The Financially Troubled Company

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Business Bankruptcy Issues The Financially Troubled Company

Section 363 Sales And Beyond: An M&A Lawyer’s Perspective On Purchasing Assets From Distressed Companies

With the economy suffering through the longest recession since the 1930s, it’s little wonder that much of the merger and acquisition ("M&A") activity these days has been focused on distressed companies. The Chrysler and General Motors cases may be the best-known examples, but Chapter 11 bankruptcy is frequently used by companies large and small to sell assets through Section 363 sales. The important intersection between bankruptcy and M&A deals in today’s business climate was recently made the focus of an article in the Wall Street Journal, aptly called "Barbarians in Bankruptcy Court."

Although Section 363 sales are quite common, some distressed companies are able to complete an asset sale outside of bankruptcy. The sale may be made directly by the company, or the seller may actually be a lender foreclosing on its collateral under the Uniform Commercial Code. In still other situations, the seller may be an assignee acting through a general assignment for the benefit of creditors under state law.

Regardless of the path chosen, the landscape of distressed asset purchases can be significantly different from that traversed by many traditional M&A lawyers and, most importantly, their clients. Fortunately, one of my M&A partners at Cooley Godward Kronish LLP with significant experience in distressed acquisitions, Jennifer Fonner DiNucci, has recently written an insightful article on the subject. Entitled "Balancing the Risks and Benefits of Transactions Involving Distressed Companies," the article discusses the unique challenges — and opportunities — posed by distressed asset acquisitions. It also highlights some of the major issues that potential asset buyers encounter when dealing with a distressed seller, and points out key differences between distressed transactions and more traditional M&A deals with solvent companies.

The article makes for interesting — and timely — reading for anyone considering a purchase of assets from a distressed company.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Fall 2008 Edition Of Bankruptcy Resource Is Now Available

The Fall 2008 edition of the Absolute Priority newsletter, published by the Cooley Godward Kronish LLP Bankruptcy & Restructuring group, of which I am a member, has just been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter or to register to receive future editions. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

  • Claims and defenses under the WARN Act;
  • The Supreme Court’s decision on transfer taxes and bankruptcy sales;
  • Section 363 "free and clear" sales in bankruptcy; and
  • The interplay between claim objections and the Section 503(b)(9) "20 day goods" administrative claim.

This edition also has information on some of our recent representations of official committees of unsecured creditors in Chapter 11 bankruptcy cases involving major retailers. These include Mervyn’s, Boscov’s, Hancock Fabrics, Steve & Barry’s, Goody’s, Sharper Image, The Bombay Company, and Shoe Pavilion, among others. In addition, a note from my partner Adam Rogoff, the editor of Absolute Priority, discusses how the current economic problems will require lenders, unsecured creditors, and others to consider the impact of Chapter 11 bankruptcy on their rights.

I hope you find this latest edition of Absolute Priority to be a helpful resource.

Business Bankruptcy Issues The Financially Troubled Company

Second Liens And Recharacterization: Is More Litigation Around The Corner?

In many Chapter 11 bankruptcy cases, unsecured creditors investigate whether a basis exists to recharacterize existing secured debt as equity. The reason? A successful challenge can turn first or second lien secured debt into "back-of-the-line" capital contributions, enabling unsecured creditors to realize a much greater recovery. A recent article by two of my Bankruptcy & Restructuring Group colleagues at Cooley Godward Kronish LLP, Ronald R. Sussman and Michael A. Klein, digs deeper into the complex issues behind these claims.

Appearing in the October 2008 edition of The Journal of Corporate Renewal published by the Turnaround Management Association, the article is entitled "Recharacterization Battles Likely in Next Round of Bankruptcies." You can access a copy of the article, reprinted with permission of The Journal of Corporate Renewal (© 2008, The Journal of Corporate Renewal), by clicking on its title in the prior sentence. It first discusses the concept of recharacterization itself, including the key factors courts typically apply. Next, the article compares recharacterization to the doctrine of equitable subordination under Section 510(c) of the Bankruptcy Code and examines some of the key differences between the two.

