• by Erik Sass  @eriksass1, August 3, 2010

One of the banks asked to confirm that the $8.2 billion Tribune buyout was solvent refused to do so in March 2007, according to The Wall Street Journal, less than a week after a court-appointed examiner said some of the transactions involved in the deal were potentially fraudulent.

Together, these confidential details from the period leading up to the buyout threaten to unravel the legal basis of the deal, and with it the plan for bankruptcy reorganization presented by Tribune's current management.

Three years ago, Sam Zell's buyout plan received a failing grade from Houlihan Lokey, an advisory-focused investment bank based in Los Angeles. It cited concerns that it would saddle Tribune with an insupportable amount of debt, and therefore refused to provide a "solvency opinion" certifying that the deal was financially sound.

However, the parties to the proposed deal -- including billionaire Sam Zell -- simply took the transaction to another firm, Valuation Research Corp., which agreed to render a favorable solvency opinion, allowing the buyout to move forward.

VRC's decision to give a stamp of approval to the deal was criticized last week by Kenneth Klee, the independent examiner appointed by the bankruptcy court to review the deal. He is investigating allegations brought by some bondholders that Tribune was doomed to bankruptcy from the start. What's more, the bondholders allege that at least some of the responsible parties knew the deal would end in insolvency, making it a "fraudulent conveyance."

By having the entire deal declared illegitimate from the beginning, the bondholders hope to halt the bankruptcy reorganization plan proposed by Tribune's current management, which would compensate banks and senior credits involved in the buyout before the bondholders.

The revelation that Houlihan Lokey considered the deal "DOA," as reported by the WSJ, is important because it suggests that responsible parties -- possibly including various individuals representing the buyers, sellers and lenders -- may have understood that the deal wasn't viable but proceeded anyway.

At the very least, the Houlihan Lokey warning about the deal's probable insolvency should have raised red flags leading to a more thorough review -- not the more superficial review it received from VRC.

In excerpts from his report to the bankruptcy court released last week, Klee cast suspicion on Tribune's assumption of $3.6 billion in debt, saying: "It is somewhat likely that a court would conclude that the Step Two Transactions constituted intentional fraudulent transfers and fraudulently incurred obligation."

The solvency of the buyout depended, in part, on the ratio of free cash flow to debt that Tribune had to maintain per its lending covenants with banks, including JP Morgan and Bank of America. That ratio fell below the agreed levels as a result of the steep decline in newspaper ad revenues, which began in 2006 and gathered speed in 2007.

Some comments from Zell suggested that he realized his team had not been given accurate information about Tribune's financial condition. In 2008, he told the newsroom of The Baltimore Sun that Tribune's previous management had overstated the company's operating cash flow by up to 20%.