To the interested observer of private equity, a typical leveraged buyout follows a relatively predictable sequence. Most buyouts begin with a sponsor such as KKR or Blackstone forming a limited partnership, serving as the general partner, and acquiring initial capital from investors who form the partnership’s limited partners.1 Once a target company has been identified, the partnership negotiates a deal for its purchase and obtains further financing in the form of loans from investment banks and from the issuance of high-yield bonds.2 After a few years under the partnership’s management, the target can be sold or its stock reissued to the market.3 When leveraged buyouts work—as they frequently do—the returns can be both significant and widespread, reaching the partners, the lenders, and in some cases even the target company’s management. When leveraged buyouts go wrong, however, the losses can be just as far reaching. A recent case out of a Southern District of New York bankruptcy court reminds those interested in private equity that the losses from a leveraged buyout can potentially stretch as far as the shareholders of the target company.
The facts from In Re Lyondell Chemical Company (“Lyondell”) depict a leveraged buyout that for the most part mirrors closely the typical sequence outlined above. In December 2007, a Luxembourg sponsor acquired the Lyondell Chemical Company, a Delaware corporation headquartered in Houston, through a leveraged buyout.4 “Lyondell took on approximately $21 billion of secured indebtedness in the LBO,” and Lyondell’s assets served as security for the entire transaction.5 Over half that sum—$12.5 billion—was eventually paid out to Lyondell stockholders.6 Less than 13 months later, the debt-laden Lyondell filed a petition for Chapter 11 relief in the Southern District of New York.7 These two events—the $12.5 million payout to Lyondell’s shareholders and the company’s subsequent bankruptcy—provided the court in Lyondell the opportunity to reexamine state law fraudulent transfer claims in bankruptcy proceedings and, by extension, the potential wide reach of failed leveraged buyouts.
The Creditor Trust in Lyondell brought a state law fraudulent transfer claim seeking to avoid the $12.5 million paid out to Lyondell’s shareholders as a part of the buyout.8 The Trust claimed that the payment to shareholders left, “Lyondell insolvent and with unreasonably small capital, having been financed by the incurrence of secured debt that Lyondell reasonably should have believed it would be unable to pay as such debt became due.”9 The defendant group, composed primarily of financial institutions, moved to dismiss the Trust’s fraudulent transfer claim on five grounds, chief among which was that §546(e) of the Bankruptcy Code both preempts and protects the defendants from a state law claim.10 Ultimately the Lyondell court found that §546(e) did neither.11 Although it required the Trust to replead some if its claims, the Lyondell court allowed the Trust to proceed with its state law fraudulent transfer claim and to seek avoidance of the dividends paid to Lyondell’s shareholders.12
On its surface, the holding in Lyondell is relatively straightforward: for the former shareholders of insolvent target companies, the Bankruptcy Code will not provide blanket protections to dividends received following a buyout. And though that alone may suffice to highlight the potential extent of a failed buyout’s repercussions, the reach may stretch further still. If, following Lyondell, shareholders of target companies stand to lose their dividends in the event of the target’s insolvency, might directors of targets begin to discount competing bids by the possibility of insolvency following the buyout? Directors currently faced with competing bids for their companies commonly consider factors beyond price alone, looking to the capital structure, the likelihood of securing financing, and even the plans to downsize or retain employees when evaluating bids. Going forward it will be interesting to see whether directors faced with buyout proposals will add the potential of insolvency to their list of considerations.
Steven N. Kaplan & Per Strömberg, Leveraged Buyouts and Private Equity, 22 J. Econ. Persp. 1, 3 (2008), available at http://faculty.chicagobooth.edu/steven.kaplan/research/ksjep.pdf. ↩
Id. at 5. ↩
Id. at 10-11. ↩
In re Lyondell Chem. Co., 503 B.R. 348, 353 (Bankr. S.D.N.Y. 2014). ↩
Id. at 355. ↩
Lyondell, 503 B.R. at 358-79. ↩
Id. at 357. ↩
Id. at 388, 391-92. ↩