Creditors Avenge Bad LBOs With Age-Old Concept : Buyouts: Fraudulent conveyance suits argue that the deals have left some companies with too much debt to operate and benefit bankers, lawyers and advisers at creditors’ expense.
By fall 1987, not even all the king’s horses and all the king’s men could have helped unpaid creditors put Wieboldt Stores back together again. The venerable Chicago retailer was more than bankrupt; its merchandise had been liquidated, and its dozen or so stores shuttered early that summer.
So the creditors did the next best thing: They staked their claim to the shattered pieces by suing the financiers, executives and even public shareholders who had made possible or profited from the leveraged buyout of Wieboldt in 1985.
And in so doing, the Wieboldt creditors pulled a string that many believe could unravel some of the business excesses of the 1980s--an intricate weave of LBOs, greenmail, golden handshakes and junk bond financing--and at the end, find and hold liable those responsible for the loss of jobs, profits and whole companies.
The Wieboldt case was the first significant application of a simple, centuries-old legal concept called fraudulent conveyance to that most modern and sophisticated of financial transactions, the leveraged buyout of a publicly traded company. In an LBO, the buyers raise money to take over a company by mortgaging or selling its assets and using the proceeds to buy out the other shareholders.
In the past few years, dozens of fraudulent conveyance suits have been filed or threatened in the wake of failed LBOs. Already they have proven to be powerful tools in creditors’ hands. And, bankruptcy experts believe, as more companies face the bills on their buyout debt in an economic downturn, the stage is set for a staggering amount of litigation.
“This . . . is going to be the dominant issue in insolvency in the next five years as more and more of the LBOs hit the wall,” said Dan S. Schechter, professor at Loyola Law School at Loyola-Marymount University in Los Angeles.
Simply put, the fraudulent conveyance suits seek to undo heavily leveraged takeovers, arguing that companies such as Wieboldt didn’t get a fair exchange when their assets were mortgaged and that the deals left them too crippled to continue to operate. Creditors are claiming that money owed them went instead to pay the people involved in the deals--not just shareholders, but investment bankers, lawyers and other advisers.
There are still many questions about how far a fraudulent conveyance suit can go in undoing an LBO or in roping back assets and money that have long since been distributed. Allan Dinkoff, a New York lawyer representing defendants in another LBO-related lawsuit, said: “Once an egg is scrambled, it’s hard to unscramble it.”
The Securities and Exchange Commission finds especially troublesome the prospect that years down the road, shareholders who had nothing to do with running the companies could be forced to return money they received in the deals. Successful suits, the SEC warned in arguments it filed last month in a case involving the 1984 sale of Kaiser Steel, could wreak havoc in the stock markets and cause investments to wither.
The suits that have been pursued are still dragging through the courts, with no end in sight. With potentially thousands of defendants and hundreds of cross-claims for each case, “it will be a terrible mess,” Schechter of Loyola said, “and no one is going to benefit except the lawyers.”
Rather than risk doubtful outcomes after lengthy and costly court battles, many players on both sides of the suit have chosen to negotiate.
In the Wieboldt case, claims against lenders who financed the deal have been settled, with the proceeds going to other creditors. Additional claims, including those against directors and inside shareholders--company executives, for example--are pending.
“I don’t think there’s any clear path yet; everyone seems to be feeling their way,” said Joel M. Wolosky, a New York lawyer who represents Wieboldt defendants. “Right now it’s being used as a wedge in order to get settlements in the bankruptcy court.”
Even though these settlements often net only a fraction of the sums involved, there have been major victories for creditors--especially unsecured creditors who traditionally stand near the end of the line in bankruptcy payouts. Some include:
* Creditors of now-bankrupt Revco D.S., an Ohio-based drugstore chain that was taken private in a $1.25-billion buyout in 1986 and into bankruptcy court in 1988, say their suit, which includes claims against 7,000 holders of junk bonds used to finance the buyout, helped prompt acceptance of their plan for the company’s reorganization. Some creditors who would have been paid only 50 cents on the dollar under earlier proposals now expect close to 67 cents.
* Bondholders first forced Resorts International into bankruptcy and then expedited the company’s reorganization, saving time and costly fees, after a fraudulent conveyance suit was threatened. The reorganization set up a $5-million fund to pursue a fraudulent conveyance suit against Donald J. Trump, who made $150 million in the sale to Merv Griffin. Creditors may also ask the courts to force Trump to turn the Taj Mahal casino back over to Resorts.
* Earlier this year, Texas Air Corp. agreed to pay $280 million to bankrupt Eastern Air Lines, which it took over in 1986. Eastern labor unions had filed suit, and the bankruptcy examiner found that Texas Air may have illegally transferred more than $400 million of Eastern’s assets.
* In a settlement that eventually led to Coleco’s sale to Hasbro Inc., unsecured creditors who had been owed $420 million triumphed in a $71-million fraudulent conveyance claim against secured lenders who had helped finance Coleco’s LBO.
