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The recent case of Mervyn’s LLC v. Lubert-Adler Group IV, LLC, et al. (In re Mervyn’s Holdings, LLC),1 serves as a warning to sellers and equity firms participating in leveraged buyouts to be wary of the effect such buyouts will have on creditors of the target company. In Mervyn’s, the Delaware Bankruptcy Court rejected a motion by Target Corporation (“Target”) to dismiss a suit by Mervyn’s, LLC (“Mervyn’s”), a former subsidiary of Target, alleging fraudulent transfer and breach of fiduciary duty claims against Target and a group of private equity firms in connection with the leveraged buyout (“LBO”) sale of Mervyn’s. By “collapsing” the steps of the LBO into a single transaction, and considering their net effect, the court determined that Mervyn’s had stated allegations sufficient to raise a triable issue of fact.
Mervyn’s was a retail store chain, wholly owned by Target, which entered into an equity purchase agreement (the “Agreement”) with a group of three private equity groups to form Mervyn’s Holdings, LLC (“Mervyn's Holdings”) and several bankruptcy remote entities (the “MDS Companies”) as vehicles to conduct a leveraged buyout of Target’s interest in Mervyn’s for $1.175 billion. The Agreement required Target to convert Mervyn’s from a corporation into a limited liability company, and prohibited Target from selling or transferring any of the Mervyn’s real estate assets other than pursuant to the Agreement. Mervyn’s Holdings, and the private equity investors, borrowed funds to purchase Mervyn’s from third-party lenders, using the real estate assets as collateral. Substantially all of the loan proceeds were used to pay Target. It is important to note that, unlike in a traditional LBO, Mervyn’s real estate assets did not remain with Mervyn’s. Rather, they were transferred from Mervyn’s Holdings to the MDS Companies, controlled by the equity investors, for little or no consideration; Mervyn’s received no residual interest in its own real estate assets, nor any of the proceeds from their sale. The MDS Companies then leased the real estate back to Mervyn’s at a substantially increased rent in order to service the acquisition debt, as well as extract, over time, the residual value of the real estate. In its adversary complaint filed against Target and the private equity investors, Mervyn’s contended that it was this loss of the value of its real estate, and the over leveraging of Mervyn’s, which led to its bankruptcy.
Mervyn’s alleged in its complaint that the leveraged buyout constituted an actual and a constructive fraudulent transfer which should be avoided under section 544(b) of the Bankruptcy Code, and that Target was liable under section 550 as the transferee of the sale proceeds. The complaint also alleged that Target and the investors violated their fiduciary duties to Mervyn’s and its creditors during their respective periods of ownership. Target moved to dismiss pursuant to Rules 8, 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure.
The Court stated that it would “collapse” the various transactions of the leveraged buyout—the execution of the Agreement, the stripping of the real estate assets, and the leaseback of the property—into a single conveyance, and consider the overall effect of the transaction. The court relied on the Third Circuit’s decision in United States v. Tabor Court Realty Corp.,2 which stated that “courts may look beyond the exchange of funds and collapse the individual transactions of a leveraged buyout,” and then consider the net effect on the creditors of the estate.3 The Court identified three factors in determining whether to collapse the transaction: (i) whether all of the parties involved had knowledge of the multiple transactions, (ii) whether each transaction would have occurred on its own, and (iii) whether each transaction was dependent or conditioned on the others.4
The Court found that the buyout of Mervyn’s should be collapsed. Target was aware of the identity of Mervyn’s Holdings and its members, and admitted in its motion that it received copies of the commitment letters from the lenders which loaned the sale proceeds. The Court also noted that the provisions of the Agreement requiring Target to convert Mervyn’s into a limited liability company were further evidence of Target’s knowledge of the true nature of the transaction. Furthermore, “all of the transactions comprising the [LBO] required the execution of the Agreement,” were interdependent, and would not have occurred without each other.
Having met the criteria for “collapsing” the transaction into a single action, the Court then considered the overall effect on the Mervyn’s creditors. Here, the Court found the alleged effect to be “devastating, including the stripping of the Mervyn’s real estate assets, the increasing of rent from the leases to enable Mervyn’s Holdings to meet its acquisition debt, and the creation of a conflict of economic interest for Mervyn’s Holdings as the owner and managing member of Mervyns and an affiliate of the MDS Companies. Mervyn’s was left with working capital as little as $22 million and acquired additional debt totaling over $800 million.” The facts as alleged by Mervyn’s were thus sufficient to raise a triable issue of fact under the Tabor Realty criteria.
