The basic model for appraising cash flow involves identifying the target’s profits

and the value of its assets juxtaposed with its capital expenditures and any preexisting debt.11

These figures will be presented to bankers and other various financial investors to negotiate how

much debt will be made available to purchase the target.12

Other factors that should protect a target from bankruptcy include evaluating the

bankruptcy risk characteristics of both the target company and the target company’s industry.13 A

10 Id. 11 PETER A. HUNT, STRUCTURING MERGERS & ACQUISITIONS, at 345 (4th ed. 2009).12 Id.13 Id.

3

Geoffrey McAleenan4/19/14

target that possesses a competitive position in the relevant market, administrated by quality

management, with a history of consistent performance will likely avoid bankruptcy because it

should maintain stable cash flows.14 Similarly, if a target company’s industry has high barriers to

entry, reliable suppliers and customers, and low cross-elasticity of demand, then the target should

continue to remain a going concern despite adverse externalities.

However, as in the TXU LBO, unforeseen circumstances may still infect a healthy target,

diminishing its ability to operate profitably and thereby service its debt. When this occurs and a

target declares bankruptcy, it is at the mercy of its numerous lenders.

C. Capitalizing a Private Equity Transaction Requires Significant Debt

The debt component to financing an LBO is crucial in bankruptcy proceedings because it

determines who gets paid when. Debt financing accounts for 60% to 80% of a target’s

capitalization,15 and most of that is senior debt secured by the target’s assets.16 The types of

assets that can be used are fairly broad, ranging from a company’s plants and equipment to its

accounts receivable and its inventories. Lenders provide debt in relation to the value of a target

company’s assets, which will vary depending on market conditions at the time of the

acquisition.17 Second-lien debt, also known as intermediate debt, is also secured using the

target’s assets, but it is junior in priority to senior debt.

Secured debt is obtained from banks and other asset-based lending institutions.18 Firms

often seek to borrow more money than any one institution is willing or able to lend out for a

single project, so a group of lenders may agree to work in concert with each other to provide the

14 Id.15 Id, at 300.16 LOUISE GULLIFER & JENNIFERY PAYNE, CORPORATE FINANCE LAW: PRINCIPLES AND POLICY 669 (2011).17 See In re Jolly’s, Inc. 188 B.R. 832, 839-40 (Bankr. D. Minn. 1995).18 See Ronald J. Mann, Explaining the Pattern of Secured Credit, 110 HARV. L. REV. 625, 639 (1997).

4

Geoffrey McAleenan4/19/14

debt to a private equity firm. Such an arrangement is known as a syndicated loan.19 Syndicated

lending spreads the risk among many lenders in case the target defaults on its loans.20 Secured

debt is insufficient to finance the entire LBO transaction, so more debt must be acquired from

additional sources, which gives rise to unsecured debt.

Mezzanine financing is unsecured debt that fills the gap between what banks are willing

to loan and what private equity firms want to acquire a target. Mezzanine financing is debt

extended on a subordinated basis, representing the part of leveraged financing that is neither

equity nor senior debt.21 Private equity firms prefer mezzanine financing as a gap-filler instead of

obtaining more equity capital because it is less expensive than equity and it can be paid off over

time. The drawback is that mezzanine financing comes with interest payments, which can

become problematic if a target’s cash flow shrinks. High-yield bonds, or “junk bonds,” represent

another source of unsecured debt financing for LBOs. High-yield bonds are paid back after all

the other debt contributions are satisfied. Although high-yield bonds fall lowest in debt priority,

they are attractive to investors because they pay higher returns to compensate for the risk of

failing to receive compensation for the investment.22

Once the financing has been secured, the acquisition may proceed. The conventional

LBO involves the merger of the target company with a shell corporation whose only purpose is

accomplishing the LBO.23 The LBO investors form the acquisition shell company and capitalize

it with their equity contribution, and the shell company uses the debt to complete the purchase,

19 Gavin R. Skene, Arranger Fees in Syndicated Loans-A Duty to Account to Participant Banks?, 24 PENN ST. INT'L L. REV. 59, 62 (2005). 20 Id.21 Id.22 Davidoff, supra note 8, at 490.23 Davidoff, supra note 8, at 29.

5

Geoffrey McAleenan4/19/14

but it induces the target to put up its assets as collateral for the loans.24 The result is that the

shareholders of the company are bought out, and the transaction is complete.

A result of an LBO is that the target starts at a disadvantage: it has pledged all its assets

away to the secured lenders, and its former shareholders were bought out using the loan proceeds

obtained by the acquirer. The result is that the target company assumed debt without getting

anything of value in return because the debt was used to purchase the shares of the company. If

the target fails to remain profitable and must declare bankruptcy, creditors may attack the entire

LBO transaction as a fraudulent transfer under federal bankruptcy laws to service the debt.

