Legal Considerations for the Buyer of a Troubled Company
© 2010 Cohn Whitesell & Goldberg
Will you as the buyer of an insolvent business be subject
to claims by the seller's unpaid creditors? Can the purchase
be set aside as a fraudulent transfer? If the seller's board
of directors commits a breach of fiduciary duty, will you be
held liable for aiding and abetting that breach? Will your company
be subject to successor liability? Do you gain any protection
by buying through a foreclosure sale or Chapter 11 bankruptcy?
In addition to the usual legal
risks involved in any purchase, the buyer of a financially troubled
company needs to consider three risks arising from the seller's
insolvency and potential bankruptcy. One is that the sale will
later be challenged as a fraudulent transfer, either by the seller's
creditors or by a bankruptcy trustee. Another risk is that unpaid
creditors of the seller will seek to hold not only the seller's
board of directors but also the buyer - and perhaps its directors
and officers - liable for breach of fiduciary duty in connection
with the transaction. A third legal risk is that creditors of
the seller may seek to collect their debts from the buyer under
the doctrine of successor liability. Before plunging ahead with
what might seem an exciting business opportunity, the buyer needs
to understand these risks and, as discussed below, adopt a strategy
to minimize them.
I. Fraudulent Transfers
For a potential buyer of a troubled company, a principal concern
is that the transaction will later be attacked under state laws
governing fraudulent transfers or, in the event that the seller
ends up in bankruptcy, under the applicable provisions of the
Bankruptcy Code. The buyer faces a conundrum. The primary reason
to buy a distressed business is because it's a bargain, i.e.,
the price is low enough according to traditional metrics such
as cash-flow multiples to offset the greater risks and costs
resulting from the compan's problems. Yet these two factors -
financial distress of the seller and purchase price that might
be viewed as less than reasonably equivalent value are key elements
inviting a fraudulent transfer attack.
There are generally two types of fraudulent transfers: (1) those
which are actually fraudulent, i.e., made with actual
intent to hinder, delay or defraud creditors, and (2) those which
are constructively fraudulent, i.e., made for less than
reasonably equivalent value at a time when the transferor is
in financial distress, measured by insolvency, inadequate capital
or knowing incurrence of obligations beyond the transferor's
ability to pay. The legal standards vary slightly depending on
whether the fraudulent transfer claim is being brought under
the Bankruptcy Code or under state law - most often, the Uniform
Fraudulent Transfer Act (UFTA). If a transfer is determined to
be fraudulent, the plaintiff (creditors or bankruptcy trustee)
may set aside the transfer or recover from the transferee the
value of the transferred assets.
A. "Actual" Fraudulent Transfers
An actual fraudulent conveyance arises from a transfer of property
by the debtor with an actual intent to hinder, delay or defraud
existing or future creditors. Courts are divided about whether
the plaintiff must establish fraudulent intent by "clear
and convincing evidence" or whether "a preponderance
of the evidence" will suffice. The burden on the plaintiff,
however expressed, is lightened considerably by being able to
prove fraud by inference from the existence of "badges of
fraud." Badges of fraud include:
1) actual or threatened litigation against the debtor;
2) the transfer involved substantially all the debtor's
assets;
3) insolvency or other unmanageable indebtedness on
the part of the debtor;
4) a special relationship between the debtor and the
transferee; and
5) after the transfer, retention by the debtor of
the property involved in the putative transfer.
In effect, presence of badges
of fraud will shift to the defendant the burden of proving lack
of fraudulent intent by showing that the transaction had a legitimate
purpose.
It would be unusual for a sale at arm's length to be challenged,
much less set aside, as a transfer made with actual intent to
hinder, delay or defraud creditors. Buyers should note, however,
that the relevant intent to defraud is that of the seller alone.
By contrast, it is the buyer that bears the consequences if the
sale is set aside as a fraudulent transfer. Especially when decision-makers
of the seller will realize personal benefit from the sale (for
example, continued employment by the business under the buyer's
ownership), unpaid creditors of the seller may have both a weapon
and a motive to attack the sale as fraudulent.
B. "Constructive" Fraudulent Transfer
Without regard to whether a debtor
has acted with the intent to hinder, delay or defraud creditors,
the transfer may still be constructively fraudulent, if the transfer
was not made for reasonably equivalent value, and made while
the debtor was in financial distress.
1. Reasonably Equivalent Value
The Bankruptcy Code defines value as:
property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor.
Based on this definition, courts
have agreed that reasonably equivalent value means that the debtor
must receive a reasonably equivalent economic benefit
even if an indirect economic benefit from the transfer.
The Supreme Court has held that in a regularly conducted, non-collusive
foreclosure sale the price paid by the buyer is conclusively
presumed to be reasonably equivalent value. Thus, a proper foreclosure
sale is effectively exempt from fraudulent transfer laws.
