Buying assets from financially distressed sellers
When a developer that has sold assets later files for bankruptcy, many of its transactions that it engaged in during the time leading up to its bankruptcy filing will be scrutinized in the bankruptcy case.
Many times, a potential buyer of assets is aware that a developer is struggling financially, and the buyer may be worried about challenges that could be asserted later to the purchase of the project that it is considering.
The concern that we most frequently get asked about is “fraudulent conveyance” risk.
What is “fraudulent conveyance” risk?
If a developer were to file later for bankruptcy, it may try to unwind a payment or asset transfer made to another party before the bankruptcy filing under an “actual fraud” theory or a “constructive fraud” theory.
The United States bankruptcy code offers two different avenues that a trustee or debtor in possession may pursue to unwind a transfer of assets.
Section 548 of the bankruptcy code lists the elements for unwinding a fraudulent transfer that was made, or an obligation that was incurred, within the two years before filing the bankruptcy case.
Section 544(b) of the bankruptcy code allows fraudulent transfers made before the two-year reach-back period of section 548 to be unwound in certain circumstances by relying on a longer reach-back period under whatever state or other non-bankruptcy laws apply to the transaction. Examples of other laws that might apply are the Uniform Fraudulent Transfer Act or the Uniform Fraudulent Conveyance Act at the state level. The reach-back periods to challenge transactions under state law are for four or six years and sometimes even longer.
Creditors of the developer may sue to unwind an asset sale or payment obligation that is considered a “fraudulent conveyance” even if the developer does not eventually file for bankruptcy.
When a bankrupt company goes into liquidation, a trustee or the company itself as the “debtor in possession” may try to claw back money into the bankruptcy case.
The trustee — or, in appropriate circumstances, a creditor — may unwind any transfer of the bankrupt company’s property within the relevant reach-back period if it can be shown that there was actual fraud. The trustee or creditor would have to show the transfer was made with actual intent to hinder, delay or defraud the company’s creditors.
This type of fraudulent conveyance claim is less likely to be an issue for someone who bought assets from the bankrupt company than a claim that there was a “constructive” fraudulent conveyance.
Constructive fraud does not require any evidence of intent. The trustee or creditor trying to unwind an asset sale would have to show two things.
The first is the now-bankrupt company did not receive “fair consideration” (for claims governed by a state Uniform Fraudulent Conveyance Act) or “reasonably equivalent value” (for claims brought under the US bankruptcy code or a state Uniform Fraudulent Transfer Act) for the assets.
The trustee or creditor would also have to show that the developer 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.
Both elements are necessary for a constructive fraudulent transfer claim.
This means that so long as a seller receives what is determined to be roughly equivalent value in exchange for the assets, an asset sale will not be unwound 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 is not subject to unwind as a constructive fraudulent conveyance even if the seller did not receive fair value in exchange for the sold assets.
There is no precise formula to determine whether a seller received reasonably equivalent value or fair consideration for an asset. Instead, the transfer is reviewed in its entirety, with a court taking into account all the facts and circumstances surrounding the transfer. To that end, while a buyer may not be able to completely avoid any subsequent review of the transaction, it can take certain actions to help reduce the likelihood that a bankruptcy trustee or creditor will be able to unwind the sale later.
Below are some suggestions that will help protect interested buyers from potential fraudulent conveyance claims, as well as other general risks that exist in connection with buying assets from a distressed seller.
Tips when buying assets
First, do your homework on the assets. This serves at least two purposes.
First, and more generally, it may very well be the case that the seller will have limited (if any) business operations and liquidity after the proposed sale transaction, meaning that you should not assume that you will be able to recover any losses from the seller through breach of representation or warranty claims under the sale contract.
Second, as part of your diligence, get a better understanding of the financial struggles that the seller is facing. Is the seller late with bill payments? Is it having trouble paying debt service on its existing debt? What other creditors does it have? Depending on how dire the financial condition is, it may be wise to tell the seller that you are only willing to purchase the assets through a “363 sale” in bankruptcy. (For more information on 363 sales, see “Asset Sales in Bankruptcy” in the February 2010 NewsWire.)