III. Bankruptcy and Fraudulent Transfer Laws

A. The Bankruptcy Code

The Bankruptcy Code is a federal statute and thus is the law in all fifty states.25 A

company declares bankruptcy when it becomes insolvent, which is defined by the Bankruptcy

Code as when the company’s debts exceed its assets.26 Bankruptcy law protects the interests of

both debtors and creditors by trying to resolve the financial dispute in a way that gives the

corporation a chance at a fresh start while honoring the debts owed to creditors.27 To accomplish

this goal, bankruptcy trustees are empowered by statute to “avoid,” or invalidate, pre-bankruptcy

transfers.28

24 Matthew T. Kirby, ET AL. Fraudulent Conveyance Concerns in Leveraged Buyout Lending, 43 BUS. LAW. 27, 34 (1987).25 Article I of the United States Constitutions vests Congress with the power to “establish uniform laws on the subject of Bankruptcies throughout the United States.” Congress has acted on this express grant of power, and the federal bankruptcy laws are codified in title 11 of the United States Code. Because bankruptcy proceedings are under federal jurisdiction, all bankruptcy claims are filed in United States Bankruptcy Courts, which are akin to United States District Courts. States, therefore, are preempted from enacting their own bankruptcy laws. However, states have passed laws that govern other aspects of the debtor-creditor relationship, and Title 11 incorporates many of these laws to protect creditors. 26 11 U.S.C.A. § 101(32) (West 2010). 27 8A C.J.S. Bankruptcy § 689 (2010); COLLIER BANKRUPTCY PRACTICE GUIDE.28 11 U.S.C.A § 544 (b). §548 allows avoidance of transfers made or obligations incurred within two years of filing the bankruptcy petition.

6

Geoffrey McAleenan4/19/14

There are three primary LBO transfers targeted in bankruptcy: the debt incurred by the

target to fund the LBO as well as the liens securing it; the payments made to the target’s former

shareholders in exchange for their equity interest or assets sold in the LBO, and any fees and

costs associated with the transaction.29 Targeting these transfers makes former shareholders and

the professionals that orchestrated the LBO’s the primary defendants in fraudulent transfer

claims.30

Although LBOs are comprised of a series of complex transactions, if a court finds that

each is part of a single, integrated transaction, the court may collapse the individual transactions

to ascertain the economic impact the creditors suffered from the LBO.31 Courts consider three

factors when deciding whether the transactions should be collapsed:

1. whether all of the parties involved had knowledge of the multiple transactions;

2. whether each transaction would have occurred on its own; and

3. whether each transaction was dependent or conditioned on the other transactions.32

Assuming the conditions are met, the separate transactions may be collapsed, and the entire

transaction may be avoided as a fraudulent transfer.33

B. Fraudulent Transfers

Fraudulent transfers are defined in § 548 of the Bankruptcy Code and can be broken into

two classes: “actual,” or intentional fraud, and “constructive fraud.” Actual fraud occurs when

the debtor voluntarily or involuntarily “made [a] transfer or incurred [an] obligation with actual

29 See generally Angelo Guisado, Revisiting the Leveraged Buyout: Is Constructive Fraud Going Too Far? 46 J. MARSHALL L. REV. 429, 435 (2013); H. Bruce Bernstein, Leveraged Buyouts and Fraudulent Conveyances: Yet Another Update, 7 J. BANKR. L. & PRAC. 315, 318 (1998); Ronald J. Mann, Explaining The Pattern of Secured Debt, 110 HARV. L. REV. 625, 645-47 (1997). 30 Hunt, supra note 11. 31 See United States v. Tabor Realty Corp., 803 F.2d 1288, 1302 (3d Cir. 1986). 32 See In re Mervyn's Holdings, LLC, 426 B.R. 488, 497 (Bankr. D. Del. 2010). 33 11 U.S.C.A. § 548.

7

Geoffrey McAleenan4/19/14

intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the

date that such transfer was made or such obligation was incurred, indebted[.]34 Constructive

fraud applies to transactions where the debtor corporation made a transfer and received less than

a reasonably equivalent value35 in exchange for the transfer or obligation and:

1. was insolvent at the time, or became insolvent as a result, of the transfer; or

2. was engaged (or was about to engage) in a business or transaction, for which any

property remaining was an unreasonably small capital; or

3. intended to incur, or believed it would incur, debts beyond the company’s ability to pay

as they matured; or

4. made such transfer, or incurred such obligation to or for the benefit of an insider, under

an employment contract and not in the ordinary course of business.36

The important distinction between actual fraud and constructive fraud is that proving actual fraud

requires demonstrating the mens rea component of intending to defraud, whereas proving

constructive fraud does not require proving intent. The absence of the intent requirement makes

constructive fraud an easier allegation to prevail on in in bankruptcy proceedings.37

