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Caveat Emptor: Bottom Fishing With No Regrets

The pros and cons of waiting for the seller to declare bankruptcy.
Fortnightly Magazine - March 15 2003

33). While the legal theories and grounds for both types of litigation are very different, the end results are similar: The buyer incurs unwanted litigation expenses and the potential for substantial liability above and beyond the purchase price already paid.

A leveraged buyout is particularly vulnerable to challenge as a constructively fraudulent transfer, because creditors of the target entity are involuntarily subordinated to the obligation to pay the purchase price, but they receive no benefit from the payment to shareholders. (A leveraged buyout is any transaction in which the creditors of the target remain unpaid, and the assets of the target entity become liable for the purchase price of the equity in that entity.)

For example, suppose the buyer is a holding company formed to purchase 100 percent of the stock of the target corporation. Suppose further that the buyer lacks sufficient cash to pay for the stock, and so must borrow the funds. In this case, the buyer can offer to pledge the stock being acquired as collateral. The lender, however, will prefer to have a security interest in the assets of the target, rather than the buyer's only asset (i.e., the stock of the target). If the lender has a lien only on the stock of the target, the lender's claims remain structurally subordinate to the claims of all creditors of the target corporation. The stock will have value only if those creditors are first paid. However, if the lender can obtain a lien on the assets of the target, its claim would then come ahead of the target's unsecured creditors.

In the simplest case the target guarantees the obligation of its new sole shareholder, the buyer, and pledges its assets to collateralize that guarantee. Such a transaction may render the target insolvent. At the same time, neither the target nor its creditors receive any consideration for the transaction because the loan proceeds are advanced to the buyer who uses them to pay the old shareholders. By definition, the target cannot, therefore, have received reasonably equivalent value.

Waiting for Bankruptcy: The Key Consequences

In general, the buyer will gain substantial protection from these sorts of risks by waiting to consummate its acquisition of assets until a Chapter 11 case is filed by, or on behalf of, the seller. But the bankruptcy process also imposes certain burdens on the buyer.

Consider seven key factors that affect a distressed sale conducted after filing bankruptcy-some beneficial to buyers, and some not.

  1. Discharge of Liens. The buyer can buy assets from a bankruptcy estate free and clear of all liens and claims. (That includes contractual claims and all tort claims held by victims already injured, so long as they receive adequate notice of the bankruptcy filing and the sale.) Outside of bankruptcy, creditors that hold liens on key assets being sold may be in a position to block a potential sale or bargain for additional consideration in exchange for their cooperation.
  2. Contract Assignment. The Bankruptcy Code also voids most contractual restrictions on the assignment of executory contracts. (But the code does not allow assignment