The Court rejected Target’s assertion that the sale fell within the “safe harbor” provision for “settlement payments” contained in section 546(e). This section provides that a trustee or debtor in possession “may not avoid a transfer that is a settlement payment...made by or to a...financial institution.” 11 U.S.C. § 546(e). A “settlement payment” is generally defined as “the transfer of cash or securities made to complete a securities transaction.”5 Third Circuit courts have held that a payment through a financial institution to a shareholder in the course of a leveraged buyout, even a sale of privately held securities, is “obviously a common securities transaction” and therefore a settlement payment.6 However, as a general rule, section 546(e) does not apply to “collapsed” transactions such as the one considered, because not all of the component transactions are “settlement payments” within the parameters of the safe harbor. Here, the transfer of the real estate assets to the MDS Companies, for virtually no consideration, was not a “settlement payment” within the meaning of the statute, and since the financing of the sale was conditioned upon the real estate transfer, section 546(e) was not applicable. In addition, section 546(e) is not applicable if actual intent to hinder, delay or defraud creditors is involved and the Mervyn’s complaint contained pointed allegations of actual fraud and how the events surrounding the sale were interdependent.
The Court also rejected Target’s contention that a sole member of a California LLC owes no fiduciary duty to the LLC or its creditors. While noting that the California Supreme Court had not explicitly ruled on the issue, the Court stated that it believed California’s high court would find that such duties are owed to the LLC and its creditors. Relying on First American Real Estate Information Services, Inc. v. Consumer Benefits Services, Inc.,7 the Court found that “a member of a California LLC owes fiduciary duties to the entity and its fellow members.” Further, Target’s arguments notwithstanding, California law holds that fiduciary duties are owed to creditors when the company is insolvent.8 As the complaint pleaded that Mervyn’s became insolvent due to the stripping of the real estate assets, Target, as the owner of Mervyn’s at the time of the closing, thus owed a fiduciary duty to the Mervyn’s creditors. Mervyn’s had thus stated facts sufficient to support a cause of action for a breach of that duty.
Finally, the Court addressed Target’s argument that the exculpation clause in the Mervyn’s operating agreement protected Target from any liability for negligence or gross negligence. The Court noted that the Third Circuit has held that “protection of an exculpatory charter provision appears to be in the nature of an affirmative defense. …affirmative defenses generally will not form the basis for dismissal under Rule 12(b)(6).”9 As such, the determination of the viability of the exculpation clause was improper at this stage.
The Mervyn’s decision is a stark reminder to the participants in leveraged buyouts of their responsibilities to creditors of the target entity. Courts are aggressively examining buyouts to determine the “net” effect on creditors, and will not be distracted by multiple-layered transactions used to effectuate a sale. By denying Target’s motion to dismiss, the Delaware Bankruptcy Court signaled its willingness to scrutinize LBOs to ensure that asset transfers are not prejudicial to the interests of creditors should the purchased company later declare bankruptcy.
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For more information on the Restructuring, Workouts and Recapitalizations group and its members, go to Restructuring, Workouts and Recapitalizations. You may also read the alert in the PDF linked below.
1 2010 Bankr. LEXIS 670 (Bankr. D. Del. Mar. 17, 2010).
2 803 F.2d 1288, 1302 (3d Cir. 1986).
3 In re Hechinger Inv. Co., 327 B.R. 537, 546-47 (Bankr. D. Del. 2005).
4 In re Hechinger at 546-47
5 Lowenschuss v. Resorts International, Inc. (In re Resorts Int’l., Inc.), 181 F.3d 505, 515 (3d Cir. 1999)
6 In re Resorts Int'l. Inc, 181 F.3d at 516; In re Plassein Int’l Corp., 366 B.R. 318, 326 (Bankr. D. Del. 2007).
7 2004 U.S. Dist. LEXIS 30317 (S.D. Cal. 2004).
8 In re Jack’s, 243 B.R. 385, 390 (Bankr. C.D. Cal. 1999).
9 In re Tower Air, Inc. 416 F.3d 229, 242 (3d Cir. 2005).