United States: Successor Liability Concerns In Distressed Transactions

Current market conditions present unique opportunities for distressed investing. Although the acquisition of distressed assets may be profitable, it is not without risk, including potential exposure to successor liability. While often present in transactions, the risk of successor liability claims increases when a purchaser acquires distressed assets given the likelihood that the seller does not have the financial wherewithal to satisfy its creditors in full. It is important to be mindful of potential successor liability claims when acquiring distressed debt or investing in distressed assets and adopt strategies to mitigate that risk.

Purchasing Distressed Assets Out of Court through an Asset Purchase Agreement

When one company acquires assets from another through an asset purchase agreement, the buyer is generally not responsible for the liabilities of the seller. However, there are four common exceptions to this general rule: (i) the buyer expressly or impliedly assumes the liabilities; (ii) the transaction in substance constitutes a merger or consolidation of buyer and seller under state law, also known as a de facto merger; (iii) the buyer is, effectively, a mere continuation of the seller; or (iv) the transfer was fraudulent or intended to defraud creditors. In addition to these traditional common law exceptions, certain courts have also imposed liability in other circumstances, such as when the buyer continues the same product line of the seller and if public policy demands a finding of successor liability. ¹

The first and fourth exceptions are relatively straightforward. Under the first exception, a buyer will succeed to the seller's liabilities if the buyer assumes those liabilities. Under the fourth exception, creditors of the seller may assert claims against the buyer if the seller used the sale to defraud its creditors.

The two other exceptions are more complicated. The de facto merger exception applies to prevent the parties from disguising what is in substance a merger by structuring the transaction as an asset acquisition specifically to avoid the seller's liabilities. The "mere continuation" exception applies where the buyer is essentially the same as the defunct seller entity (such as by having the same directors, equity owners, officers, etc.), preventing debtors from simply moving their business to a new legal entity to avoid liabilities incurred by the old legal entity.

Buyers of distressed assets may seek to minimize the risk of successor liability following distressed asset purchases by, among other measures:

• Performing targeted due diligence on areas involving enhanced risks, such as products liability, environmental conditions, employment issues, and tax obligations. For transactions with potential environmental components, consider having a Phase I (and, if warranted, a Phase II) site assessment performed to obtain more information on the environmental condition of any owned or leased real estate that is part of the transaction.
• Acquiring the distressed investment through a newly-formed subsidiary to insulate the buyer's other assets from potential successor liability.
• Clearly identifying the purchased assets, the excluded assets, the assumed liabilities, and the excluded liabilities in the purchase agreement. Identify specific categories of excluded liabilities as concretely as possible and do not rely solely on a blanket statement that all pre-closing liabilities are excluded excepting only the assumed liabilities. Avoid broad language that may create confusion post-closing as to the parties' intent with respect to a particular liability or obligation.
• Requiring the seller to remain in existence for a period of time following the closing.
• Announcing the new ownership of the acquired business and that it is an entity entirely separate from the seller.
• Obtaining an insurance policy written on an "occurrence basis" to remain available to the purchaser after closing for claims occurring prior to closing.
• To the extent possible, obtain seller solvency representations and warranties.

Purchasing Distressed Assets that are Subject to a Lien or Mortgage

One avenue that may be available to minimize potential exposure to successor liability if the seller is in financial distress is to purchase assets that are subject to a real estate mortgage or security interest through a foreclosure sale or a sale under Article 9 of the Uniform Commercial Code. These procedures allow a secured lender to sell assets of its debtor that are subject to its lien free and clear of junior liens. A properly-run, "commercially reasonable" Article 9 sale or foreclosure auction will also typically provide the purchaser with assurances that it will not later be subject to a fraudulent transfer claim asserting that the assets were purchased at an unreasonably low price. However, foreclosure sales and Article 9 sales do not typically provide a buyer with any assurances that it will not be subject to future successor liability claims, especially where the buyer intends to continue the seller's business operations.

