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Last week, a New York bankruptcy judge ruled that former shareholders of the bankrupt Lyondell Chemical Company, who sold their shares as part of Lyondell’s 2007 leveraged buyout, may not take refuge in the Bankruptcy Code’s safe harbor provisions and therefore cannot shield themselves from state law fraudulent transfer claims brought by Lyondell’s creditors.

In 2007, a Luxembourg entity controlled by Leonard Blavatnik acquired Lyondell, a Texas-based chemical company, in a transaction that was 100% financed by debt secured by Lyondell’s assets (an LBO).  As part of the LBO transaction, Lyondell shareholders received $12.5 billion in exchange for their Lyondell shares.

The Bankruptcy Code allows creditors to claw back transfers made by a bankrupt entity in the two years prior to the bankruptcy filing under two scenarios.  Under a “constructive” fraud theory, a transfer may be clawed back where the bankrupt company received less

than reasonably equivalent value in exchange for the transfer and either (a) was insolvent on the transfer date or became insolvent as a result of the transfer, (b) was left with unreasonably small capital after the transfer, or (c) intended to incur, or believed it would incur, debts that would be beyond its ability to pay.  Under an “intentional” fraud theory, a transfer may be clawed back if it was made with the actual intent to hinder, delay, or defraud one of the company’s creditors. 

Proving intentional fraud is usually much more difficult for a plaintiff as it needs to present evidence that the bankrupt entity made the transfer with the actual intent to defraud creditors.  Notably, the intent of the party receiving the allegedly fraudulent transfer (whether fraudulent or otherwise) is not at issue under either an intentional or constructive fraud claim.

The Bankruptcy Code’s safe harbor provisions shield former shareholders such as Lyondell’s from most constructive fraud lawsuits, but not intentional fraud ones.  Therefore, unless they can prove fraudulent intent, Lyondell’s creditors cannot use the Bankruptcy Code to recoup payments made to Lyondell shareholders during the 2007 LBO. 

Given this impediment, Lyondell’s creditors argue that the Bankruptcy Code does not prevent them from using state law to claw back the shareholder payments (most states have claw back laws similar to the Bankruptcy Code).  In other words, Lyondell’s creditors seek to claw back the Lyondell shareholder payments under a state law constructive fraud theory.  In total, Lyondell’s creditors, through a litigation trust, seek to claw back $6.3 billion of 2007 LBO payments made to Lyondell’s former shareholders.

Lyondell is not the only case where this legal theory is being tested.  In claw back litigation stemming from the Tribune Company’s bankruptcy case, a Tribune creditor litigation trust seeks to recoup $8.2 billion paid to Tribune’s shareholders as part of Tribune’s failed 2007 LBO.

If the Lyondell ruling withstands appeal, shareholders who cash out during an LBO face the prospect of being targeted in future claw back lawsuits if the surviving company fails.  This presents a difficult conundrum to shareholders facing a buy-out of

their shares.  If they do not agree to sell back their shares, the shares will become worthless when the transaction closes.  If they choose to sell back their shares and the resulting company fails, they could be hit with a lawsuit years after the sale.  Further, because the individual shareholder’s intent is not at issue under either an intentional or constructive fraud theory, the shareholder’s good faith in cashing out his or her shares does not shield the transfer from possible claw back.