Fraudulent transfer claims may be brought under both the Bankruptcy Code and the

Uniform Fraudulent Transfer Act,38 and each allows a court to avoid fraudulent transfers.39

1. Commonly Asserted Fraudulent Transfer Claims in LBOs

34 Id. § 548(a)(A).35 This is a problem in LBOs because the target incurs the debt used to purchase it and secures the loans using its assets. Therefore, the target does not receive the proceeds of the loan. Rather, the shareholders, not the company, receive the funds.36 Id. § 548(a)(B). 37 Kevin J. Liss, Fraudulent Conveyance Law and Leveraged Buyouts, 87 COLUM. L. REV.1491, 1495-96 (1987).38 § 544 of the Bankruptcy Code allows a trustee to avoid transfers under applicable non-bankruptcy law.39 § 550 allows a trustee to recover property that was fraudulently transferred.

8

Geoffrey McAleenan4/19/14

Most fraudulent transfer claims turn on the issue of whether the target was left with

“unreasonably small capital” because private equity firms and other acquirers select targets that

already have and are likely to maintain stable cash flows. Therefore, it is unlikely that the target

was insolvent or likely to become insolvent as a result of the deal. Similarly, in an LBO the

private equity firm has performed its due diligence and reasonably believes that it will be able to

increase the target’s profits, which would allow it to service debts as they matured. For these

reasons, unreasonably small capital is most often the theory of financial distress that will be

argued by creditors.

Unreasonably small capital is not defined in the Bankruptcy Code, but courts have held

that a debtor corporation is left with unreasonably small capital when it was “reasonably

foreseeable” at the time of the transfer that the target company would be left with insufficient

cash flow to operate as a going concern.40 As one court put it, “[t]he difference between

insolvency and unreasonably small capital in the LBO context is the difference between being

bankrupt on the day the LBO is consummated and having at that moment such meager assets that

bankruptcy is a consequence both likely and foreseeable.”41 Courts have resolved the reasonably

foreseeable inquiry by analyzing the reasonableness of the target-company’s cash flow

projections prepared in connection with the LBO, while recognizing that such projections “tend

to be optimistic.”42

Until recently, the prevailing jurisprudence suggested that proving unreasonably small

capital was exceedingly difficult. One court summarized unreasonably small capital as follows:

Unreasonably small capital means something more than insolvency or inability

40 Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787, 794 (7th Cir. 2009). 41 Moody v. Security Pacific Business Credit, 971 F.2d 1056, 1069-70 (3d Cir. 1992).42 Id. at 1072 (“If projects are unreasonable…it will follow that the debtor was left with unreasonably small capital.”).

9

Geoffrey McAleenan4/19/14

to pay debts as they come due. Being left without adequate capital would mean that the transaction in issue put [the corporation] on the road to ruin.[]To sustain his burden, the Trustee must show something more than a deteriorated balance sheet after the LBO or that [the corporation] had difficulty paying its trade creditors. [¶] [T]here is no doubt that the LBO significantly ‘increased the risk’ to [the corporation’s] creditors as claimed by [the solvency expert]. However, reducing the test for ‘unreasonably small capital’ to such a showing would likely mean that any LBO would be a fraudulent conveyance. As stated above, the goal of fraudulent conveyance law is not to provide an insurance policy against business risk for creditors. Rather, the court must balance the need to protect creditors from transactions that cripple a company with the need to preserve the market for a debtor’s assets.43

One scholar criticized the state of fraudulent transfer law by noting that under this regime all a

debtor corporation needed to show in order to overcome a fraudulent transfer claim was

demonstrating that the debtor’s “cash flow forecasts [were] reasonable and [left] enough margin

for error to account for reasonably foreseeable difficulties.”44 However, a recent decision by the

Seventh Circuit has changed the landscape of fraudulent transfer law by making it more difficult

for defendants to overcome fraudulent transfer allegations.

