Recent Developments in Acquisition Finance

October 05, 2016

A recent Delaware bankruptcy court decision may potentially place at risk an equity sponsor’s ability to retain proceeds from the sale of a portfolio company whose performance later deteriorates, where the selling sponsor acted in bad faith and the portfolio company was or became insolvent at the time of or on account of the sale. 

Circuit Break? Delaware Bankruptcy Court Rejects Second Circuit Ruling on State Law Fraudulent Transfers 

The U.S. bankruptcy court in Delaware, in In re Physiotherapy Holdings, Inc.,1 declined to follow a recent ruling of the Court of Appeals for the Second Circuit in Tribune,2 addressing the issue of whether creditors’ constructive fraudulent transfer claims under state law are preempted -- and thus barred -- by the U.S. Bankruptcy Code.3 The resulting difference in law in the second and third circuits, at least while it continues (pending appeals), could have significant implications for the finality of certain leveraged acquisition transactions and the payments received by sellers in connection with such transactions. 

Like fraudulent transfer actions under U.S. federal law, those under state law generally allow payments made by an insolvent entity for insufficient value to be disgorged from the recipients. In the context of a leveraged buyout, creditors of the target may later assert that the target became insolvent by virtue of the debt it incurred to finance the acquisition. The creditors may then also allege, in or outside of a bankruptcy case, that the target received insufficient value in return for the debt it incurred, since the proceeds of the debt would typically have been unavailable for use by the target, having been used instead to fund the purchase price owing to the sellers under the related acquisition agreement. In such event, the payments would generally be eligible to be clawed back from the sellers and made available for distribution to creditors of the insolvent target. 

At issue in the case was the scope of one of the exceptions4 under the U.S. Bankruptcy Code to the ability to assert certain fraudulent transfer claims. The exception is a “safe harbor” that precludes constructive (i.e., non-intentional) fraudulent transfer claims if the transfer in question is a “margin payment” or “settlement payment” made by or to certain brokers, financial institutions or securities clearing agencies (among others) in connection with a “securities contract.” The exception protects recipients of payments made and obligations owing under certain swap agreements and other derivative instruments, shielding them from claims of avoidance and claw-back even if asserted to have been made or incurred by an insolvent party for less than fair value. 

Because of the broad definitions of certain terms used in this federal exemption, such as that of “securities contract,” the exemption can be read broadly as covering all payments made to a financial institution under a contract to acquire securities, including any acquisition agreement pursuant to which a buyer agrees to purchase a target’s equity securities from the existing equity owners, and thus as shielding all such payments under the safe-harbor. Even when so read, however, the federal exemption expressly covers only constructive fraudulent transfer claims under federal law,5 and not those under state law. State law fraudulent transfer claims typically would cover many of the same transactions and payments as the corresponding federal claims, and often with longer “look-back” periods than under federal law, making them even more attractive to creditors in many cases.6 In order to hold that the federal exception bars the state law claims as well, it must be held to “preempt” state law in the area. This question of preemption is the main issue addressed by and separating the courts’ rulings. 

Background of the Physiotherapy Case 

In 2007, the target entity in question, Physiotherapy Holdings, Inc., a provider of physical therapy services across the U.S. (the “Target” or “Debtor”), was acquired by a private equity firm and later, in 2012, sold for a profit to another private equity firm in a leveraged acquisition under which a portion of the proceeds of the Target’s acquisition financing funded the payment of the purchase price to the Target’s shareholders. (The remaining proceeds of the acquisition financing refinanced the target’s existing credit facility and funded transaction fees and expenses.) On closing of the 2012 acquisition, the Target had incurred or assumed US$210 million of senior secured notes and US$100 million of term loans. In 2013, the Target defaulted on its senior secured notes and filed a bankruptcy petition under Chapter 11 of the U.S. Bankruptcy Code. 

