By Tom Hals
WILMINGTON, Delaware (Reuters) - An $8.4 billion lawsuit brought last week against Blackstone LP <BX.N> by creditors of the bankrupt Extended Stay hotel chain ranks as one of the largest ever filed over a failed leveraged buyout.
It could also take its direction from one of the smallest ever -- the recent, and otherwise forgotten bankruptcy of a New York restaurant that sold for just $1.1 million.
Essentially, a trust representing creditors of Extended Stay accused Blackstone and others of arranging an overpriced sale of the hotel chain to private equity investor David Lichtenstein with an allegedly conflicted Citigroup Inc <C.N> in between.
The lawsuit accuses Blackstone and other parties of lining their pockets at the expense of the hotel chain and its creditors, who suffered in the bankruptcy two years later.
That much is pretty standard fare for so-called fraudulent transfer cases, which often follow in the wake of failed leveraged buyouts.
Blackstone has said the lawsuit was without merit and Citigroup declined to comment.
The lawsuit, in Manhattan bankruptcy court, follows a recent decision in the district that could undermine the use of the so-called "settlement payment defense" to shield shareholders who sold into a buyout that went bust.
"It's actually become much harder to litigate LBOs because of the development of the settlement payment defense," said Stephen Lubben, a professor at Seton Hall Law School. "If the payments went through a financial institution, it's much harder to unwind them."
That may have changed, however, because of a ruling arising from a tiny failed leveraged buyout involving MacMenamin's Grill of the New York City suburb of New Rochelle.
Owners of the restaurant agreed to sell their shares to the restaurant in 2007 for a total $1.1 million -- a leveraged buyout so small that it was done with a Small Business Administration loan.
A year later the restaurant went bankrupt.
When a trustee for creditors sued the shareholders, they cited the settlement payment defense. Judge Robert Drain of the Southern District of New York rejected that, in part because the transaction did not involve publicly traded stock -- just as in the Extended Stay sale.
Shmuel Vasser, a bankruptcy attorney with Dechert LLP, said he expects the settlement payment defense issue to be "pervasive" to the Blackstone case following the MacMenamin's Grill decision, even though it was a minuscule bankruptcy.
"The size of the case is irrelevant," he said.
Jonathan Lipson, a professor at the University of Wisconsin Law School, said that settlement payments defense has been enlisted to protect a far broader group than intended by lawmakers, who were trying to prevent the roiling of stock markets if a deal was voided in a fraudulent transfer case.
"Settlement payment doctrine was intended by Congress to perform a different function than people want to use it for today," said Lipson.
Even if Blackstone is unable to use the settlement payment defense, it may have other ways to attack the lawsuit.
Blackstone will likely argue the bankruptcy was caused by a broader industry decline or economic recession and not its forecasts that were used to value the leveraged buyout.
There are other aspects of the case that are unusual.
For example, the creditors' trust also seeks punitive damages for the defendants breach of their fiduciary duty to the company and creditors.
"I can't think of a case where I've heard of that," said Gordon Smith, a law professor at Brigham Young University Law School.
The complaint seeks punitive damages of $6.3 billion, or triple the $2.1 billion that Blackstone is accused of "siphoning" off in the Extended Stay sale.
Some on-the-fly research by Smith turned up only 12 cases seeking punitive damages filed in Delaware, whose corporate law is governing that claim, with 162 cases in New York.
The standard for punitive damages generally requires evidence of intent to harm and involves something far outside the norm.
"A bad LBO would have be pretty bad," said Smith. "Business deals just aren't like that. There's always a story about how they could have turned out well. There's some story of why you're taking the risk."
The trust's case is The Extended Stay Litigation Trust v The Blackstone Group LP, et al, U.S. Bankruptcy Court, Southern District of New York, Adv. Pro. No. 11-02254. Similar complaints were also filed under the numbers 11-2255 and 11-2256.
The main bankruptcy case is Extended Stay Inc, U.S. Bankruptcy Court, Southern District of New York, No. 09-13764.
(Reporting by Tom Hals)