2. Financial Test
A transfer may be set aside as constructively fraudulent only
if the transfer was for less than reasonably equivalent value
and the debtor at the time of the transfer meets one of three
financial tests: (a) insolvency, (b) inadequate capitalization,
or (c) known inability to pay debt.
Insolvency. The issue of solvency is often contested in
an action to recover a fraudulent transfer. The Bankruptcy Code
and UFTA define insolvency as a financial condition such that
the sum of the entity's debts is greater than all of such entity's
property, at a fair valuation.
The burden of proving that the debtor was insolvent at the time
of the transfer is on the plaintiff. Under the UFTA, this burden
is subject to a presumption that a debtor is insolvent if it
is generally not paying its debts as they become due.
Although excess of liabilities over assets is commonly referred
to as "balance sheet insolvency," the balance sheet
utilized to compute insolvency differs from a GAAP balance sheet
in important respects. On the asset side, market value rather
than book value is utilized. If the debtor is at death's door,
market value means liquidation value; otherwise, assets are valued
on a going-concern basis. Contingent assets are evaluated by
the amount due and the likelihood of collection. On the liability
side of the balance sheet, in addition to all GAAP liabilities
there must be included contingent liabilities such as guaranties
or legal claims, in an amount determined by multiplying the amount
of the contingent liability by the probability that the contingency
will occur.
Unreasonably Small Capital. Unreasonably small capital
has been defined as a level of capitalization that renders a
debtor unable to generate sufficient profits, or at least cash
flow, to sustain operations. A debtor need not be insolvent to
have unreasonably small capital. Whether a transfer leaves the
debtor with unreasonably small capital is a question of fact.
Typically the court will examine adequacy of capital over a period
of time surrounding the transfer, rather than just on the date
of the transfer.
Incurring Debt Beyond Ability to Pay. The third financial
test is whether the debtor intended to incur, or reasonably believed
that it would incur, debts beyond the debtor's ability to pay
them as they matured. This type of constructive fraud is rarely
invoked, given the difficulty of proving the debtor's state of
mind. Typically, it will be less difficult for the plaintiff
to prove, with the benefit of "badges of fraud," an
actual intent to defraud creditors.
3. Sale Context
It is not at all rare for the sale of a troubled company or its
assets to be challenged as a constructively fraudulent transfer.
The seller's financial distress means that it will likely flunk
at least one of the three financial tests, so the buyer's only
effective defense will be to show that it paid "reasonably
equivalent value." The buyer's ability to make this showing
will typically be subject to considerable doubt. It is sound
practice to obtain an appraisal contemporaneously with the sale.
But especially if the business prospers under the buyer's ownership,
a judge or jury might be too ready in hindsight to conclude that
the bargain price paid by the buyer was less than reasonably
equivalent value. In any event, the buyer faces the very real
possibility of being forced to bear major litigation costs that
would erode the value of the deal. To reflect this risk a buyer
might be tempted to cut the purchase price still further but,
perversely, this would have the effect of increasing the legal
risk. So most buyers, instead, look for ways to decrease legal
risk.
There are two ways to do it. First, if a secured creditor has
a lien on all of the assets that the buyer wants to purchase,
the transaction could be accomplished as a foreclosure sale.
As noted above, the Supreme Court has held that a regularly conducted,
non-collusive foreclosure sale is immune from attack as a constructive
fraudulent transfer. Second, the transaction could be accomplished
as a judicial sale, either through bankruptcy or receivership.
Notice to creditors and an opportunity for them to object to
the sale before it occurs will bar later attack. There may be
business risks and, especially in the case of bankruptcy or receivership,
significant incremental expenses associated with these approaches.
Typically the buyer will try to off these risks and costs on
the seller and its creditors.
II. Aiding and Abetting a Breach of Fiduciary Duty
In the absence of financial distress, the directors' and officers'
fiduciary duties - duties of care, loyalty and good faith - are
owed solely to the corporation and its shareholders. However,
under the corporate law of Delaware and other jurisdictions,
once a corporation has entered the "zone of insolvency,"
the directors' fiduciary duties will shift to the creditors.
To learn more about the fiduciary duties of directors and officers
of a troubled company, click here.
While the fiduciary duties of directors and officers are primarily
a concern for the seller, the buyer could be liable for aiding
and abetting a breach of fiduciary duty. In order to sustain
a claim for aiding and abetting a breach of fiduciary duty, the
plaintiff must establish: (a) a breach of fiduciary duty on the
part of the primary wrongdoer; (b) that the defendant had knowledge
of the fiduciary's wrongful conduct; and (c) that the defendant's
conduct gave substantial assistance or encouragement to the fiduciary's
wrongful conduct. A minority of courts have declined to recognize
a cause of action for aiding and abetting a breach of fiduciary
duty. Except in the rare case where the buyer can be certain
that any lawsuit would take place in a jurisdiction that does
not recognize "aiding and abetting," the buyer of a
distressed company cannot shrug off the possibility of ending
up as a co-defendant of the seller's officers and directors.
