[BETA] Fortnightly

The pros and cons of waiting for the seller to declare bankruptcy.

Sometimes a great opportunity is just too good to be true. Consider, for example, a purchase of distressed assets from one of the many energy companies now mired in well-publicized financial difficulties.

Many of these companies cannot raise capital in the public markets. Their debt securities are downgraded, some to junk status, and are trading at a fraction of their face values, with new financing perhaps unavailable. And their stock prices have fallen, making any new public offerings unattractive or even infeasible. Such companies may be forced to sell assets on the cheap, offering apparent deals for buyers who can lay claim to the necessary cash or credit.

This prospect puts the question to the buyer: Move quickly and buy now, while the getting is good, or wait until after the "target" has filed for bankruptcy under Chapter 11?

The first strategy gives a buyer a jump on the competition, but it may anger creditors. It may draw a fight from lienholders, and expose the buyer to unnecessary risk from potential litigation, such as that arising from successor liability or the rule against fraudulent conveyances, especially in the case of a leveraged buyout.

The second strategy puts most litigation risk to rest, yet it opens the buyer's offer to the light of day, through an open bidding process. That invites new offers from competitors, putting the buyer at risk for an overbid and possible loss of any investment sunk into the due diligence process.

Risks and Rewards

Overall, a fair review of the pros and cons may well come down on the side of waiting for Chapter 11. It is true that the buyer's offer will face heightened advertising and soliciting for competing offers, and these competing offers may prove difficult to analyze and compare. Each offer may include different scenarios for the continuation of the seller's business, or the retention of union contracts or highly paid executives, and so forth. Yet, on the positive side, the buyer can protect its investment in due diligence by perfecting a right of reimbursement of any such expenses and, at least in most jurisdictions, collect a modest "breakup fee" if a competing buyer wins the day. Moreover, in many cases, the original buyer (think of the buyer as a "stalking horse") may end up as the only bidder.

In either case, the prospective purchaser must understand that the primary cost of "cleansing" assets through a bankruptcy filing will come in opening up the bidding to generate the greatest possible return for creditors. After all, the purpose of the bankruptcy laws is to protect creditors-especially unsecured creditors-and not to preserve great deals at fire sale prices for takeover artists.

If you buy the assets without having the seller first file a Chapter 11 case, and if the seller thereafter fails to pay its creditors, then the unsatisfied creditors may launch litigation after the sale closes. Such litigation will most likely ensue under the doctrine of fraudulent conveyance or successor liability (see sidebar on p.