Former shareholders in leveraged buyouts may be sued by the estate representative or by creditors to recover funds paid to them for their shares as fraudulent transfers under federal or state law if the debtor subsequently files for bankruptcy. The authors discuss the claims and defenses in such suits, focusing on two pending bankruptcy cases that raise, among other things, the scope of the "safe harbor" for payments made to complete a securities transaction or a securities contract.

In a bankruptcy fraudulent transfer suit, a representative of the bankruptcy estate, usually a bankruptcy trustee or a debtor-in-possession, sues individuals and business entities to unwind (or "avoid") the fraudulent transfer, and to recover the money or property that was transferred before the debtor filed for bankruptcy. If the estate representative prevails in the suit, the net proceeds of the recovery will be distributed to the debtor's creditors according to the payment priority scheme set forth in the Bankruptcy Code.

Former shareholders of a company that has gone into bankruptcy may find themselves on the receiving end of a fraudulent transfer suit, which may come as a rude awakening to those who participated in open transactions in public markets with no expectation that the company from which they received a payment or distribution was destined for bankruptcy. Nevertheless, former shareholders may be found legally obligated to return the sums of money paid to them. This article examines the implications and risks presented to shareholders for fraudulently transferred property, focusing in particular on one type of transaction that, under certain circumstances, may be avoided as a fraudulent transfer – the leveraged buyout.

In some cases, former shareholders sued for alleged fraudulent transfers have found a so-called "safe harbor" created under amendments to the Bankruptcy Code for the protection of settlement payments in the securities markets.1 Creditors' efforts to skirt that safe harbor or – depending on your point of view – to confine it within its statutory limits, are now at issue in the fraudulent transfer cases arising from two recent bankruptcies, Lyondell and Tribune Company. We discuss these cases below.

CLAWING BACK THE DEBTOR'S PROPERTY: FRAUDULENT TRANSFER LAWS

"Fraudulent transfer law originally developed in response to a very specific problem: debtors on the verge of insolvency would sometimes transfer their assets to friends or relatives for nominal consideration, leaving little or no value in their estates to satisfy the claims of other creditors."2 To curb this problem, which was thought to be widespread in sixteenth-century England, Parliament in 1571 passed the "Statute of 13 Elizabeth," making transfers made to hinder, delay, or defraud creditors illegal and void.3 The Statute of 13 Elizabeth "has been either enacted [in substance] in American statutes prohibiting such transactions or has been incorporated into American law as a part of the English common law heritage."4 Although their roots trace back hundreds of years, fraudulent transfer laws and doctrines have significant and complex implications for modern corporate transactions.

Types of Fraudulent Transfers

Generally, there are two types of fraudulent transfers. The first is an actual or intentional fraudulent transfer, which occurs when debtors transfer their property with the intent to "hinder, delay, or defraud" their creditors. For this issue generally, it is the intent of the debtor that most courts regard as relevant. The knowledge or good faith of the transferee may be relevant as to other issues. Because debtors trying to shield their property from creditors rarely admit that they have intended to do so, the law recognizes certain circumstantial evidence from which fraudulent intent may be inferred, known as the badges of fraud. A creditor can thus establish that the debtor intended to hinder, delay, or defraud creditors by showing some or all of the following badges: (i) the transfer was to an insider; (ii) the debtor retained possession or control of the transferred property after the transfer; (iii) the transfer was concealed; (iv) before the transfer was made, the debtor had been sued or threatened with suit; (v) the transfer was of substantially all the debtor's assets; (vi) the debtor absconded; (vii) the debtor removed or concealed assets; (viii) the value of the consideration received by the debtor was not reasonably equivalent to the value of the asset transferred; (ix) the debtor was insolvent or became insolvent shortly after the transfer was made; (x) the transfer occurred shortly before or shortly after a substantial debt was incurred; and (xi) the debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor.5

The second type is a constructive fraudulent transfer. In a constructive fraudulent transfer, a creditor need not prove actual intent, but must show that the debtor transferred its property to another person in exchange for something of no value or less than fair value and (i) the debtor was insolvent when the transfer was made; or (ii) the debtor was rendered insolvent as a result of the transfer.6 Generally, a debtor is considered insolvent if the total fair value of its assets is less than the total amount of its debts.7 Another form of constructive fraudulent transfer might occur if the debtor transferred property or incurred an obligation in exchange for less than a reasonably equivalent value and (i) the debtor was engaged or was about to engage in a business or a transaction for which the debtor's remaining assets were unreasonably small in relation to the business or transaction; or (ii) the debtor intended to incur, or believed or reasonably should have believed that it would incur, debts beyond its ability to pay as they became due.8

State Fraudulent Transfer Laws

Most states in the U.S. have codified their fraudulent transfer laws in the form of either the Uniform Fraudulent Conveyance Act ("UFCA") or the Uniform Fraudulent Transfer Act ("UFTA").9 In substance, the UFCA and the UFTA are substantially similar. Courts endeavor to apply these two statutes uniformly, looking to the legal precedents of other states as authoritative.10 Moreover, as explained below, bankruptcy trustees or other authorized representatives of the bankruptcy estate can assert state-law fraudulent claims derivatively, standing in the shoes of creditors, in addition to avoidance claims premised on parallel fraudulent transfer provisions contained in the Bankruptcy Code. Because state fraudulent transfer laws and the fraudulent transfer provisions of the Bankruptcy Code share the same purpose of protecting creditors, a court's interpretation of the Bankruptcy Code provisions may be instructive as to the meaning or application of the state fraudulent transfer laws, and vice-versa.11