IV. The Boyer Decision Departs From Conventional Fraudulent Transfer Jurisprudence, but Remains the Minority View

In 2009, Judge Richard Posner wrote an opinion rejecting popular jurisprudence in

fraudulent transfer allegations involving LBOs by placing a higher burden on defendants refuting

fraudulent transfer claims. Prior cases involving fraudulent transfer laws and LBOs held that

factors like reasonable survivability, the foreseeability of events causing the target’s insolvency,

and the length of time between the LBO and the bankruptcy filing could defeat fraudulent

transfer claims.45 In Boyer v. Crown Stock Distribution Inc., the Seventh Circuit held that such

43 In re Joy Recovery Technology Corp. 286 B.R. 54, 76 (Bankr. N.D. Ill. 2002) internal citations omitted. 44 Lee B.Shepard, Beyond Moody: A Re-Examination of Unreasonably Small Capital, 57 HASTINGS L.J. 891, 892 (2006). 45 See MFS/Sun Life Trust-High Yield Series v. Van Dusen Airport Servs. Co., 910 F. Supp. 913, 943 (S.D.N.Y. 1995) (holding that plaintiff’s fraudulent transfer claim would fail even if the standard was whether defendants should have foreseen the company’s inability to service its debt); see also Moody v. Security Pac. Bus. Credit, Inc.,

10

Geoffrey McAleenan4/19/14

popular defenses were insufficient to defeat fraudulent transfer claims when a company is

virtually drained of all its cash.46

The Boyer case involved the acquisition of a target corporation through a purchase of the

company’s assets by one of its competitors.47 When the transaction closed, the target’s

shareholders received $3.1 million in cash and a promissory note for $2.9 million. 48 The entire

$6 million purchase price was borrowed from a bank, which was granted a first-priority security

interest on the target’s assets.49 The former shareholders were granted a second-priority lien on

the target’s assets under the promissory note, which was payable several years after the

transaction.50 Prior to the closing, the shareholders transferred roughly $600,000 from the

company’s corporate bank account into a separate account to be distributed to them as a

dividend.51

It quickly became clear that the target had virtually no working capital, and despite

operating for three and a half years after the transaction, it struggled to service its debt, which

had risen to $8.3 million.5253 The target filed for bankruptcy and sold its assets in a Chapter 7

proceeding for approximately $3.7 million, which was used to service the bank debt,54 but the

unsecured creditors were still owed approximately $1.6 million.55 The bankruptcy trustee brought

an action under § 544 of the Bankruptcy Code to recover the funds transferred to the former

971 F.2d 1056, 1073-74 (3d Cir. 1992) (holding that an LBO target that survived a year and a half after its acquisition evidenced that the transaction was not fraudulent). 46 Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787, 795-97 (7th Cir. 2009). 47 Id. at 79048 Id.49 Id.50 Id.51 Id.52 Id. at 794.53 Id. at 791.54 Id. at 791.55 Id.

11

Geoffrey McAleenan4/19/14

shareholders as a fraudulent transfer.56 The bankruptcy court avoided the $6 million transaction

for the company’s assets on the theory that they had been conveyed without the target receiving

reasonably equivalent value in exchange and that the target’s remaining assets were

unreasonably small.57 Despite so holding, the court rejected the trustee’s arguments that the

purchase of the company’s assets was an LBO, that the transaction should be collapsed, and that

the sale of the company’s assets should be considered an asset of the estate recoverable by the

trustee for the benefit of the unsecured creditors.58

On appeal, the Seventh Circuit affirmed the bankruptcy court’s decision to avoid the

transaction, but it applied different reasoning. Rejecting part of the bankruptcy court’s holding,

the Seventh Circuit court found that the purchase of the company’s assets was an LBO regardless

of the form the transaction took.59 The court reasoned that the Uniform Fraudulent Transfer Act

applies to every transfer of assets that leaves the transferor either insolvent, with an unreasonably

small amount of capital, or unable to pay its debts, including LBOs.60 The court went on to say

that fraudulent transfer laws should be applied flexibly, considering a transaction’s substance,

rather than form to avoid unjust results.61 The fact that the target was able to continue operating

for several years after the transaction closed was unpersuasive because of the conditions that

existed at the time the transfer was made.62 By so holding, the Seventh Circuit placed a higher 56 Id.57 Id.58 Id.59 Id. at 792. “[W]hether one calls it an LBO or not is not critical…fraudulent conveyance doctrine…is a flexible principle that looks to substance, rather than form[.]”60 Id. “[The target] started life almost with no assets at all, for all its physical assets were encumbered twice over, and the dividend plus…the interest obligation drained the company of virtually all its cash…so the statutory condition for a fraudulent conveyance was satisfied[.]” 61 Id.62 Id at 795. “The interval was longer than in previous cases, but the defendants are unable to sketch a plausible narrative in which [the target] could have survived indefinitely despite being cash starved as a result of the terms of the LBO that brought it into being. The fact that [the new owner] made mistakes in running the company does not weigh as strongly as the defendants think. Everyone makes mistakes. That’s one reason why businesses need

12

Geoffrey McAleenan4/19/14

burden on defendants who could previously rely on a showing that the transaction’s immediate

effect did not ruin the company.

