Buying a Business Out of Bankruptcy: Everyone Wants a Good Deal
Author: Guy C. Fustine
Originally published in October 2017
Copyright © 2017 Knox McLaughlin Gornall & Sennett, P.C.
The assets of a business can be purchased out of bankruptcy, free and clear of liens, as a going-concern or in-bulk, even after the business has been terminated. In either case, the value of the assets would be greater than the value of the assets in a forced liquidation, which is usually on a piecemeal basis.
There are three general topics for us to discuss regarding a bankruptcy sale:
- (1) the assets and liabilities which are transferred to the buyer, or which are left behind in the bankruptcy estate;
- (2) the consideration paid, including the tax consequences and the distribution consequences in the bankruptcy case as a result of the allocation of the purchase price; and,
- (3) the mechanics related to the sale and closing, including interim arrangements, the “stalking horse” fee and the assumption and assignment of unexpired leases and executory contracts.
Describing the Assets to be Sold
It is extremely important to accurately describe the assets to be sold, including the real estate, tangible personal property and intangible personal property. The asset purchase agreement (“APA”) should also identify any assets which are excluded, including but not limited to assets associated with the executory contracts that are “rejected” under Section 365 of the Bankruptcy Code.
An executory contract is a contract with respect to which both parties to the contract have unfulfilled obligations to be performed in the future, as of the Petition date. The APA should also identify any liabilities to be transferred, although the assumption of liabilities by a buyer in a bankruptcy case should be strictly limited and well defined. The description of the assets to be sold should also include avoidance actions. Avoidance actions include fraudulent transfer actions and preference actions against third parties, including insiders, who were paid prior to the filing of the bankruptcy.
Allocating the Consideration to be Paid
The consideration for a going-concern sale may involve allocations between affiliated entities in separate or consolidated cases; allocations between the fixed assets, including the real estate and equipment; and, allocations to certain assets which are constantly changing, assuming that the business is still operating and that the assets are being sold as a going-concern. In the latter case, adjustments to the purchase price are made just prior to closing based upon the results of a current inventory. The inventory would include finished work in process and raw materials. The estimate set forth in the APA would be adjusted accordingly, and the adjusted amounts would be paid at the time of closing. A Report of Sale would be filed with the Bankruptcy Court after the closing with the final figures.
The allocation of the purchase price to the real or personal property obviously has tax consequences for the buyer. That allocation would also have distribution consequences for the banks involved, in those cases where there is more than one lien against the property sold. The owner of the business is usually responsible for the deficiency which is owed to the Bank after the net proceeds of a sale in the bankruptcy are paid to the Bank and applied on account.
Consequently, the buyer’s allocation would also affect the owner’s personal guaranty of the bank debt. The owner is usually not required to pay the Bank in advance of the sale, even though the signed guaranty is almost always a “payment” guaranty rather than a “collection” guaranty.
Generally, a buyer prefers to allocate more to the tangible personal property that can be depreciated more quickly than real estate. Sometimes the type of entity which is used or formed to accomplish the bankruptcy sale may also effect the timing of the buyer’s ability to depreciate the assets. These issues are negotiated between the parties under the APA.
The Mechanics Related to the Sale and Closing
Sale Free and Clear of Liens and Claims under §363 of the Bankruptcy Code
The single most significant aspect of a bankruptcy sale is the fact that the assets are sold free and clear of liens, claims, encumbrances and other interests, which are divested from the assets sold and transferred to the proceeds of sale. The liens, claims, encumbrances and other interests are divested before the assets are transferred to the buyer.
In order to accomplish this, it is imperative that the claimants and interest holders be notified of the proposed sale. The due process requirements of both the United States Constitution and the Pennsylvania Constitution require that the lienholders be notified in advance of the sale and that they are provided with the opportunity for a hearing, before being deprived of their property rights. This due process of law requirement is satisfied by a Motion for Court Approval under §363 of the Bankruptcy Code, which is served upon the lienholders. In addition, notice of the sale is given to all of the creditors. The Notice is also published in the legal journal and a newspaper of general circulation where the property is located.
In the Western District of Pennsylvania, the standard practice is to name the lienholders as respondents in the caption of the sale motion. The respondents, however, may be served by first class mail. Personal service is not required. It is also good practice to notify the attorneys for the lienholders, if known.
Break-up Fee a/k/a Stalking Horse Fee
In many cases, the insolvent debtor in business must find a buyer of the going concern sooner rather than later to preserve the going-concern value of the business and to avoid the inevitable foreclosure or repossession which would occur if the business continues to be unable to pay its debts in a timely manner. There are many situations wherein the underlying economics of a certain enterprise would not support a reorganization of the business, especially with the same ownership team in place. However, if the market demand for the goods or services produced by the debtor is high enough to create significant value to certain third parties, especially those third parties who have synergistic business operations, the buyer and the seller may be able to negotiate terms which are mutually beneficial.
All bankruptcy sales require a hearing and the rules also require that, at the sale confirmation hearing, other qualified bidders will be given the opportunity to bid more for the assets than the stalking horse bidder. In those cases, where there is a qualified bid for more than the amount of the stalking horse offer, the Court will deny the stalking horse offer and use the upset bid as an opening bid at a public auction. The party who submits the highest bid at the auction will be determined to be the successful purchaser and enjoy all of the protections and benefits which were initially designed to protect and benefit the stalking horse.
