Guidance for Purchasing Distressed Assets

The COVID-19 pandemic has caused economic turmoil that may provide opportunities for financially secure companies with capital to make a strategic acquisition of distressed assets and for investors to acquire valuable assets. The following highlights some important considerations when evaluating a purchase of distressed assets.[1]
 

How to Finance the Purchase of Distressed Assets

Often, distressed assets do not meet the criteria for traditional debt financing. There are a number of alternative ways to finance the purchase of distressed assets, including: (i) utilizing cash flow from purchaser’s existing business; (ii) obtaining a secured loan from a lender with a security interest in purchaser’s assets; (iii) using an asset-based lender (“ABL”) to receive quick access to capital; (iv) seeking a loan from the seller’s existing lender; and (v) potentially leveraging the acquisition by securing the acquisition financing with the target company's assets (an "LBO"). However, as discussed below, LBOs can be associated with increased risk of attack (a fraudulent conveyance action) by the target company's creditors, if the company is insolvent or rendered insolvent as a result of the LBO.
 

How to Acquire Distressed Assets

Buyers can decide whether to purchase distressed assets in a formal bankruptcy process, a state court insolvency (such as "assignment for the benefit of creditors" or "ABC") or receivership proceeding or to proceed out of court with a more traditional acquisition process. 

Chapter 11 Bankruptcy and a 363 Sale

A chapter 11 bankruptcy traditionally involves a debtor proposing a plan of reorganization for the restructuring of its debts with the objective of continuing to operate. More often, however, chapter 11 is being used as a vehicle for distressed companies to sell some or all of their assets—commonly known as a “363 sales” in reference to the applicable section of the Bankruptcy Code. Following bankruptcy court approval of the debtor's "bid procedures," and after conducting an auction and selecting the highest and best bid, the debtor submits the proposed transaction to the bankruptcy court for approval. Approval of a 363 sale does not involve the same extensive voting and confirmation process required for approval of a chapter 11 plan. One of the greatest benefits to a buyer who acquires assets through a 363 sale is the conveyance of the assets by court order that conveys title “free and clear”—that is, the buyer takes the assets “free and clear” of all liens, claims, interests, and encumbrances against those assets, leaving those infirmities with the bankruptcy estate. The “free and clear” concept is memorialized in an order entered by the bankruptcy court approving the sale transaction. The holders of the liens and claims seek recovery on their claims from the proceeds of sale held by the bankruptcy estate while the buyer receives significant protection against acquiring unwanted liabilities including, often, successor liability claims. Further, a 363 sale eliminates the risk that the sale could be set aside as a fraudulent transfer that otherwise exists in out-of-court distressed acquisitions. In out-of-court transactions, valuation is important because creditors can challenge a transaction that was not for "fair and adequate consideration." The sale order entered in a chapter 11 process protects the buyer from such a challenge.

A buyer who identifies distressed asset acquisition opportunities early can further benefit by acting as the “stalking horse” bidder in a 363 sale. The stalking horse bidder is the baseline bid—both in terms of dollar amount and the various terms and conditions in the proposed asset purchase agreement—for an auction. A stalking horse bidder typically receives certain bid protections, such as a break-up fee (i.e., a fee payable to the stalking horse bidder if another bidder ultimately is selected as the winning bidder) and an expense reimbursement to compensate the stalking horse bidder for its time and investment in the process (which can be argued to set a benchmark for bidding that brings value to the bankruptcy estate). Not only do these bid protections offer compensation in the event that another bidder is selected as the winner after an auction, but they also offer an advantage to the stalking horse bidder during an auction because other bidders will need to outbid the stalking horse bidder by at least the value of the bid protections to make the alternative bid more valuable to the bankruptcy estate than the stalking horse bid. Conversely, the stalking horse bidder does not need to take bid protections into account when overbidding against other bidders at auction. In addition, a stalking horse bidder may have greater and longer access to due diligence prior to making its bid and may have a greater ability to negotiate certain terms of sale (although a 363 sale will usually be on an “as is, where is” basis).

Drawbacks to a 363 sale are that the process can be expensive and slow, every term of sale is public record, and the buyer risks being outbid at auction. Due diligence may also be limited— or at least subject to a very short review period (compared to non-distressed out of court acquisitions)—for bidders other than the stalking horse bidder. 

