Dealing with Corporate Distress 18: Buying & Selling Distressed Businesses

The ABCs of ABCs, Business Bankruptcy, & Corporate Restructuring/Insolvency

Those unfamiliar with the world of business distress may not realize the potential value in buying or selling a distressed business or its assets. But for those in the know, acquiring distressed businesses and their assets can present a unique opportunity for both sellers and buyers. In this installment, we discuss some of the key elements of selling a distressed business outside of bankruptcy.

Deciding How the Business Will Be Sold

Both sellers and buyers should contemplate the mechanism by which a distressed business will be sold, including whether to do so through a bankruptcy process. Depending on the form of the sale, the level of protection afforded to both buyer and seller will vary, making this a key consideration for all parties involved.

Outside of bankruptcy, there are three overarching categories of distressed business sales: (1) through an ordinary stock or asset purchase acquisition; (2) under an assignment for the benefit of creditors (ABC) or by a court-appointed receiver; and (3) under Article 9 of the Uniform Commercial Code.

There are pros and cons to each of these structures. Each of them is generally a less public process than a bankruptcy sale, may not involve an auction or competitive bidding process, and are usually less complicated. For stock/asset sales, most ABC sales, and Article 9 sales, no court is involved that will have to approve the sale, meaning a buyer may have more leverage over key terms and that a deal can get done faster.

For context, distress sales can be thought of along a spectrum of the relative levels of protection each affords to buyers:

Form of Sale	Relative Protection Level	Risks Associated
Stock Purchase	Lowest	Stock purchasers assume liabilities of acquired company
“Naked” asset purchase (bill of sale or asset purchase agreement)	Lower	no bidding process; buyers advised to seek representations, warranties, and guarantor to stand behind them, or a holdback from the sales proceeds, to have recourse against the seller and principals in the event of creditor claims
Asset purchase following commercially reasonable marketing process	Medium	Marketing process strengthens defenses to fraudulent transfer and successor liability claims
Asset purchase from proper Article 9, ABC, or Receiver process	Higher	Properly noticed and conducted sales offer greater protections against potential creditor suits
Bankruptcy sale	Highest	Safest route requiring potentially greater expense, and public disclosure and competition

Strategic Debt Acquisition & Foreclosure

Prospective buyers considering the most efficient or effective means of acquiring a distressed business’s assets should consider acquiring the debt of the business’s senior secured lender where the distressed business is loaded with significant secured debt.

Why? Because the senior secured lender may be happy to offload its debt to a third party at a discount if doing so will save it the cost and time of foreclosing its liens against its debtor. And by acquiring the secured debt of the business, a buyer steps into the lender’s shoes, capable of foreclosing on the assets of the business through an Article 9 sale. Additionally, when the Article 9 sale is conducted, the buyer (now senior lender) will be able to credit bid up to the face value of the debt it purchased at a discount at such Article 9 sale or auction. Debt acquisition can be a highly effective means of acquiring distressed assets where the right facts present themselves, and good restructuring counsel will be capable of advising buyers regarding how effective such an approach will be.

To Stalk or Not to Stalk?

In the event that a sale will be conducted through a competitive marketing and auction process, one way for a buyer to gain a competitive advantage in the sale process is to enter into a “stalking horse” bid agreement with the seller-debtor. Stalking horse agreements are seen more frequently in the bankruptcy context but may be used outside of bankruptcy too. In effect, when a prospective buyer enters into a stalking horse bid agreement with a debtor, it commits to purchasing the seller’s assets at a specific price unless a higher and better offer is received for the assets. In exchange, the stalking horse bidder is granted specific protections, such as a break-up fee in the event a competing buyer acquires the assets. There are other benefits and drawbacks to serving as a stalking horse bidder, and being familiar with the concept can pay dividends for savvy asset buyers.

Due Diligence & Risk Assessment

Performing due diligence is important in any commercial business transaction, but in the context of a distressed asset sale, it can be even more so. Understanding why a debtor is looking to sell its assets, the factors leading to its financial or operational distress, and creditor claims against the debtor’s business will weigh heavily in determining whether a buyer will want to move forward with a sale, whether the purchase price being paid is appropriate under the circumstances and how to structure the sale.

One key piece of diligence that any prospective buyer should perform (as well as counsel to the debtor business) is to search public records for UCC financing statements, tax and judgment liens, and lawsuits. Doing so will help assess the claims against the debtor, painting a more realistic picture of the value of the business and its assets. This process will also assist a buyer in understanding who may pursue the buyer post-sale in the event there may be claims against the buyer for potential fraud or successor liability.

Another important part of the due diligence process when dealing with the sale of a distressed business is understanding the potential that creditors may assert fraud or successor liability claims against the buyer post-sale. If this likelihood is high, buyers may be well counseled to pass on the sale, as these claims can saddle a buyer with expensive litigation costs and potential judgments, undermining the deal’s value to the buyer.

Fraudulent Transfer Risks

Every state in the US has fraudulent transfer laws, and in most states, the laws are generally based on the Uniform Fraudulent Transfer Act (“UFTA”) (which also happens to be consistent in most respects with Bankruptcy Code § 548). Under the UFTA, a party can avoid (i.e., unwind) a transfer and claw back the value of the transfer to the transferor if the transfer was actually or constructively fraudulent. In the context of a transfer involving the sale of assets of a distressed business, therefore, creditors successfully asserting fraudulent transfer claims can undo a sale and claw back the assets of the seller or recover monetary damages from a transferee/buyer to pay claims of the seller’s creditors.

