Recent LBO Decisions Provide Little Comfort to Banks
Since the very beginning of the takeover era, the banking community has been concerned about its exposure to fraudulent-conveyance claims.
Bankers have recognized that they would be an attractive target for the trustees in bankruptcy and unsecured creditors' committees of failed companies that have engaged in leveraged acquisitions, buyouts, and recapitalizations.
Until recently, however, there has been inadequate judicial guidance as to the nature of the legal standards that would be applied to the role of lenders in these transactions.
Lenders attempted to protect themselves by requiring solvency opinions from independent experts; putting net-worth limitations on upstream subsidiary guarantees; placing acquisition loans and working capital revolvers at different levels of the borrower's organization; and, to some extent, through the syndication process.
Success Protects the Lender
But lenders generally recognized that their best protection was good credit analysis and -- obviously -- an ultimately successful transaction.
That analysis determines initial credit approval, how much debt an enterprise can carry, pricing, structuring of asset sales, repayment schedules and prepayment triggers, and the need for additional layers of junior debt and equity.
It can be reduced to a basic question: Taking into account the new leverage, can the borrower pay its debts as they come due? This is the same question that fraudulent-conveyance analysis should involve.
In circumstances where standard credit analysis has been performed, it has been understandably difficult for most lenders to comprehend how their loans could be characterized as fraudulent conveyances.
By definition, a lender does not extend credit if it believes that a borrower will be rendered insolvent or be unable to pay its debts as they mature.
Legal Scrutiny of Solvency
Nevertheless, practitioners have assumed that if loan proceeds were ultimately used to pay sellers, declare dividends, or repurchase shares -- rather than being employed in the business -- courts would find a lack of fair consideration.
Under such circumstances, if a borrower failed, the leveraged transaction would be subjected to a legal scrutiny of solvency and adequate capital. Lenders and their counsel have been waiting for decisions that would set guidelines by which they could safely structure loans.
These guidelines should devise tests for solvency and reasonable capital. At best, they would conform to good and customary credit analysis and take into account lenders' good-faith business judgment. At worst, they would provide predictability.
Recently, two decisions applied to fraudulent-conveyance laws to failed LBOs and came to starkly differing conclusions.
Some Troubling Insights
These cases will be useful to lenders who seek greater insight into the tests courts are likely to apply to leveraged transactions. But, despite the favorable outcome in one of these decisions, some of these insights will not provide the degree of guidance that lenders need.
In Murphy v. Meritor Savings Bank, concerning the O'Day Corp., a U.S. Bankruptcy Court voided an LBO lender's liens under a "constructive" fraudulent-conveyance theory. The lender's claims were subordinated to the claims of general unsecured creditors, although the court did not require the bank to disgorge any payments of principal or interest already made.
In contrast, a U.S. District Court in Pennsylvania, in Moody v. Security Pacific Business Credit Inc. (concerning Jeannette Corp.) decided that transactions consummated by a lender and the sole former shareholder, in connection with an LBO, were not avoidable as fraudulent conveyances.
Both courts found that the acquisition loans and the liens granted on all of the borrowers' assets were not incurred or granted in exchange for fair consideration. Jeannette was found to be solvent and to have adequate capital; O'Day was not.
Both courts used straight balance-sheet tests to determine solvency. Neither assessed the borrower's value using a method based on earnings or cash flow. Most critically, goodwill was assigned a value of zero by both courts.
If this approach is widely adopted, it will be very difficult for many leveraged transactions in which sound credit analysis was applied to pass the solvency test.
In a typical leveraged acquisition or recapitalization, the borrower's going-concern value substantially exceeds book value by generally accepted accounting principles. As a result, goodwill will become one of the most significant assets on the balance sheet.
The O'Day court identified its solvency alternatives as a balance-sheet test or a going-concern test. It defined a going-concern valuation as one that is based either on the purchase price -- "provided that LBO interest payments do not turn profits into losses" -- or on a capitalization of earnings.
It is common for successful and unsuccessful companies alike to suffer income-statement losses in the immediate wake of a leveraged transaction. But this has no necessary bearing on the validity of purchase price as an indicator of value.
Nonetheless, because the proviso was appropriate to O'Day, purchase price was dismissed as a relevant standard. Addressing the possible use of a capitalization-of-earnings approach, the court engaged in a detailed analysis of O'Day's historical results of operations. It also analyzed the credibility of the purchaser's and the bank's projections.
Goodwill on the Sidelines
Concluding that the projections were unreasonable, the court rejected this version of a going-concern valuation.
The O'Day court, instead, adopted a balance-sheet test. Although it discussed all of the differences between the asset valuations of each party's experts, the court found it unnecessary to choose between them.
By attributing little value to specific intangibles and none to goodwill, the court easily determined that the borrower's liabilities exceeded its assets. On a pre-closing basis, O'Day had total GAAP assets of $5.8 million and liabilities of $3 million.
The purchase price was $14.5 million (more than 2.5 times pre-closing book value), of which $12 million was financed through debt that was added to O'Day's balance sheet. Assets were written up to $17.5 million after the transaction and intangibles accounted for 37% of the assets.