Assignment for the Benefit of Creditors

An ABC is an insolvency proceeding under state law that can be an alternative to chapter 7 or chapter 11 bankruptcies. ABC processes vary by state—some require a court proceeding while others do not. ABCs usually require the cooperation of the debtor and its secured lender. The seller assigns its assets to a third party who is then responsible for selling the assets and distributing the proceeds to the seller’s creditors. Immediately after the execution of the ABC document, the assignee takes possession of the assets. Because the buyer acquires the assets from an independent third party (the "assignee") and the sale is approved by the state court overseeing the ABC in states involving a court proceeding, the buyer likely reduces its risk that a creditor will bring a fraudulent transfer claim versus an arms’ length transaction with the seller. This is particularly true as more and more states' ABC laws allow sales to be approved "free and clear" of such claims.

Equity Receivership

A neutral third-party receiver is most often court-appointed at the request of a secured creditor who fears that its collateral will be dissipated or otherwise harmed. A receiver’s powers and duties are imposed by statute and the court order appointing the receiver and may include operating the business, taking possession of property, bringing or defending actions, collecting rent or debts owed, and selling the assets of the company. If a receiver is authorized to sell the assets, it will do so under the supervision of the court. Usually, the receiver will ask the court to approve a sale procedure and then advertise the sale for several weeks in order to maximize recovery. The receiver sale process can be much less expensive and time consuming than a bankruptcy. The "art" of maximizing value out of a sale in a receivership case is to make sure the order approving the sale protects the distressed debt and asset purchaser from attacks by the company's creditors and others. Crafting an order that shields the transaction from fraudulent conveyance claims and finds that the sale is for value and the purchaser is acquiring good title in good faith should enable the purchaser to obtain unencumbered title.

UCC Article 9 Sales, Receivers, and Friendly Foreclosures

In addition to a lender's rights and remedies negotiated and incorporated into the governing loan documents that are triggered upon default by a borrower (or, sometimes, a guarantor), Article 9 of the Uniform Commercial Code governs the relationship between a debtor and its secured creditors. A secured party’s remedies upon a borrower’s default include the right to sell the collateral to a third party. An Article 9 sale provides the least protection from successor liability, but tends to be cheaper than a 363 sale, ABC, or receivership. 

Particularly when a borrower wants to reduce liability on a personal guaranty to the secured creditor, the borrower may engage in a “friendly foreclosure.” In a friendly foreclosure, the secured creditor and the seller agree the secured creditor will foreclose on the assets and transfer title to a buyer. The buyer should expect the secured creditor to sell the assets in as-is condition with few representations and warranties or indemnity. The structure of a friendly foreclosure may provide incremental protection against claims made by unsecured creditors and third parties asserting successor liability, because technically the purchaser is acquiring title from the foreclosing lender, not the distressed debtor/borrower. Again, how the notice and sale documents are drafted and the value paid in the transaction (which is truly out-of-court) are critical to assuring no later attacks by creditors (or others) asserting that the sale was not "commercially reasonable."      

THE RISK OF FRAUDULENT CONVEYANCE

When a company that sold assets later files for bankruptcy, its transactions leading up to the bankruptcy filing will be scrutinized. Upon filing for bankruptcy, a trustee or, in some instances, a creditor may try to unwind a payment or asset transfer made before the bankruptcy filing under one of two fraudulent transfer theories: “actual fraud” or “constructive fraud.” 

To prove actual fraud, the trustee or creditor must show that the transfer was made with actual intent to hinder, delay, or defraud the company’s creditors. Constructive fraud does not require any evidence of intent. Rather, constructive fraud requires the trustee or creditor to prove that the now-bankrupt company did not receive “fair consideration” or “reasonably equivalent value” for the assets and show that the bankrupt company was insolvent at the time of the asset sale, became insolvent or was left with unreasonably small capital as a result of the asset sale, or intended or believed that it would incur debts beyond its ability to pay such debts as they matured. 