After setting the stage, the article then looks ahead to what appears to be a coming wave of bankruptcy cases. It focuses on how future efforts by unsecured creditors to challenge second lien loans — a type of financing that has become a major part of corporate capital structures over the past several years — may fare:

The next wave of bankruptcies undoubtedly will include attempts by unsecured creditors to recharacterize second lien debt as equity, especially when the second lien holder is an insider of the debtor. However, the current framework established by Bankruptcy Courts presents significant obstacles to unsecured creditors seeking to knock out the second lien claims of lenders that provided capital on a purportedly secured basis to a struggling debtor that was unable to find capital from alternative sources.

The article observes that, given the present state of the law, courts will have to embrace a more flexible legal standard if unsecured creditors are to have success in recharacterizing second lien debt as equity. It concludes by offering a different approach for addressing recharacterization with this new landscape in mind. Unsecured creditors, lenders, insolvency professionals and others confronting these issues will find the article to be a helpful and interesting read.

Recent Developments The Financially Troubled Company

Recent California Decision Addresses Whether Directors And Officers Can Be Liable For Unpaid Wages Of A Bankrupt Company

When insolvent companies are unable to make payroll or to pay accrued vacation or other amounts owed employees, the question often arises whether directors, officers, or shareholders face personal liability for these unpaid amounts. The California Court of Appeal recently addressed that issue, examining whether particular sections of the California Labor Code, as well as section 17200 of the Business and Professions Code (California’s unfair competition law), impose personal liability.

The Court of Appeal Decision. In its April 2008 decision in Bradstreet v. Wong, the Court of Appeal for the First Appellate District held that owners, officers, and managers of an insolvent company, which later filed bankruptcy, were not personally liable for unpaid wages, overtime, vacation pay, and other amounts based on a series of alleged California Labor Code violations. The Court also ruled that these individuals were not liable to pay restitution under Business and Professions Code section 17200. A copy of the Court of Appeal’s opinion is available here.

Risks Remain. Although the decision is a favorable one for officers and directors, risks remain. Be sure to read the informative discussion written by my colleagues in the Employment & Labor Group at Cooley Godward Kronish LLP for a careful analysis of the decision. As they explain, despite this new decision, and the California Supreme Court’s 2005 decision on similar issues in the Reynolds v. Bement case, it’s possible that directors and officers may still face a risk of individual liability under other California Labor Code sections or based on different legal theories. Depending on the facts and statutes involved, there may also be individual liability under federal law or the laws of other states.

Get Advice. The issues presented when an insolvent company is, or might be, unable to pay wages are complicated. Directors and officers of a company facing this situation should be sure to get both insolvency and employment law advice to help guide them, and the company, through these difficult straits.

The Financially Troubled Company

Leading Venture Capitalists Reflect On Business Failure

David Feinlieb of Mohr Davidow Ventures has an interesting post on his Tech, Startups, Capital, Ideas blog entitled "Why Startups Fail." David highlights four main reasons around his general theme of "they run out of money":

  • They spend too much on sales and marketing before they’re ready.
  • The market outpaces the startup’s ability to execute.
  • There is no entrepreneur.
  • The market takes too long to develop.

David’s explanations behind each of these headlines are incisive and thought-provoking, and they underscore the challenging road startups must travel. I would add to the list the impact an industry or general economic slowdown can have on a particular startup, including when it comes to raising additional capital. (For more on the topic, you may find interesting an earlier post discussing the views of another VC on why early stage businesses fail and another one examining how a recession may affect investment decisions of VCs.)

On a similar theme is a post by Brad Feld of Foundry Ventures entitled "Do VCs Fund Entrepreneurs Who Have Failed At Previous Ventures?" over at the Ask The VC blog. Thanks to Brad as well for first blogging on David Feinlieb’s post on startups, where Brad observes that "we are heading for another wave of failure as companies run out of gas after their Series B / Series C rounds and their investors lose patience with them."