The decision in Boyer departed from previous LBO jurisprudence by applying fraudulent

transfer laws to LBOs and by refusing to find that the length of time a target survived after an

LBO was a defense against inadequate capitalization.63 By contrast, three other circuit courts

rendered decisions protecting payments made to shareholders in LBOs from fraudulent transfer

claims under § 546(e) of the Bankruptcy Code64 the same year that Boyer was decided.

A. The Eighth Circuit Renders the First Decision Protecting LBO Transfers Under § 546(e) Safe Harbor Provision.

The “safe harbor” provision in § 546(e) provides that

[a] trustee may not avoid a transfer that is a margin payment, as defined in sections 101, 741,65…or settlement payment, as defined in section 101 or 74166…made by or to (or for the benefit of) a …financial institution…or that is a transfer made by or to (or for the benefit of) a commodity broker…[or] financial institution…in connection with a securities contract

unless it can be shown that the transfer was actually, not constructively, fraudulent.67 Before

2009, courts did not consider private securities to fall under the ambit of 546(e) because they

adequate capital to have a good chance of surviving in the Darwinian jungle that we call the market.” 63 This is a common defense asserted by defendants in fraudulent transfer litigation. See e.g., Moody v. Security Pac. Bus. Credit, Inc., 971 F.2d 1056, 1073-74 (3d Cir. 1992); MFS/Sun Life Trust-High Yield Series v. Van Dusen Airport Servs. Co., 910 F. Supp. 913, 944 (S.D.N.Y. 1995); In re Joy Recovery Technology Corp., 286 B.R. 54, 76 (Bankr. N.D. Ill. 2002).64 In re Plassein Int'l Corp., 590 F.3d 252, 258 (3d Cir. 2009); In re QSI Holdings, Inc., 571 F.3d 545, 550 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 986 (8th Cir. 2009).65 11 U.S.C.A. § 101(38) (West 2010). “Margin payment means… payment or deposit of cash, a security or other property, that is commonly known in the forward contract trade as original margin, initial margin, maintenance margin, or variation margin, including mark-to-mark payments, or variation payments.” 66 Id. § 101(51A) “Settlement payment” is defined as “a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade.” Emphasis added. 67 Id § 546(e). Emphasis added.

13

Geoffrey McAleenan4/19/14

interpreted the definition of “settlement payments” as referring only to public securities

markets.68

The Eighth Circuit was the first to exempt from avoidance payments that were made to

shareholders in exchange for privately held securities in an LBO transaction as settlement

payments.69 Contemporary Indus. Corp. v. Frost involved a closely held corporation whose

shareholders sold their shares for $26.5 million in an LBO.70 The investment group initially

deposited the funds into a bank, and the shareholders deposited their shares with the same bank.71

The parties then entered into an escrow agreement controlling the distribution of the funds to the

shareholders.72

Two years after the LBO completed, Contemporary Industries filed bankruptcy, and the

creditors’ committee appointed to oversee the bankruptcy proceedings sought to avoid the

payment made to the former shareholders as a fraudulent transfer.73 The shareholders argued that

the payments were exempt from avoidance under section 546(e) as settlement payments, and the

bankruptcy court granted summary judgment to the shareholders.74 On appeal, the Eighth Circuit

affirmed, holding that nothing in the definition of settlement payments suggested Congress did

not intend the term to apply to private securities.75 The creditors’ argued that the payments were

68 In re Norstan Apparel Shops, Inc., 367 B.R. 68, 76 (Bankr. E.D.N.Y. 2007) (holding that the modifying phrase at the end of 11 U.S.C. § 741(8) must be understood to mean that in order to be encompassed in the statutory definition of “settlement payment,” a transaction must involve the public securities markets).69 Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 986 (8th Cir. 2009). 70 Id. at 983. 71 Id.72 Id.73 Id. 74 Id. at 981. 75 Id. at 985.

14

Geoffrey McAleenan4/19/14

not made by or to a financial institution76 (as required to invoke 546(e))77 because the bank acted

only as a conduit for the payments and never obtained a beneficial interest in the payments.78 The

court rejected their argument reasoning once more that the plain language of 546(e) does not

require the financial institution involved to obtain a beneficial interest in the funds.79

While acknowledging that 546(e) provided a strong defense for former shareholders, the

court continued to rely on the plain language of the statute when it cautioned in dicta that the

requirement that a settlement payment must be commonly used in the securities trade would

probably not include transactions clearly abusing the exemption.80

B. The Sixth Circuit Adopts the Plain Language Reasoning of the Eighth Circuit in Expanding the Definition of “Settlement Payment.”