This is a competitive environment which has given rise to the expectation that the stalking horse will be able to recover its out-of-pocket expenses in the event that the stalking horse is out-bid at the sale confirmation hearing. This is often called a “break-up fee” or “stalking horse fee” and is based upon the out-of-pocket expenses of the stalking horse. Depending upon the law of the jurisdiction where the bankruptcy case is pending, the stalking horse fee may not always be limited to the provable and actual out-of-pocket expenses. Some of the larger, due diligence expenses incurred by the stalking horse (in addition to the legal and accounting fees) are real estate surveys and phase one environmental studies. These expenses are usually included in the break-up fee, but only if the reports are also made available to the competing buyers.
The amount of the deposit under the APA is also an important part of the break-up fee analysis. For example, any other bidder would be required to qualify to bid in advance of the sale hearing. This would usually require any other bidder to make a deposit in the same amount as the deposit made by the stalking horse. Moreover, the initial upset bid at the sale confirmation hearing should be established in an amount which is sure to be in excess of the break-up fee. This would ensure that if the stalking horse is outbid, the stalking horse would be able to recover its out-of-pocket expenses and the bankruptcy estate would also benefit to the extent that it would recover the amount of the upset bid which is in excess of the break-up fee. The upset bid should always be more than the break-up fee! This approach encourages interested parties to make an initial bid knowing that its expenses will be paid if another party bids more; and, the estate recovers more and benefits from the net additional amount paid.
Any interested bidders are of course entitled to conduct due diligence in advance of the deadline for qualifying. Those interested bidders should be required to sign a confidentiality agreement regarding the information to be reviewed in deciding whether or not to make a competitive bid.
Assignment of Executory Contracts and Unexpired Leases
Another advantage of this process is the buyer’s ability to have certain contracts and leases assumed by the debtor and assigned to the purchaser. The assumption of the executory contracts and unexpired leases is conditioned upon the past-due payments being brought current prior to the time of the closing. In addition to curing the arrearages, assignment of the executory contracts and unexpired leases is also conditioned upon the buyer being able to demonstrate “adequate assurance of future performance”. If the contract or lease is cured and the buyer provides adequate assurance of future performance, even if the other party to the contract or lease does not consent to the assignment, the assignment can be ordered and enforced by the court. There are certain exceptions to this rule. For example, personal service contracts cannot be assumed and assigned without the consent of the third party.
In order to keep all potential bidders on the same playing field, the seller may require the ultimate purchaser to cure the arrearages on the contracts and leases that the particular buyer designated to be assumed. This issue can be very important in cases where a certain contract or specialized equipment lease is essential to the business. If only one party has the right to assume it, there may be no real opportunity for competitive bidding.
Sometimes the mechanics of a closing will be preceded by a sublicense agreement between the seller and the buyer, which would enable the seller to command a higher purchase price and which would enable the buyer to get started sooner which is sometimes essential to maintaining a workforce or customer base. However, bankruptcy professionals and trustees are often reluctant to enter into such arrangements because it would be less likely that other parties would bid more for the assets, if the initial offeror (sometimes referred to as a “stalking horse”) has already been operating the assets pursuant to a subcontract agreement, sublicense agreement or lease. There are also risks for the buyer who is spending time and money without knowing for sure if they will be the high bidder at the auction and ultimately acquire the assets.
Your knowledge of the substance and procedure of a bankruptcy sale should help with your merger and acquisition practice. There are many advantages to buying assets out of bankruptcy. The fact that the assets are sold free and clear of liens by virtue of a federal court order is even better than a certificate of title. Another advantage is the fact that important contracts and leases can be assigned to the buyer, over the objection of the third party.
Even though the business is insolvent, the real and personal property can nevertheless be sold as a package, even if the business has been terminated and the assets are being sold in bulk rather than as a going concern. This is an advantage over state court proceedings which have different procedures for secured creditors to foreclose on real estate and to execute against personal property. Because of the different procedures, which often include different timelines, a buyer of the business real estate in a state court foreclosure proceeding is usually not sure whether or not it will also be able to acquire the personal property which was used in the business. This is a significant benefit of a bankruptcy sale. The real and personal property, including the necessary contracts and leases, can be purchased together at one time, and command a higher price in consideration of that fact. The buyer has the benefit of knowing that all of the assets essential to the operation of the business can be acquired at one time.
We have all seen operating businesses go through bankruptcy and wonder how it was possible. At least now you have an outline of the process and how it works. It is a very competitive process and involves a significant amount of strategic planning and dynamic negotiating. Depending upon the size of the business, it would probably be a good idea to have an experienced bankruptcy lawyer and an experienced accountant involved, who may also need the services of other professionals, e.g. an appraiser, management analyst or environmental analyst.
Author: Guy C. Fustine
Originally published in October 2017
Copyright © 2017 Knox McLaughlin Gornall & Sennett, P.C.
Note: the following publication was helpful in the creation of this article, and may be of use to those seeking more information:
From the American Bar Association Business Bankruptcy Committee, 2017