In other cases, victims of failed LBOs are still waiting to realize benefits from their suits. This includes sufferers of asbestos-caused diseases who had thousands of claims against Jim Walter Co. and its Celotex subsidiary, a major producer of asbestos. The asbestos claimants sued in Texas after Jim Walter was taken over in an LBO led by Kohlberg Kravis Roberts & Co., but they have made no progress since the company--minus a newly spun-off Celotex--was taken into bankruptcy in Florida.
In the case of Kaiser Steel Resources, the reorganized survivor of old Kaiser Steel, administrative costs and attorneys fees ate up most of the $27 million that Kaiser received in settlement of several claims relating to the steel company’s sale. Former employees, who lost their promised lifetime medical benefits when Kaiser Steel declared bankruptcy in 1987, recently got a $3-million chunk of a settlement and are hoping future proceeds will help fund much reduced medical and pension benefits.
Lawyers and bankruptcy negotiators have been closely watching the Kaiser fraudulent conveyance litigation, anticipating that upcoming decisions will influence the course of other such suits.
Although many attorneys say settling such claims is in the best interest of the companies and creditors, they admit that they would like to see a few cases go through litigation. “Between the financiers, banks and bondholders, the selling and buying shareholders, who should bear the loss? These are important questions and they ought to be resolved,” said Kenneth N. Klee, a noted Los Angeles bankruptcy lawyer involved in cases of Campeau Corp. and Resorts International.
Before certain rulings were made in the Wieboldt case, much of the debate had concerned whether fraudulent conveyance statutes even applied to such modern transactions as takeovers and leveraged buyouts. The laws date back to Elizabethan England and were designed to cope with fairly simple situations. Suppose, for instance, that a financially strapped farmer on the verge of bankruptcy gave his possessions to friends or family members for little or no payment. With his assets parceled out, the farmer’s bankruptcy would be all but assured. But his creditors--butchers, bakers, landlords and the like--would have no way of collecting from him.
The Elizabethans declared that pre-bankruptcy deals in which assets changed hands without a fair-value exchange were “fraudulent conveyances.” The butcher or baker who could prove that a fraudulent transfer of a debtor’s assets had taken place could then, through the courts, force the family and friends to return the possessions, which then would be used to pay off the farmer’s debts.
In such cases, it was assumed that the farmer had intended to defraud his creditors. But as fraudulent conveyance statutes have been written in the United States, they have been expanded to cover such transfers regardless of intent. It is this “constructive” fraud--where there may have been no intent to defraud--that has been applied to many of the LBO cases.
Wieboldt was the first significant constructive fraud case involving an LBO. Two important tests of whether the law could be applied to LBOs were met when the court found reason to support the creditors’ claim that the company did not receive a fair-value exchange in the deal and that the complicated LBO financial transactions--although seemingly separate--were in fact all linked.
According to attorney Wolosky, who represents two Wieboldt directors and an inside shareholder, if courts follow the reasoning of the Wieboldt case, fraudulent conveyance laws could be applied to “virtually every failed LBO.”
Kaiser Steel Resources is the fraudulent conveyance case now capturing the most attention. The reorganized company claimed that Kaiser was left insolvent by its sale in 1984 to a group led by Denver coal man Monty Rial and Tulsa businessman Joseph A. Frates. In 1985, Rial bought out Frates, who received additional payments and Kaiser property.
While still under bankruptcy court protection, Kaiser began planning suits against officers and directors who approved the sale and firms that provided advice. Kaiser has already gained settlements with many defendants.
Kaiser also sued Kaiser Steel’s public shareholders--those outside the company--who accepted the buyout offer and the brokerages that handled their shares. The 10th Circuit Court in Denver has already upheld a lower court’s dismissal of claims against the brokers, saying they were not parties to the transfer but merely conduits for the payments to shareholders. And the court is expected to dismiss claims against the public shareholders as well.
Kaiser’s attorneys are already preparing a Supreme Court appeal.
One of Kaiser’s main contentions is that a failed LBO cheats a company’s creditors because the shareholders got their money first, thwarting a well-established principle of corporate law.
Judge Joseph L. Cosetti, chief bankruptcy judge in the Western District of Pennsylvania and president of the National Conference of Bankruptcy Judges, said: “In priority, generally speaking, common shareholders are at the bottom. Secured creditors are first, then unsecured, then shareholders.”
Kaiser President Daniel Larson said it is a question not so much whether there was intentional wrongdoing by the public shareholders but of who should be paid first. “It’s always been the creditors,” he said, “and if the shareholders get paid first, those are ill-gotten gains whether there was intent (to defraud) or not on the part of the shareholders.”
Constructive fraudulent conveyance: A transfer, or sale, can be ruled a constructive fraud if it is determined that the company resulting from the buyout received less than a “reasonably equivalent” value for the payments it made to shareholders and meets one of the following criteria: It became insolvent because of those payments, was too cash-poor to conduct its regular business or was taking on debts that it couldn’t pay as they came due.