Brad sums up his views this way on the topic of funding entrepreneurs with a prior failed business:

My favorite entrepreneurs to fund are those that have had at least one success and one failure.  While it is a cliche, failure teaches the big lessons.  Most importantly, entrepreneurs that have some failure under their belt have humility and perspective that I think is deeply useful in the creation of the company.

Startups are inherently risky, even in a strong economic climate. As the potentially recessionary economy produces more failed startups, it’s especially valuable to have insights and perspectives like these from experienced VCs.

Business Bankruptcy Issues The Financially Troubled Company

Assignments For The Benefit Of Creditors: Simple As ABC?

Companies in financial trouble are often forced to liquidate their assets to pay creditors. While a Chapter 11 bankruptcy sometimes makes the most sense, other times a Chapter 7 bankruptcy is required, and in still other situations a corporate dissolution may be best. This post examines another of the options, the assignment for the benefit of creditors, commonly known as an "ABC."

A Few Caveats. It’s important to remember that determining which path an insolvent company should take depends on the specific facts and circumstances involved. As in many areas of the law, one size most definitely does not fit all for financially troubled companies. With those caveats in mind, let’s consider one scenario sometimes seen when a venture-backed or other investor-funded company runs out of money.

One Scenario. After a number of rounds of investment, the investors of a privately held corporation have decided not to put in more money to fund the company’s operations. The company will be out of cash within a few months and borrowing from the company’s lender is no longer an option. The accounts payable list is growing (and aging) and some creditors have started to demand payment. A sale of the business may be possible, however, and a term sheet from a potential buyer is anticipated soon. The company’s real property lease will expire in nine months, but it’s possible that a buyer might want to take over the lease.

  • A Chapter 11 bankruptcy filing is problematic because there is insufficient cash to fund operations going forward, no significant revenues are being generated, and debtor in possession financing seems highly unlikely unless the buyer itself would make a loan. 
  • The board prefers to avoid a Chapter 7 bankruptcy because it’s concerned that a bankruptcy trustee, unfamiliar with the company’s technology, would not be able to generate the best recovery for creditors.

The ABC Option. In many states, another option that may be available to companies in financial trouble is an assignment for the benefit of creditors (or "general assignment for the benefit of creditors" as it is sometimes called). The ABC is an insolvency proceeding governed by state law rather than federal bankruptcy law.

California ABCs. In California, where ABCs have been done for years, the primary governing law is found in California Code of Civil Procedure sections 493.010 to 493.060 and sections 1800 to 1802, among other provisions of California law. California Code of Civil Procedure section 1802 sets forth, in remarkably brief terms, the main procedural requirements for a company (or individual) making, and an assignee accepting, a general assignment for the benefit of creditors:

1802.  (a) In any general assignment for the benefit of creditors, as defined in Section 493.010, the assignee shall, within 30 days after the assignment has been accepted in writing, give written notice of the assignment to the assignor’s creditors, equityholders, and other parties in interest as set forth on the list provided by the assignor pursuant to subdivision (c).
   (b) In the notice given pursuant to subdivision (a), the assignee shall establish a date by which creditors must file their claims to be able to share in the distribution of proceeds of the liquidation of the assignor’s assets.  That date shall be not less than 150 days and not greater than 180 days after the date of the first giving of the written notice to creditors and parties in interest.
   (c) The assignor shall provide to the assignee at the time of the making of the assignment a list of creditors, equityholders, and other parties in interest, signed under penalty of  perjury, which shall include the names, addresses, cities, states, and ZIP Codes for each person together with the amount of that person’s anticipated claim in the assignment proceedings.

In California, the company and the assignee enter into a formal "Assignment Agreement." The company must also provide the assignee with a list of creditors, equityholders, and other interested parties (names, addresses, and claim amounts). The assignee is required to give notice to creditors of the assignment, setting a bar date for filing claims with the assignee that is between five to six months later.

