An LBO is a type of acquisition whereby the cost of buying a company is financed primarily with loans to be repaid by the company. LBOs are often executed by private equity firms who raise the debt needed to complete the purchase from banks, mezzanine financing, and bond issues. The exiting ownership (i.e., the sellers) may also provide financing by taking delayed payments and creating a further debt of the company.
A key feature of an LBO is that the borrowing takes place at the company rather than the equity level. The purchased company borrows money from a lender to pay out the former owner and usually secures the loan with liens on the company’s assets. Usually, following the transaction, the company whose ownership was purchased will owe more, and will have less net worth, than before the transaction, most of the difference having been paid to the company’s former owners.
The company’s unsecured creditors may be unhappy or pleased with this development, depending on the particular creditor and the circumstances of the transaction. In many cases, a sophisticated, well-financed new equity investor group with the determination to make the company a success, or a strong new management team that is highly motivated by its equity interest, can more than offset any risk to creditors created by the additional debt taken on by the company. LBOs may also result in substantial tax advantages to the company and other parties to the transaction.
Not all LBOs are successful, however, and when the company subsequently fails or files for bankruptcy with insufficient assets to pay all of its creditors, the lender who financed the LBO and whose liens now encumber all of the company’s assets is almost always one of the targets of the company’s bankruptcy trustee and/or other creditors. Such parties often assert claims for “constructive fraud” against both the selling owners and the financing lender under state and federal bankruptcy laws, including fraudulent transfer laws. These claims assert that the grant of liens to the lender occurred while the company was insolvent or left with unreasonably small capital and that the company received less than reasonably equivalent value for granting the liens thus making such liens and claims potentially avoidable and/or unenforceable. Bankruptcy trustees may also seek to “equitably subordinate” the claims and liens of the LBO lender. If the lender’s liens are equitably subordinated, the lender will not be paid from its collateral until such collateral has been used to pay some or all of the claims of the unsecured creditors.
Ever since corporate raiders of the 1980s first used LBOs to take over public companies, there has been tension about the legality of LBOs. The earliest and most well-known cases to impose liability on lenders who financed an LBO were the “Gleneagles” cases decided in the early 1980s. In those cases, the parties had utilized a complex LBO structure which was apparently intended to create the appearance of separation between the equity purchases and the lender’s mortgages. The Gleneagles court collapsed the transactions and found that the mortgages were part of an attempt to use the debtor’s assets for the stockholders’ benefit at the expense of the unsecured creditors. Since the Gleneagles cases, there have been numerous challenges around the country to the liens and claims of lenders who financed LBOs.
The 1991 “O’Day Corporation” case in the Bankruptcy Court for the District of Massachusetts involved the post-LBO bankruptcy of a sailboat manufacturer. The buyout was primarily financed by loans from Meritor Savings Bank. The Trustee successfully sued Meritor and avoided certain of its security interests in O’Day’s property as fraudulent transfers. The Court concluded that the LBO left O’Day both insolvent and with unreasonably small capital. Similar to the Gleneagles cases, the LBO had been structured in multiple parts to help defend against fraudulent transfer claims, however, the Court collapsed the various parts of the transaction and determined that almost all of the loan proceeds had been paid to the shareholders with no corresponding value paid to O’Day. The O’Day Court also equitably subordinated certain of Meritor’s secured claims to the claims of unsecured creditors based upon Meritor’s conduct in the administration of its loan including demanding that O’Day delay payments to other creditors.
More recently, lenders have been less concerned with LBO related liability based upon Section 546(e) of the Bankruptcy Code. This section provides a “safe harbor” that protects certain types of transfers involving securities settlement payments and securities contracts from being “avoided” as constructive fraudulent transfers. The safe harbor is intended to ensure “certainty, speed, finality, and stability” in the securities markets. Courts have interpreted Section 546(e) broadly to protect lenders from liability in many failed LBO transactions.
While the protections of Section 546(e) have been supported and expanded by many courts, including in the recent “Tribune” case in New York, other courts, including the United States Supreme Court in the “Merit Management” case, have placed limitations on the use of the safe harbor. Several courts have held that the Section 546(e) safe harbor is not available to protect lenders and selling shareholders in LBOs of privately held companies where there is no danger or risk to any securities market. The Section 546(e) safe harbor also does not appear to bar law suits by bankruptcy trustees to equitably subordinate the claims and liens of lenders participating in LBOs to the claims of unsecured creditors of the target company.
Here are some protective measures and other considerations for lenders to take into account when financing an LBO:
(i) Structuring the Transaction / Assumption of Risk. The net result, in most LBO transactions is that the existing owners of the business are paid for their interest in the business and the business assets are used to secure the loans from financial institutions to fund the payment. Despite efforts to insulate LBO deals from attack at a later date, courts do not hesitate to collapse such transactions. Lenders should consider structuring the risk involved in the deal to require that the selling owners bear the risk of the transaction being unwound in a later bankruptcy or state court proceeding.
(ii) Financial Condition. In most LBOs, it will be difficult if not impossible for the lenders to establish that the target borrower has received reasonably equivalent value or fair consideration for the transaction. Thus, the issue of insolvency and continued economic viability becomes an important focus. For example, access to a line of credit may be considered to be an important element in determining whether the debtor retained sufficient capital following the transaction. A lender should require, as a condition to financing an LBO, a fair valuation appraisal of the borrower’s assets by a capable appraiser which shows solvency of the borrower following the transaction. The Lender should also analyze the borrower’s liabilities including contingent liabilities that may not appear on its balance sheet, such as under- or unfunded pension plan liabilities and guaranties. The lender will also need to determine whether the debtor will have sufficient cash flow to service the debt which is to be incurred in the LBO. These projections should initially be provided by the borrower but should also be reviewed by an independent third party such as an investment banker retained by the borrower. The lender should also review the sales budgets, cash budgets, gross and net profit margins, inventory turnover and accounts receivable collectability based upon a historical record of the borrower/company. In addition to the borrower’s certified projections, the lender should rely upon a solvency letter from at least one outside expert and its own realistic projections.
(iii) Financial Ratios. Following most LBOs, certain financial ratios (e.g., debt/equity ratios) will be skewed when compared with traditional ratios within which lenders have required borrowers to perform. If the ratios are out of line with other companies in the same line of business, however, there may be some questions regarding the accuracy of the borrower company’s projected cash flow and how the cash flow will overcome the negative effect of the ratios. The lender may mitigate this problem by requiring the selling equity owners to receive payment of at least a portion of their equity over time in the form of subordinated debt.
(iv) Identity of Purchaser. If the potential purchaser in an LBO has a seasoned track record in business and business acquisitions, this improves the chances that the LBO will later be viewed by a court as having been performed in a careful manner with the participants reasonably believing that the LBO would be successful. If the seller in an LBO took no interest in the background of the buyer and its business acumen, there will arise negative implications concerning the intent of the parties in going through with the LBO.
(v) Creditor Notification. The participants should consider providing notice of the LBO to creditors of the target company. The ability to challenge an LBO may be impaired if there are only creditors whose claims arose post-buyout and/or who were aware of the LBO when they extended credit. Conducting the LBO in a public manner may reduce the ability of existing creditors who are put on notice of the LBO to assert claims resulting from the failure of the LBO at a later date.
These are some (but certainly not all) of the steps that a lender can take when considering financing an LBO. It is critical that a lender consider the potential issues involved in LBO transactions and accurately assess the likelihood of the transaction being challenged. Lenders should certainly seek the advice of experienced consultants, accountants and legal counsel for these types of deals.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.