11.16 Leveraged Buyouts


In General

A leveraged buyout (LBO) can be defined as the purchase of a corporation through the pledging of the acquired corporation's own assets as security for the loans which provide most of the funds for the purchase. The stockholders of a corporation sell the corporate stock to a purchaser, and then, the purchaser borrows against the corporate assets in order to pay for the stock.

Leveraged buyouts may also involve partnerships and other types of legal entities.

The special risk inherent in this type of transaction is the acquired corporation's taking a debt for which it receives none of the proceeds of the loan--such proceeds being disbursed to the selling shareholders as payment for their shares. Present or future creditors of the corporation may challenge the validity or priority of the debt at some future time on the basis that:

  • The corporation may have become insolvent immediately or at sometime in the future,

  • The new lender may have obtained priority over the general creditors of the corporation in the event that legal recourse against the assets of the acquired company is necessary for the collection of debts.

Under the Bankruptcy Code, the debtor in possession or trustee may, pursuant to section 548, avoid and recover from the recipient thereof any payment, incurrence of indebtedness, or other transfer of property made voluntarily or involuntarily by the debtor on or within one year before the date of the filing of the petition commencing the case if:

  • The transfer was made by the debtor "with actual intent to hinder, delay, or defraud" any creditor of the debtor; or,

  • The debtor received "less than a reasonably equivalent value" for such transfer; and

    • Was insolvent on the date such transfer was made, or became insolvent as a result thereof;

    • Was engaged or was about to engage in a business or a transaction for which the remaining property of the debtor was "an unreasonably small capital"; or,

    • Intended to or believed that it would incur debts beyond its ability to pay as such debts matured.

The Bankruptcy Code provision is derived from and substantially similar to the Uniform Fraudulent Conveyance Act. A number of states have adopted similar but nonuniform fraudulent transfer laws. It should be noted that, in some cases, state statutes of limitations are longer than the Bankruptcy Code's one-year limit.

Finally, in most states, if not all, corporations are not permitted to pledge their assets to secure obligations of their shareholders.


Identifying The Leveraged Transaction Buyout

In the absence of direct information from the proposed insured, the identification of the proposed transaction as a leveraged buyout is not always an easy task. Leveraged buyouts, aside from being part of extremely large and complex transactions, have the tendency to assume different formats in their creation. Unless the transaction is timely identified, the economic consequences for the title insurance company may be catastrophic.

Although there are no established guidelines for the identification of a leveraged buyout transaction due to the different forms that its structure may assume, the following steps are suggested:

  • Familiarity with the type of transaction.

  • Careful examination of all the documents to be recorded.

  • Careful review of all the documents that are part of the transaction.

  • Careful analysis of the closing instructions.

  • Determination of the recipient of the full proceeds of the loan.