October 10, 2016
A financially distressed business presents an opportunity and bargain for persons interested in purchasing its assets. With the threat of foreclosure by its creditors at its doorstep, the business becomes an inspired seller. However, there are several concerns when a distressed business is exploring its options to sell its assets. The two concerns are: (1) successor liability law and (2) fraudulent transfer law. Although both of these concerns present a problem for a financially distressed business, they can be avoided or limited by sage legal advice. To avoid these two doctrines completely, filing a bankruptcy and conducting a 363 sale of the business’s assets is often a cost effective approach that minimizes risks.
I. Successor Liability
When a purchaser acquires a seller’s assets, the general rule is that the purchaser is not responsible for any of the seller’s obligations existing at the time of the purchase. As with all general rules, there are exceptions. A purchaser will be liable for the seller’s obligations that existed before consummation of the sale: “(1) where there is an express or implied assumption of liability; (2) where the transaction amounts to a consolidation or merger; (3) where the transaction was fraudulent; (4) where some of the elements of a purchase in good faith were lacking, or where the transfer was without consideration and the creditors of the transferor were not provided for; or (5) where the transferee corporation was a mere continuation or reincarnation of the old corporation.” Foster v Cone-Blanchard Mach Co, 460 Mich 696, 702; 597 NW2d 506 (1999).
It is well established that liability follows the assets where there has been a merger or consolidation between the seller and the purchaser. Even if the transaction does not amount to a formal merger or consolidation, the purchaser of assets may be subject to successor liability for the selling of corporation’s debts. If the sale of a corporation’s assets is followed by a substantial continuation of the seller’s business after the sale, the courts may find that a “de facto merger” has occurred and impose successor liability on the asset purchaser. In other words, the purchaser becomes liable for the seller’s debts and obligations. The underlying principle behind a “de facto merger” is that if, after the sale, the same owners are running the same business under a different name, the surviving new entity should be liable for the old entity’s debts.
A de facto merger can be found when:
(1) There is a continuation of the enterprise of the seller corporation, so that there is a continuity of management, personnel, physical location, assets, and general business operations.
(2) There is a continuity of shareholders which results from the purchasing corporation paying for the acquired assets with shares of its own stock, this stock ultimately coming to be held by the shareholders of the seller corporation so that they become a constituent part of the purchasing corporation.
(3) The seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible.
(4) The purchasing corporation assumes those liabilities and obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations of the seller corporation. [Shannon v Samuel Langston Co, 379 F Supp 797, 801 (WD Mich, 1974).]
However, if the purchaser acquires the seller’s assets for cash rather than shares in the purchasing corporation, the requisite continuity of shareholders is lacking and a de facto merger does not rise. Even if the purchaser acquires the seller’s assets with cash, there is a concern that the seller sold its assets for less than reasonably equivalent value, which would trigger fraudulent transfer law. Thus, even when a purchaser avoids the “de facto merger,” the purchaser can still be liable for the seller’s debts if fraudulent transfer law.
II. Fraudulent Transfer
A creditor can effectively unwind a transaction, if it can demonstrate that a constructive fraudulent transfer or actual fraudulent transfer took place. A sale may be avoided by the seller’s creditors as a constructive fraudulent transfer if the transfer is made without reasonably equivalent value, and if, after the transfer, the seller (1) is insolvent, MCL 566.35; (2) is left with an unreasonably small amount of capital, MCL 566.34; or (3) believes that it is about to incur debts that are beyond its ability to pay, MCL 566.34. Similarly, a cause of action for actual fraudulent transfer occurs if the seller transfers its assets with the actual intent to hinder, delay, or defraud any creditor of the seller. The factors to be considered in determining whether there is actual intent are:
(a) The transfer or obligation was to an insider.
(b) The debtor retained possession or control of the property transferred after the transfer.
(c) The transfer or obligation was disclosed or concealed.
(d) Before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit.
(e) The transfer was of substantially all of the debtor’s assets.
