Tribune bankruptcy case may set precedents on leveraged buyouts

This month, a two-page letter from an angry Colorado investor arrived on Tribune Co.'s Bankruptcy Court docket.

The investor, Mark Lies, was among thousands of Tribune shareholders who cashed out when the media conglomerate went private in 2007. And like those others, he stands to lose some of his winnings if junior creditors succeed in their legal bid to claw back more than $2.5 billion of the $8.2 billion in proceeds from Tribune's disastrous leveraged buyout.

"What seems grossly unfair," Lies wrote to U.S. Bankruptcy Judge Kevin J. Carey, "is there doesn't seem to be any adult supervision looking out for the average investor like myself."

Lies and his fellow shareholders are caught in a legal battle that may be the most perplexing yet in a Tribune bankruptcy that has groaned on for three years. The junior creditors, led by New York hedge fund Aurelius Capital Management, claim that the complex deal orchestrated by Chicago billionaire Sam Zell was a fraudulent conveyance, doomed to fail from the start.

If the buyout is proved to be a fraudulent conveyance, creditors argue, investors shouldn't have benefited, and proceeds from their stock transactions should be made available to satisfy the $2.5 billion that creditors claim they are owed.

In all, 33,000 to 35,000 investors are potentially on the hook for money they received in 2007, when the company went private at $34 a share. Defendants include thousands of current and former employees of Tribune, which owns the Los Angeles Times, KTLA-TV Channel 5, the Chicago Tribune and other media assets.

Many others are people around the country like Lies who had nothing to do with the company — they simply bought the stock.

It is far from clear that the creditors' maneuver will work. And defendants warn that if Aurelius and its allies prevail, markets that depend on the sanctity of a settled transaction could be disrupted by making it difficult for investors to assess risks in participating in a leveraged buyout.

"I've heard from investors whose entire life savings was dependent on Tribune stock," said Gary Lawson, a Texas attorney representing the Employees Retirement Fund of the City of Dallas. "But they can't afford to defend themselves. It's outrageous."

Fraudulent conveyance laws have been on the books for decades to protect a company and creditors from transactions that harm the enterprise by extracting value without giving anything in return.

Anyone who benefited from the transaction can be found liable for the fraudulent transfer in suits filed on behalf of the debtor's estate. But typically, legal experts say, the company or the pre-buyout creditors sue for recovery from banks and other parties with the deepest pockets, not rank-and-file investors such as Lies.

The U.S. Bankruptcy Code also discourages lawsuits targeting shareholders of bankrupt companies for another reason. Several years ago, Congress tweaked the code with a provision called 546(e), which has been broadly interpreted to insulate investors who sold stock into a busted leveraged buyout like the Zell deal.

Lawyers familiar with Tribune's situation say that twists and turns in the case have opened the door for Aurelius to find a way past the provision: suing shareholders for constructive fraudulent conveyance under state law in 44 courts around the country, where, they contend, 546(e) doesn't apply.

"They came up with a work-around," said Kenneth Klee, the court-appointed independent examiner in the Tribune case and one of the authors of the Bankruptcy Code.

Fraudulent conveyance claims gained a new head of steam in 2010 when Klee and his team of examiners found that it was "highly likely" that the second step in the two-step Zell deal to take the company private led to insolvency. That hardened positions among creditors on both sides of the charges and pushed the case toward its two-year anniversary with little hope of a settlement.

The Tribune case also differed from many others in that it featured a number of deep-pocketed shareholders who sold billions of dollars' worth of stock in the deal, most notably the Robert R. McCormick Foundation and several large institutions such as mutual fund company T. Rowe Price.

These shareholders presented a fat target for the junior creditors, though they were relatively well insulated by 546(e).

Fraudulent conveyance law distinguishes between two types of fraud: constructive fraud, which merely requires a finding that the deal left the company insolvent; and intentional fraud, which requires a finding that participants in the deal had actual fraudulent intent.

Either determination allows the plaintiff to go after the banks that lent the money to fund the deal. But 546(e) requires that plaintiffs prove intentional fraud to extract money from shareholders, a much higher hurdle.

Klee said the evidence supporting constructive fraud was much more compelling. Aurelius and the other junior creditors saw a chance to target shareholders who sold $4 billion worth of stock in the vulnerable second step alone.

How could they find a way around 546(e)? Look outside Bankruptcy Court altogether. That opportunity presented itself as the Tribune case dragged on toward its second anniversary in December 2010.

The Official Committee of Unsecured Creditors got permission from Carey to file a claim alleging intentional fraud against shareholders before the two-year limit. However, the committee didn't sue shareholders under constructive fraudulent conveyance law. It left that up to individual creditors like Aurelius to pursue in state courts around the country, arguably beyond the reach of 546(e).

This strategy got baked into a new restructuring plan and was immediately opposed by the McCormick Foundation and other large shareholders. Carey has twice affirmed his intention to let the suits go forward outside his jurisdiction. What he refused to do, however, is rule on whether it was appropriate to circumvent 546(e) in this way.

The company demanded its own provision in the plan that would grant releases to Tribune employees who sold stock through their 401(k) accounts. It also sought to shield the first $100,000 sold by an employee. Carey, however, quashed that plan in October, saying it could not be supported legally.

What shareholders are left with is this: They are being sued by the creditors committee via the intentional fraud case filed in Bankruptcy Court, and they are being sued by Aurelius and its allies via the 44 suits scattered across the country.

Aurelius, which declined to comment, has asked a judicial panel to merge them before U.S. District Judge Richard Holwell in the Southern District of New York. The first hearing on the matter will be Thursday in lower Manhattan.

Despite the objections, most experts believe the cases will be consolidated before Holwell.

Legal experts say the shareholder suits are likely to turn on the 546(e) issue. If the creditors win on that score, they will probably press for a settlement from the big shareholders who have always provided the biggest target. If the creditors lose, shareholders can turn their attention to defending themselves in a much weaker Bankruptcy Court case.

In any event, the Tribune case is likely to break new ground when it comes to defining the protections shareholders can expect when they become involved in a leveraged buyout, either willingly or unwillingly.

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