In the Chapter 11 case, a litigation trust was created to pursue the individual claims of creditors of the Target, now the Debtor in the case. The trustee for the litigation trust filed a complaint in the case that included an action, on behalf of the senior secured noteholders, to avoid and disgorge the payments made to the selling shareholders in the 2012 acquisition, as constructive fraudulent transfers under the Pennsylvania Uniform Fraudulent Transfer Act.7 The complaint alleged that the selling shareholders, in the 2012 acquisition, had “fraudulently overstated the Debtor’s revenue stream and its overall firm value”8 in the related securities offering memorandum in selling “an insolvent company,”9 with the secured noteholders receiving “debt instruments worth far less than their face value.”10 According to the complaint, “the sum of all of the foregoing was that Physiotherapy incurred a massive amount of new debt -- predicated on false financials -- the proceeds of which were transferred out to Physiotherapy’s former owners without receiving anything of value in return.”11 The selling shareholders argued that the payments made to them under the 2012 acquisition were protected by the Bankruptcy Code’s safe harbor exception,12 which they asserted had preempted the state law fraudulent transfer claims brought by the trustee. 

The court acknowledged that the same issue had recently been addressed by the Second Circuit Court of Appeals in Tribune, but noted that the Second Circuit decision was not binding on the Delaware bankruptcy court, and proceeded to examine the relevant issues. 

The Court’s Preemption Analysis 

The Physiotherapy court noted that the field of fraudulent transfer law is one that had traditionally been occupied by the states, given the considerable history of state fraudulent transfer and fraudulent conveyance legislation, and applied a presumption against federal preemption of the state law that could be overcome only by evidence of a clear intention of Congress to preempt state law. The court was not eager to infer preemption absent a “clear and manifest purpose of Congress.”13

Notably, the Second Circuit Court of Appeals in Tribune had shown considerably less deference to the states in this connection, stating that “the policies reflected in [the Bankruptcy Code safe harbor] relate to securities markets, which are subject to extensive federal regulation”14 and concluding that there was thus “no measurable concern about federal intrusion into traditional state domains.”15 In other words, because federal regulation in the area had become extensive, it effectively overrode the tradition of state law in the field and made the presumption against preemption inapplicable. 

The Physiotherapy court cited the legislative history of the federal safe harbor in question and concluded that its purpose “is to mitigate the potential systemic risk of certain complex financial transactions.”16 Specifically, the court referenced a 1990 House Report which stated that the purpose of the provision was “to ensure that the swap and forward contract financial markets are not destabilized by uncertainties regarding the treatment of their financial instruments under the Bankruptcy Code.”17 The court concluded that allowing the state law fraudulent transfer claims at issue could pose no systemic risk of destabilization or “ripple effect” in securities markets, since no swaps or derivative securities, and for that matter no public securities at all, were involved in the case at hand.18 The court rejected Tribune’s broader view of the reach of the federal safe harbor that included within its purpose the achievement of finality in securities transactions.19 Reading this purpose into the federal law militates strongly in favor of preemption of the state law, since avoiding a prior transfer as fraudulent under state law obviously cuts against the finality of prior transactions. 

Ultimately the Physiotherapy court distinguished the facts in the case before it from those at issue in Tribune by noting that Tribune had not involved defendants who were corporate insiders alleged to have acted in bad faith. According to the Physiotherapy court, allowing bad-faith transferees to escape liability under state fraudulent transfer laws by using the federal safe harbor would “run counter to Congress’ policy of providing remedies for creditors who have been defrauded by corporate insiders.”20 Tribune, on the other hand, had involved numerous public security holders as the potential targets of the state law fraudulent transfer action and the related payment clawbacks. 

The Physiotherapy court also found that the plain language of the federal safe harbor does not support preemption, noting the absence of language such as “notwithstanding any applicable law,”21 and noting the use only of the word “trustee” in the provision and its lack of reference to other parties, such as the individual creditors who were the parties-in-interest in the state law claims at issue (as assignors of such claims to the related litigation trust). 

