& Transactions Group TThehe PPracticalractical LLenderender

Highlighting the practical effects of law on the fi nance business. September 2006

LLeveragedeveraged BuyoutsBuyouts asas FraudulentFraudulent TransfersTransfers

The heyday of highly leveraged transactions in the acquiring entity (the “Purchaser”) and secured the late 1980s and early 1990s was followed by the Target’s assets. The proceeds of the by a spate of failed companies and unhappy secured by the Target’s assets are advanced to . These dynamics resulted in signifi cant the Purchaser, which uses the funds to pay the developments in the application of fraudulent purchase price owed to the selling shareholders transfer laws to leveraged (“LBOs”). of the Target. In addition to being secured by the Today, the competitive lending market and Target’s assets, the are often supported by signifi cant availability of funds have resulted in upstream guarantees by the Target. more highly leveraged buyouts, and more , thereby bringing fraudulent transfer analyses The Elements of a Fraudulent Transfer back in play. In fact, Reuters Loan Pricing Corp. Under the Code (“RLPC”) reports that LBOs are on track to hit a record $98.8 billion in 2006. RLPC also reports There are two separate types of fraudulent that the debt ratio of the average LBO, measured transfers under the Bankruptcy Code: as a debt multiple of fl ow, is 6.2 for the year-to-date, up from 4.49 in 2001.1 Secured (1) Actual fraud or subjective “actual intent lenders should have a good understanding of the to hinder, delay or defraud” creditors; and interplay between LBOs and fraudulent transfer laws in such transactions (even (2) Constructive fraud, which requires no where lower historical interest rates and industry intent to defraud. sectors with strong cash fl ow make it easier for companies to carry debt). Although a few courts have applied the actual fraud standard to lenders involved in LBOs, the What is an LBO? large majority of cases involve the constructive fraudulent transfer theories. In order to attempt In its most basic form, an LBO involves the to avoid a leveraged transaction as a acquisition of a company (the “Target”) fi nanced constructive fraudulent transfer, the trustee, primarily by loans made directly or indirectly to -in-possession, or, in many cases, the creditors’ committee, will assert the following elements: 1 Source: Business Week Online, August 29, 2006, “The Rising Tower of Debt” by Steven Rosenbush.

VEDDER, PRICE, KAUFMAN & KAMMHOLZ, P.C. www.vedderprice.com The Practical Lender—September 2006

(a) a transfer by the debtor of value specifi c risk to the secured lender relates to the and/or assets—under an LBO, the transfer amount of proceeds that went to shareholders is likely to be the granting of a instead of the borrower. interest in the Target’s assets to the lender or an upstream guarantee by the Target; Application of Fraudulent Transfers Analysis to LBOs (b) the debtor corporation does not receive “reasonably equivalent value” Various commentaries have suggested it is in exchange for its or doubtful that any LBO can pass the “reasonably guarantee—at least for that portion of the equivalent value” test for that portion of the loan proceeds that is transferred to the Target/ that is paid to the Target’s shareholders, as opposed debtor’s shareholders, and not retained or to being used for operations of the Target. Of used by the Target/debtor itself; and course, that portion of the loan proceeds that is used to refi nance or pay off current secured loans, (c) the transaction left the Target/ for purchase of equipment or for operations debtor: should provide fair value to the Target, but not the proceeds that go to the shareholders of the (i) insolvent—here, fair market Target. value of its assets vs. all claims, As a result, typically, the most practical potentially including contingent defense is that the Target/debtor is not left claims against the Target company; insolvent or without reasonable capital after the LBO, which should be the focus of underwriting (ii) with “unreasonably small an LBO loan. capital” for its business—usually considered a condition just of insolvency; or Practical Lender Tips

(iii) with believed by the • Confi rm by appraisals and/or accountants Target/debtor to be beyond the that the Target/borrower will be solvent and will debtor’s ability to pay as such debts be left with reasonable capital after the LBO. An mature. appraisal or accountant’s opinion prepared at the time of the transaction is typically more credible Risk of a Fraudulent Transfer to a Court than one conducted years later at the direction of a trustee or debtor-in-possession in The risk of a fraudulent transfer to a secured fraudulent transfer litigation. lender is that the other creditors will claim the lender cannot benefi t from its security interest • The lender should confi rm and document, because the borrower itself (as opposed to its including in recitals and use of proceeds sections shareholders) did not receive any benefi t of the in the loan documents, all consideration to the loan proceeds (i.e., shareholders benefi ted at the Target/borrower from the loan proceeds that expense of creditors). As a general matter, the does not go to the shareholders of the Target—

