## Facts

- Bay Plastics, Inc. manufactured PVC plastic pipe and was owned by three founders/shareholders.
- Bay had entered a requirements contract with a supplier that held a security interest in all Bay assets and had personal guaranties from the selling shareholders.
- On October 31, 1988, the selling shareholders sold all Bay stock to an acquisition buyer for $3.5 million cash plus $1.8 million in deferred payments.
- The purchase was structured as a leveraged buyout (LBO) in which Bay, at the buyer’s direction, borrowed approximately $3.95 million from a lender; about $3.5 million of the loan proceeds was paid from escrow to the selling shareholders.
- To close the transaction, the supplier released its security interest and the selling shareholders’ guaranties; the supplier was not informed that the acquisition would be financed by Bay’s incurrence of new debt used to pay the shareholders.
- Immediately before the LBO, Bay’s balance sheet reflected roughly $1.1 million in net equity.
- Immediately after the LBO, Bay’s balance sheet reflected roughly $7 million in assets and $9 million in liabilities, including newly recorded goodwill of about $2.6 million.
- Bay was unable to service the new debt load and filed Chapter 11 on January 25, 1990.
- Bay, as debtor-in-possession, sued to avoid and recover the LBO payments as fraudulent transfers; the lender settled, leaving the selling shareholders as defendants on the summary-judgment motion.

## Issues

1. Whether the LBO payments to the selling shareholders were avoidable as constructive fraudulent transfers under California UFTA, as invoked through 11 U.S.C. § 544(b), because Bay did not receive reasonably equivalent value and was rendered insolvent (or left with inadequate capital).
2. Whether the selling shareholders could defeat avoidance or recovery by establishing a good-faith defense.
3. Whether Bay could recover the value transferred from the selling shareholders as transferees of an avoidable transfer.

## Decision

- The court granted summary judgment for Bay on undisputed facts.
- The court held the LBO payments were avoidable as constructive fraudulent transfers under California UFTA via 11 U.S.C. § 544(b).
- The court found Bay did not receive reasonably equivalent value in exchange for the debt-funded payment to the selling shareholders.
- The court found the transaction rendered Bay insolvent.
- The court held the selling shareholders did not act in good faith and could not rely on a good-faith defense.
- The court held Bay was entitled to recover from the selling shareholders the amounts they received in the LBO.

## Legal Principles

- Under 11 U.S.C. § 544(b), a debtor-in-possession may avoid a transfer that an actual unsecured creditor could avoid under applicable state law, including a state’s Uniform Fraudulent Transfer Act.
- A transfer (or obligation) is constructively fraudulent under California UFTA when the debtor does not receive reasonably equivalent value and the transfer leaves the debtor insolvent or otherwise financially impaired as defined by the statute.
- In an LBO, where the target company incurs new debt and the proceeds are used to pay selling shareholders, the payment may be treated as a transfer of the debtor’s property to or for the benefit of the shareholders for fraudulent-transfer purposes.
- Reasonably equivalent value is assessed from the debtor’s standpoint; an accounting entry such as newly recorded goodwill does not establish value if it does not reflect a real economic benefit to the debtor.
- A transferee asserting good faith must show more than lack of intent to defraud; knowledge of the transaction’s debt-loading structure and associated creditor risk can defeat a good-faith defense.
- Upon avoidance, the estate may recover the value of the transfer from transferees subject to applicable statutory limits and defenses.

## Conclusion

The court treated the debt-funded shareholder payout in an LBO as a transfer of the debtor’s property and held it avoidable as a constructive fraudulent transfer where the debtor received no reasonably equivalent value and was rendered insolvent; because the selling shareholders lacked good faith, the estate could recover the amounts paid to them.


Bay Plastics, Inc. v. BT Commercial Corp. (In re Bay Plastics, Inc.), 187 B.R. 315 (Bankr. C.D. Cal. 1995)