It is useful for the buyer to understand the perspective of the
seller's directors and officers. The directors and officers of
a troubled company, who typically own blocks of stock and accepted
their positions in order to serve the interests of stockholders,
often feel subjected to a type of involuntary servitude upon
learning from their counsel that their fiduciary duties shifted
to creditors when the company entered the zone of insolvency.
Their sense of pique does not abate when informed that there
is no judicial consensus concerning how exactly to discharge
their newfound duties. Do directors of an insolvent company have
any remaining duty to stockholders? If even the unsecured creditors
are out of the money, do directors have a duty to them or solely
to the secured creditors? These are questions that no lawyer
can definitively answer based on the caselaw to date.
Against this backdrop of uncertainty, it is not surprising that
even the most conscientious directors will think of protecting
not only the creditors but also themselves. In the sale context,
obtaining prior judicial approval of a sale supplies the best
assurance that the directors' decisions concerning the sale will
not subject them to personal liability after the fact. Chapter
11 provides the closest thing to a "safe harbor" for
directors of a troubled company that must be sold on terms that
will leave some creditors unpaid. However, bankruptcy comes with
its own costs and disadvantages including, for the directors,
potentially increased scrutiny of their role in the company's
financial slide and potential obstacles to being protected by
the company's insurance policy for director and officer liability.
The directors' tolerance for risk, and for the particular jeopardy
of selling outside bankruptcy versus seeking safe harbor through
a Chapter 11 filing, will vary depending on the situation, the
personalities involved, and the extent of D&O liability insurance.
From the buyer's perspective, the possibility of being sued by
creditors of the seller for inducing the seller's board to breach
its fiduciary duties might at first glance appear to add little
to the buyer's risk. After all, if the alleged breach of duty
consisted of transferring the seller's assets for less than reasonably
equivalent value, creditors could just sue the buyer directly
to set the transaction aside as a fraudulent transfer (as discussed
in the previous section of this article). However, while the
only defendant in a fraudulent transfer action is the buyer itself
- which may be a single-purpose entity and whose assets may be
subject to liens, thus making it an unattractive target for the
seller's creditors - defendants in an "aiding and abetting"
lawsuit may include the buyer's corporate parent and individuals
such as directors, officers, employees and professionals of the
buyer or its parent.
If the buyer and seller are willing to proceed outside bankruptcy,
fiduciary liability can be minimized if the directors act concerning
the sale transaction in such manner as to cloak themselves in
the full protections offered by corporate law. First, directors
should make sure that creditors in any future action will need
to establish breach of the duty of care rather than the duties
of loyalty or good faith. Thus, directors should make sure that
they have no personal interest in the sale transaction (which
might implicate the duty of loyalty) and that they apply appropriate
and sustained effort to evaluating the sale transaction (obviating
any claim of bad faith based on inattention to duty). Second,
directors should obtain and rely upon the advice of competent
and disinterested professionals, thus invoking in addition
to the general protection of the business judgment rule; the
specific protection afforded to directors who rely in good faith
upon information, opinions, reports or statements of professionals
reasonably believed to be competent. Third, in order to avoid
any factual dispute about what the directors did, they should
keep adequate records (especially corporate minutes) concerning
their consideration of the sale.
III. Successor Liability
When a company is sold, the buyer must be aware that under
the doctrine of "successor liability," the buyer may
be held liable for some or all of the seller's liabilities even
though the transaction was structured as a purchase of assets.
The general rule of corporate successor liability is that where
one company sells or otherwise transfers all of its assets to
another company, the acquiring company is not liable for the
debts and liabilities of the selling company. However, under
theories of successor liability, an asset purchaser may under
certain circumstances be held liable for the debts of the original
corporation even though the purchaser does not contractually
assume any responsibility for the seller's liabilities.
A. Types of Successor Liability
Successor liability is a matter of non-uniform state law.
However, the circumstances under which a buyer may be held liable
as a successor are generally as follows: (1) the buyer explicitly
or implicitly agrees to assume the seller's liabilities; (2)
the transaction constitutes a de facto merger or consolidation
of the buyer and the seller; (3) the buyer is a mere continuation
of the seller; or (4) the transaction amounts to a fraudulent
or collusive attempt to avoid the seller's liabilities.
1. Express or Implied Assumption
In order to maintain uninterrupted business, buyers often expressly
agree to assume some or all of the seller's debt and liabilities.
