In the current economic climate, it is likely that more businesses will suffer from some form of economic distress. Falling revenues may make it harder for many businesses to meet ongoing obligations, particularly obligations to pay fixed costs such as bank loans and real estate lease rentals. For companies that have access to the necessary resources, opportunities may arise to purchase distressed businesses for bargain prices. From a legal standpoint buying a distressed business presents certain additional and different problems than purchasing a healthy, solvent business.
In evaluating any opportunity to purchase a distressed business, the first and most fundamental decision is whether to purchase the assets outside of or through a Chapter 11 bankruptcy proceeding. There are a number of considerations to be examined in either case.
Purchases Prior To Or AbsentChapter 11
In most situations it is advisable for a buyer to directly purchase the assets of the distressed business rather than purchase the equity interests of the entity that owns that business. With some exceptions, in most states it is well established that a buyer can "cherry pick" the assets and liabilities it wants to purchase or assume, leaving unwanted assets and liabilities with the owner.
However, there are some exceptions to the general rule that the buyer is not required to assume any liabilities of a purchased business (whether distressed or not):
• Under the laws in most states, the buyer can be liable for unpaid state and local taxes of a purchased business. A business in financial distress may be more likely to have unpaid state and local taxes, and in some states a "tax clearance" can be obtained from the taxing authorities.
• A buyer may be obligated to provide COBRA coverage to former employees. The medical plans and applicable federal regulations should be carefully reviewed in order to avoid unexpected COBRA responsibilities.
• Some states retain some form of the historic "Bulk Sales Law,"requiring certain notices and procedures when the buyer is purchasing substantially the entire inventory of a business but is not assuming its liabilities. Failure to assure compliance with this law in states where it is still applicable could result in the buyer being forced to assume the liabilities of the distressed business, at least to the extent of the purchase price.
It is essential to perform the proper due diligence on any business before purchase, but especially so with respect to a distressed business. The first and most important step is to perform searches of the relevant state and local records for financing statements, tax and judgment liens and lawsuit filings. Depending on the circumstances and the applicable state law, a review of state and local tax filings should be undertaken; if allowed, contact with the taxing authorities should be made to obtain clearances. Without properly identifying and dealing with these obligations, the buyer runs the risk of a purchase that may carry hidden debts or obligations, defeating one of the primary purposes of "cherry-picking" the desired assets.
The alternative to purchasing the assets of a distressed business is to purchase the equity interests of the entity operating the business. The owners usually would prefer to sell their equity interests instead of the assets - that way the buyer takes ownership of the entire entity and with it all potential liabilities and problems. Conversely the buyer will want to pick and choose the liabilities it wants to take on, and that can only be accomplished through an asset purchase.
In most situations the buyer should set up a new and separate entity to affect the purchase. Setting up such a separate entity isolates the good and profitable assets of the buyer's existing successful businesses from possible unknown liabilities that may arise in connection with the purchase. The purchase should also be structured to limit any post-closing attacks on fraudulent-transfer grounds. As part of that analysis it is essential to understand and evaluate all obligations - such as possible environmental contamination or "landlord's liens" on inventory and equipment - to gauge the solvency level of the business, both before and as a result of the purchase transaction.
Avoiding Post-Closing Challenges
One of the biggest risks of purchasing a distressed business is that after the closing of the purchase one or more creditors will attempt to set aside the sale on "fraudulent transfer" grounds. All states have enacted "fraudulent transfer" laws, while federal bankruptcy law has its own separate provisions that operate similarly to the state laws. In essence these laws give creditors a cause of action to have a transfer of property by a debtor set aside if the transfer was in actual or constructive fraud of creditors. Actual fraud usually involves a blatant attempt by the debtor to hinder, delay or defraud creditors. More often the creditors make a claim for constructive fraud, which involves a transfer of assets for less than fair consideration when the seller was either already insolvent or made insolvent by the sale.
While a fraudulent transfer claim can be brought under state law, bankruptcy laws allow the trustee to bring both the state claim and the separate federal claim if the seller later winds up in bankruptcy, which is always a strong possibility. In some situations a trustee may be more likely to pursue claims for fraudulent transfer than private creditors, so the associated risks can still affect the purchase even if the bankruptcy filing occurs after the sale closes. In order to create defenses against post-closing fraudulent transfer claims, the buyer should consider obtaining an opinion of the value of the assets to be purchased from a reputable appraiser and make certain that the owners of the entity operating the distressed business apply the sale proceeds to the existing creditors.
