Mitigating Lender Risk in Constructive Fraudulent Transfer Litigation

There is some ambiguity in the case law over what constitutes knowledge for purposes of collapsing the multi-step loan transaction. At a minimum, knowledge means that the lender in a multi-step loan transaction such as an LBO or dividend recapitalization knows the various steps of the loan transaction and purpose and use of proceeds of the underlying loan — i.e., redemption of stock or payment of a dividend. To that end, virtually all syndicated loans will satisfy this requirement, as the use of loan proceeds will be disclosed in any confidential information memorandum circulated to prospective lenders, and the loan agreement itself will likely have a section outlining the use of proceeds.

Some case law suggests that in order to satisfy the "knowledge" prong of the collapsing doctrine, the plaintiff must also prove that the lender "knew or consciously avoided discovering that" the LBO or dividend that the lender was funding was a constructive fraudulent transfer "or that the Debtor was insolvent or that it would be rendered insolvent as a result of the acquisition." See, In re Sunbeam, 284 B.R. 355, 372-73 (Bankr. S.D.N.Y. 2002). Such "knowledge" standard is harder to prove, as there is effectively a rebuttable presumption that a lender would not knowingly fund into an insolvent enterprise, with a potential clawback exposure. To state the obvious, defending against collapsing is one of the lender's primary lines of defense in fending off a constructive fraudulent transfer claim.

Since a large portion of syndicated loans are made to fund LBOs and dividend recapitalizations, a lender party to such transactions must be aware of the risk that its loan is subject to a fraudulent transfer challenge and strategically position itself to defend against that risk. Even a refinancing of an LBO loan has some risk to the new lenders, which should be accounted for when such loans are made. The fraudulent transfer argument made in this context is that refinancing a tainted fraudulent transfer loan does not provide a benefit to the debtor. The counter-argument is that the debtor actually received the proceeds of the refinancing and the real target should remain the original lender to the LBO or dividend recapitalization.

Derivative Standing

It is important that a lender understand the procedural considerations related to the prosecution of bankruptcy estate claims, including a constructive fraudulent transfer claim against a lender. Typically, the debtor-in-possession through its board of directors decides whether to prosecute or settle estate claims. In certain situations, the board may have been involved in the transactions at issue, in which case an independent director may be appointed for purposes of investigating such transaction. In this and other circumstances, many courts, including the Second Circuit in Unsecured Creditors Comm. of Debtor STN Enters. v. Noyes (In re STN Enterprises), 779 F.2d 901 (2d Cir. 1985), have granted control over the prosecution and/or settlement of estate claims to creditor committees (i.e., obtain "derivative standing"). To obtain derivative standing, a creditors' committee must either: 1) file a motion with the bankruptcy court that (a) presents colorable claims for relief "that on appropriate proof would support a recovery" and (b) demonstrates that the "debtor unjustifiably failed to bring suit"; or 2) obtain it consensually from the debtor-in-possession.

A lender may be able to leverage its support for the creditors' committee's efforts to obtain derivative standing for certain estate claims in exchange for the creditors' committee's agreement to support the non-prosecution and release of constructive fraudulent transfer claims against such lender in connection with a plan of reorganization or separate settlement agreement. Other consideration commonly provided by a lender include: 1) "gifting" additional economic consideration to other creditors in connection with a plan of reorganization or other bankruptcy transactions; 2) stipulating or settling certain contested issues favorably to other creditors, such as valuation of collateral, intercompany claim reconciliation or the scope of unencumbered property; and 3) conceding points ancillary to creditor recoveries that are important to trade creditors and other stakeholders, such as assumption of executory contracts and less debt in the capital structure at emergence.

In addition, lenders must ensure that their diligence and communications (both internal and external) at the time of the loan substantiate the lender's belief that the borrower and any subsidiary guarantors are each solvent immediately after the loan was made. Lenders should also keep records of any such diligence and communications. Oftentimes, third party solvency opinions are made a condition precedent for the loan. In the case of guarantor-obligors, it is useful to document the direct and indirect benefits received by the guarantor in exchange for providing its guaranty.

It is also important to remember that constructive fraudulent transfer litigation is often brought years after the transfer were made. In such circumstance, it may be that economic events occurring after the loan is what caused the insolvency of the debtor. Lenders should document these unforeseen changes in the borrower's financial condition after the loan was made in order to bolster their defense to a constructive fraudulent transfer claim.

Moreover, where possible, the lender should structure the loan to avail itself of Bankruptcy Code §546(e), which bars a transfer from being avoided as a constructive fraudulent transfer if such transfer is made by a "financial institution" in connection with a "securities contract."

Analysis

Finally, though constructive fraudulent transfer claims against pre-petition equity holders and D&Os may boost a lender's recovery either directly (through participation in any recovery) or indirectly (by distributing the recovery to other creditors for purposes of a consensual plan of reorganization), the same underlying facts and considerations that give rise to the constructive fraudulent transfer claims against others may also support loan avoidance. Accordingly, lenders must carefully analyze the full ramifications of how best to approach the constructive fraudulent transfer issue when it emerges in their bankruptcy case.

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Arthur Steinberg is a partner in King & Spalding's financial restructuring practice. Michael R. Handler is a senior associate in the practice. This article also appeared in the New York Law Journal, an ALM sibling of The Bankruptcy Strategist.