April 03, 2009
It’s official! We are in a recession. You would have to have been living in a cave to not realize this fact. The Associated Press reported recently that “[t]he United States — already in recession for a year, may not be out of it until the spring of 2010 — making for the longest downturn since the Great Depression of the 1930s, economists are now saying. Recessions in the mid-1970s and early 1980s lasted 16 months.” (Jeannie Aversa, AP Economics Writer, December 5, 2008).
Whether or not you believe the United States is in a recession, there is no ignoring the fact that we are in an economic downward of historical proportions. Open the paper and you read about businesses, big and small, failing or on the brink of collapse every day. Millions of consumers are faced with the prospect of financial demise resulting from the mortgage industry crisis. It is estimated that over 50 of the Fortune 100 companies will either file for bankruptcy protection or significantly restructure their business and financial operations this year.
Although gloomy, the state of the economy presents a unique opportunity for otherwise healthy businesses to acquire assets on the cheap. In these troubled economic times it can be extremely tempting to move quickly to acquire the assets of a failing competitor’s business, including its valuable intellectual property rights, inventory, and customer lists. However, before taking the acquisition leap there are some things you should consider.
Purchasing Assets Outside of Bankruptcy
When considering whether to purchase all or part of the assets of a troubled business outside of bankruptcy, the desire to move quickly should not outweigh the necessity of thorough due diligence. Even if you know the business involved, you will want to examine its financial books and records to determine what, if any, liabilities may or may not follow the asset purchase. Unlike purchases in bankruptcy, which involve a statutorily prescribed level of protection for the purchaser, buying assets outside of bankruptcy often presents unforeseen challenges from unforeseen competing interests – e.g., lien creditors, creditors claiming fraudulent conveyance, taxing authorities, and/or shareholders feeling management sold out for less than maximum value. Due diligence can provide some preview and cover for these pitfalls.
If all of the seller’s creditors will receive full payment from the sale of assets or if it would not be unreasonable for the businesses’ shareholders to question the purchase price, it will be less likely that the transaction will be questioned.
It is not uncommon, particularly when creditors are looking for any pocket to recover their losses, for creditors or disgruntled shareholder/owners of a selling business to question the sale of assets under state or federal transfer laws. In such a circumstance, the buyer may be compelled to establish that it paid reasonably equivalent value for the purchased assets, which may be an expensive and difficult task involving insolvency accounting, as well as liquidation and going-concern valuations.
Successor Liability/De Facto Merger
The purchase of assets outside of bankruptcy implicates state law successor (buyer) liability doctrines. Judicially created doctrines such as “de facto merger” enable creditors to challenge sales as nothing more than a merger without actually merging.
The “de facto” merger doctrine holds that, under the attendant facts and circumstances, the scope of assets purchased and the purchase price therefore, may combine to result in the creditor accessing the resources of the purchaser to satisfy seller claims. The factors often considered when determining whether a purchase and sale transaction amounts to a “de facto merger” include:
- Whether there is a continuation of the seller’s business (i.e., management, location, assets, customers, employees, etc.)?
- Whether there is a continuity of ownership following the sale (i.e., whether the owners of the seller acquired ownership in the purchaser)?
- Whether the seller continues its business following the sale (i.e., did the seller shut down its business operations and liquidate it remaining assets following the transaction)?
- Whether and to what extent liabilities of the seller are assumed by the buyer (i.e., did the seller assume obligations of the buyer which are necessary to the continued operation of the successor business).
A positive answer to any or all of these questions may result in the buyer’s unwilling assumption of the seller’s liabilities. Attention to detail and consultation with a professional will help alleviate the possible negative impact of the sale transaction.
Purchasing Assets in Bankruptcy
With many businesses on the brink of bankruptcy and/or already filing, one strategy for limiting liability is to purchase all or part of the businesses’ assets out of bankruptcy.
Whether the business-debtor files for relief under chapter 7 (liquidation) or chapter 11 (reorganization), scheduled assets of value may be available for purchase. Contacting the chapter 7 Trustee or the chapter 11 debtor will determine whether and to what extent the assets are available for purchase.
Section 363 of the Bankruptcy Code generally permits the sale of assets of the debtor “free and clear of any interest in such property of an entity other than the [bankruptcy] estate.” On the surface this appears to be a good deal for the buyer. However, it should be understood that, while the chapter 7 trustee or chapter 11 debtor-in-possession are selling assets free and clear of certain liabilities, these sales are often “as is/where is” and “without any representations or warranties.” The protections afforded under section 363 apply primarily to creditor demands – e.g., taxing authorities, lien-holders, etc. It may not, however, protect the buyer against other less quantifiable or identifiable liabilities – e.g., federal and state environmental claims, product liability, patent or trademark infringement claims will often follow the sale of real estate, intellectual property, and products. Whether liability may be imposed will depend on a variety of facts, factors, and legal precedents.
Steps can be taken to avoid potential successor liability when acquiring assets out of bankruptcy. For example:
- make sure notice and an opportunity to object is provided to the widest possible group of potential claimants;
- place provisions in the court order approving the sale which addresses known interests and the scope and extent of assumed liability;
- determine whether and to what extent insurance may be available to reduce the risk of potential liability; and
- consider a hold-back on the purchase price for a specified period of time to apply to potential claims.
In addition to the foregoing, the prospective purchaser should be aware that sales under section 363 often result in auctions before the bankruptcy court. In these circumstances, the potential buyer should be prepared to pay more than offered for the subject assets.
Buying assets from distressed companies can be a lucrative way to grow a profitable business. Before taking this step, the buyer should undertake a requisite amount of due diligence to determine whether the sale will not only be profitable but will also be relatively risk free. Whether the sale is outside or inside bankruptcy, the prospective buyer is always encouraged to consult competent and effective counsel and other professional advisors.
Bruce W. Akerly is the chair of the financial restructuring/creditor rights section of the Dallas law firm of Bell Nunnally & Martin LLP. He can be reached at [email protected].
The foregoing is presented for educational purposes only and should not be relied upon as legal advice. Although prepared by professionals, it should not be utilized as a substitute for professional services in specific situations. If legal advice or other expert assistance is required, the services of a professional should be sought.
© Bruce W. Akerly - 2009. All Rights Reserved.