ABCs In Other States. Many other states have ABC statutes although in practice they have been used to varying degrees. For example, ABCs have been more common in California than in states on the East Coast, but important exceptions exist. Delaware corporations can generally avail themselves of Delaware’s voluntary assignment statutes, and its procedures have both similarities and important differences from the approach taken in California. Scott Riddle of the Georgia Bankruptcy Law Blog has an interesting post discussing ABC’s under Georgia law. Florida is another state in which ABCs are done under specific statutory procedures. For an excellent book that has information on how ABCs are conducted in various states, see Geoffrey Berman’s General Assignments for the Benefit of Creditors: The ABCs of ABCs, published by the American Bankruptcy Institute.

Important Features Of ABCs. A full analysis of how ABCs function in a particular state and how one might affect a specific company requires legal advice from insolvency counsel. The following highlights some (but by no means all) of the key features of ABCs:

  • Court Filing Issue. In California, making an ABC does not require a public court filing. Some other states, however, do require a court filing to initiate or complete an ABC.
  • Select The Assignee. Unlike a Chapter 7 bankruptcy trustee, who is randomly appointed from those on an approved panel, a corporation making an assignment is generally able to choose the assignee.
  • Shareholder Approval. Most corporations require both board and shareholder approval for an ABC because it involves the transfer to the assignee of substantially all of the corporation’s assets. This makes ABCs impractical for most publicly held corporations.
  • Liquidator As Fiduciary. The assignee is a fiduciary to the creditors and is typically a professional liquidator.
  • Assignee Fees. The fees charged by assignees often involve an upfront payment and a percentage based on the assets liquidated.
  • No Automatic Stay. In many states, including California, an ABC does not give rise to an automatic stay like bankruptcy, although an assignee can often block judgment creditors from attaching assets.
  • Event Of Default. The making of a general assignment for the benefit of creditors is typically a default under most contracts. As a result, contracts may be terminated upon the assignment under an ipso facto clause.
  • Proof Of Claim. For creditors, an ABC process generally involves the submission to the assignee of a proof of claim by a stated deadline or bar date, similar to bankruptcy. (Click on the link for an example of an ABC proof of claim form.)
  • Employee Priority. Employee and other claim priorities are governed by state law and may involve different amounts than apply under the Bankruptcy Code. In California, for example, the employee wage and salary priority is $4,300, not the $10,950 amount currently in force under the Bankruptcy Code.
  • 20 Day Goods. Generally, ABC statutes do not have a provision similar to that under Bankruptcy Code Section 503(b)(9), which gives an administrative claim priority to vendors who sold goods in the ordinary course of business to a debtor during the 20 days before a bankruptcy filing. As a result, these vendors may recover less in an ABC than in a bankruptcy case, subject to assertion of their reclamation rights.
  • Landlord Claim. Unlike bankruptcy, there generally is no cap imposed on a landlord’s claim for breach of a real property lease in an ABC.
  • Sale Of Assets. In many states, including California, sales by the assignee of the company’s assets are completed as a private transaction without approval of a court. However, unlike a bankruptcy Section 363 sale, there is usually no ability to sell assets "free and clear" of liens and security interests without the consent or full payoff of lienholders. Likewise, leases or executory contracts cannot be assigned without required consents from the other contracting party.
  • Avoidance Actions. Most states allow assignees to pursue preferences and fraudulent transfers. However, the U.S. Court of Appeals for the Ninth Circuit has held that the Bankruptcy Code pre-empts California’s preference statute, California Code of Civil Procedure section 1800. Nevertheless, to date the California state courts have refused to follow the Ninth Circuit’s decision and still permit assignees to sue for preferences in California state court. In February 2008, a Delaware state court followed the California state court decisions, refusing either to follow the Ninth Circuit position or to hold that the California preference statute was pre-empted by the Bankruptcy Code. The Delaware court was required to apply California’s ABC preference statute because the avoidance action arose out of an earlier California ABC.