The court concluded that the presumption against preemption was not rebutted and that the federal safe harbor thus did not preempt the state law constructive fraudulent transfer claims in the case at hand. The court framed its ruling as follows: “[A] litigation trustee may assert state law fraudulent transfer claims in the capacity of a creditor-assignee when: (1) the transaction sought to be avoided poses no threat of “ripple effects” in the relevant securities markets; (2) the transferees received payment for non-public securities; and (3) the transferees were corporate insiders that allegedly acted in bad faith.”22

What This Means for Sponsors 

If not reversed on appeal, the holding in Physiotherapy could give an insolvent company and its creditors an attractive venue for a bankruptcy case -- Delaware -- where state law constructive fraudulent transfer claims may be available against the previous selling sponsor if accused of bad faith and/or willful misrepresentation in connection with the earlier sale, where the company is alleged to have become insolvent by virtue of the related acquisition financing whose proceeds were used to pay the selling sponsor its purchase price in exchange for the target’s shares. Such state law actions may not currently be asserted in a bankruptcy case within the Second Circuit on account of the Tribune decision that controls there, as discussed above. 

The scope of the Physiotherapy holding is limited in certain respects, applying only to non-public securities transactions involving corporate insiders alleged to have acted in bad faith and which are unlikely to have systemic “ripple effects”23 in the securities markets if avoided. Yet, the holding seems particularly relevant in the context of certain private equity transactions, where privately held shares in a target are sold by one sponsor to another in a leveraged acquisition and the solvency of the target on the date of sale may ultimately be called into question by alleged accounting irregularities or other alleged willful misrepresentation or bad faith on the part of the selling sponsor. 

It would not be surprising to see more such claims asserted in Delaware bankruptcy cases going forward. However, as they presuppose acts by the sellers consisting of intentional wrongdoing, their impact should be limited. We look forward to updating you on additional developments in our next newsletter. 


1) PAH Litig. Tr. v. Water St. Healthcare Partners, L.P. (In re Physiotherapy Holdings, Inc.), Adv. Pro. No. 15-51238, ECF No. 250 (Bankr. D. Del. June 20, 2016) (“Physiotherapy”).
2) Deutsche Bank Tr. Co. Americas v. Large Private Beneficial Owners (In re Tribune Co. Fraudulent Conveyance Litig.), 818 F.3d 98 (2d Cir. 2016) (“Tribune”).
3) 11 U.S.C. § 546(e).
4) Id.
5) Id. § 548.
6) For example, the statute of limitations under New York’s fraudulent conveyance statute is six years. See NY CPLR § 213 (2015). See also Orr v. Kinderhill Corp., 991 F.2d 31, 35 (2d Cir. 1993) (“[A]ctions for constructive - rather than actual - fraud have long been subject to the catch-all limitations period of CPLR § 213(1)…”).
7) See Compl. ¶¶ 156-165 (seeking avoidance and recovery of distributions pursuant to 12 Pa.C.S.A. §§ 5104(a)(2), 5105, and 5107) (Adv. Pro. No. 15-51238, ECF No. 1).
8) See Physiotherapy, Case No. 15-51238, at 2.
9) Id.
10) Id.
11) See Comp. ¶ 89.
12) 11 U.S.C. § 546(e).
13) Physiotherapy, Case No. 15-51238, at 16 (quoting Wyeth v. Levine, 555 U.S. 555, 565 (2009)).
14) Tribune, 818 F.3d at 112.
15) Id.
16) Physiotherapy, Case No. 15-51238, at 19.
17) Id. (quoting H.R. Rep. 101-484 (1990)) (emphasis added by the court).
18) See id. at 20.
19) See id. at 18-19.
20) Id. at 21.
21) See, e.g., 11 U.S.C. § 541(c)(1).
22) Physiotherapy, Case No. 15-51238, at 22.
23) Physiotherapy, Case No. 15-51238, at 22.

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