Liabilities Linger After Bankruptcy Filings

A bankruptcy filing that wipes out the value of an equity investment marks the worst possible result for a buyout shop. Unfortunately, the pain doesn’t always end there.

Creditors unhappy with their share of the proceeds in a subsequent reorganization, sale, or liquidation have plenty of options to boost their recoveries. One is to take legal action against the company’s owners for any perceived misdeeds.

Unfortunately, buyout firms could find themselves defending themselves in such suits more often in the months ahead. In light of the run-down economy, and sputtering credit markets, Standard & Poor’s last month predicted that the U.S. speculative-grade default rate would “accelerate substantially” from near its 25-year low of 1.09 percent in January to 4.6 percent in the next 12 months. A good portion of the speculative-grade debt outstanding was issued to finance leveraged buyouts.

Victor G. Milione, a partner at Nixon Peabody LLP, and practice group leader for its financial restructuring and bankruptcy group, points to several kinds of liabilities that remain in the wake of a bankruptcy filing. By far the most important are breach of fiduciary duty claims and avoidance claims.

The premise underpinning both kinds of suits is that companies don’t just drop into bankruptcy overnight. They struggle for months, if not years. At some point, the company enters the “zone of insolvency”—the point at which business decisions start to impact creditors, and insolvency looks (or should look) inevitable.

Over the last five or six years, Milione said, bankruptcy courts have established that, once inside the zone of insolvency, the duty of loyalty and care that company directors ordinarily owe to just shareholders expands to include creditors as well. Once actually insolvent, that duty shifts entirely to creditors.

Consider a buyout firm facing the loss of its equity investment in a company. It might be tempted to approve the launch of an expensive advertising campaign in a last-ditch effort to reverse the company’s fortunes. If the company fails anyway, creditors could accuse the buyout shop of violating its duty to preserve assets for creditors by having swung for the fences.

Avoidance claims seek to unwind transactions that a failing company arguably should not have undertaken because they harmed creditors. Say a buyout shop extends a short-term, secured loan to a struggling portfolio company to get it out of a pinch—an increasingly likely scenario given the many debt funds being raised by sponsors. Say further that the gamble fails, and the company files for Chapter 11 anyway. Creditors livid that the buyout firm will get its secured loan paid off before they get their money could file a “recharacterization” claim, arguing that the loan should have been an equity infusion that’s subordinate to their own claims.

In a similar vein, creditors can try to bring “fraudulent conveyance” claims against buyout shops. These involve pre-bankruptcy-filing transactions in which the company arguably received inadequate compensation for something it sold, or overpaid for something it bought, while either insolvent or on the cusp of insolvency. Creditors sometimes argue that the transaction itself hastened the company’s fall into bankruptcy. Such was the case when the unsecured creditors committee of KB Toys brought suit against Bain Capital and others in 2005 for taking a $121 million dividend from the company in 2002. The dividend recapitalization, the creditors argued, effectively left the company unable to compete and led to a bankruptcy filing in early 2004. The case later settled.

Michael J. Venditto, a partner at Reed Smith LLP, and an expert in bankruptcy law, warns that any transactions taking place less than six years before a bankruptcy filing can be subject to avoidance claims; after the filing, creditors have two years to file a complaint. Venditto offers the following advice to buyout shops that find themselves working with shaky portfolio companies:

• Should the company become insolvent, try to reach an out-of-court restructuring settlement with creditors rather than file for bankruptcy; working things out out of court sidesteps many of the liabilities that arise only in a Chapter 11 or Chapter 7 setting;

• When structuring transactions, make sure that financial statements demonstrate that the company will be adequately capitalized after the transaction is finished. Include a bankruptcy attorney on your deal-review team, and take the time to secure fairness opinions and solvency opinions from an independent financial advisor; avoid taking money out of the company if possible;

• Have an attorney review the D&O insurance coverage of directors, officers, the portfolio company, and your fund, and make sure that it’s adequate to cover any anticipated defense costs and damage awards. Bear in mind that different groups of creditors may end up fighting for a limited pool of insurance payouts; once the insurance runs out, they’ll turn to any deep pockets they can find to pay damages awarded.