In addition to acting as a buyer in a foreclosure auction or Article 9 sale, strategic purchasers may also purchase the target company's secured debt (often at a discount) and seek to acquire the target company's assets through the exercise of secured party remedies, such as a strict foreclosure or secured party sale to an affiliate under Article 9. So long as the requisite state law is complied with regarding the secured party sale and the sale is otherwise "commercially reasonable," purchasing the secured debt in order to effectively acquire the assets free of creditor claims may be an effective process after adequate due diligence on the lien priority and target business is complete. Be aware, however, that purchasing secured debt is not a guaranteed or risk-free strategy for acquiring assets. Secured parties ultimately are only entitled to repayment of the loan, and the borrower can always stop the secured party from foreclosing on the assets by repaying the loan in full or filing a bankruptcy proceeding to restructure the debt.

Purchasing Distressed Assets through Receivership

A receivership is an increasingly popular mechanism for preserving, managing, and ultimately selling certain assets while protecting lenders from liability. A receiver is a court-appointed individual given statutory or custodial responsibility for certain property and receives his or her authority solely from statutes and court orders. A receiver's duty is, among other things, to protect the assets of the entity in receivership. A receiver can also sell assets "as is, where is," hold assets to maximize value through improvements or the passage of time, and provide experienced day-to-day management of the asset. A receivership sale may save considerable time and expense depending on the asset's value and minimize potential future liability and losses for both the lender and borrower. It will also likely moot successor liability claims because the actual control of the company will change during the period the receiver is in place, and any sale would have to be approved by the Court appointing the receiver, making it unlikely the facts will support a "mere continuation" or "de facto merger" claim. Nevertheless, purchasing assets through a statutory or custodial receiver does not completely eliminate future successor liability claims.

Purchasing Distressed Assets through Bankruptcy

If the risk of successor liability is significant, purchasing distressed assets through a bankruptcy court-approved sale will likely provide a buyer with the greatest level of protection. In a bankruptcy proceeding, a debtor has multiple means of selling its assets. One approach is to consummate the sale through a formal plan of reorganization whereby the debtor's assets are sold, its pre-bankruptcy liabilities are channeled into a liquidation trust, and the buyer obtains a formal release from liability and claims. In some cases, the buyer can benefit from an injunction enjoining claimants from pursuing the purchaser for their claims against the selling debtor. However, a sale pursuant to a formal reorganization plan may be expensive and time consuming because it requires creditor solicitation, balloting, and court approval of a disclosure statement and plan, which takes time and is expensive. Another approach debtors often undertake, which may be less costly and consummated more quickly, is a sale under section 363 of the Bankruptcy Code (the "Code").

Section 363 of the Code allows a debtor to sell some or all of its assets outside of the ordinary course of business "free and clear" of all liens, claims, interests, and encumbrances. A section 363 sale is often faster than a sale pursuant to a formal plan of reorganization and is appropriate where the value of the assets may rapidly deteriorate or the seller urgently needs cash to avoid liquidation. Since a section 363 sale may potentially disenfranchise creditors, bankruptcy courts often require a strong showing that a sale outside of the confirmation process is justified. The object of a section 363 sale is to obtain the "highest and best" offer for the assets.

Section 363 sales often protect buyers from successor liability and fraudulent transfer claims because the order approving the sale typically includes findings that the purchase price was fair and reasonable, and it puts on notice creditors whose objections will be either adjudicated or waived before the 363 sale actually closes. Further, under section 363(m), orders approving bankruptcy sales are insulated from reversal or modification on appeal unless the sale was stayed pending appeal under an order of the bankruptcy or reviewing court or the buyer was not a good faith purchaser. Most courts have defined a good faith purchaser as one who purchases in good faith, for value, and without knowledge of adverse claims. The practical implication of securing a section 363(m) finding is that once a good faith purchaser closes on the sale, the sale cannot be undone by a reversal or modification of the sale order.

While these features of a section 363 sale do not completely eliminate successor liability, they should help discourage all but the most ardent creditor from pursuing such a claim. Counsel to a purchaser is well advised to require court findings (following notice to creditors and other parties in interest) that the sale is expressly free and clear of successor liability claims. A buyer may then rely on the bankruptcy court's order and findings of fact to enjoin the creditor from pursuing its claim or defend against its merits. Thus, the ability to purchase assets "free and clear" should prove attractive to buyers faced with successor liability risk.