The Sixth Circuit followed the Eighth Circuit’s lead and concluded that § 546(e) applied

to payments made to former shareholders.81 In re QSI Holdings, Inc. involved a debtor

corporation whose principal shareholders agreed to a merger with another company and its

subsidiary. 82 The total purchase price for the LBO was approximately $208 million, and the

shareholders received $111.5 million of the balance in cash and $91.8 million in stock.83 To

complete the transaction, the acquirer deposited the $111.5 million with a bank acting as an

76 11 U.S.C.A. § 101(22) (West 2010). The term “financial institution” means a Federal reserve bank, or any entity that is a commercial or savings bank, industrial savings bank, savings and loan association, trust company, federally-insured credit union, or receiver, liquidating agent, or conservator for such entity[.]” 77 “[T]he trustee may not avid a transfer that is a…settlement payment…made by or to (or for the benefit of) …a financial institution.” 11 U.S.C.A § 546(e) (West 2010) emphasis added.78 Contemporary Indus. Corp., at 986. 79 Id. at 987.80 Id n.5. 81 In re QSI Holdings, Inc., 571 F.3d 545 (6th Cir. 2009). 82 Id. at 547. 83 Id. at 548.

15

Geoffrey McAleenan4/19/14

exchange agent.84 The same bank collected the stock from the shareholders and then transferred

the securities to the acquirer and transferred the cash to the former shareholders.85

Two years after the LBO, the acquired company declared bankruptcy and asserted

fraudulent transfer claims against its 170 former shareholders to recover the money paid to

them,86 arguing that the payments were not exempt from avoidance under 546(e).87 Consistent

with the Eighth Circuit, the Sixth Circuit held that the transfer of consideration in an LBO is

satisfies the definition of “settlement payment” as defined in the securities industry, and that

nothing in 546(e) prevents its application from settlement payments involving private

securities.88 Additionally, the court held that a financial institution does not need to obtain a

beneficial interest in a transaction to receive 546(e) protection.89

C. The Third Circuit Relies on the Eighth and Sixth Circuit Decisions to Reach The Same Conclusion

Finally, the Third Circuit rendered a decision aligning with the Sixth and Eighth Circuits,

holding that payments made to shareholders of target companies through LBOs are settlement

payments shielded from avoidance.90 In re Plassein Int’l. Corp. involved a corporation that was

formed for the express purpose of acquiring several privately held companies through LBOs.91

After agreeing to the buyouts, each target delivered its shares to directly to the acquirer, who in

turn directed its bank to wire funds to the shareholders’ accounts at their various banks.92 When 84 Id.85 Id.86 Id. at 547. 87 Id at 549. 88 Id. at 550. 89 Id. at 551. 90 In re Plassein Int’l. Corp., 590 F.3d 252, 258 (3d Cir. 2009). 91 Id. at 254.92 Id. at 255.

16

Geoffrey McAleenan4/19/14

the corporation later filed bankruptcy, the trustee initiated fraudulent transfer proceedings against

the former shareholders.93

The Third Circuit held that the payments were settlement payments made by or to a

financial institution and therefore were exempt under 546(e),94 stating “a payment for shares

during [an LBO] is obviously a common securities transaction, and…therefore…is also a

settlement payment.”95 The court also explained that even though the payments did not travel

through the system of intermediaries usually employed in securities transactions, the transactions

still satisfied the financial institution requirement in 546(e) because banks were implicated in the

transfers.96

D. Reconciling the Majority View with the Minority View Expressed in Boyer

The safe harbor provision contained in 546(e) appears to give shareholders that receive

LBO payments through one of the statutorily enumerated financial institutions a strong defense

against constructive fraudulent transfer claims. A subtle, but crucial difference between the

Boyer case and the decisions by the Third, Sixth, and Eighth Circuits is that the shareholders in

Boyer received their payment directly from the acquirer, whereas the shareholders in the other

three cases had their funds distributed to them by a financial institution. Those decisions did not

even need to address the elements of constructively fraudulent claims like the Seventh Circuit in

Boyer because 546(e) dispenses with the need to conduct the analysis.

However, two recent cases have called into question the straightforward application of

the plain language in 546(e) to fraudulent transfer claims levied against bankrupt LBOs. Instead,

these decisions have relied on Congressional intent to determine that 546(e) does not 93 Id. at 255.94 Id. at 258.95 Id. (quoting In re Resorts Int’l. Inc., 181 F.3d 505, 515 (3d Cir. 1999).96 Id. at 258.

17

Geoffrey McAleenan4/19/14

ubiquitously apply to LBOs.

