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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

succeed in negotiating a very limited "no shop" order that prohibits the debtor from soliciting other bidders. In a Chapter 11 case, the debtor's management will, however, have a fiduciary duty to creditors to provide information to any qualified competing bidder who signs an appropriate confidentiality agreement.

Indeed, the publicity surrounding any material Chapter 11 case and the accompanying public sale process will bring buyers forward without any direct solicitation by the seller, and creditors will solicit potential buyers.

Litigation Risk: Buying Outside Chapter 11

Successor Liability

  • Concept. Where the seller transfers substantially all of its assets or operations, and afterward is unable to pay all its creditors, the buyer may be treated as matter of law or contract as the seller's successor in interest. The buyer may be forced to assume the seller's outstanding liabilities.
  • Defense. The buyer can sign a waiver with the seller beforehand providing that the buyer does not assume liabilities, thus reducing risk. This tactic works well if the buyer's equity owners have no relationship with their counterparts for the seller.
  • Counter-Defense. The waiver defense noted above will not protect the buyer from claims by tort victims who may have the right to sue any buyer that acquires the seller's manufacturing operations, if the seller cannot compensate the tort victims. This successor liability may apply in some states even if the buyer acquires only a single operating division (and even if the seller continues to control the division operations) if it turns out that tort victims suffered injury from products manufactured by the transferred division.
  • Indemnification. The buyer can negotiate for indemnity from the seller to protect against these liabilities, but indemnity will hold little value if the seller is insolvent, unless the buyer has withheld a portion of the purchase price to secure the indemnity claim. (The buyer may have to pay the claim first, then ask the seller for reimbursement.) If the seller is a subsidiary, the buyer may be able to obtain indemnification from the seller's holding company.

Fraudulent Conveyance

  • Concept. In most states, creditors of the seller can challenge the seller's transfer of assets if they can prove that: (1) the seller did not receive reasonably equivalent value for the sale; and (2) that the seller meets one of several standards defining severe financial distress. [For instance, if a seller is "balance-sheet insolvent" (the seller's liabilities exceed fair market value of the seller's remaining assets after sale), knew, or should have known it would be unable to pay future debts as they become due, or is undercapitalized after the sale.] Such a challenge may require costly expert testimony. Actual fraud or fraudulent intent need not be shown.
  • Procedure. The trustee in the bankruptcy has the power to allege and prosecute a fraudulent transfer claim on behalf of all creditors if the bankruptcy is filed by or against the seller after the sale closes.
  • Probative Evidence. Factors suggesting fraudulent transfer: (1) the better the buyer's bargain compared to historical prices; (2) the more limited the seller's marketing efforts before the sale; and (3) the