The Scenario Revisited. With this overview in mind, let’s return to our company in distress.

  • The prospect of a term sheet from a potential buyer may influence whether our hypothetical company should choose an ABC or another approach. Some buyers will refuse to purchase assets outside of a Chapter 11 bankruptcy or a Chapter 7 case. Others are comfortable with the ABC process and believe it provides an added level of protection from fraudulent transfer claims compared to purchasing the assets directly from the insolvent company. Depending on the value to be generated by a sale, these considerations may lead the company to select one approach over the other available options.
  • In states like California where no court approval is required for a sale, the ABC can also mean a much faster closing — often within a day or two of the ABC itself provided that the assignee has had time to perform due diligence on the sale and any alternatives — instead of the more typical 30-60 days required for bankruptcy court approval of a Section 363 sale. Given the speed at which they can be done, in the right situation an ABC can permit a "going concern" sale to be achieved.
  • Secured creditors with liens against the assets to be sold will either need to be paid off through the sale or will have to consent to release their liens; forced "free and clear" sales generally are not possible in an ABC.
  • If the buyer decides to take the real property lease, the landlord will need to consent to the lease assignment. Unlike bankruptcy, the ABC process generally cannot force a landlord or other third party to accept assignment of a lease or executory contract.
  • If the buyer decides not to take the lease, or no sale occurs, the fact that only nine months remains on the lease means that this company would not benefit from bankruptcy’s cap on landlord claims. If the company’s lease had years remaining, and if the landlord were unwilling to agree to a lease termination approximating the result under bankruptcy’s landlord claim cap, the company would need to consider whether a bankruptcy filing was necessary to avoid substantial dilution to other unsecured creditor claims that a large, uncapped landlord claim would produce in an ABC.
  • If the potential buyer walks away, the assignee would be responsible for determining whether a sale of all or a part of the assets was still possible. In any event, assets would be liquidated by the assignee to the extent feasible and any proceeds would be distributed to creditors in order of their priority through the ABC’s claims process.
  • While other options are available and should be explored, an ABC may make sense for this company depending upon the buyer’s views, the value to creditors and other constituencies that a sale would produce, and a clear-eyed assessment of alternative insolvency methods. 

Conclusion. When weighing all of the relevant issues, an insolvent company’s management and board would be well-served to seek the advice of counsel and other insolvency professionals as early as possible in the process. The old song may say that ABC is as "easy as 1-2-3," but assessing whether an assignment for the benefit of creditors is best for an insolvent company involves the analysis of a myriad of complex factors.

Business Bankruptcy Issues The Financially Troubled Company

New Article Examines Latest Deepening Insolvency Trends

For a number of years, the concept of deepening insolvency has been one of the more hotly debated issues in the insolvency arena. Two of my colleagues in the Bankruptcy & Restructuring group at Cooley Godward Kronish LLP, Michael Klein and Ronald Sussman, have written an interesting article entitled "Tide Has Turned On Deepening Insolvency – Courts Now Rejecting Theory As Cause Of Action," published in the February 2008 issue of the Journal of Corporate Renewal by the Turnaround Management Association. You can read the article by clicking on its title above.

The article gives a succinct overview of the impact of last year’s Delaware Supreme Court decisions in the North American Catholic Educational Programming, Inc. v. Gheewalla and Trenwick America cases (as well as the Chancery Court’s Trenwick decision that was adopted by the Supreme Court). In particular, the article describes how the Gheewalla decision altered the "zone of insolvency" analysis and how Trenwick’s rejection of deepening insolvency as a cause of action in Delaware has led courts in other jurisdictions to follow suit. Directors of financially troubled companies and their counsel will find the article an informative read.

For more information on the Gheewalla decision, including a copy of the Delaware Supreme Court’s opinion, click here. For more on the Trenwick decision, including copies of the Delaware Supreme Court order and Chancery Court opinion, click here.