However, unless the purchase agreement expressly disclaims responsibility
for all liabilities (or all those not explicitly enumerated),
the buyer may be held to have implicitly assumed liabilities.
In general, courts will review the purchase agreement and the
post-acquisition conduct of the buyer to determine whether the
buyer intended to assume the seller's liabilities.
2. De Facto Merger
If the transaction amounts to a consolidation or merger of
the seller and the buyer, courts will impose successor liability
on the buyer. In determining whether a de facto merger
has occurred, courts will review whether each of the following
factors are present:
(1) there is a continuity of the business enterprise between seller and buyer, including continuity of management, employees, location, general business operations and assets; (2) there is a continuity of shareholders, in that shareholders of the seller become shareholders of the buyer so that they become a constituent part of the buyer corporation; (3) the seller ceases operations and dissolves as soon as possible after the transaction; and (4) the buyer assumes those liabilities and obligations necessary for the uninterrupted continuation of the seller's business.
3. Mere Continuation
The mere continuation exception to the non-liability of successors
applies when the buyer corporation is merely a continuation or
reincarnation of the seller corporation. While similarities exist
between the de facto merger theory and the mere continuation
theory, the primary focus of the mere continuation theory is
on whether there is a continuity of ownership and control.
The standards for "mere continuation" vary from jurisdiction
to jurisdiction. Under the strict continuation test, the more
favorable test for purchasers, courts only look to the following
factors:
(1) whether the seller corporation
is dissolved; and (2) whether the buyer's officers, directors
and shareholders are identical to the seller's officers, directors
and shareholders. But many courts apply a broader test, such
as:
(1) whether there has been a transfer of corporate assets, (2)
whether less than adequate consideration was paid for those assets,
(3) whether the acquiring entity continues the divesting corporation's
business, (4) whether there is at least one officer or director
instrumental to the transaction who is common to both entities,
and (5) whether the divesting corporation is unable to satisfy
its creditors because of the transfer.
4. Fraudulent Transaction
The fourth theory of successor liability covers transactions
that are entered into fraudulently in order to evade liability
for debts. Essentially, the theory is an application of the general
rule against actual fraudulent transfers (as discussed above).
5. Product Line Liability
In addition to the four theories discussed above, a minority
of states have adopted a "product-line" liability exception
to the general rule of successor non-liability. Its elements
commonly include: (1) the total or virtual extinguishment of
tort remedies against the seller as a consequence of an asset
sale; (2) the buyer's continued manufacture of the same product
lines under the same product names; (3) the buyer's continued
use of the seller's corporate name or identity, and trading on
the seller's goodwill; and (4) the buyer's representation (e.g.,
advertising) to the public that it is an ongoing enterprise.
This doctrine was developed to serve a public policy in favor
of permitting anyone injured by a defective product to be able
to recover from the current manufacturer, even if different from
the company that manufactured the defective unit. In addition
to product liability cases, expanded tests of successorship have
been used, again on public policy grounds, in labor relations
and federal environmental regulation.
B. Sale Context
Except where specific considerations of public policy warrant
imposing liability on a buyer, the doctrine of successor liability
is a mere artifact - an ossified set of rules divorced from any
commercial justification. If successor liability were simply
a trap that any buyer could avoid by engaging competent counsel,
it would be harmless enough. However, minimizing the risk of
successor liability may entail enormous economic cost in the
situation where the buyer acquires assets of a business that
it wishes to continue in operation as a going concern. The very
steps that the buyer will wish to take in order to maximize going-concern
value after the closing - such as using the same name, keeping
the same location, employing the same key personnel, producing
the same products and selling them to the same customers - can
be cited as factors which, under successor liability doctrine,
may result in liability for all debts of the seller. So how,
if at all, may the buyer of a going concern eliminate or at least
minimize the chance of successor liability?
It might seem logical to suppose that purchasing at a regularly
conducted, non-collusive foreclosure sale would provide a "safe
harbor" from successor liability. After all, Article 9 of
the Uniform Commercial Code was designed to promote the sale
of businesses on a going-concern basis in order to maximize the
sale price for the benefit of the seller and its creditors. However,
courts have decided that buying at foreclosure affords the buyer
no automatic exemption from successor liability. Some courts
and commentators have even questioned whether a bankruptcy sale
can preclude claims against the buyer based on successor liability.
It is reasonably clear, however, that a sale order or Chapter
11 plan that includes a well-drafted prohibition against successor
liability claims will be binding upon any creditor that receives
proper notice and does not object. Thus, in most situations,
bankruptcy provides a means for buyer to obtain the assets of
a distressed seller without being subject to successor liability.
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information concerning its topic. It is not intended to provide
legal advice or to create an attorney-client relationship.