“One man’s rubbish is another man’s treasure.”
-William & Robert Chambers Journal of popular literature, science and arts (1879)
“A little learning is a dangerous thing”
-Alexander Pope, An Essay on Criticism (1709)
Buying a business from a financially distressed seller can present a fantastic opportunity to buy low. Before doing so, however, any buyer must take into account a host of considerations. These include, but aren’t limited to, operational, competitive, integration, and legal issues.
Buying a business, or business assets, from a financially distressed seller poses legal risks that are not present in the typical healthy company deal. These transactions are nonetheless common, with attorneys typically helping their buyers understand and assess the risks and those buyers making the ultimate decision whether to do the deal in the face of a particular set of risks.
Lawyers tend to view risk differently than their clients, though. The result? Some deals that should get done are abandoned as too risky and other deals get done at a price or in a way in which they should not get done because risks are underestimated.
Basic risk avoidance includes ensuring that the buyer takes title to assets it buys free and clear of liens of record. This is fairly straightforward because the rules for doing so are clearly codified in the Uniform Commercial Code (which varies little from state to state).
Other legal risks, however, are not as straightforward because some important rules surrounding them are set by courts in case law, which is subject to subsequent change by other courts and is anything but uniform among the States (or, for that matter, is not necessarily uniform even within a given State).
[Editor’s note: To learn more about buying a distressed asset, please see Opportunity Amidst Crisis – Buying Distressed Assets, Claims and Securities for Fun & Profit.]
The principal, less straightforward, risks a buyer of a distressed business or its assets needs to weigh are potential claims by the seller’s creditors based on fraudulent transfer and successor liability theories.
This article provides a framework for analyzing these risks. The good news is that this is not nearly as complicated as one might assume.
The focus here is not to examine whether a lawsuit by a seller’s creditors can be successfully defended. Rather, the point here is to examine the likelihood that such litigation will be brought in the first place, whether it can survive a motion to dismiss or for summary judgment, and how to structure a particular transaction to forestall these risks.
The intent is to give the potential buyer a plain English tool to help answer the bottom line question, “should we do this deal?”
[Editor’s note: For more information on turning coal into diamonds in bankruptcy, read Opportunities in Bankruptcy: Turning Coal into Diamonds.]
Fraudulent transfer laws have existed since at least England’s Statute of Elizabeth, 13 Eliz., ch. 5 (1570). Their original purpose was to prevent judgment debtors from transferring property to family members and then, when the judgment creditors were no longer a threat, taking back the property.
Fraudulent transfer law in most of the States is generally based on the Uniform Fraudulent Transfer Act promulgated in 1984 by the National Conference of Commissioners on Uniform State Laws, which is consistent in most important respects with Bankruptcy Code §548.
Under both the UFTA and Bankruptcy Code §548, a transfer can be “avoided” (undone) and the value clawed back to the transferor if the transfer involved “actual” or “constructive” fraud.
Actual fraud is fraud as it is commonly understood; it is the actual intent to hinder, delay, or defraud a creditor. Courts agree that direct proof of such fraud is not required and may be proven by circumstantial evidence. Courts differ, though, as to the appropriate standard of proof that must be met to avoid a transfer for actual fraud.
Actual fraud is very hard to prove because those engaged in it generally take pains to cover their tracks. Further, many transactions that do not involve actual fraud are subject to avoidance because they are unfair to other creditors – for the recipient of the transfer has received property at the expense of other creditors. As a result, most of the action under the UFTA and Bankruptcy Code §548 is in the constructive fraud context.
Transfers may be avoided as constructively fraudulent where (a) a transferor transferred its assets for less than reasonably equivalent value and (b) the transferor:
This is a simplified and generalized definition but it covers the essentials.
There is no fixed formula for determining reasonably equivalent value for purposes of the constructive fraud test. Rather, whether the value given to the seller was reasonably equivalent to the assets conveyed is a question of fact to be determined as of the date of the transfer. And, the plaintiff bears the burden of proof to establish lack of reasonably equivalent value.