Broad Concept of "Transfer"

Courts and state laws tend to give broad definition to the notion of a "transfer." For example, the UFTA defines "transfer" as "every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with an asset or an interest in an asset, and includes payment of money, release, lease, and creation of a lien or other encumbrance."12 This UFTA definition is not limitless but is obviously crafted to encompasses a vast array of transactions. In addition, a debtor's incurrence of a debt or obligation may be subject to avoidance as a fraudulent transfer.13

BANKRUPTCY: CORE CONCEPTS

Absent Bankruptcy, a Potential "Race to the Courthouse"

If a debtor is facing multiple creditors seeking to collect the debts owed to them, a "race to the courthouse" by creditors may ensue – e.g., unsecured creditors, out of self-interest, may race to the courthouse in order to be the first to obtain judgments against their debtor and thereby be the first to collect the debtor's assets in order to satisfy the debt. Needless to say, if the debtor is in dire financial straits and holds few remaining assets that are capable of being converted into cash, the creditor who reaches the debtor's assets first is more likely to have a larger percentage of its claim paid than similarly situated creditors who act slowly. Although legal, such a state of affairs often leads to inequitable outcomes, since similarly situated unsecured creditors will have varying recoveries depending on how quickly they initiated collection against the debtor. The same concept applies to other creditor remedies, such as the fraudulent transfer laws – creditors who are the first to avoid and recover property from the debtor's transferees are more likely to have a greater percentage of the debt owed to them paid than the slower-moving creditors.

Bankruptcy: A Collective Proceeding Among Creditors

Bankruptcy is intended to stop a race to the courthouse and thereby avoid its downsides. Bankruptcy law "in large measure simply requires many diverse creditors to act as one. . . . [B]ecause of the presence of bankruptcy law, each creditor may have to spend less to ensure that it isn't left behind in any ensuing race."14 Bankruptcy law modifies or adjusts the creditors' state-law rights to ensure an orderly administration of the debtor's assets for the purposes of maximizing asset values and making an equitable distribution to creditors.15

Automatic Stay. Once a debtor files for bankruptcy protection, a statutory stay goes into effect automatically, preventing creditors from exercising their legal rights and remedies against the debtor.16 Thus, the automatic stay halts the race to the courthouse. Among other things, the filing of a bankruptcy will stay "any act to collect . . . or recover a claim against the debtor."17 The bankruptcy filing also stays any act to obtain possession of "property of the estate," a topic that is addressed below.18 Some courts interpret acts to "recover a claim against the debtor" to include actions against non-bankrupt transferees to avoid and recover fraudulent transfers.19 Other courts have concluded that actions to avoid and recover fraudulent transfers are stayed as acts to obtain possession of property of the estate.20 Either way, the automatic stay bars creditors from pursuing fraudulent transfer claims that, absent the bankruptcy filing, would have been available to them under state law.

Chapter 7 Liquidation. Chapter 7 of the Bankruptcy Code provides for a "straight liquidation" of the debtor's assets. Generally, in a Chapter 7 liquidation, a trustee is appointed to take control of the debtor's assets and to convert those assets capable of being liquidated into cash. The net proceeds of liquidation, if any, are then distributed on an equitable or pro rata basis to unsecured creditors. In most cases, individuals who file Chapter 7 are discharged from their debts at the conclusion of their case.21 Business entities, such as corporations, that file Chapter 7 do not receive a discharge of their debts.22 Instead, their business operations cease, and their assets are sold or abandoned by the Chapter 7 trustee.

Chapter 11 Reorganization. Generally, in a Chapter 11 reorganization, the debtor becomes a debtor-in-possession with most, but not all, of the powers of a Chapter 7 trustee. In a Chapter 11 reorganization, the debtor's business operations may continue, and the debtor's assets are administered and its debts restructured and paid in accordance with a plan of reorganization that is accepted by a vote of the creditors and is approved (confirmed) by the bankruptcy court if the plan satisfies the requirements of the Bankruptcy Code.23 If a corporate debtor remains in business in accordance with the confirmed plan of reorganization, that debtor will be discharged of its debts.24 Nevertheless, if the confirmed plan of reorganization does not provide for payment in full of the debts owed to any class of unsecured creditors, and if that class of unsecured creditors did not accept the plan, the shares or equity interests in the corporate debtor likely will be extinguished.

Absolute Priority Rule. As a general matter, a bankruptcy court cannot confirm a plan that permits equity holders to retain their interests in the reorganized debtor but fails to pay in full a class of creditors that did not vote to accept the plan.25 The requirement that dissenting creditors be paid in full before the debtor's equity holders may retain their shares or interests in the reorganized debtor is called the "Absolute Priority Rule." As a result of the Absolute Priority Rule, it is not uncommon for general unsecured creditors to become the new equity holders, or to find themselves among the new equity holders, of the reorganized company.

