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Grace under pressure: Revisiting fraudulent conveyance risk

In the 1980s and early 1990s it was not unusual for leveraged buy-outs to be found to constitute fraudulent conveyances. Andrew Bab of Debevoise & Plimpton suggests that the problem could be re-emerging and discusses the implications and possible solutions for private equity firms.

Most private equity players haven't been overly troubled by fraudulent conveyance risks since their transactions were called leveraged buyouts. A recent case, however, has some commentators and practitioners concerned that fraudulent conveyance could be resurfacing as a real transactional risk, at least under certain circumstances. Although a closer look at the case reveals that its relevance and applicability may be limited, still, private equity firms would be prudent to take it into account when due diligencing, structuring and pricing a deal.

The Old Days
Back in the 1980s and early 1990s, a number of courts around the nation were finding leveraged buyout transactions to constitute fraudulent conveyances. A typical transaction might have an acquisition vehicle, capitalized with minimal equity and substantial debt, acquire the target's stock through a merger in which the target would assume, by operation of law, all the debt of the acquisition vehicle. Courts sometimes collapsed these transactions and viewed the target as leveraging itself to pay out cash to its stockholders. If things went bad quickly, the cash paid to the stockholders (especially in a private company) could constitute a fraudulent conveyance, voidable by a trustee in bankruptcy.

The trustee would have to demonstrate two things. First, the debtor would have had to receive less than reasonably equivalent value for the assets it transferred. Courts had little trouble concluding that the target did not receive reasonably equivalent value when it effectively paid out cash to its stockholders in the transaction. Second, there must have been actual or constructive fraud. Actual fraud requires that the debtor actually intended to hinder or defraud a creditor, or intended to incur, or believed or reasonably should have believed that it would incur, debts beyond its ability to pay as they became due. Constructive fraud only requires that at the time of the transfer, the debtor was insolvent or became insolvent as a result of the transfer (or had unreasonably small capital to conduct its business). Dealmakers got a stark reminder recently from the decision in In re: W.R. Grace & Co. v. Sealed Air Corporation that solvency for fraudulent conveyance purposes may be determined in hindsight, and that the risk of calculating wrong at the time of a transaction may fall on the debtor and transferee, not the creditors.

The Sealed Air Decision
Sealed Air arose out of Grace's sale in 1998 to Sealed Air of its packaging division. This particularly complex deal was structured as a “reverse Morris Trust” transaction in order to obtain tax-free treatment for both Grace's and Sealed Air's stockholders. At the time of the transaction, Grace was comprised of two businesses: its specialty chemicals business and its packaging business. The specialty chemicals business had sold products containing asbestos for many years, and was at the time of the deal subject to thousands of pending tort claims, with the promise of thousands more.

Despite its labyrinthine form, the transaction was effectively an acquisition by Sealed Air of Grace's packaging division (Packco). The value of the transaction was put at about $4.9 billion - $1.2 billion in cash, which was effectively paid to Grace, and about $3.7 billion in new equity issued directly to Grace's stockholders. Because about three-quarters of the consideration went directly to Grace's stockholders and not to Grace itself, it seems clear that while Sealed Air may have paid reasonably equivalent value for Packco, Grace did not receive reasonably equivalent value, and the first prong of a constructive fraudulent conveyance analysis was met.

The case itself, however, addressed only Grace's solvency at the time of the transfer. When Grace went bankrupt, certain creditors argued that Grace was insolvent at the time of the transaction with Sealed Air, because the tens of thousands of asbestos claims that were filed after the transaction should be considered liabilities of Grace as of the date of the transaction. What about the fact that neither Grace nor Sealed Air could predict the number of claims that would be filed or the dollar amount of those claims? Doesn't matter - it was irrelevant whether the future-filed claims were reasonably foreseeable. The only issue in the Sealed Air court's mind was whether, given hindsight, there existed liabilities at the time of the transaction that rendered Grace insolvent.

The application of hindsight and the rejection of “reasonable foreseeability” are not terribly new concepts to fraudulent conveyance lore. However, in the mass tort context, given the unpredictability and potentially massive number of claims, burdening the debtor and the transferor with the entire risk of not guessing right or simply not knowing at the time of the transfer seems unfair - and indeed some other courts have flatly rejected the application of hindsight in the mass tort context. The Sealed Air court, though, felt that the victims of asbestos exposure “have their debtor forced upon them,” and that “the commercial expectations involved in corporate tax-avoidance must take second place.” Ultimately, the parties settled, and Sealed Air paid Grace's estate more than $800 million in cash and stock, effectively increasing the original purchase price by 17%.

Lessons for Private Equity
So what are the lessons for private equity firms? Perhaps the most important message is that when acquiring a business from a parent company, the buyer may want to look at whether the parent is rendered insolvent by the transaction. Performing some measure of due diligence on the parent may be as critical as performing it on the target business. What are the parent's liabilities? What might they be expected to be? In particular, are the parent's products prone to result in mass tort liability? This might be true, for instance, of chemical or drug manufacturers.

But another important message is that no matter how good the due diligence is, no matter how carefully the solvency of the parent was analyzed (for instance, Sealed Air obtained a solvency opinion as a condition to the closing of the transaction), under the Sealed Air case, none of that matters - the only question is whether in fact, based on hindsight, the seller's liabilities exceeded its assets at the time of the transaction. There is very little that a buyer can do to protect itself if there are liabilities that are simply unknown at the time of the transaction. Due diligence may, however, uncover risks or the tip of what an alert buyer may predict to be a much larger iceberg. The buyer could then decide against going forward, or focus more carefully on the structure of the transaction.
Even where a private equity buyer is acquiring an entire company (rather than a business or subsidiary of a larger entity), awareness of the fraudulent conveyance risk can prove to be quite important. For instance, if a buyer wanted to acquire Sealed Air (before the lawsuit was filed), an investigation of its former transactions might have uncovered the fraudulent transfer risk inherent in the Grace deal.

Evaluating the structure of transactions is also critical. Even if there is a question of solvency, there can be no fraudulent conveyance if the debtor receives reasonably equivalent value in the transaction. Buyers should try to avoid structures where value paid for an asset goes to stockholders rather than the seller itself. Fraudulent conveyance concerns may also arise where a portfolio company returns value to its stockholders in the form of a dividend - something that may become more common under the recently enacted tax rules. While these types of structures have always raised a red flag, the Sealed Air case highlights the fact that through the application of hindsight, the risks may be greater than one might think, particularly where mass torts are involved.

Andrew L. Bab (albab@debevoise.com) a Debevoise & Plimpton partner, is based in the firm's New York office, and is active in the firm's corporate, mergers and acquisitions and securities practices.

Debevoise & Plimpton, an international law firm, was founded in 1931. The firm, which now has more than 500 lawyers, provides international services in corporate, litigation, tax, and trusts and estates law. Debevoise & Plimpton offices are located in New York, Washington, DC, London, Paris, Frankfurt, Moscow, Hong Kong and Shanghai.

Reprinted with permission from The Debevoise & Plimpton Private Equity Report.  © 2003 Debevoise & Plimpton.  All rights reserved.  No portion of this article may be reproduced without the express consent of the authors.