Ex Ante Review of Leveraged Buyouts
Femino, Laura, The Yale Law Journal
I. OVERVIEW OF LEVERAGED BUYOUTS AND FRAUDULENT TRANSFER LAW II. PROBLEMS WITH THE CURRENT REGIME A. The Impact of FTL on the LBO Market B. The Problem of Free Insurance C. Reduced Monitoring Incentives D. Difficult Post-Hoc Valuations E. Hindsight Bias F. Litigation Costs G. Inadequate Remedy H. Ex Ante Uncertainty III. PROPOSAL FOR EX ANTE REVIEW A. Implementation B. Procedural Details IV. ADVANTAGES OF EX ANTE REVIEW A. Hindsight Bias B. Improved Valuation C. Discrimination Between LBOs that Will Fail the Standards of Financial Distress and LBOs that Will Pass Them D. Sharing the Benefits of an LBO: Turning Kaldor-Hicks-Optimal Buyouts into Pareto-Optimal Buyouts E. Risk Sharing and Monitoring Incentives F. Remedy and Costs G. Assimilation of Fraudulent Transfer Law into Fraud Tort Law V. POTENTIAL CRITICISMS OF EX ANTE REVIEW A. Why Don't Creditors Just Protect Themselves? B. Type I Errors in Ex Ante Review C. Information and Transaction Costs D. Restricting Market Forces E. Bad Faith Objections and Disclosure Timing F. Risk Externalities and Imperfect Adjusters CONCLUSION
In 1989, Kohlberg Kravis bought RJR Nabisco for $24 billion, using $19 billion in debt guaranteed by RJR Nabisco. (1) At the time, it was the largest leveraged buyout (LBO) in history. (2) After struggling to meet its debt burden for a decade, (3) RJR Nabisco was eventually broken up, and a large piece was sold off in 1999. (4) In 2003, it announced it would cut forty percent of its workforce and reduce its scope to just two brands. (5)
The financial community generally agrees that the massive debt load incurred in the LBO precipitated or at least accelerated the failure of RJR Nabisco. (6) Under current bankruptcy law, LBOs that eventually lead to bankruptcy may later be challenged and partially unwound as fraudulent transfers (sometimes called "fraudulent conveyances"). Such ex post review of buyouts seeks to determine whether, at the time of the transaction, the buyout left the target meeting any one of three standards of financial distress. (7) In short, ex post review asks whether the buyout was doomed to fail from the start.
Reviewing the LBO months or years after the transaction entails a number of problems, including hindsight bias, free insurance for creditors, misaligned monitoring incentives, and heavy litigation costs. This Note proposes a new solution: review LBOs for potential problems before the buyout takes place, rather than after the damage has already been done. I propose that LBOs be analyzed in much the same way and by the same standards of financial distress used in the current regime, but only at an earlier time. This would substantially ameliorate many of the problems with the current fraudulent transfer law (FTL) regime.
This Note will begin with an overview of current FTL and how it applies to LBOs. It will then explore some of the problems with this current regime before proposing a new regime of ex ante review and detailing its implementation and procedure. Finally, it will detail some of the benefits of ex ante review and explore some possible criticisms of the proposed regime.
I. OVERVIEW OF LEVERAGED BUYOUTS AND FRAUDULENT TRANSFER LAW
An LBO is the acquisition of a target company financed by debt that is secured by the assets of the target company and paid with the target's future cash flows. (8) Put more simply: The acquiring company borrows money from the lending bank to purchase the target company. That loan is secured by the target's assets and future cash flows. The acquirer might also use some of its own capital for the purchase along with the borrowed funds. (9) The acquirer then uses these funds to buy the target from the target's current shareholders, often at a large premium, and the acquirer becomes the new owner. …