(f) The debtor absconded.
(g) The debtor removed or concealed assets.
(h) The value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred.
(i) The debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred.
(j) The transfer occurred shortly before or shortly after a substantial debt was incurred.
(k) The debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor.
On the constructive fraudulent transfer side, “a person gives a reasonably equivalent value if the person acquires an interest of the debtor in an asset pursuant to a regularly conducted, noncollusive foreclosure sale or execution of a power of sale for the acquisition or disposition of the interest of the debtor upon default under a mortgage, deed of trust, or security agreement.” MCL 566.33(2). Value is given for a transfer or an obligation if, “in exchange for the transfer or obligation, property is transferred or an antecedent debt is secured or satisfied.” MCL 566.33(1).
In a case where the previous owners attempt to purchase the distressed business by forming a new entity, the new entity runs the risk of having a fraudulent transfer claim brought against it. First, the new/previous owners are considered insiders under the law. Second, there is an arguable basis that the sale of the distressed business was not an arm’s length transaction. In other words, the distressed business did not receive equivalent value. This poses a problem for the new owners/old owners because the transaction may be unwound. Finally and most importantly, distressed business will be insolvent and unable to pay its debts in the ordinary course of business because it will have not assets. Frequently, the money that is to be exchanged will not cover the outstanding debts. Due to the high likelihood that creditors may unwind the transaction through a fraudulent transfer theory or impose liability on the new owners and entity through a successor liability theory, the distressed business and its owners are well advised to pursue bankruptcy relief and purchase the assets through a bankruptcy 363 sale.
If the selling corporation is a debtor under the U.S. Bankruptcy Code, 11 USC 101 et seq., the debtor’s bankruptcy trustee or the debtor, if it remains in possession of its assets in a Chapter 11 bankruptcy case may be entitled, with the bankruptcy court’s approval to sell the debtor’s assets free and clear of all interests in the property being sold. To do so, the trustee must meet one of the requirements set forth in 11 USC 363(f). The ability and authority of the bankruptcy court to order the sale of the debtor’s assets free and clear of all interests may conceivably preempt state law doctrines of successorliability and fraudulent transfer law such that the purchaser of assets from a 363 sale will not later become liable to the debtor’s existing creditors under a state law successorliability theory. See In re Trans World Airlines, Inc, 322 F3d 283, 289–290 (3rd Cir 2003) (finding that decision under Bankruptcy Code could extinguish successorliability claims under civil rights laws); Car-Tec, Inc v Venture Indus, Inc (In re Autostyle Plastics, Inc), 227 BR 797, 800 (Bankr WD Mich 1998) (“a bankruptcy court sale free and clear of liens, claims and interests bars successorliability claims”); In re White Motor Credit Corp, 75 BR 944, 950–951 (Bankr ND Ohio 1987) (citing both text and purpose of Bankruptcy Code as grounds for abrogating successorliability under state law). Thus, a 363 sale provides for an avenue to limit or completely avoid a successor liability claim.
Similarly, the fraudulent transfer law risk is also eliminated by filing a bankruptcy and purchasing the assets through 363 sale. When the purchaser is buying assets from a distressed business, requiring the seller to file a bankruptcy petition and then purchasing the seller’s assets from the bankruptcy estate is the surest way to avoid having the sale set aside by the seller’s creditors as a fraudulent transfer The concern is eliminated because the debtor/seller receives reasonably equivalent value and the bankruptcy court signs off on the purchaser, regardless of whether he or she is an insider. Thus, a 363 sale provides for an avenue to eliminate the risk of the transaction being unwound by a fraudulent transfer claim.
In sum, the sale of a distressed business poses problems for the purchaser. The problems posed for the purchaser are successor liability and fraudulent transfer law. Both of these problems may limited or completely avoided by selling the distressed business’s assets in a 363 sale. Because the risks are substantially reduced by filing a bankruptcy, a distressed business is well advised to file a bankruptcy to sell its assets, especially if the potential purchaser is the previous owners.