Practically speaking, so long as a seller receives what is determined to be a fair value in exchange for the assets, an asset sale will not be invalidated as a fraudulent conveyance, even if it is later determined that the seller was insolvent at the time of sale. Likewise, an asset sale by a solvent and adequately capitalized seller will not be invalidated as a fraudulent conveyance even if the seller did not receive fair value in exchange for the sold assets and so long as the sale did not render the seller insolvent, unreasonably capitalized or unable to pay its debts. In order to minimize fraudulent transfer risk when acquiring assets from a distressed seller in an arms’ length transaction, it is advisable for the buyer to obtain a competent valuation from an independent valuation expert (i.e., not from the seller) prior to the sale and to ensure that the consideration being paid is reasonable equivalent to the value of the assets being acquired.

WHAT MAKES A “GOOD” DISTRESSED ASSET PURCHASE?

The short answer: due diligence. It is imperative to conduct proper due diligence when determining whether to buy distressed assets since it is far preferable to avoid buying liabilities by discovering them in advance than discovering them post-closing and with limited recourse against an insolvent seller. A buyer should not assume that he or she will be able to recover any losses from the seller through breach or representation or warranty claims under the contract since the seller may have limited, if any, business operations or liquidity after the sale. 

1. Identify all the assets that come with the purchase, including intellectual property, client contracts, and goods.
2. Review client contracts scrupulously to determine whether they will be voided by insolvency or breached by nonperformance.
3. Ensure the fair value for every asset being purchased and evaluate the real underlying performance of the asset.
4. Determine the company’s supply chain risk and the availability of, and costs associated with, using alternative sources of supply.
5. Analyze the company’s potential employment law issues and compliance with relevant government health guidelines.

Buyers should consider going beyond their traditional diligence and obtain a third-party valuation of the assets being acquired and seek releases and waivers from third-parties who might have claims against the seller. Additionally, the buyer should consider requiring the seller to provide a fairness opinion in connection with the proposed transaction. Typically prepared by an investment bank, it provides an opinion as to whether the proposed sale price is fair to the seller. If the transaction is later challenged as a fraudulent conveyance, the fairness opinion will serve as evidence for the buyer that the price it paid provided the seller with reasonably equivalent value, making it difficult for the sale to be invalidated. Similarly, buyers should consider getting a solvency opinion because if the sale is challenged, the buyer can use the opinion as evidence that the seller was not insolvent at the time of the transfer.

Additionally, buyers should determine whether it makes sense to “holdback” a portion of the purchase price to be used to cover any losses to the buyer if there are breaches under the sale agreement. Absent such a holdback, if the seller were to file for bankruptcy after the sale, then any claim by the buyer under the sale agreement for indemnification or a purchase price adjustment will typically be treated as an unsecured claim after a bankruptcy filing.

Purchasing distressed assets often provides a unique opportunity to acquire property, expand your business, reach new markets or merely make a profit on the strategic purchase of a troubled asset that can be improved and sold for a profit—but steering clear of all the landmines and pitfalls associated with such transactions, and maximizing the protections that can be obtained by and through court-approved sales requires the guidance of experienced insolvency professionals.  
 
Ice Miller’s Bankruptcy, Restructuring, and Creditors’ Rights Group represents clients in a broad array of industries and can help evaluate what options might be available. If you need advice on selling or purchasing distressed assets, the attorneys at Ice Miller are available.

This publication is intended for general informational purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstance.
  Chelsea Abramowitz is a law clerk in Ice Miller’s Business and Bankruptcy, Restructuring, and Creditors’ Rights Groups (admission to the New York state bar pending). Chelsea earned her juris doctor from Fordham University School of Law and has a degree in public health from Tulane University.

Louis DeLucia is a partner in and chair of Ice Miller’s Bankruptcy, Restructuring, and Creditors’ Rights Group. His representation encompasses a wide range of issues, including complex Chapter 11 cases, bankruptcy and creditors’ rights related litigation in state and federal courts, liquidation proceedings, receiverships, cross-border insolvency proceedings, non-judicial loan restructuring, workouts and other alternatives to the bankruptcy process, and state court asset recoveries and foreclosures.

Alyson Fiedler is a partner in Ice Miller’s Bankruptcy, Restructuring, and Creditors’ Rights Group. She has been involved in some of the largest and most complex bankruptcy cases in recent years, having served as counsel to creditors, creditors’ committees, debtors, fiduciaries and other interested parties.