Second, sweetheart or insider deals with a distressed seller are not a good idea. The benefit of paying what may be a below-market price is significantly offset by the fraudulent conveyance risk that has been introduced to the transaction.
The best way to avoid a fraudulent conveyance challenge to an asset purchase is to ensure that you have paid reasonably equivalent value for the assets. If the developer has run a sale process for a project, working with a banker and marketing the project to the right audience of potential bidders, then the ultimate price that the developer agrees to with the winning buyer is going to be reasonably equivalent value for that project. The seller will have received what the market is willing to pay.
It may be that what the market is willing to pay is still less than the developer could have received if it were not in some financial distress, but that will not change the result — when the developer chose to sell the project, it received what the market was willing to pay for it, which should eliminate fraudulent conveyance risk.
SunEdison sold many project assets outside of its bankruptcy case through a market process, and this process gave buyers some comfort that the SunEdison subsidiaries that made the sales, and that had not filed for bankruptcy, would not later file and be able to challenge those asset sales.
Third, whether or not a project has been put out for bid, a buyer should consider requiring the seller to provide a fairness opinion in connection with the proposed transaction. That opinion is typically prepared by an investment bank, and 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, thereby making it difficult for the sale to be unwound.
Getting a solvency opinion, if possible, is helpful for the same reason. If the sale is later challenged, the buyer can use the opinion as evidence that the seller was not insolvent at the time of the transfer, which thereby undercuts the other allegation that a bankruptcy trustee or creditor would have to prove (that the seller was insolvent at the time of transfer) in order to unwind the sale later on grounds that it was a fraudulent conveyance.
If an opinion is not possible, then obtaining an appraisal or expert valuation of the project can also provide comfort to the buyer that it is paying fair price.
Fourth, the buyer should memorialize its discussions when negotiating the sale price and related agreements with the seller. This will happen naturally to some extent through emails between the parties and their counsel and to changes in the documentation. Phone calls should also be memorialized afterwards, and this also happens to some extent already when people send emails updating others on their team of the results of phone calls.
Buyers should be more systematic, though, about memorializing the negotiations if they have any concern about the seller being in financial distress. The emails and other documents should also be saved in files with the related sale documentation, so that the buyer has them if the transaction is later challenged. Remember that if the transaction is later challenged, a court will take into account all circumstances surrounding the sale, so if there are unique challenges or considerations that are affecting the sale price, including that should be considered value to the seller, make sure that those are documented as well.
Fifth, consider whether it makes sense to provide for a “holdback” for a portion of the purchase price. These funds can 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 a bankruptcy filing, frequently leading to a recovery of only pennies on the dollar. Holding back some of the purchase price, or putting it in escrow, ensures that the buyer will not be left without any recourse against the seller.
Sixth, limit as much as possible the time between signing and closing the asset purchase. If the seller were to file for bankruptcy after signing but before closing, the seller will have the option to “reject” (in essence, terminate) the transaction in its bankruptcy case so that it does not need to proceed with closing.
This same advice applies if there are multiple agreements that will be entered into as part of the transaction. These agreements should be executed as much as possible at the same time. In addition, include language in each agreement that states the parties’ intention that the agreements should be integrated and treated as a single agreement and transaction. The goal is to limit the seller’s ability in a subsequent bankruptcy case to cherry pick among the agreements to keep those that favor the seller, but reject those that it views as less favorable.
Finally, when structuring the sale, if possible consider arranging it as a sale of assets and not equity. While this may not always work because a purchase of the project company is unavoidable, when structured as an asset sale, the buyer is more likely to avoid inheriting all of the debts of the seller relating to the project. While there are exceptions, the general rule is that a buyer of assets (as opposed to equity) will not be liable for the debts of the seller related to the assets. ¥