No matter how diligent the buyer, post-closing problems can still occur. The buyer should consider taking certain additional steps to further mitigate these risks, including:
• If possible the buyer should attempt to obtain indemnification from post-closing attacks on the sale, including charges of fraudulent transfer or assertions of liability from creditors.Any indemnification agreement from the entity that operates the distressed business will be of little practical use to the buyer, since that entity will likely be liquidated after the closing. However, the equity owners may have assets worth pursuing to make good on an indemnification agreement.
• The buyer should negotiate a holdback or place into escrow a substantial amount of the purchase price to cover post-closing issues and indemnification agreements. This approach can be especially valuable to the buyer if the equity owners are unwilling to agree to any indemnity. Typically escrows or holdbacks range from 10 percent to 25 percent of the purchase price in connection with the purchase of a healthy company, but should be even larger for a financially distressed business - consider 50 percent or more.
• The buyer should consider negotiating for a substantial portion of the purchase price to be paid after the closing only if the distressed business achieves certain pre-agreed financial targets - usually based on either revenue or net income. This can serve a similar function to the escrow or holdback by providing a hedge against post-closing problems that have the effect of reducing the earnings of the purchased business.
• The buyer should avoid entering into any binding agreements to purchase the business prior to the actual closing. Instead the buyer should only sign a binding agreement to purchase simultaneously with the closing. In the negotiation process it can be advisable to enter into a letter of intent with the owner of the targeted business, provided that the letter of intent is non-binding as to the buyer's obligation to purchase.
Purchases Through Chapter 11
There are some distinct advantages and disadvantages in waiting to purchase a business through a Chapter 11 proceeding.
For certain businesses a bankruptcy filing, even if handled smoothly with a pre-packaged plan, could damage the reputation of the business and its customers' willingness to continue purchasing goods and services, especially those businesses that rely on a long-standing reputation with their customers. By waiting to purchase through a Chapter 11 proceeding the buyer runs all of the risks associated with the bankruptcy process, including objections by creditors, the threat of higher bids, a lengthy approval process or even the failure of the reorganization plan to obtain court approval.
The principal advantage to a buyer of purchasing a distressed business through a Chapter 11 bankruptcy proceeding is that under Section 363 of the Bankruptcy Code the court can approve the sale of the assets to the buyer "free and clear" of all liens and liabilities. In addition the approval of the sale by the bankruptcy court should prevent any subsequent fraudulent conveyance claims by creditors and effectively override any burdensome provisions in existing contracts.
If it is the buyer's desire to purchase a business in a Chapter 11 proceeding, then it is advisable to plan ahead and attempt to control the outcome to the extent possible. These steps could include:
• Attempt to put together a pre-packaged Chapter 11 plan (a "Pre-Pack") by negotiating with the seller and major creditors as to the terms of the reorganization plan. The Pre-Pack could include a sale of assets to the buyer under Section 363 of the Bankruptcy Code, and the timeframe to complete the purchase can be significantly shortened.
• Consider playing the role of a "stalking horse" by being the first bidder. The advantage to this strategy is that the buyer sets the price and likely receives additional time to perform due diligence on the targeted business. The risk of this strategy is that the first bidder may turn out to be the only bidder.
• Whether a Pre-Pack is submitted or not, the buyer needs to be proactive throughout the bankruptcy process, including appropriately negotiating with secured creditors, unsecured creditors, landlords and existing management. Usually any sale in the bankruptcy proceeding will require the approval of all of the secured creditors, and failure to deal adequately with them can lead to the sale being denied by the court.
Whether a bankruptcy proceeding is involved or not, any prospective buyer of a financially distressed business must take extra care to address not only the legal issues that would ordinarily pertain to any acquisition of a business but also those additional issues that are relevant to a financially distressed business.
Robert W. Van Amburgh is a Shareholder in the Dallas-based firm of Hiersche, Hayward, Drakeley & Urbach, P.C. More information about Mr. Van Amburgh and the firm is available by calling (866) 240-5197 or by visiting www.hhdulaw.com.