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.
For another, nearly all solvency opinions related to the deal that was initially proposed, not the one that actually took place. Typically, there were significant differences between the two as a result of negotiations, bidding wars, and changes in the market.
Investment bankers' opinions were also sought by management to document that the shareholders were receiving the highest price. Usually, several investment bankers prepared analyses of share value, and typically the one with the highest estimate was awarded the business - a strong incentive to be giddily optimistic.
More realistic views can be found in the files of the firms that lost out.
Valuation a Problem
In many cases, the market value of real estate was shown to be far over book value. The excess was cited as a valuable asset and an enhancer of solvency. And sure enough, there would always be a professional appraisal solemnly affirming that the property was, in fact, worth the value placed on it buy management.
The problem is that often these appraised values were based on the sale of the property and leasing it back to the company at rents far in excess of market rates - or of the company's ability to pay.
But even this and other tricks often failed to produce the desired valuation. The gap between the sale price and the value of the company was still embarrassingly large. The difference was then often wrongly categorized as goodwill.
Goodwill is a perfectly respectable accounting term for the value of a company's intangible advantages in excess of the fair value of tangible assets - factors such as customer preference, name recognition, market niche, and business synergy.
If many LBOs of the late 1980s were fraudulent conveyances, why have so few bankers taken beneficiaries to court?
First, bankers tend to recoil at the idea of accusing their customers of breaking the law. While they may be mad as hell at a customer who can't pay, they still believe that the customer would never deliberately practice deceit or commit fraud.
The second problem is that the concept of fraudulent conveyance is based largely upon financial and accounting issues that are difficult to explain to a jury.
They may require, for example, demonstrating insolvency by explaining complicated accounting and cash flow matters.
But this is not an insurmountable problem. It simply requires a patient explanation.
As bankers begin to realize they have legal recourse, beneficiaries will become only too familiar with the risks inherent in undertaking a fraudulent conveyance.