E. Recent Decisions Hold That Stock Payments Made to Shareholders in LBOs May Not Be Protected By 546(e) in Certain Circumstances

A pair of decisions from New York declined to extend the safe harbor protection of

546(e) to LBOs that seemingly fell within the ambit of the statute. In re MacMenamin’s Grill

Ltd. involved facts substantially similar to the cases in the Eighth, Sixth, and Third Circuits.97

The parties, the trustee, and the court all agreed that the payments made to the former

shareholders of a bankrupt LBO target fell within the statutory definition of 546(e), and everyone

agreed that the payments were securities made by and/or to a financial institution.98 However, the

judge held that the payments were not entitled to the safe harbor of 546(e).99

The court reasoned that the definition of settlement payments was ambiguous because it

is circular and self-referential, rendering it unhelpful.100 To resolve the ambiguity, the court

consulted the statute’s legislative history to determine Congress’s intent when it passed the

statute, which was to reduce the systemic risk to the financial markets in the event of a major

bankruptcy.101 The court found that applying 546(e) in this case would violate congressional

intent because neither the shareholders nor the bank through which the LBO was financed were

participants in any securities market, and therefore the avoidance of the payments would not

pose a threat to any particular market.102

Two years after In re MacMenamin’s Grill Ltd. was decided, the Southern District of

97 In re MacMenamin’s Grill Ltd., 450 B.R. 414, 417-18 (Bankr. S.D.N.Y. 2011). The debtor corporation used a loan to fund a stock repurchase from shareholders owning 93% of the company’s stock. A bank disbursed the payments to the shareholders’ financial institutions. However, the buyout was peculiar because it was for a small bar owned by three shareholders for roughly $1 million.98 Id at. 418-19. 99 Id. at 425-26. 100 Id. at 422. 101 Id. at 419-20. 102 Id. at 425-26.

18

Geoffrey McAleenan4/19/14

New York decided In re Tribute Co. Fraudulent Conveyance Litig., holding that the safe harbor

afforded by 546(e) did not preclude individual creditors from filing state-fraudulent transfer

claims.103 The court reached this conclusion by examining the statutory language of 546(e).

Specifically, the court reasoned that if Congress meant to bar individual creditors from asserting

state-fraudulent transfer claims involving settlement payments made by or to a financial

institution, it could have simply said so.104 Additionally, the court noted that because trustees

have a unique rule in bankruptcy proceedings, it was plausible that Congress would apply

limitations to trustees and not to others.105 In conclusion, the court held that creditors who had no

relation to the bankruptcy trustee were not barred by 546(e) from asserting state fraudulent

transfer claims the trustee could not.106

These decisions cast doubt on whether 546(e) is an all-encompassing safe harbor. The

Third, Sixth, and Eighth Circuits rendered decisions based on the plain meaning of the statute,

yet the courts in New York found the language ambiguous and unhelpful. Meanwhile, the

Seventh Circuit decision in Boyer did not involve a financial institution, but it placed a higher

burden on shareholder defendants in LBOs to avert avoidance. The shifting state of fraudulent

transfer jurisprudence may force the Supreme Court to address the disagreement among the

courts, and the magnitude of the impending EFH bankruptcy may give it the platform to do so.

V. The TXU Leveraged Buyout

103 In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310, 321 (S.D.N.Y. 2013) (citing Kathy B. Enterprises, Inc. v. United States, 779 F.2d 1413, 1415 (9th Cir. 1986). “The trustee’s exclusive right to maintain a fraudulent conveyance action expires and creditors may step in (or resume actions) when the trustee no longer has a viable cause of action.” 104 Id. at 315. “Section 546(e) addresses its prohibition on avoiding settlement payments only to the bankruptcy trustee…[and] Congress says in a statute what it means and means in a statute what it says there.” 105 Beth Jinks and Richard Bravo, Holdings, the Biggest-Ever LBO, BLOOMBERG BUSINESSWEEK (Oct. 24, 2013) http://www.businessweek.com/articles/2013-10-24/buyout-firms-clash-over-energy-future-holdings-the-biggest-ever-lbo 106 Id.

19

Geoffrey McAleenan4/19/14

Private equity firms Kohlberg, Kravis, Roberts, & Co. (KKR), TPG Capital, and

Goldman Sachs acquired TXU (later renamed Energy Future Holdings) through a leveraged

buyout in 2007 for $48 billion.107 KKR and TPG each contributed $3.5 billion to fund the

acquisition, and Goldman Sachs contributed another $1.5 billion.108 The remaining investment

capital came from debt.109 The private equity sponsors were confident in their investment

because TXU was the largest power company in Texas and because TXU’s plants were coal-

powered during a time when natural gas prices were reaching record highs.110 The sponsors

optimistically predicted that natural gas prices would either remain stable or continue to rise,

which would give TXU’s coal-powered plants a competitive advantage in the market.

