Buying Operating Assets from a Distressed Seller

Assessing Legal Risk

 

 “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) 

 

Purchasing operating assets from a financially distressed seller is a fantastic opportunity to buy low. Before doing so, however, any buyer must take into account a host of considerations, including, but not limited to, operational, competitive, integration, and legal issues, such as fraudulent transfers and successor liability.

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 deciding whether to proceed with the deal in light of those risks.

However, lawyers tend to view risk differently than their clients. The result? Some deals that should get done are abandoned as too risky, and others get done at a price or in a way that they should not because the risks are underestimated.

Basic risk avoidance includes ensuring that the buyer takes title to the assets it buys free and clear of liens of record. This is fairly straightforward because the rules for doing so are 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 and can even vary within the same state.

This article seeks to give the potential buyer a plain English tool to help answer the question, “Should we do this deal?”

What to Consider Before Buying Operating Assets

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’ claims.

In assessing exposure to fraudulent transfer and successor liability claims, the focus is not to examine whether a lawsuit can be successfully defended, but 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 those risks.

Fraudulent Transfer Law

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 the property back.

Fraudulent transfer law in most states is generally based on the Uniform Fraudulent Transfer Act (UFTA) 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

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.

Courts often look for ‘badges of fraud’ when considering whether or not to avoid a transfer for actual fraud. Some badges of actual fraud generally 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.

Actual fraud is very hard to prove because those engaged in it generally take pains to cover their tracks. Transactions that do not involve actual fraud may still be subject to avoidance because they are unfair to other creditors, i.e., 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.

Constructive Fraud

Transfers may be avoided as constructively fraudulent where (a) a transferor transferred its assets for less than ‘reasonably equivalent value’ and (b) the transferor:

• was insolvent on the date the transfer was made 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.

This is a simplified and generalized definition, but it covers the essentials.

A Note About Reasonably Equivalent Value

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. The plaintiff bears the burden of proof to establish lack of reasonably equivalent value.

Reasonably equivalent value often takes the form of cash or property but may also include the satisfaction of a prior debt, the release of a lien on the transferor’s property, or a transferee’s promise to forego contractual remedies against the transferor.

Successor Liability

Successor liability is completely unrelated to fraudulent transfer liability, a point lost upon many lawyers. A claim based on successor liability can succeed even if a purchaser paid reasonably 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 the full value of the assets while at the same time leaving behind the liabilities of those distressed assets from the former owner, like claims of unsecured creditors.

Successor liability is a rapidly developing area of the law comprised of at least four constituent theories:

• Intentional Assumption of Liabilities: This is the simplest of the theories; a court examines whether the buyer has meant to assume liabilities, either by express agreement or by its actions.
• De Facto Merger: In determining whether a de facto merger or consolidation has occurred, many courts look to whether: (1) there is a continuity of the business enterprise between the seller and buyer, including continuity of management, employees, location, general business operations and assets; (2) there is a continuity of shareholders; (3) the seller ceases operations and dissolves soon after the transaction; and (4) the buyer assumes those liabilities and obligations necessary for the uninterrupted continuation of the seller’s business.
• Mere Continuation Theory: The ‘mere continuation’ exception to the general rule of successor non-liability is designed to address a situation where the specific purpose of acquiring assets is to place those assets out of the reach of the predecessor’s creditors and to allow the predecessor to escape liability merely by changing hats. If a corporation goes through a change in form without a significant change in substance, it should not be allowed to escape liability.
• ‘Continuity of Enterprise’ Exception: This theory expands the traditional ‘mere continuation’ exception by holding a successor company liable if the basic business operation continues rather than merely the corporate entity.

Buying Through Bankruptcy

Buying through bankruptcy is not a panacea, but it’s the closest thing there is from the buyer’s perspective. 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 that 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, it carries its own set of negatives. These include a much ‘harder landing’ for the business as compared to Chapter 11, given most Chapter 7 cases involve an immediate shutdown 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.

Practical Application of the Legal Framework

Treatises have been written on this stuff; a beamish ‘Big Law’ associate could spend countless hours drafting a memo applying the law to the facts of any given situation, only to render an answer that is qualified 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 with a deal.

In approaching any risk analysis, it is critical to recall the fundamental purpose of fraudulent transfer and successor liability: to prevent and/or remedy an inequitable result. Allow these principles to be your guide and you are on your way to avoiding what the seller’s creditors may later argue is an inequitable result.

To increase your chances of avoiding litigation further, and being best prepared should you not be able to do so, follow these ‘rules of thumb’:

• 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.’ A professionally conducted, transparent auction can be the ‘magic bullet’ a buyer needs to defeat a constructive fraudulent transfer claim. Needless to say, the competition inherent to auctions may result in you not getting the deal in the end. Ultimately, what you decide is a judgment call based on the facts of each situation.
• Create facts to weaken any successor liability claim. The foundation of all 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, walk away. Sameness of ownership before and after the sale is a bad fact if you are trying to avoid successor liability.

In addition to these two guiding principles, buyers can take several steps to deflate any potential claim, including

• issuing a press release about the transaction;
• informing customers and vendors about the transaction;
• making meaningful changes to the business like trade name, website, address, and phone number.

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.

Though there are best practices for purchasing a troubled company and steps you can take to limit your exposure to a claim, at the end of the day, there will always be some risk inherent to the transaction. You simply have to be comfortable taking some risk; otherwise, this sort of deal may not be for you.

Distressed deals typically don’t come with too many reps or warranties, and the indemnification provisions don’t appear as they do 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 paydown of its secured debt. And lenders generally don’t give indemnifications.

How to Buy Operating Assets

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:

• What’s most risky? A stock purchase, although ‘risky,’ may not be quite the right description because there is no uncertainty involved: when you buy the equity of a business, all of the creditors of that business remain creditors after your purchase.
• You can do a ‘naked’ purchase of operating assets with a simple bill of sale or asset purchase agreement without any competitive bidding process involved. If you can get representations, warranties, and a deep pocket to stand behind them, you can have recourse against the seller and/or its principals if creditors sue you.
• An asset purchase following a commercially reasonable marketing of the business is better, of course.
• Better still is a purchase from a properly conducted Article 9, Assignee or Receiver sale, particularly if there is a non-insider secured creditor with a lien on all assets who is not paid in full as a result of the sale.
• Bankruptcy is the safest but most expensive and public choice.

Generally speaking, the safer the option, the more expensive and 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.

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

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3. The Nuts & Bolts Of Bankruptcy Law | The Nuts & Bolts of a Chapter 11 Plan

This is an updated version of an article originally published June 9, 2013 and updated February 3, 2020.]

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