Though the pandemic is the cause of the rising number of retail bankruptcies, major retailers were facing cash flow and insolvency issues prior to COVID-19. Many of them were over-leveraged by virtue of funding the leveraged buyouts of prior ownership. With the change in the retail environment, retailer buyers could no longer sustain the debt used to acquire a targeted retailer. COVID-19 was simply the straw that broke the camel’s back.
With that in mind, creditors are often frustrated that they cannot use the fraudulent transfer statute under the Bankruptcy Code to claw back the proceeds that old shareholders received (which were funded by debt), often referred to as fraudulent transfer LBOs.
The Bankruptcy Court for the Southern District of New York came out with a guide as to how to avoid a fraudulent transfer allegation in connection with a leveraged buyout. Bottom line: any shareholders who received the leveraged funds should retain a financial institution as their agent to receive the funds and then, as a conduit, distribute same.
It all starts with Section 546(e) of the Bankruptcy Code, which is often referred to as the “Safe Harbor Rule.” Section 546(e) provides that a trustee may not avoid a "settlement payment … made by or to (or for the benefit of) . . a financial institution."
In construing Section 546(e), the U.S. Supreme Court in Merit Mgmt. Grp., LP v. FTI Consulting, Inc., ––– U.S. ––––, 138 S. Ct. 883 (2018) (“Merit”), held that the presence of a financial institution as a conduit in the chain of payments in a leveraged buyout was insufficient to invoke the safe harbor in Section 546(e). Thus, the Trustee could pursue the transferee of the conduit bank. Prior to Merit, if a bank was a conduit of a payment relating to a leveraged buyout, the safe harbor rule prevented the trustee from pursuing a fraudulent transfer against the lender and the transferee. After Merit, courts could no longer immunize ultimate transferees of alleged fraudulent transfers if the bank was used as a conduit. Merit was obviously a significant ruling as it affected the manner in which leveraged buyouts and other transactions were structured in terms of using the financial institution/bank as a conduit.
Following Merit, the Second Circuit Court of Appeals, in a case commonly referred to as Tribune II, found a loophole in the Merit ruling finding that a fraudulent transfer based not on intent to hinder, delay, or defraud creditors, but instead based on the transferor receiving less than reasonably equivalent value while the transferor was insolvent or the transfer rendered the transferor insolvent, protected the transaction from attack if a "financial institution" was used as the agent of the ultimate transferee.
In Holliday v. K Road Power, a bankruptcy case out of the Southern District of New York, the bankruptcy judge went further by first dissecting the definition of “financial institution” by noting that a financial institution is defined as a “bank … trust company, … and when any such … entity is acting as agent … for a ‘customer’ … in connection with a securities contract … such customer ." The bankruptcy judge found that based on the opinion of the Second Circuit, i.e. Tribune II, and the definition of “financial institution,” if a financial institution was acting as the customer's agent, then the customer became a "financial institution." And by virtue of being defined as a financial institution, a transferee of an alleged fraudulent transfer was therefore immune from liability. In addition, the bankruptcy court followed Tribune II by finding that the Safe Harbor Rule preempts not just fraudulent transfer claims under the Bankruptcy Code but also state law fraudulent transfers.
So, even though the ruling in Holliday v. K Road Power is not necessarily binding in other jurisdictions, it is instructional for anyone who is structuring a transaction — especially a leveraged buyout. The takeaway is: to avoid a “claw back” of a transfer in a transaction that could allegedly be considered a fraudulent transfer, a transferee needs to use a financial institution as a conduit and in that way, the transferee can be defined as a financial institution and thus protected by the Safe Harbor Rule in the event the transferor files bankruptcy. Note, however, this only applies if the transferor files bankruptcy.