Fraudulent Conveyances, Agency Costs, and Leveraged Buyouts

Abstract

WHEN the managers of RJR-Nabisco announced that they wanted to take the company private, the value of its bonds dropped by $500 million in a single day. The manager's plan, as in most buyouts, called for dramatically increasing the debt-equity ratio of the firm. Instead of holding a senior interest in a firm that had assets greatly in excess of its liabilities, the bondholders found that they would be left with an interest in a firm with the same assets but encumbered with much more debt. They would have claims against a firm with a greater risk of becoming insolvent and of being unable to pay its creditors in full. The same promise from a riskier debtor is worth less-in this case, it might seem, $500 million less. Transactions in which a firm is sold and becomes substantially more leveraged were commonplace in the late 1980s. They accounted for over 20 percent of takeover activity in the United States and totaled almost $50 billion a year.' The legal rights of prebuyout creditors will be a focal point of litigation in any of these transactions that unravel in the 1990s, as some already have and more inevitably will. Before they lend, creditors can insist on a variety of event risk covenants such as poison that allow them to accelerate the firm's obligations to repay in the event that the firm dramatically changes its capital structure. Poison puts and other clauses, however, aid only those who have them. Those parties who do not, like parties to any other agreement, must look to the background legal rules to flesh out their obligations. The rules governing the rights of the bondholders fall within