assignment for the benefit of creditors

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Recent Developments The Financially Troubled Company

Fiduciary Duties And Financial Distress In The Time Of COVID-19

The COVID-19 pandemic has caused unprecedented economic disruption, creating sudden financial distress across industries. Companies are now facing impacts ranging from a dramatic decline in revenue of uncertain duration, to potential setbacks to M&A transactions, to delayed or canceled financing rounds.

With even some previously well-performing companies potentially entering the so-called zone of insolvency, it’s important to review the fiduciary duties owed by directors and officers and how discharging those duties may change in the face of financial distress.

A Refresher On Fiduciary Duties. Let’s start with a high-level overview of the fiduciary duties of directors and officers of a Delaware corporation. This primer is not a substitute for specific legal advice but may help provide context for discussions with counsel.

  • The Key Duties. Under Delaware law, directors and officers owe fiduciary duties of due care and loyalty.
    • The duty of due care requires directors and officers to make informed decisions in good faith and in the best interests of the company.
    • The duty of loyalty requires directors and officers not to engage in self-dealing and to put the interests of the company ahead of their own.
  • Solvency. Under Delaware law, when a company is solvent, the directors and officers owe their fiduciary duties of due care and loyalty to the corporation and to the stockholders.
    • This remains true even for a company in the zone of insolvency (more on that concept below).
    • Stockholders of a solvent company have standing to bring derivative claims for breach of fiduciary duty against directors and officers.
  • Insolvency. When a company is insolvent, meaning it’s not able to pay its creditors in full, the directors and officers still owe their fiduciary duties of due care and loyalty to the corporation.
  • Zone of Insolvency. The zone of insolvency is a term used to describe a company that is still solvent but is approaching insolvency.
    • For a number of years the courts suggested that if a company entered the zone of insolvency, fiduciary duties expanded to include creditors (as well as shareholders).
    • That’s no longer the case. The Delaware Supreme Court clarified that the key inflection point for fiduciary duties is actual insolvency, not the zone of insolvency. Upon actual insolvency, fiduciary duties are still owed to the corporation (rather than being expanded to include creditors) but creditors gain the right to bring derivative claims for breach of fiduciary duty.
    • However, it can be challenging to determine whether a company is still solvent or has already crossed into actual insolvency. The zone of insolvency concept therefore can serve as a useful “caution flag” for directors and officers assessing the issue.
  • Discharging Fiduciary Duties in Insolvency. With that refresher in mind, how should directors and officers best discharge fiduciary duties for a company that has become insolvent? This is a very fact-intensive analysis, and directors and officers should seek specific legal advice for their company’s particular situation, but here are some issues to consider.
    • Generally, the focus should be on maximizing enterprise value without taking undue risk, which will maximize recovery for creditors as the new residual rights holders.
    • Maximizing value may also benefit stockholders but care should be taken if pursuing an upside for stockholders puts creditor recoveries at greater risk.
    • Directors should assess all aspects of the company’s business, seek input from legal and financial advisers where helpful, hold Board meetings as often as needed, follow good corporate process, and continue to avoid conflicts of interest.
    • This will allow directors to enjoy the protection of the business judgment rule, which provides that courts will not second guess a director’s good faith business judgment made with due care.
    • Many companies may have to make immediate or longer-term reductions in expenses and cash burn in an attempt to extend the runway for a turnaround, financing, or sale transaction.
    • If the company has borrowed money from a bank or other secured lender, it’s also critical to assess the lender’s rights, potential remedies, and prospects for a restructuring.
    • Even in difficult situations, maximizing value may mean continuing operations — even though that burns cash — for a limited period to allow the company to complete a sale that the directors believe is likely to close and produce significant value for creditors.
    • In other cases, it may mean winding down (or even shutting down) operations quickly to conserve cash, especially if any asset sale is not expected to generate more than the cash required to pursue it.
    • Restructuring and wind-down alternatives, including Chapter 11 bankruptcy and assignments for the benefit of creditors, may need to be considered as well.

