How can I protect myself from liability when buying a financially distressed business?

You can get a pretty good deal if you want to buy a distressed business. But the trouble is that buying from a struggling seller brings dangers you don’t see in ordinary deals, and the standard deal protections alone won’t cover them. You can limit your risks in other ways.

Below are the risks involved in buying distressed businesses, and why the usual protections you might try to get for yourself may not work when the chips are down. You will also find other ways to cut risk.

Successor Liability

The main idea of an asset sale is a contract spelling out what assets the buyer is getting, and what debts they are taking over from the seller. The buyer disclaims everything else, pays the seller a fair value for the lot of them, and the rest belong to the seller. The problem when the seller is in distress is that successor liability may be more of a risk, and it can nullify those “usual protections.”

Successor liability is a state law doctrine which defeats the asset buyer’s ability to pick and choose which liabilities it will assume, and which it will leave to the seller.

A company that buys assets may be treated as if it were the seller’s successor even if the contract says otherwise. Fraudulent transfer and de facto merger are both risks for asset buyers in distressed situations.

In the classic fraudulent transfer, one party sells property on purpose to make it harder for creditors to collect on their debts. It’s a tough position to be in, but an asset buyer in a distressed sale must be aware of the risk.

Many asset buyers don’t realize that fraudulent transfer may not require any actual bad intent. It can be enough if the price you paid wasn’t enough and the seller was insolvent. The creditors on the bad side of that deal could have a fraudulent transfer claim against the buyer. So the price you pay and how the seller treats its creditors can be your problem too.

If the claim is successful, the court can undo the sale and have the assets or their value given back. The creditor may also have a claim for more money. The buyer could be stuck with the seller’s debts.

Is a price adequate or inadequate? The answer is in the eye of the beholder. A price can be fine for one party and bad for the other. The discount that makes a distressed deal attractive is what also makes it risky. Be careful.

In some cases, a court may decide that an asset sale has been a merger, regardless of what the contract says. The court will apply a test, which varies from state to state. The usual factors include:

• Whether the seller’s employees, premises, assets and daily operations all pass over to the buyer.
• Whether the owners of the seller before the deal still own the buyer afterwards.
• Whether the seller stops doing business, liquidates and dissolves quickly, and whether the buyer takes on obligations to keep business running without interruption.

Courts often look at distressed asset sales more critically. Was the deal just a way to unload the insolvent company’s debts? Buyers may find themselves liable for the seller’s debts after the sale. Expect more scrutiny than in a “normal” deal.

The Standard Protections Buyers Use

The usual ways buyers protect themselves may be of little or no value in a distressed deal. The contract is supposed to protect the buyer from anything that isn’t revealed in the due diligence process, but when the ship goes down that may not work. Indemnities and reps and warranties offer only the tiniest bit of protection. Post closing recourse can be almost worthless.

Those reps, warranties and indemnities are only as good as the credit of the people on the other end. Buying distressed means the seller is unlikely to have the resources to cover those things.

Generally, a buyer will have the right to come back after the sale if the seller breaches any reps or causes indemnified losses. Distressed sellers may argue the discounted price takes care of that.

Often buyers hold back or escrow part of the price to protect themselves. When the price is discounted, there isn’t much left to hold back. Rep and warranty insurance, while increasingly common, may be unavailable or unaffordable in a distressed sale.

If you want to get any protection at all, think about other approaches and use other tools. Here are other ways to cut risk.

Way to Cut Risk

First, conduct more detailed diligence to make sure what you’re buying is as represented.

Pay careful attention to identify any liabilities early on and either settle or factor the price accordingly.

You might want to pay a little more to have an independent valuation of the business to make sure the business is actually worth the amount you’re paying for it.

Finally, make sure that the buyer is sufficiently distinct from the seller and has entered into releases with the seller’s major creditors.

Diligence is a buyer’s most important responsibility. Ordinarily, a buyer can rely on a seller’s reps to make sure the diligence is accurate. In a distressed deal, those reps may not apply. With reps cut back, and little or no recourse after closing, any problems discovered in diligence before signing, are probably all the protection you’ll have in the deal. It is better to spot the liabilities early on, and negotiate a lower price or reach a deal with the creditors.

If the seller received a PPP loan, be sure to dig into that transaction carefully.

• Whether the seller actually satisfied the requirements to get a PPP loan under the CARES Act and SBA guidance.
• Whether the seller has used all the money for purposes that satisfy the CARES Act and SBA guidelines and how much money, if any, will be forgiven.

A party claiming fraudulent conveyance on a sale will argue, among other things, that the buyer paid too little for the assets. An independent valuation on the buyer’s side can deter such a claim, or defeat it.

For asset sales, buyer should make sure seller’s entity continues to exist after the sale. No money for the seller’s shareholders should be paid out until it is part of a settlement with creditors. There is risk in paying out early. After all, if the sale price goes out to the sellers’ wallets before all the debts are paid, then the creditors have another reason to pursue the buyers.

You can cut the chance of a de facto merger finding, as a buyer, by setting the buyer apart from the seller in a few simple ways.

• To begin, announce publicly that the business is under new ownership, and that the buyer is an independent entity, having no connection to the seller.
• Change the name of the business and replace at least a few of the officers at closing.
• Move the headquarters from the original location to a new one.

You can pay the seller’s managers reasonable compensation for their help after you buy the business, but you should not favor their claims over the claims of other creditors in paying them off after closing.

It is highly likely that a seller in distress will have claims against it by third-party creditors. Instead of gambling on any of those claims surfacing after the close, seek them out early and settle and release them directly.

One way to do that is to leave some of the purchase price in a pool to settle the claims of the seller’s creditors. You give the seller what’s left after all the claims are settled. Don’t give that money to the seller right away. Hold it back until you have a signed release of all those claims.

There are other ways besides a plain distressed asset sale to buy distressed assets. You could try an ABC or a lender’s friendly foreclosure. You could try a Chapter 11 363 Sale.

An ABC or assignment for the benefit of creditors is a state law tool where the distressed company voluntarily hands over all assets to a trustee who then sells them and pays the creditors as far as there is money.

An assignment for the benefit of creditors can be a quicker, cheaper alternative to Chapter 7 in some states. However, there is no discharge, no automatic stay, and you don’t buy free and clear of liens. That is a real trade-off for a buyer, who gives up the protections a bankruptcy court could offer.

ABCs are not a way to reorganize a business. They are generally for distressed companies that want to sell assets or wind down operations.

A friendly foreclosure is a UCC Article 9 foreclosure, under which the senior secured lender forecloses its liens and transfers the assets to a buyer. For a friendly foreclosure to work, the buyer, the lender and the debtor all must agree.

A 363 Sale is a sale of assets in a Chapter 11. The debtor markets assets, decides who the stalking horse bidder will be and files that bidder’s offer with the court so other parties can make higher offers.

The upside to a 363 Sale is that it can protect the buyer from a claim that the transfer of assets was a fraudulent conveyance. The downsides are that the auction can drive up the price, and that the delays of the process can degrade the value of the assets. A court supervised sale can be expensive, but it may be worth the price if the risk of a later fraudulent conveyance claim is one you don’t want to live with.