Avoidance Powers

The Bankruptcy Code grants the bankruptcy trustee, or a debtor-in-possession acting as a trustee in Chapter 11, the exclusive right to avoid and recover fraudulent transfers for the benefit of creditors. As noted above, creditors are stayed from pursuing their individual rights or claims against the recipients of fraudulently transferred property. The trustee pursues actions to avoid and recover fraudulent transfers in order to augment the bankruptcy estate for the collective benefit of all unsecured creditors of the debtor.26

Section 548 of the Bankruptcy Code is the federal fraudulent transfer law that is operative in bankruptcy cases, and it enables a trustee to avoid intentional and constructive fraudulent transfers made within two years of the debtor's bankruptcy filing.27 Additionally, section 544(b) of the Bankruptcy Code provides in relevant part that "the trustee may avoid any transfer of an interest of the debtor in property that is voidable under applicable law by a creditor holding an unsecured claim."28 In other words, under section 544(b), the trustee wields derivatively the avoidance rights of an actual creditor under the UFCA, the UFTA, or other law that may be applicable.

It may be more advantageous for the trustee to invoke "applicable [non-bankruptcy] law" – usually, state law – under section 544(b) in lieu of, or in addition to, section 548. For example, whereas the "reach-back" period under section 548 is two years, the UFTA provides for a longer period with respect to most types of fraudulent transfer claims, enabling the trustee to avoid transfers made within four years of the bankruptcy filing.29 Moreover, even if only one unsecured creditor is entitled to avoid the transfer under applicable law, the trustee may, in accordance with section 544(b), step into that creditor's shoes and avoid the transfer, not merely to the extent of that creditor's claim, but in its entirety for the benefit of the debtor's unsecured creditors as a whole.30

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Footnotes

1 11 U.S.C. § 546(e).

2 Michael Simkovic and Benjamin S. Kaminetzky, Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution, 2011 Colum. Bus. L. Rev. 118, 135 (2011).

3 Douglas G. Baird and Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829, 829 (1985) (citing 13 Eliz., ch. 5 (1571)).

4 Wieboldt Stores, Inc. v. Schottenstein, 94 B.R. 488, 499 (N.D. Ill. 1988).

5 Uniform Fraudulent Transfer Act § 4(b) (hereinafter, "UFTA").

6 See, e.g., id. § 5(a).

7 See, e.g., id. § 2(a). Additionally, a debtor is presumed to be insolvent if it is generally not paying its debts as they become due. Id. § 2(b).

8 Id. § 4(a)(2).

9 The UFCA is the earlier of the two uniform laws, first adopted in 1918. The UFTA has been adopted in more than 40 states and the District of Columbia. 1 Grant W. Newton, Bankruptcy and Insolvency Accounting, Practice and Procedure § 5.40(a) at 250 (7th ed. 2009).

10 UFTA § 11 (requiring that the UFTA be construed and applied to effectuate its general purpose to make the law uniform among the states that have enacted the UFTA); UFCA § 11 (same with respect to the UFCA); see also, e.g., Farstveet v. Rudolph ex rel. Eileen Rudolph Estate, 630 N.W.2d 24, 30 (N.D. 2001).

11 In re Tiger Petroleum Co., 319 B.R. 225, 232 (Bankr. N.D. Okla. 2004); Schempp v. Lucre Mgmt. Grp., 18 P.3d 762, 764 (Colo. App. 2000).

12 UFTA § 1(12).

13 See, e.g., id. §§ 4(a) & 5(a).

14 Douglas G. Baird and Thomas H. Jackson, Cases, Problems, and Materials on Bankruptcy 40 (2d ed. 1990).

15 NLRB v. Martin Arsham Sewing Co., 873 F.2d 884, 887 (6th Cir. 1989).

16 11 U.S.C. § 362(a).

17 Id. § 362(a)(6).

18 Id. § 362(a)(3).

19 In re Colonial Realty Co., 980 F.2d 125, 131-32 (2d Cir. 1992).

20 In re MortgageAmerica Corp., 714 F.2d 1266, 1277 (5th Cir. 1983).

21 11 U.S.C. § 727(a).

22 Id. § 727(a)(1).

23 Id. §§ 1108 & 1129(a).

24 Id. § 1141(d).

25 Id. § 1129(b).

26 See, e.g., Nat'l Am. Ins. Co. v. Ruppert Landscaping Co., 187 F.3d 439, 441-42 (4th Cir. 1999) ("As a general matter, [t]he trustee's single effort eliminates the many wasteful and competitive suits of individual creditors." (internal quotation marks omitted)).

27 11 U.S.C. § 548.

28 Id. § 544(b)(1).

29 UFTA § 9(a) & (b). Generally, the reach-back period under New York law is six years. Island Holding, LLC v. O'Brien, 775 N.Y.S.2d 72, 74 (N.Y. App. Div. 2004).

30 Moore v. Bay, 284 U.S. 4, 5 (1931).

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.