Successor liability is completely unrelated to fraudulent transfer liability, a point lost upon many lawyers. A claim based on a successor liability can succeed even if a purchaser paid reasonable equivalent value for a set of assets. The point of the claim is that, under the circumstances, the purchaser should not be allowed to enjoy full value of the assets while at the same time leaving behind the liabilities of the distressed former owner of the assets (i.e. claims of unsecured creditors against the former going concern). Successor liability is a rapidly developing area of the law comprised of at least four constituent theories:
Buying through bankruptcy is not a panacea but it’s the closest thing there is
One rule of thumb, that buying through bankruptcy is the safest route from the perspective of a buyer, is more than a generalization; it is absolutely correct. A sale order approved by a bankruptcy court, with very few exceptions, provides a shield against all of the risks discussed in this article. The vast majority of buy/sell transactions are simply too small, however, to justify the significant cost involved with Chapter 11. Increased publicity about the situation is also generally undesirable. Moreover, some situations involve circumstances which make bankruptcy less attractive for other reasons, such as delay and potential harm to the business. Chapter 7 can also be an option but, like Chapter 11, carries its own set of negatives. These include a much “harder landing” for the business as compared to Chapter 11, since most Chapter 7 cases involve an immediate shut down of the business and, thus, an immediate loss of going concern value. For these reasons, perhaps ironically, the one rule of thumb on this subject is one with limited utility.
Treatises have been written on this stuff, literally; a beamish Big Law associate could spend hours upon hours drafting a memo applying the law to the facts of any given situation, only to render an answer that is qualified, caveated, and uncertain. Meanwhile, real life transactions require real life answers that, while not bulletproof, must help the potential buyer decide whether or not to move forward on a deal. Here’s a way to approach every analysis.
First, go back to first principles: what is the purpose of fraudulent transfer and successor liability law? The purpose of each is to prevent and/or remedy an inequitable result.
Fraudulent transfer law essentially says this: it is not fair — in certain circumstances — to allow a company to sell its assets for less than they are worth and thereby leave it with insufficient funds to pay its creditors.
Successor liability law says something different: even assuming a buyer pays fair consideration for assets, it is nonetheless unfair in certain circumstances if the sale resulted in insufficient funds for the seller to pay its creditors. What circumstances? One obvious answer is that if an objective third party cannot tell that newco is not the same as oldco, then the buyer may have a risk. I’m not suggesting this is the only question but it is a very good first question.
With these first principles in mind, ask: what can my buyer do to stay clear of being a participant in what the seller’s creditors will later argue is such an inequitable result? Here are two rules of thumb:
First, buy through a competitive process. Many judges believe (and those who don’t, respectfully, should) that the best indicator of value is what a willing buyer will pay at a commercially reasonable sale. Can you instead hire a valuation expert and rely on that expert’s opinion? Well, like chicken soup, it can’t hurt. But my view is that nothing beats a real auction that is done “right” (what this means can be the subject of its own article). That can be a magic bullet with which a buyer defeats a constructive fraudulent transfer claim. Needless to say, competition may result in you not getting the deal; what you do is a judgment call, based on the facts of each situation.
Second, create facts to weaken any successor liability claim.
The underpinning of the various successor liability theories is that a buyer is getting the benefits of a going concern business that walks and talks much the same as when the seller owned it but is leaving behind liabilities. So, if you’re the buyer, don’t do this. Sameness of ownership before and after sale is a bad fact if you are trying to avoid successor liability. Other things a buyer can do to try to take the wind out of the argument: issue a press release about the transaction; inform customers and vendors about the transaction; do not use the same trade name, website, address, or phone number; and make other meaningful changes to the business. Of course, if a buyer does too many of these things the result is a dissipation of the going concern value that may have driven the purchase in the first place.
Follow these two basic rules of thumb and you will increase your chances of not wearing a target on your back that invites litigation and you will be better positioned to defend litigation if it comes. Is there more to it? Of course there is. As the beginning of the article states, a little bit of learning is a dangerous thing.
One last rule of thumb – not for avoiding liability but – for getting the deal done. Have you ever heard the expression, “you don’t hire Michelangelo to paint your garage?” Likewise, a supremely skilled Big Law healthy company M&A lawyer is probably not the best person to advise on a private, middle-market distressed deal if you actually want to do the deal.
Distressed deals typically don’t come with too many reps or warranties and the indemnification provisions don’t look like they look in a large, healthy company deal. In a distressed deal, the seller’s (that is, the troubled company whose assets are at play) lender is often getting the entire sales price as only a partial pay down of its secured debt. And lenders generally don’t give indemnifications. The broader point is this: if you buy a private troubled company, you simply have to be comfortable taking some risks. Otherwise, this sort of deal may not be for you.
Assuming you still want to do the deal after your initial analysis of the risks, the biggest decision you need to make is how to buy. Looking at the options as a continuum:
Generally speaking, the safer the option, the more expensive it is and the more likely it is that you will be outbid for the deal. Getting to the answer in a particular situation is more of an art than a science.
Jonathan Friedland is a partner in Sugar Felsenthal Grais & Helsinger LLP’s Chicago office. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer”, by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts…
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