Befuddlement Betwixt Two Fulcrums: Calibrating the Scales of Justice to Ascertain Fraudulent Transfers in Leveraged Buyouts

In a leveraged buyout, a company goes deep in debt and grants liens on its assets to finance the purchase of itself. The debt burden increases the company’s risk of insolvency. The company’s unsecured creditors are exposed to that risk without compensation. The parties to the leveraged buyout - buyer, seller and lender - expect good returns on the lesser risks to which they are exposed. When a leveraged buyout leaves the acquired company with “unreasonably small capital” such that insolvency is “reasonably foreseeable” upon consummation of the buyout, unsecured creditors may have recourse to constructive-fraudulent-transfer law. They need legal recourse because: (1) they are not party to the leveraged buyout; (2) they have no good proxy among the parties, and (3) absent legal recourse, many have no ability to negotiate protection against uncompensated harm. Constructive-fraudulent-transfer law is defective in providing needed recourse. Proof of “unreasonably small capital” is exceedingly expensive, requiring hiring experts to conduct forensic financial analysis of whether insolvency was “reasonably foreseeable” upon closing of the buyout in light of the company’s historical performance, the terms of the buyout loans and all foreseeable risks faced by the company. The “unreasonably small capital” standard is so vague that it is impossible for litigants (or deal parties trying to design terms to avoid risk of liability) to predict the outcome of litigation. This makes it hard for litigants to determine a reasonable settlement figure, and lengthy, expensive trials ensue. More often, aggrieved creditors recognize that pursuing legal recourse is a high-stakes gamble with unpredictable odds, and they settle at a steep discount from the recourse the law purportedly offers. Harm goes unremedied and thus doing harm not properly disincentivized. To fix these defects, we recommend carefully recalibrating the scales of justice through several clarifications of the standard for “unreasonably small capital.” We recommend that the law specify: • the probability at which cash-flow insolvency becomes “reasonably foreseeable;”• the post-transaction period over which the probability of insolvency is to be projected; • how margin-of-error is to be treated in determining whether insolvency is reasonably foreseeable; and• whether a transfer is fraudulent if insolvency was reasonably foreseeable ex ante but the specific conditions ultimately precipitating insolvency were not.