We are pleased to announce the winner of the Weil Bankruptcy Blog’s First Annual Law Student Note Competition, Laura Femino. Although we received a number of excellent papers on a wide range of subjects (and learned a lot in the process), Ms. Femino’s Note, titled “Ex Ante Review of Leveraged Buyouts” stood out as a thoroughly-researched, creative, and thoughtful work, and we are pleased to share it with you here. Originally published in the Yale Law Journal (123 Yale L.J. 1830 (2014)), the Note questions existing fraudulent transfer law as it applies to failed leveraged buyouts. The Note proposes to replace the current law with a system of ex ante review of LBOs, shielding certain qualifying LBOs from prospective, ex post, litigation. The full text of the Note is available here. Ms. Femino’s abbreviated proposal follows.
Sections 544, 548, and 550 of the Bankruptcy Code permit a trustee Laura Femino, winner of @weilbankruptcy’s 1st annual note contest, explains her proposal for ex ante LBO revieto avoid, and recover property transferred in, transactions deemed actually or constructively fraudulent within the relevant look-back period preceding a bankruptcy filing. These provisions can be used in a bankruptcy proceeding to challenge an earlier LBO in which the debtor, as the target company, was purchased with debt secured by its own assets and paid with its then-future cash flows. Such transactions are deemed constructively fraudulent, and may thus be avoided, if it can be shown that the debtor (i) received less than reasonably equivalent value in return for encumbering its assets to finance the buyout, and (ii) was left in one of three states of financial distress: with unreasonably small capital, with the reasonable expectation that it would not be able to pay its debts as they became due, or insolvent either before or as a result of the buyout. Because prong (i) is nearly always met by the very nature of an LBO, in which the target company secures loans for funds directed not to it but to its selling shareholders, fraudulent transfer actions generally focus on prong (ii), essentially asking if the LBO was a financially sound transaction at the time it was effected.
Attempting to evaluate an LBO months or even years after its completion involves a number of serious difficulties. Chief among them is the hindsight bias inherent in asking a court to determine if a transaction which led to bankruptcy was, in fact, likely to lead to bankruptcy. Next are the obvious litigation and uncertainty costs of ex post review which, if factored in to the cost of an LBO, may bar value-creating LBOs from ever taking place. Further, the remedy available to unsecured creditors that successfully pursue fraudulent transfer actions is woefully inadequate; the liens issued in connection with the LBO may be avoided, but most of the funds borrowed to finance the buyout have already been distributed to the target’s pre-buyout shareholders. To make matters worse, these inadequate remedies are only available where the bankruptcy filing occurred within the applicable look-back period—bankruptcies resulting from poorly structured LBOs falling outside that period leave injured parties with no recourse at all under the current fraudulent transfer law.
Most importantly, ex post review does little to distinguish between likely-to-succeed LBOs and LBOs likely to fail; it imposes uncertainty discounting on both ex ante, and it does not encourage monitoring of proposed LBOs by those with incentive to discern between the two—namely, pre-existing unsecured creditors who stand to lose the most if over-leverage leads to the target’s eventual bankruptcy.
In light of these shortcomings, the Note proposes to supplant the current regime of ex post review with an ex ante review that grants likely-to-succeed LBOs a safe harbor from ex post fraudulent transfer litigation, while functionally blocking likely-to-fail LBOs from ever taking place. This would be implemented by (1) a statutory amendment to sections 544 and 548 of the Bankruptcy Code providing that LBO transactions that undergo review and are approved by an independent, court-appointed valuation expert are not later subject to fraudulent transfer litigation, while those that do not undergo such review will face a rebuttable presumption of constructive fraud in any subsequent fraudulent transfer litigation (a shift in the burden of proof as compared to the current regime), and (2) the addition of a flexible definition of “LBO” to the Bankruptcy Code specifying which transactions are governed by this amendment. Parties structuring an LBO, although not yet subject to the Bankruptcy Code, would be cognizant of the potentially applicable safe harbor (or rebuttable presumption) and would be driven, in all likelihood, to choose “voluntary” ex ante review in any contemplated buyout. Importantly, since the proposed regime denies creditors the opportunity to litigate constructive fraud in an eventual bankruptcy proceeding, it would permit them to participate in the review by opposing the transaction ex ante, a feature which could turn the review into a process of negotiation between creditors and shareholders and thereby serves to ensure the financial viability of the target post-LBO.
Ex ante review alleviates the many shortcomings of ex post review: it eliminates hindsight bias, reduces uncertainty and litigation expenses, and precludes likely-to-fail LBOs altogether instead of trying unsuccessfully, if at all, to unwind them after the fact. Most importantly, it distinguishes between LBOs likely to pass the standards of financial of distress and those likely to fail, encouraging the former while chilling the latter. By providing a safe harbor to likely-to-succeed LBOs, ex ante review makes these transactions less expensive, as parties need not discount for the expense of later litigation. By putting extra scrutiny on LBOs generally, and specifically scrutiny by those with the best monitoring incentives, it blocks value-destroying buyouts put up for review and, even better for transaction costs, discourages parties forced to satisfy stricter standards from proposing those transactions in the first place. The result of this discernment is a reduction, compared to ex post review, in both Type I or “false negative” errors (preventing what would have been a value-creating LBO) and Type II or “false positive” errors (permitting a value-destroying LBO to proceed where it should not).
Laura Femino is an Associate in the Miami office of White & Case LLP. She graduated from Yale Law School in 2014.