Denice R. Preston
Bankruptcy can be an excellent opportunity for those with the right qualifications and the cash to buy top-quality assets for a bargain price. But it also presents an enormous challenge: How do you determine the worth of companies that employ uncertain strategies, declining liquidity, limited resources, and uncertain outlooks? Before deciding to purchase in a distressed situation, a prudent investor should determine the reason for the distress, assess the overall financial condition, determine whether it is possible to save its operations, and, if so, be aware of the time and effort needed to turn a company around.
Pre-bankruptcy: Beware Fraudulent Transfer Risk
When buying the assets of a struggling company, It is crucial to know the fraud transfer risks. A fraudulent transaction occurred when the seller was financially insolvent when the deal was made (or became insolvent due to the agreement), and the purchase had “less than reasonably equivalent value.” Any transfer of assets within the two years preceding the seller’s bankruptcy could be considered fraudulent under federal law, which means the transaction may be invalidated. Furthermore, the law on fraudulent transfers in most states provides a four-year lookback period of four years. In bankruptcy, if the seller’s creditor suspects the transfer was fraudulent, the creditors may bring a lawsuit against the buyer to rescind the transaction and hold the purchaser responsible for the economic damage. Because every before-bankruptcy M&A transaction is a fraudulent transfer risk, buyers must be careful when approaching distressed sellers before a bankruptcy filing.
Fraudulent Transfers Defined
“Less than reasonably equivalent value” is a deliberately vague phrase that isn’t defined within the Bankruptcy Code, allowing judges to determine its meaning on a case-by-case basis. It is generally accepted that courts look at reasonably equivalent value as not always equal to an amount that is fair to the market but usually more than the value of a price or forced liquidation cost as well as a value of forced liquidation. Although a reasonably equivalent value can be approximated using Net Orderly Liquidation Value, these estimates could require a lot of speculation. Since the definition of these terms is an unreliable judgment of court judges, sellers must examine and meticulously document seller-buyer communications and recent transactions to protect themselves against fraud accusations made by disgruntled creditors in a future bankruptcy proceeding.
In general, buyers must be cautious of sweetheart deals with a seller who is in distress. If the offer appears too appealing and too good to be accurate, it most likely is! While purchasing the assets of a distressed seller through a pre-bankruptcy auction could lower the risk of fraudulent transfers, buying the seller’s help via a post-bankruptcy 363 sale is the best option. If the buyer hopes to prevail in a fraudulent transfer lawsuit, the expense, delay, and stress of litigation could be an essential dissuasion.
Distressed M&A Works Best Through 363 Sales
If a company is fortunate enough to have plenty of cash, A macroeconomic or industry-specific crisis can provide a favorable opportunity to purchase assets from competitors in bankruptcy at a bargain price. The primary mechanism to facilitate such transactions in bankruptcy is referred to as a 363 sale since selling assets during bankruptcy is controlled by Section 363 of the Bankruptcy Code (11 U.S.C. SS 101, et seq.). Unlike traditional M&A, distressed M&A through 363 sales typically involves an all-cash deal that sells assets to the buyer on the “as is, where is” basis, with only limited warranties, representations, and the possibility of escrows.
363 Sales: Assets Purchased “Free and Clear”
Apart from reducing fraud-related transfer risks, The main reason to sell a 363 is the ability to purchase the assets “free and clear” of any claims, liabilities, and resulting debts (see 11 U.S.C. SS 363). The purpose of a 363 auction is to achieve the most value for the assets being transferred without regard to the legitimacy and value of pre-bankruptcy claims, liabilities, and other debts that are owed against these assets. In the absence of this, buyers will likely reduce their bids due to insufficient knowledge and understanding of the claims of creditors.
“Free and clear” does not cover certain contracts specific to industries, such as leases, joint ventures, and other agreements, since they are not considered obligations such as claims or debts under the Bankruptcy Code. These types of agreements are subject to another section in the Bankruptcy Code that permits the seller to (i) take over and transfer them or (ii) decide to reject the agreement in the sale under 363 (see 11 U.S.C. SS 360). The winner can stipulate in the purchase contract which contracts to retain and which to leave. The seller takes over, assigns the first, and refuses the latter before closing.
If it is assumed and transferred in the event of assumption and assignment, the buyer and seller must resolve all issues in the contract before closing, for example, paying the rent due for the office lease. In addition, the buyers might require other contract conditions, including making a deposit or further credit improvements. If it is not accepted, the person who signed the agreement gets rejected damages as a general unsecured right against the business. Like other claims of creditors, the rejection damages are settled within the bankruptcy procedure. In addition, the “free and clear” benefit of a 363 sale implies that the purchaser of a 363 sale does not have any liability for general claims, such as rejection damage.
As we have seen, the law of contract, bankruptcy law, and court precedents are continually evolving, making it more challenging to determine which arrangements can be rejected in bankruptcy as part of the 363 sales. Therefore, before taking part in a deal under 363, prospective bidders must consult with an experienced attorney to know the specifics of the contract that they are relying on a. Thenterpretation of state laws that may affect their ability to refuse specific agreements.
Creditors’ Negotiating Leverage to Influence 363 Sales
Only the bankrupt entity can legally propose an offer of 363. This could create conflicts of interest when the management is firmly in place and prefers a separate restructuring plan where the company continues to operate independently. Creditors have many options within their toolkits to persuade the debtor to begin selling its 363 assets. Secured creditors may try to limit liquidity available for operations during a Chapter 11 proceeding or lift the automatic stay to take their collateral. Additionally, creditors can decide to vote against any reorganization plan, ask that the court revoke the debtor’s right to propose, or nominate an official named Chief Restructuring Officer (C.R.O.) and a Chapter 11 Trustee. The creditors would like to believe that such an appointment will remove any conflicts of interest to make it easier to complete the 363 sales. However, they could face new obstacles to achieving their goals.