Even if the balance of the assets had been assigned their GAAP values, in the absence of goodwill, this balance-sheet approach rendered O'Day insolvent.
The Jeannette court purported to use a going-concern test. In reality, this meant that the court merely rejected a balance-sheet valuation which assumed a rapid liquidation sale of the assets of a failed business. Rather, it used a balance-sheet analysis performed in the context of a going concern.
By looking at post-closing realizations on accounts receivable, inventory, and sales of other assets, it found values that either exceeded book value or were substantially greater than fire-sale values.
Bought on Borrowed Funds
Unlike O'Day, the $12 million purchase price of Jeannette, almost all of which was borrowed, was well below its preclosing book value. Prior to the closing, Jeannette had assets of $52 million and liabilities of $12 million.
The court devalued its assets (including the elimination of goodwill) to $27 million, and added to pre-existing liabilities the LBO debt and an off-balance-sheet pension plan termination liability. Yet, the borrower's assets still exceeded liabilities. This is not a typical LBO balance sheet.
The other fraudulent-conveyance test turns on whether the borrower was left with unreasonably small capital to conduct its business as it had prior to the transfer. Both courts recognized that this requires the showing of linkage between the challenged transfer and an insufficiency of working capital or the borrower's inability to pay debts as they mature.
Both identify the prudence of the borrower's cash-flow projections as a critical element in making this assessment. Despite courts' statements to the contrary, it is safe to say that the application of hindsight -- and a substitution of the court's business judgment for the bank's -- is likely.
The O'Day and Jeannette courts reacted differently to:
* The way projections were used.
* The effect of unforeseeable intervening events on revenues and costs.
* Value of the availability of working-capital lines of credit.
* Stretching of payables after the closing.
* Characterization of a revolver as a current or long-term liability.
* Relevant period of post-closing analysis.
The O'Day court showed little inclination to accept the purchaser's and bank's business judgment in developing projections. It found them totally inconsistent with historical figures because the worst-case scenario assumed O'Day would match or exceed its best financial performance of the 1980s.
It found that predictable labor problems, cost increases, and industry cyclicality had a much greater impact on its failure than other unforeseeable events. The stretching of payables was found to indicate a working capital problem, not prudent cash management.
Availability under a revolver was ignored as a source of working capital because "[c]ommon sense dictates that an ability to borrow is not a substitute for operating profit." Outstanding amounts under a revolver were classified as current, which obviously severely expressed the current ratio.
The O'Day court looked at events that took place 18 months after the closing and found them relevant in assessing the adequacy of capital at the closing.
The Jeannette court reached the opposite conclusion in every respect, even though Jeannette survived for 14 months and O'Day for 22 months.
Courts View Business Judgment
The best explanation is that one court was predisposed to be skeptical of, and the other deferential to, the business judgments exercised at the time of the transaction. There were factual differences:
* In O'Day, some highly adverse trends may have been apparent immediately before the closing, in contrast to an improving outlook at Jeannette.
* O'Day's results were consistently poor after the closing, while Jeannette's were consistent with projections for six months.
* O'Day employees expressed serious concern about liquidity immediately after the closing; Jeannette apparently had no difficulty in doing so.
* O'Day was in a much worse position than Jeannette with respect to internally generated working capital -- and payables were stretched further at O'Day.
* The O'Day lender sought to restructure the loan relatively quickly.
Differences in the facts appeared to be less important than the extent to which the courts decided to impose their own business judgment.
These decisions are troubling primarily because the balance-sheet test they apply will be difficult for typical borrowers to satisfy. Asset values do not necessarily reflect financial strength or weakness.
Rarity of Book-Value Deals
Most leveraged transactions are not book-value deals. They are driven by valuations based on earnings or cash flow, and the balance-sheet result of such transactions will be a significant write-up of goodwill.
If effect, buyers and lenders recognize that the assets of different businesses are capable of generating vastly different earnings. And goodwill is the logical place on the balance sheet to reflect that value, in the wake of an acquisition or recapitalization.
Lenders continue to be well-advised to commission appraisals and solvency opinions that value every asset category and also emphasize the intangible aspects of the borrower's values.
Ultimately, however, courts will need to be convinced that solvency analysis should be based less on comparisons of assets and liabilities than on going-concern value and the probable ability of the business to pay its debts as they mature.
Predictability of Hindsight
The hindsight of these courts and their attention to post-closing events are predictable in the determination of reasonable capital. They underscore the need for well-documented projections that anticipate skepticism concerning what may seem to be optimistic assumptions.
It is also apparent that loan agreements should be structured to leave borrowers with adequate working-capital availability and flexibility in terms of financial covenants, excess cashflow provisions, and the application of prepayments.
The O'Day court subordinated the bank's senior secured loans to those of the unsecured creditors because of their perceived role in slowing payments to vendors, requiring prepayments of other loans so that it could obtain more collateral. It also required prepayments of its loans.
The fraudulent-conveyance risk implicit in both Jeannette and O'Day emphasizes the importance of working diligently to keep borrowers out of bankruptcy.