Lose Money in an LBO Deal? You May Be a Fraud Victim
Ballenger, Bruce W., American Banker
The 1980s left many banks with big loan losses, many involving leveraged buyouts. Fortunately, there is a way for creditors to recover on some of those LBO-related losses.
If you lent to a now-failed company with an LBO in its history, ask yourself, "Could this LBO have been a fraudulent conveyance?"
If the answer is yes, then you may be able to collect - not from your corporate borrower, but from the previous owners of the company, especially large shareholders who were insiders. That's because it is fraudulent for a debtor to transfer or convey property with the intent or effect of placing it beyond the reach of creditors.
Principle Isn't New
Such transactions have been illegal ever since they were described in the Statute of Queen Elizabeth I in 1570. This principle has since been incorporated into U.S. federal and state laws.
Sadly, fraudulent conveyances involving LBOs happened many times during the past decade. The LBO pledged virtually all assets as security for the borrowed money used to buy the company, but the deal wasn't legitimate because the resulting company wasn't viable.
After the LBO, all too often the previous owners - the "beneficiaries," as the law so aptly terms them - sailed away in their yachts, figuratively or literally, while their old company sank like a stone.
But if the transaction was, in fact, fraudulent, it can be voided and the previous owners compelled to replace the money received from the sale, thereby making it possible to repay the creditors of the LBO.
Conditions for Fraud
An LBO is fraudulent if any of four conditions is proved.
* The company was insolvent prior to the leveraged buyout.
* The LBO rendered the company insolvent.
* The company was engaged in a business or transaction for which its remaining unencumbered assets constituted unreasonably small capital.
* The LBO was undertaken with the belief or intention that it would incur debts beyond the resulting company's ability to pay as they matured.
Potential beneficiaries of LBOs were well aware of the fraudulent-conveyance laws. Many paid professionals to prepare opinions stating that the company was solvent before the LBO and would be so afterwards. This spawned a mini-industry of appraisers and solvency experts who seldom if ever met an LBO they didn't like.
The American Institute of Certified Public Accountants, alarmed at the implications of such opinions and wanting to distance itself from the looming LBO failure scandal, forbade its members from issuing or being associated with such opinions.
Status of Opinions Shaky
In fact, these opinions provide beneficiaries of LBOs little protection from liability. For one thing, they are based on figures provided by management, whose financial projections and estimates of value were frequently influenced by the prospect of a high payoff - provided that the pro-forma balance sheet of the post-LBO company showed solvency even under the burden of heavy debt. …