2 The Practical Lender—September 2006 refi nancing a current , a new revolving Conclusion facility, new capital improvements or the purchase of equipment, and the like. A fraudulent transfer analysis should always be considered in underwriting an LBO, and a • Courts typically will collapse complicated good underwriting fi le that provides evidence component transactions used in an attempt of solvency, a healthy and to avoid a fraudulent transfer claim, at times reasonably equivalent value at the time of the suggesting they were used to hinder, delay or LBO is likely to discourage or help with the defraud creditors. Such complex transactions defense of a fraudulent transfer claim years after should have loan agreement recitals refl ecting the LBO. the “enterprise” nature of the relationship among the obligor entities. The Practical Lender is published by the law fi rm of Vedder, Price, • Although the Bankruptcy Code has a Kaufman & Kammholz, P.C. It is intended to keep our clients and interested parties generally informed on developments in the commercial fi nance two-year statute of limitations for fraudulent industry. It is not a substitute for professional advice. transfers, it allows a trustee, debtor-in-possession © 2006 Vedder, Price, Kaufman & Kammholz, P.C. Reproduction of this bulletin is permitted only with credit to Vedder, Price, Kaufman & or creditors’ committee to use state-law fraudulent Kammholz, P.C. For an electronic copy of this newsletter, please contact transfer statutes, which typically have a four- us at [email protected]. year statute of limitations, but the specifi c statute If you have any questions regarding material in this issue of The should be reviewed. Practical Lender or suggestions for a specifi c topic you would like addressed in a future issue, please contact the executive editor and • Scienter or intent is not an element of group Chair, Michael A. Nemeroff (312) 609-7858. constructive fraudulent transfer analysis—the Authors: Douglas J. Lipke and Eric S. Prezant lender’s good intentions and belief at the time of the LBO that there is reasonably equivalent value in exchange for the security interest or guarantee, the debtor is solvent and the debtor would be left with reasonable capital is not relevant, only whether the Court believes it.

3 The Practical Lender—September 2006

VEDDER, PRICE, KAUFMAN & KAMMHOLZ, P.C.

About Vedder Price Principal Members (cont'd.)

Vedder, Price, Kaufman & Kammholz, P.C. is a national full-service William A. Kummerer Kathryn L. Stevens law fi rm with approximately 230 attorneys in Chicago, New York City, Michael G. Beemer James W. Morrissey Washington, D.C. and Roseland, New Jersey. Robert J. Moran Leslie Allen Bayles Dalius F. Vasys Allen J. Gable Daniel T. Sherlock Venu V. Talanki The Finance and Transactions Group Douglas M. Hambleton Nicholas S. Harned Richard L. Williams III The Finance and Transactions Group of Vedder Price actively represents Marie H. Godush Timothy W. O’Donnell publicly held and private corporations, fi nanciers, leveraged buy- John M. Gall Lane R. Moyer out fi rms, private funds, venture capitalists, lenders, and Magda M. Boyles Jeffrey C. Davis related parties in a broad range of matters, including mergers and Laura Carroll DeBolt Michael M. Eidelman acquisitions; equity and debt fi nancing; mezzanine fi nancing; venture J.L. Cherwin, Jr. Geoffrey R. Kass capital; investments; and related transactions. Joel V. Sestito William J. Bettman David J. Borkon Paul R. Hoffman Eliza W. Hommel Principal Members of the Finance and Transactions Group: John T. Blatchford Bridget A. Adaska Dana S. Armagno Dozie Okpalaobieri Chicago: N. Paul Coyle Michael A. Nemeroff (Chair) Matthew T. O’Connor New York and New Jersey: Robert J. Stucker Peter J. Kelly Steven R. Berger Thomas P. Desmond Ernest W. Torain, Jr. Amy S. Berns John T. McEnroe Eric S. Prezant Denise L. Blau Daniel O’Rourke Eric J. Rietz John E. Bradley Guy E. Snyder Joseph H. Kye John I. Karesh Douglas J. Lipke David P. Kaminski Francis X. Nolan III Thomas E. Schnur Adam S. Lewis Ronald Scheinberg Dean N. Gerber Jennifer Durham King Donald A. Wassall John R. Obiala Megan E. Meyers Daniel Barlin Jonathan H. Bogaard

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