What is an assignment for the benefit of creditors, and when does it beat bankruptcy?

The prospect of reorganizing a struggling firm successfully in bankruptcy is often dim. If that happens the best strategy may be liquidating the business through a bankruptcy sale. A sale in bankruptcy can transfer assets free of liens and claims.

A Chapter 7 case is administered by a trustee, who is paid based on the amount of the assets she brings in for the estate. In Chapter 11, the owner or original management usually stays in charge of the business.

The alternative is an assignment for the benefit of creditors (ABC), a state-law substitute for bankruptcy liquidation. The advantage of an ABC is that it avoids the delay, complexity, and cost of going through a formal bankruptcy process in the federal court system. Colorado’s ABC system sets few formal requirements, allowing a quick sale to go through on a reduced time frame.

An ABC is not a restructuring process, so it is a bad fit for a business that might actually have a future in Chapter 11. It also lacks some of the features of bankruptcy that help in a sale. Since it happens under state law, there is generally no automatic stay to freeze creditors’ actions the way there is at the start of a bankruptcy.

If the sale falls short, the firm’s debts will not be discharged. One problem is that creditors are often suspicious about a company’s assets and whether they were hidden from the process. In that climate, the conduct of the case can help reduce the likelihood that angry creditors may bring litigation against those who were in charge of the corporation. If there are no secured creditors, or their claims will be paid in full, the ABC is often a good fit.

The ABC is an old legal device. In America they are mostly governed by state statutes. How they work is the owner signs a deed assigning the business assets to an independent, neutral third party assignee. The assignment is irrevocable, with no way to change the mind and go back to normal business. The property is then sold and the assignee pays creditors pro rata out of the proceeds of the sale. As you can see, this is like a trust. The transferor is placing the business’s property into the hands of the assignee for the benefit of the creditors. There are rules on how the assignment goes forward, which vary by state. Some states require extensive court supervision, others little or none.

An ABC is only for liquidating. There will be no reorganization, discharge, or business emerging from the case. The board members, officers, and investors surrender control of the corporation to the assignee. Shareholders are paid only if anything is left after costs and creditors are paid in full.

Here are the signs that it’s time to talk about liquidating your business:

You are probably burning through cash to keep the doors open and have no new debt or equity sources.

Lenders are unwilling to consider a forbearance or extend a due date. They are not advancing funds on existing debt.

If there is no cash to cover a fiduciary obligation like paying the accrued wages, vacation pay and tax obligations of your employees, you could be held personally liable.

Your expectations of value may not be realized on the open market. The true value is what someone will pay for it, and at the end of the day the business’s value will not support the debts against it. If your efforts to sell a distressed firm were thwarted by too little interest and too few buyers, that’s a sign it might not be worth it.

The Biggest Pluses

Every case is different, but one of the biggest pluses is the ability to choose an assignee with deep experience in the field. Here, the company chooses the assignee, who can have industry know-how and contacts. That kind of information can help get the most value for the assets.

The second advantage is that the assignee, an independent person and fiduciary of creditors, runs the sale. That provides a strong defense against later challenges by creditors that the sale was a mistake, they were not heard, there was no marketing, or the price was low.

A third plus is the reduced cost. Administrative expenses usually run lower than Chapter 11, because there are fewer or no court filings and no creditors’ committee to pay for.

For some directors and investors, the reduced visibility of an ABC in comparison with bankruptcy is a welcome benefit.

Lenders with liens on the assets to be sold will want assurance their collateral will not lose value while waiting for the sale. They will often back a sale for the benefit of creditors if the budget is reasonable, the proceeds will be distributed promptly, and their liens will be validated.

The Cons Most Businesses Must Weigh

Every state is different, but here are the drawbacks to consider.

The first problem for a company considering an ABC is the absence of an automatic stay, with few exceptions. That means litigation against the firm can continue while it is attempting to sell. Here’s the trouble with that: if the corporation has been liquidated, those lawsuits or judgments may mean little. The assignee has no reason to defend these suits and will not have the funds to pay lawyers to litigate. Angry or suspicious creditors may turn to the remaining targets: directors and officers, whether as guarantors or as fiduciaries.