Sound reasoning notwithstanding, the venture has proven disastrous for the sponsors and

investors. Ironically, the national average price for natural gas plummeted; due largely in part to

shale drilling that provided an abundance of domestic natural gas.111 The resulting decline in

natural gas prices created easier entry into the energy market for new competitors, which forced

EFH to reduce its prices, effectively preventing the company from expanding. EFH’s inability to

generate profits has made it difficult to service its bank debt, which in turn has forced it into

bankruptcy.

107 Id. 108 Id.109 Beth Jinks & Richard Bravo, KKR to Goldman Skirmish for Scraps as LBO Bankruptcy Looms, BLOOMBERG (Oct. 21, 2013, 10:17 AM) http://www.bloomberg.com/news/2013-10-21/kkr-to-goldman-joined-in-scraps-skirmish-as-lbo-bankruptcy-looms.html 110 James Osborne, EFH files for SEC extension, delays interest payment as bankruptcy negotiations continue, DALLAS NEWS (Mar. 31, 2014, 3:58 PM) http://bizbeatblog.dallasnews.com/2014/03/efh-files-for-sec-extension-as-bankruptcy-negotiations-continue.html/111 NASDAQ (last visited Apr. 4, 2014) http://www.nasdaq.com/markets/natural-gas.aspx?timeframe=7y

20

Geoffrey McAleenan4/19/14

Currently, EFH is buried under a mountain of debt in excess of $40 billion.112

Negotiations with creditors to restructure the company’s debt are still ongoing, but it appears that

an amicable solution may not be reached. With all roads leading to a contentious bankruptcy, it is

likely that fraudulent transfer claims may become a central issue in the proceedings.

A. TXU Fraudulent Transfer Claims

The strongest fraudulent transfer claim creditors have against the TXU LBO is that it left

the company with unreasonably small capital. Courts have held that a debtor corporation is left

with unreasonably small capital when it was “reasonably foreseeable” at the time of the transfer

that the target company would be left with insufficient cash flow to operate as a going concern.113

Apparently, it was reasonably foreseeable to everyone except the private equity firms that

the deal would render TXU with unreasonably small capital. The TXU LBO was met with

opposition from the Texas Legislature, as well as a variety of economic experts and consumer

advocates, who insisted that the Public Utility Commission of Texas (PUC) review the deal

before allowing it to go forward.114 The private equity firms sunk $17 million into hiring

lobbyists to keep the deal progressing, which culminated in the Texas Legislature passing a bill

requiring PUC oversight of future buyouts, but not TXU.115 EFH immediately experienced

setbacks. EFH reported losses of $8.86 billion following the LBO, forcing it to shut down 15

generating plants in Texas that could not be operated profitably.116 In 2010, the company

112 Richard Bravo and Beth Jinks, Energy Future Said to Arrange Bankruptcy Loans, BLOOMBERG (Mar. 13, 2014, 4:31 PM) http://www.bloomberg.com/news/2014-03-13/energy-future-said-to-arrange-7-billion-of-bankruptcy-financing.html 113 Id. 114 Will Deener, Energy Future Holdings Hit Hard By Lower Gas Prices After Huge Leveraged Buyout, DALLAS MORNING NEWS, (Nov. 26, 2010, 2:27 PM) http://www.dallasnews.com/business/headlines/20100822-Energy-Future-Holdings-hit-hard-by-4828.ece. 115 Supra note 11.116 Supra note 12.

21

Geoffrey McAleenan4/19/14

reported a net loss of $2.8 billion and another loss of $1.9 billion in 2011.117

It is possible that a court could find that TXU “had been so depleted by the debt it had

taken on that it had been…on “life support” from the get-go[,]”118 thereby upholding fraudulent

transfer claims against former shareholders despite the company’s seven years of operation since

the LBO. On the other hand, because the private equity firms employed Mellon Investor

Services, LLC as a disbursing agent to pay out the LBO funds to the shareholders, a court could

find that the shareholder payments are protected by the safe harbor of section 546(e).119 Whatever

the decision, if any, it could finally lead the Supreme Court to settle the dispute concerning

fraudulent transfer claims and provide some much needed guidance to the lower courts.

VI. Conclusion

The largest LBO in history filed bankruptcy, and fraudulent transfer claims may abound

to satisfy EFH’s debt obligations. A bankruptcy of this magnitude, and any ensuing decision

regarding fraudulent transfer claims, could potentially lead the Supreme Court to grant cert and

settle the tension surrounding fraudulent transfer jurisprudence.

117 Supra note 12. 118 Boyer v. Crown Stock Distribution, Inc. 587 F.3d 787, 791 (7th Cir. 2009). 119 TXU Corp. Announces Completion of Acquisition By Investors Led by KKR and TPG, KKR (Oct. 10, 2007) http://media.kkr.com/media/media_releasedetail.cfm?ReleaseID=332996.

22