Caveat Emptor: Bottom Fishing With No Regrets

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. 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.

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.

Contract Assignment. The Bankruptcy Code also voids most contractual restrictions on the assignment of executory contracts. (But the code does not allow assignment of personal services contracts or other contracts that are ordinarily with or without an express contract provision, which may include key intellectual property licenses.)
A buyer may not be interested in purchasing the seller's business if that business is built upon a critical supply agreement, lease, or license. Outside of a bankruptcy filing, such suppliers, lessors, and licensors would enjoy tremendous bargaining leverage, allowing them to ask for additional consideration in exchange for their consent to the assignment.

Shedding of Contracts. A bankruptcy filing may also allow a seller to shed itself of undesirable contracts and make its business more attractive to a buyer. Over the past few years, for example, several large theater chains filed Chapter 11 cases designed primarily to reject leases of old money-losing theater locations. They then sold the downsized chain (typically by way of new ownership of the reorganized debtor).

Public Filings. Shortly after the commencement of a Chapter 11 case, the debtor must file a list of all of its assets and liabilities, including all existing contracts with third parties. Absent special dispensation, the existence of contracts with existing suppliers and existing customers must be disclosed to the world.
Moreover, bankruptcy law allows the debtor to use cash proceeds in which lenders have a security interest only with the consent of those lenders or with permission from the court.
In essence, Chapter 11 means the debtor's budget will be subject to scrutiny and debate, especially if the debtor has secured lenders with a lien on inventory or accounts receivable. Secured lenders likely will try to keep the debtor on a short leash.
Often the seller will be concerned that competitors will gain leverage by the disclosures required by Chapter 11, and with good reason.

Employees and Management. A Chapter 11 case also will increase scrutiny on any provisions made part and parcel of the sale that may include incentives for employees concerned about uncertainty or discontinuity. Severance and/or retention programs for rank-and-file employees are not usually controversial. But it goes without saying that offers to senior management are likely to be questioned, particularly in the current climate.
If there are multiple competing offers for the debtor's assets, members of senior management may be motivated to select the offer that provides them with the greatest severance benefits or new employment agreements, rather than the offer that provides the maximum distribution to creditors. This conflict of interest is likely to be particularly acute when a financial buyer that needs senior management to run the business is competing with a strategic buyer that intends to consolidate operations and terminate senior management. If one potential bidder is prepared to engage former management and another potential bidder is not, the bidder who is not may encounter inappropriate resistance from management, and this can severely impede its due diligence efforts. The unsecured creditors and bankruptcy court should seek to prevent management from imposing such resistance.

Competing Bidders. If the seller reaches a deal with one bidder before the bankruptcy case is filed, the Chapter 11 filing will likely impose a second "overbidding" process to solicit additional offers and ensure that creditors are protected. Time is of the essence here. How the court conducts this overbidding process will depend on several factors, such as: (a) the scope of prior marketing efforts; (b) whether the debtor's operations are deteriorating; (c) whether the debtor is running out of the cash necessary to continue operations and preserve going-concern value pending a sale; (d) whether other potential bidders that have been contacted are willing to sign confidentiality agreements and invest the time and money necessary to commence due diligence; and (e) the size and complexity of the business.
If the seller cannot meet payroll or other key expenditures to get to the point where it can close a sale as an ongoing business, the bargaining leverage of the seller and its creditors will be substantially reduced. The new potential buyer may be the only source of a bridge loan to meet payroll pending a closing. Perhaps most importantly, the shorter the time available to other potential bidders, the less likely they will be able to complete their due diligence in time to submit a competing bid.
By waiting until the last minute, which often happens while the seller is trying to negotiate the best possible deal with the initial bidder, the seller may reduce the chances of creating a competitive bidding process.

Buyer Protections. In most jurisdictions, a buyer that guarantees an opening minimum bid for a Chapter 11 auction can obtain reasonable protections to compensate it for the time and money it has spent in completing due diligence and negotiating its agreement with the debtor.
In typical cases, courts will assure the stalking horse bidder that if it is outbid, it will be reimbursed for its out-of-pocket costs, within reason, and will receive a breakup fee. Such fees are usually in the range of 2 to 4 percent of the total purchase price.

These sorts of provisions may chill the willingness of other bidders to submit an overbid by increasing the initial minimum overbid to cover these costs. Moreover, such provisions always reduce the benefit of any overbid for creditors, because the stalking horse bidder must first be paid from any higher bid.

Some courts also will approve: (a) a "matching right" that allows the stalking horse bidder to prevail merely by equaling a competing bid; and (b) the right to "bid" the breakup fee and costs, so that it can "match" by bidding the amount a competitor bids, minus the amount it would receive if it is outbid. Virtually all courts will approve reasonable restrictions on competing bids, like a material minimum overbid relative to the size of the transaction.

Competing bids must usually be completely noncontingent. This gives the stalking horse bidder, which often has completed due diligence before the sale motion is even filed, a distinct advantage in large complex transactions. Other bidders are, quite literally, running to catch up so they can learn enough about the assets and operations to determine a fair price and remove all contingencies.

Some stalking horse bidders also may 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 greater the buyer's success with assets after the sale.

Remedy. Creditors or the trustee may force the buyer to return all purchased assets (subject to the buyer's lien for the amount paid, if in good faith). More common-the buyer must pay full fair market value, as determined by the court. -J.C.K.

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