The Unique Impact of COVID-19. The COVID-19 pandemic and government orders precluding non-essential business operations have produced widespread financial impacts.

  • Companies that have been performing well previously, but are now experiencing financial distress primarily because of COVID-19, may need to assess factors that go beyond those of a traditional distressed company.
  • These could include, among others: financial contingency planning based on the possible duration of the pandemic and stay-at-home or similar orders; negotiations with lenders for short or near-term debt service extensions, additional liquidity, or a restructuring of loan facilities; and potential changes in customer preferences or supplier availability once the pandemic eases.
  • In addition, COVID-19 has prompted federal, state, and local governments to consider assistance programs for specific industries and potentially for businesses across the economy.
  • If these programs are enacted, companies will have to assess whether they are eligible for financial assistance, the conditions placed on receiving assistance, and how long it could take before relief would actually be received.

Conclusion. The COVID-19 pandemic has disrupted businesses across the economy and caused unexpected and immediate financial impacts. Directors and officers faced with managing through these issues will benefit from specific legal advice about their fiduciary duties and how best to discharge them in these newly uncertain times.

 

 

Photo by Drew Beamer on Unsplash

The Financially Troubled Company

The Venture-Backed Company Running Out Of Cash: Fiduciary Duties And Wind Down Options

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Many start-up companies backed by venture capital financing, especially those still in the development phase or which otherwise are not cash flow breakeven, at some point may face the prospect of running out of cash. Although many will timely close another round of financing, others may not. This post focuses on options available to companies when investors have decided not to fund and the company needs to consider a wind down.

Fiduciary Duties And Maximizing Value. Let’s start with a refresher on the fiduciary duties of directors and officers of a Delaware corporation in financial distress. Please note that this high-level overview is no substitute for actual legal advice on a company’s specific situation.

  • Under Delaware law, directors and officers owe fiduciary duties of due care and loyalty. The duty of due care requires directors and officers to make fully-informed, good faith decisions in the best interests of the company. The duty of loyalty imposes on directors and officers the obligation not to engage in self-dealing and instead to put the interests of the company ahead of their own.
  • When a company is solvent, the directors and officers owe their fiduciary duties of due care and loyalty to the corporation and its stockholders. That remains true even if the company is in the so-called “zone of insolvency.”
  • When a company is insolvent and will not be able to pay its creditors in full, the directors and officers still owe their fiduciary duties of due care and loyalty to the corporation. However, upon insolvency, the creditors have the right to bring derivative (but not direct) claims for breach of fiduciary duty against directors and officers.
  • Follow this link for more on the key Delaware decision discussing the fiduciary duties of directors and officers in the insolvency context.
  • Remember, it can be challenging to determine whether a company is just in the zone of insolvency (meaning still solvent but approaching insolvency) or whether it has crossed the line into actual insolvency.
  • Discharging fiduciary duties when a company is insolvent means a focus on maximizing enterprise value. This is a highly fact-dependent exercise with no one-size-fits-all approach. In some cases, maximizing value may mean continuing operations — even though that burns dwindling cash — to allow the company to complete a sale that the directors believe is likely to close and produce significant value for creditors. In other cases, it may mean winding down (or even shutting down) operations quickly to conserve cash, especially if any asset sale is not expected to generate more than the cash required to pursue it.
  • These complexities make it critical for directors and officers of a company in financial distress to get legal advice tailored to the specific facts and circumstances at hand.

Legal Options For A Wind Down. When the board decides that the company needs to wind down, options range from an informal approach all the way to a public bankruptcy filing. Note that if the company owes money to a bank or other secured creditor, the lender’s right to foreclose on the company’s assets could become a paramount consideration and affect how the wind down is accomplished. Although beyond the scope of this post to analyze each wind down option in detail, the following is a brief overview of different approaches, together with links giving more information.