Some contracts are expressly non-assignable. Others require consent by the other party to transfer. An assignee cannot get around these rules. It is left to track down the necessary consents. The assignee has to seek out the non-selling party and ask for permission. They often have no particular interest in helping the process, and may just say no. Consent requirements may be an obstacle, and that can lower the price or sink the sale. A Chapter 11 debtor has more flexibility to keep advantageous contracts, but that is not available in an ABC.

One last disadvantage is that most states, including Colorado, do not provide a court order from an ABC cleansing the assets of the liens of creditors. The buyer usually gets an assignee’s bill of sale, which is backed by the reputation and skill of the independent, respected fiduciary who oversaw the process. That may be good enough, but a court order from a bankruptcy judge may make some buyers happier.

The company must be able to point to the articles of incorporation or LLC operating agreement to show its authority to engage in the ABC. State law has to be satisfied as well.

A potential assignee will have a number of issues to think about.

The assignee’s first task is to assemble an accurate inventory of what the business owns and owes, and will rely on the company’s records to start. If the records show material errors or uncertainty, that could undermine the proceeding, or cost the company time and money to sort out.

Environmental exposure counts too, since any real estate could be hiding a big environmental time bomb.

It is important to confirm the company has all the licenses needed to operate, because it is sometimes hard to put a license into the sale.

The assignee will check public records to confirm no liens are out there that will derail the sale. If there are, and the secured lenders are not on board, the project is likely doomed.

While creditors do not have the power to pick the assignee, they can go to court to challenge one who fails to perform his or her duties. The ABC generally begins when the assignee accepts the assignment, which must be put in writing, usually in the form of a trust.

Once the trust is formed, the assignee must notify all those who have a stake in the business, both creditors and equity holders. Taxing authorities are given notice, just like other creditors. The trust is legally distinct from the old corporation, so judgments against the company after the assignment generally do not reach the trust’s assets.

If there are opportunities to increase the value by keeping the business operating, the assignee may continue operations. This is risky, and an expensive way to go, so the returns will have to justify the costs. Operating the business requires cash, so this is only possible if there is cash in the till or assets to sell which can keep the bills paid while waiting to sell.

Finishing work on projects in progress, or completing confirmed purchase orders from customers can increase value.

Running a going-out-of-business sale can do the same. Retailers often do this.

If a buyer is on hand who wants the firm as a going concern, it is worth it to keep the lights on.

The next step in liquidating a business is to get rid of assets. They may be sold by public auction, private auction, or negotiation. A public sale requires notice to creditors and other parties in interest. A big question is whether the buyer is getting the property “free and clear” of liens. Because buyers often want a “free and clear” sale, assignment proceedings often follow Article 9 of the Uniform Commercial Code for selling inventory and personal property.

Each creditor has to be told they have a date to file a claim against the estate.

The assignee will then pay out the money collected from the sale to the creditors in order.

The final step is to close down the company.

The claims process is essential to distributing the proceeds from the sale. Soon after the case starts, the assignee sends out notices to creditors and others, including a form to submit a proof of claim. The assignee will check the claim for proof to support it, and may object if the claim appears to be inflated, questionable, or improper.

Any money collected by the assignee must be paid out according to state law on who gets what first. The priorities of creditors in an ABC generally follow those in bankruptcy. If there are not enough funds to pay all claims in full, those at the bottom get cents on the dollar. The priorities make a big difference. Arguments among creditors may break out over how they are applied. Creditor disputes are sorted out cheaply where possible, though a lawsuit for declaratory relief in state court may be needed. The state statute should be checked before going ahead, because some states can change the priorities.

There are long lists of last chores to be done at the finish line. Documents must be kept, tax returns must be filed, 401(k) plans must be wrapped up, and premises and leased equipment handed back. Cleaning up the mess is an unglamorous part of the process, because the company is out of cash and the officers and directors don’t want to spend their time to return equipment and wind up the business. There may be final tasks that you would rather an outsider deal with. In an ABC, the assignee takes them on. Once the claims are paid and all issues resolved, the ABC trust is closed and the case is done.