LBOs leading to bankruptcy: how can directors protect themselves and creditors?

Scott J. Davis and William R. Kucera, in a Director Notes paper edited by the Conference Board, analyze this kind of transaction, where a large part of a cash merge is financed through debt. It is a not so rare that a certain time afterwards, the target company fails to comply with its obligations, not being able to repay principal and/or interest, to all creditors, preexistent, (that could not oppose), and those financing the transaction, (perfectly aware of the new situation).

 

A typical case is the acquisition of Lyondell by Basell. Just a year after the merge, the target filed for bankruptcy. The Court sued the former directors, for having approved a transaction that although beneficial to shareholders, introduced a large risk for creditors.

 

Curiously, those directors had been sued by shareholders under Revlon vs. McAndrews & Forbes doctrine, for failing to obtain the best value for shareholders once they approved a change in control, although without Courts favored them. But the positive resolution is used by plaintiffs now arguing directors acted against creditors legitimate interests.

 

Theories used to sue directors in cases like this are described below:

 

–         Payment to shareholders as an unlawful distribution, (one that forces the company into bankruptcy). An opinion by outside experts may help directors discharge their responsibilities. The fact though, is an acquisition is a different animal than a distribution.

–         The case is also made that directors breach their fiduciary duties to creditors or the company while accepting too much debt for the capacity of the target. But some bylaws prohibit companies from seeking compensation for the breach of the duty of care; second, it can also be argued that when approved, the company was not insolvent, and duties to creditors don`t appear until the company becomes actually insolvent.

–         Sometimes creditors argue directors violated state or federal fraudulent transfer or conveyance statutes.

 

Those are the claims in the Lyondell case, in particular that they breached their fiduciary duties of good faith, care and loyalty.

 

What can be done so that directors remain protected against such claims?

 

In general, directors need to be sure that they have a strong case if litigation ever takes place. For that they need to be able to show that they analysed the case and considered the insolvency event as improbable.

 

At least, in order to be able to strongly argue that, they need to evaluate -prior to accepting the leveraged transaction- the post transaction financial situation and expected evolution of the company, in terms of solvency.

 

In fact, directors should look for additional comfort, asking for management`s informed advise, outside advisors counsel, or representations from the buyer as for the post transaction solvency of the target.

 

In particular a third-party opinion on post closing solvency is not usual, but could be the best option.

 

In general, directors need to be able to act with the belief that they complied with their duties, (loyalty, care, good faith…).