  • Informal wind down: In an informal wind down, the company typically tries to find a buyer for its assets, eventually lays off its employees, and shuts down any unsold business operations, but does not complete a formal end to the corporate existence. This lack of finality can leave legal loose ends, so alternatives should be carefully considered.
  • Corporate dissolution: A corporate dissolution is a formal process under Delaware law, typically managed by a company officer, for winding up the affairs of the corporation, liquidating assets, and ending the company’s legal existence. A company may choose to do a corporate dissolution when it doesn’t need bankruptcy protection (and prefers not to file bankruptcy) but wants a formal, legal wind down of the corporate entity. Follow this link for more details on corporate dissolution.
  • Assignment for the benefit of creditors: Many states, notably including California and Delaware, recognize a formal process through which a company can hire a professional fiduciary and make a general assignment of the company’s assets and liabilities to that fiduciary, known as the Assignee. In California, no court filing is involved. The Assignee in turn is charged with liquidating the company’s assets for the benefit of creditors, who are notified of the ABC process and instructed to submit claims to the Assignee. If a buyer has been identified, an Assignee may be able to close an asset sale soon after the ABC is made. Follow this link for a an in-depth look at the ABC process.
  • Chapter 7 bankruptcy: A Chapter 7 bankruptcy is a public filing with the United States Bankruptcy Court. A bankruptcy trustee is appointed to take control of all of the company’s assets, including the company’s attorney-client privilege, and the directors and officers no longer have any decision-making authority over the company or its assets. A Chapter 7 trustee rarely operates the business and instead typically terminates any remaining employees and liquidates all assets of the company. The filing triggers the bankruptcy automatic stay, which prevents secured creditors from foreclosing on the company’s assets and creditors from pursuing or continuing lawsuits. The trustee has authority to bring litigation claims on behalf of the corporation, often to recover preferential transfers but sometimes asserting breach of fiduciary duty claims against directors or officers. Unlike a dissolution or an ABC, the bankruptcy trustee in charge of the liquidation process is not chosen by the company.
  • Chapter 11 bankruptcy: A Chapter 11 bankruptcy is also a public filing with the U.S. Bankruptcy Court, and it similarly triggers the bankruptcy automatic stay. Unlike a Chapter 7 bankruptcy, in Chapter 11 — often known as a reorganization bankruptcy — the board and management remain in control of the company’s assets (at least initially) as a “debtor in possession” or DIP. Business operations often continue and funding them and the higher cost of the Chapter 11 process require DIP financing and/or use of a lender’s cash collateral. One primary use of Chapter 11 by a venture-backed company is to sell assets “free and clear” of liens, claims and interests through a Bankruptcy Court-approved sale process under Section 363 of the Bankruptcy Code. Follow this link for a discussion of how a Section 363 bankruptcy sale in the right circumstances can maximize value for creditors and shareholders.

Conclusion. When a company’s cash is running out and investors have decided not to provide additional financing, the board may conclude that a wind down is required to fulfill fiduciary duties and maximize value. The discussion above is a general description of certain wind down options. Determining whether any of these paths is best for a particular company is fact-specific and dependent on many factors. Be sure to get advice from experienced corporate and insolvency counsel when considering wind down or other restructuring options.

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

Latest Edition Of Bankruptcy Resource Now Available

The Spring 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 give updates on current developments in bankruptcies and workouts with the goal of keeping you "ahead of the curve" on these issues. Follow the links in this sentence to access a copy of the newsletter or to register to receive future editions.

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

  • The ability of unsecured creditors to recover post-petition attorney’s fees;
  • Key issues when selling claims in bankruptcy;
  • Jury trials and proofs of claim;
  • Assignments for the benefit of creditors; and
  • The impact of post-petition performance on executory contracts.

We have also included information on some of our recent representations of official committees of unsecured creditors in Chapter 11 bankruptcy cases, and unofficial committees in out-of-court workouts, involving major retailers. These include Sharper Image, Lillian Vernon, CompUSA, Wickes Furniture, and The Bombay Company, among others. In addition, a note from my partner Adam Rogoff, the editor of Absolute Priority, discusses the increasing number of bankruptcy filings nationwide and our representation of Bayonne Medical Center in its Chapter 11 reorganization.

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

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.