Shareholders Retain LBO Payments in Exchange for Stock under Bankruptcy Code Exception



Posted: Wednesday, April 16, 2008

by
Montgomery McCracken

Usually in the context of bankruptcy, shareholders receive nothing for their equity interests unless all other creditors are paid in full. Even when shareholders receive payment prior to a bankruptcy filing, the Bankruptcy Code provides that such transfers may be subject to avoidance and therefore recovered by the bankruptcy estate. The Code, however, contains several exceptions to these general principles, one of which was recently examined on appeal before the United States District Court for the Western District of Michigan in the case of QSI Holdings, Inc. and Quality Stores, Inc. v. Cheryl A. Alford, et al., 2007 WL 4557855 (W.D. Mich.).

The catalyst of the dispute was a 1999 LBO in which Quality Stores, a privately held retailer of agricultural products agreed to merge with Central Tractor and Farm Country, Inc. and its parent company, CT Holdings. The merger agreement provided for payment to Quality's shareholders in cash or stock for their equity interests. Of the $208 million purchase price (obtained through a loan secured by all of the assets of Quality and CT Tractor), Quality shareholders received $111.5 million in cash and $91.8 million in stock in CT Holdings. In order to facilitate the transaction, CT Holdings deposited the $111.5 million with HSBC Bank, which in turn collected the outstanding shares of Quality stock and disbursed the funds to the shareholders.

After the merger, Quality experienced financial difficulties due to substantial integration costs and an aggressive rapid expansion plan. This led to the filing of an involuntary bankruptcy petition by a group of creditors against Quality, which was subsequently converted to a voluntary petition. Thereafter in 2003, Quality filed an action seeking to avoid the cash payments to the shareholders as fraudulent conveyances alleging that the shareholders gave less than reasonably equivalent value in exchange for the payments, that the transfer left Quality with unreasonably small capital and caused Quality to incur debts in excess of its ability to pay.

On motion for summary judgment, the shareholders argued that the payments at issue were settlement payments made by a financial institution and therefore were exempt from avoidance under Code Section 546(e). The bankruptcy agreed and granted the shareholders' motion, prompting an appeal by Quality.

The District Court, noting that the issue was one of first impression in the Sixth Circuit, upheld the bankruptcy court. At the core of the dispute was the lack of specificity concerning the definition of the term "settlement payment" in section 741(8) of the Bankruptcy Code. This section sets forth a range of types of payments that qualify as settlement payments, without any further guidance as to whether the term was limited to settlement payments on account of publicly traded securities or whether it extended to privately held companies as well. Due to this lack of specificity, the Court found there to be a split of authority on the issue-the broad view including both public and private and the narrow view, limited only to public. The bankruptcy court sided with the broad view.

The District Court refused to adopt Quality's argument that Congress intended to limit the settlement payment exemption to publicly traded companies and to transactions such as an LBO involving privately held stock, because in the Court's view, nothing contained in the language of the statute indicated that there was any such limitation. Further, the Court did not agree that public policy favored the narrow view in order to prevent the "absurd result" of shareholders retaining otherwise avoidable payments and jumping ahead of creditors, contrary to Bankruptcy Code policy. Rather, the District Court noted that equity favored the shareholders who no doubt had taken the proceeds and invested them elsewhere, which furthered Congressional intent in promoting the stability of the financial and securities markets, so as to prevent potentially reversing hundreds of transactions in connection with the LBO and consequentially disrupting market stability.

Comment: The decision finds that the Section 546(e) exemption draws no distinction between publicly traded and privately held securities. However, as noted by the Court, there may be "exceptional cases" where the exemption is not applicable as discussed in the case law (most notably in the Enron case), indicating that transactions involving payments to shareholders will continue to be subject to bankruptcy court review, with mixed results.

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