A bankruptcy proceeding may also provide additional opportunities for buyers and sellers. For instance, section 365 of the Code allows a debtor to assume and assign executory contracts and unexpired leases and in certain circumstances, allowing the debtor to override certain contractual restrictions on assignment that would be enforceable outside of a bankruptcy proceeding-restrictions that might derail an out-of-court transaction. For example, section 365(f) of the Code voids anti-assignment provisions in certain executory contracts and leases (and in some cases, license agreements) that would likely be enforceable outside of bankruptcy. Accordingly, a seller may be able to assign certain executory contracts that it has under a license or other agreement without the non-debtor party's consent. This is a significant difference from traditional, out-of-court mergers and acquisition transactions and Article 9 sales since buyers in those cases cannot compel counterparties to consent to the assignment of contracts and leases, essentially forcing buyers into a series of negotiations that can be costly and time-consuming.

While acquiring distressed assets may be accompanied by exposure to potential successor liability, there are procedures that may be employed to minimize, and, if judicially approved, potentially eliminate such risk from the transaction.

The COVID-19 crisis is a fluid situation generating a multitude of issues daily, and Ice Miller's Distressed Investments Group is uniquely prepared to represent clients in a broad array of industries and evaluate what options are available. If you need advice on selling or purchasing distressed assets, the attorneys at Ice Miller are available.

This publication is intended for general informational purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstance.

Chelsea Abramowitz is a law clerk in Ice Miller's Business and Bankruptcy, Restructuring, and Creditors' Rights Groups (admission to the New York state bar pending). Chelsea earned her juris doctor from Fordham University School of Law and her bachelor of science from Tulane University.

John Burke is a partner in and chair of Ice Miller's Litigation Group and the managing partner of the Chicago office. He litigates a variety of commercial disputes involving complex contracts and other business-related matters such as breaches of contract, the Uniform Commercial Code, fraud, real estate and partnership disputes, and reorganizations and bankruptcy. He also serves as outside general counsel to middle market companies.

Louis DeLucia is a partner in and chair of Ice Miller's Bankruptcy, Restructuring, and Creditors' Rights Group. His representation encompasses a wide range of issues, including complex Chapter 11 cases, bankruptcy and creditors' rights related litigation in state and federal courts, liquidation proceedings, receiverships, cross-border insolvency proceedings, non-judicial loan restructuring, workouts and other alternatives to the bankruptcy process, and state court asset recoveries and foreclosures.

Alyson Fiedler is a partner in Ice Miller's Bankruptcy, Restructuring, and Creditors' Rights Group. She has been involved in some of the largest and most complex bankruptcy cases, having served as counsel to creditors, creditors' committees, debtors, fiduciaries and other interested parties. She is also a founding member of Ice Miller's Distressed Investment Group ("DIG"), which focuses on distressed investment strategies and transactions, including bankruptcy and in-court restructurings, out-of-court restructurings and other insolvency related transactions.

Michael Ott is of counsel in Ice Miller's Bankruptcy, Restructuring, and Creditors' Rights Group. He represents a wide array of clients inside and outside of bankruptcy proceedings with complex restructuring and workout situations. He also has served as counsel to senior lenders, creditors, creditors' committees, and corporate fiduciaries.

Eric Singer is a partner in Ice Miller's Litigation group. Eric is a construction lawyer and litigator, concentrating in contracts, insurance and counseling for construction and design projects, as well as disputes related to real estate, construction, mechanics liens, mortgages, title insurance, easements and injunctions.

Footnotes

1 These exceptions vary by state, as some courts are more reluctant than others to hold a buyer responsible for seller's liabilities that the buyer did not expressly assume. For instance, the Delaware Court of Chancery has noted that, while the general rule of non-liability is not absolute, "[a]bsent unusual circumstances, a successor corporation is liable only for liabilities it expressly assumes." Mason v. Network of Wilmington, Inc., No. CIV.A. 19434-NC, 2005 WL 1653954, at *5 (Del. Ch. July 1, 2005) (quoting Corp. Prop. Assoc. 8, L.P. v. Amersig Graphics, Inc., 1994 WL 148269, at *4 (Del. Ch. Mar. 31, 1994)).