Under the UFTA, “actual fraud” exists where a transfer is made with the actual intent to hinder, defraud, or delay a creditor. Claims for actual fraud are very difficult to prove, even by circumstantial evidence. Regardless, courts allow for proof of actual fraud by circumstantial evidence, looking for so-called “badges of fraud” to determine whether a party acted with actual intent. The common badges of fraud considered by courts include whether:

• a personal relationship existed between the transferor and the transferee;
• the transfer included all or substantially all the transferor’s assets;
• the transferee was a party owned or controlled by the transferor, or
• the transferor was sued or threatened with litigation before the transfer.

Constructive fraud is comparatively easier to prove under the UFTA. Constructive fraud can be found where a transfer takes place that is unfair to the transferor/seller’s creditors because the transferee/buyer received property at the expense of the seller’s other creditors.

A successful claim for constructive fraud is made where the party asserting fraud can show essentially that the transferor transferred its assets for less than reasonably equivalent value, and the transferor:

• was insolvent at the time of the transfer or became insolvent as a result of the transfer;
• was engaged or about to engage in business or a transaction for which any property remaining with the transferor was unreasonably small; or
• intended to incur, or believed it would incur, debts that would be beyond its ability to repay.

The concept of “reasonably equivalent value” does not always mean that a transferee paid a fair purchase price for the assets transferred to it. Reasonably equivalent value can be established alternatively by the satisfaction of the existing debt, a release of a lien against the transferor’s property, or the transferee’s agreement to forego contractual remedies it holds against the transferor. Regardless, the party asserting constructive fraud bears the burden of showing that a transfer was made for less than reasonably equivalent value.

Successor Liability Risks

Another risk associated with acquiring the assets of a distressed business is the potential that claims based on successor liability theories will be brought against the buyer post-sale. Successor liability claims are not based in fraud. Rather, successor liability claims assert that, under the circumstances, a buyer should not be allowed to enjoy the full value of the assets it acquired and, at the same time, leave behind the liabilities of the distressed seller. The general rule is that buyers do not assume their seller’s liabilities. Thus, successor liability claims are presented as exceptions to this general rule, and theories of liability can take different forms, bearing different factors or criteria considered by courts when determining whether to impose liability against a buyer. They include

• Intentional assumption of liabilities: The most straightforward successor liability claim is based on an intentional assumption of liabilities by a buyer. Courts analyzing these claims determine whether a buyer assumed a seller’s liabilities by expressly agreeing to do so or through its actions.
• De facto merger theory: under a “de facto merger” or de facto consolidation analysis, liability can be imposed against a buyer after considering several factors, including whether (a) there is a continuity of the business enterprise between the seller and buyer, including continuity of management, employees, location, general business operations and assets; (b) there is a continuity of shareholders between the seller and buyer; (c) the seller ceases operations and dissolves soon after the transaction, and (d) the buyer assumes the liabilities and obligations of the seller necessary for the uninterrupted continuation of the seller’s business.
• Mere continuation theory: under a “mere continuation” analysis, liability can be imposed on a buyer if a court determines that the specific purpose of a sale was to place the seller’s assets out of the reach of the seller’s creditors, allowing the seller to escape liability merely by changing hats (effectively making the seller judgment-proof because it has no more assets).
• Continuity of enterprise theory: courts have expanded the mere continuation theory to hold that a successor company can be liable if the seller’s basic business operations continue, as opposed to simply continuing the corporate entity.

Planning Ahead & Mitigating Risk in a Distressed Sale Process

As we discuss above and in Installment 19, buying assets out of a bankruptcy process provides the greatest level of protection against fraudulent transfer and successor liability claims, but this doesn’t mean that it’s always the best way to purchase assets from a distressed seller. From a practical perspective, there are significant steps that sellers and buyers can take outside of a bankruptcy process to mitigate the risk of fraudulent transfer or successor liability claims by disgruntled creditors.

First, fraudulent transfer claims can be weakened by a competitive sale or auction process. While buyers may not be thrilled to invite competition into a sale process, doing so provides a good means of demonstrating that a sale was conducted properly. Publishing notice of the sale or auction and holding a true auction for the assets of the seller’s business can establish that a sale was conducted in a commercially reasonable manner and that the purchase price paid constituted reasonably equivalent value if challenged in court. And, buyers can still insist on certain stalking horse bidder protections (i.e., break-up fees and expenses reimbursement) to mitigate the downside of agreeing to a competitive sale.

Second, buyers can position themselves to prevent or defend against successor liability claims by ensuring that potential claimants don’t have facts to support any such claims. Buyers should avoid continuity of the seller’s ownership, for starters. Buyers can also take other steps (as appropriate) to proactively avoid creating bad facts, like using a different trade name; different website; address; phone number; informing customers and vendors about the sale; or informing the public about the sale via press releases.

The name of the game here is to reduce risk. Fraudulent transfer and successor liability law and litigation are complex, and angry creditors may be willing to chase buyers even if they have a low likelihood of success. But by taking these steps, the likelihood that a buyer is inoculated against such claims is increased significantly.

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[Editors’ Note: This article, while written to be read and understood on a standalone basis, is part of a series. To read Installment 1, which includes a table of contents and links to every article in the series, click here.

The authors are corporate restructuring and insolvency attorneys. Read more about ]them at the end of Installment 1.

Understanding all this stuff in the context of bankruptcy is important, but not every distressed company winds up in bankruptcy. So, you also need to understand how it works outside of bankruptcy.

To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

• Opportunity Amidst Crisis- Buying Distressed Assets, Claims, and Securities for Fun & Profit
• Representing Asset Purchasers in Bankruptcy
• Single Asset Real Estate Cases

©2023. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.]