distressed asset sales both in bankruptcy and out-of-court alter feb 2015

Polsinelli PC. In California, Polsinelli LLP

Distressed Asset Sales in Both Bankruptcy and Its Out-of-Court Alternatives James E. Bird

Christopher A. WardRandye B. SorefJerry L. Switzer, Jr.

real challenges. real answers. sm

Distressed Asset Sales in Both Bankruptcy and Its Out-of-Court Alternatives

Agenda

1. Discussion of considerations for selling distressed assets in bankruptcy and out-of-court

arrangements and minimizing the risk to the purchaser

2. Available Distressed Asset Sale Mechanisms, Pros & Cons of Each Alternative

A. Bankruptcy

B. UCC - Article 9 ”Friendly Foreclosure” Sale

C. Assignment for the Benefit of Creditors

D. Receivership (Federal vs. State)

E. Comparison of Each Alternative

3. Why explore non-bankruptcy alternatives

A. Cost

B. Control

C. Timing

4. What is on the horizon for 2015?

A. More non-bankruptcy asset sales

B. Focus on Distressed Health Care and Energy Sector Transactions

C. Increased use of receiverships


Panelists

� Jim Bird – Kansas City (Practice Group Co-Chair)� Chris Ward – Delaware (Practice Group Co-Chair)� Randye Soref – Los Angeles� Jerry Switzer - Chicago

Complete biographies of our panelists can be found at the end of the presentation or at www.polsinelli.com.


PURCHASE OF A DISTRESSEDBUSINESS OUTSIDE OF BANKRUPTCY

� In most distressed business situations, it isadvisable for a buyer to directly purchase theassets of such business rather than purchasethe equity of the entity that owns the business.

� With some exceptions, in most states it is wellestablished that a buyer can “cherry pick” theassets and liabilities it wants to purchase orassume, leaving undesired assets and liabilitieswith the owner. However, the seller or its lendermay resist a partial sale of assets.


� In evaluating any opportunity to purchase adistressed business, a fundamental decision iswhether to purchase assets through abankruptcy proceeding or one of several out-of-court alternatives.

� There are several factors that purchasersshould consider in this analysis:

Considerations for Distressed Asset Sales



1. Secured Debt. If the acquisition target has secureddebt, the only way to obtain the assets free andclear of liens is to get consensual lien releases fromall lienholders or pay the senior secured creditors infull or an agreed upon amount.

2. State and Local Taxes. Several states imposesuccessor liability on an asset purchaser withrespect to unpaid taxes of the seller, unless thepurchaser either (i) withholds the taxes from thepurchase price or (ii) obtains a tax clearancecertificate. If a business is distressed, this is morethan likely an issue.



3. Bulk Sales Act. A few states still have “Bulk SalesLaws” requiring certain notices and procedures tocreditors when the buyer is purchasing substantiallythe entire inventory of a business but is notassuming its liabilities. Failure to comply generallyresults in liability for the purchaser to creditors of theseller.

4. Collective Bargaining Agreements. A purchaser ofdistressed assets may be required to recognize andbargain with a union that represented the seller’semployees.



5. Underfunded Pensions. If seller participates in anunderfunded multi-employer union pension plan, asale of assets can result in immediate withdrawalliability by the seller. Some courts have held abuyer liable for a seller’s delinquent contributionsand withdrawal liability under such pension plans.

6. Environment Liabilities. Potential risk of liability tofederal and state environmental authorities.



7. WARN Act Liability. Buyer may have liabilityrelated to unpaid wages for the seller’s failure toprovide adequate notice to employees that thebusiness is closing, assuming that the seller hasenough employees to be covered by the WARNAct or similar state labor laws.

8. Product Liabilities. Buyer may inherit certainseller product liabilities pursuant to existing caselaw.



9. Successor Liability. Pursuant to common law, in certaincircumstances a seller and buyer may be considered to haveundergone a “de facto” merger or the buyer may be considereda “mere continuation” of the seller, with the result that the buyeris liable to creditors of the seller. The successor liabilityanalysis is similar to piercing the corporate veil discussedimmediately below.

10. Piercing the Corporate Veil. If there appears to be too manycorporate similarities between the seller and purchaser, acreditor may seek to pierce the corporate veil of the purchaserin order to hold it liable for the debts of the seller. There arestrong legal doctrines that protect the sanctity of a corporation,but the parties need to be aware of the risk in structuring adistressed asset transaction.



11. Fraudulent Transfers. One of the biggest risks of purchasing a distressed business is that, after closing, one or more creditors of the seller (or a bankruptcy trustee) may attempt to set aside the sale on “fraudulent transfer grounds” (based on actual or constructive fraud of creditors). Actual fraud involves an attempt by the debtor to hinder, delay, or defraud its creditors. Most often creditors make a claim for constructive fraud, which involves a transfer of assets for less than fair consideration when the seller was insolvent or became insolvent as a result of the sale. These actions can be brought under state law or federal bankruptcy law (with 2-6 year statute of limitations).

12. Seller’s Creditor Body. If the seller has aggressive or disgruntled creditors holding large claims, there may be a greater risk of a successor liability or fraudulent transfer claim. The same may be true if the nature of the seller’s business is such that future (but currently unknown) and large general liability or similar claims might arise. The holders of such future claims may be motivated to pursue the buyer. In contrast, if the seller’s creditors are passive, disorganized or hold relatively small claims, and if there is low risk of future claims, the risk of successor liability or fraudulent transfer claims may be small.



Considerations to Mitigate Risk

1. Perform proper due diligence – especially so with adistressed business. Perform searches of state andlocal records for financing statements and consensualliens, tax and judgment liens, and lawsuit filings.

2. Buyer should consider setting up a new and separateentity to affect the purchase in order to isolate thepurchased assets from possible unknown liabilities.




3. To create a defense against post-closing fraudulenttransfer claims, the buyer should consider obtainingan opinion of the value of the assets to be purchasedfrom a reputable appraiser.

4. Make certain that the sales proceeds are allocatedand distributed by the seller properly in order todemonstrate to existing creditors that the sale wasconducted in good faith.

5. Purchaser should obtain seller indemnification fromattacks on the sale, including fraudulent transferclaims, piercing the veil, or successor liability claimsfrom creditors.




6. Negotiate a holdback or third party escrow fora substantial amount of the purchase price tocover post-closing issues and indemnificationagreements.


11 USC Section 363 Bankruptcy Sales

If sufficient value is involved, and if thedistressed business can survive thebankruptcy process, the parties often willbenefit from a section 363 sale in abankruptcy proceeding. This provision allowsthe Bankruptcy Court to approve a sale ofassets free and clear of liens, encumbrances,and adverse claims and interests.


A. Pros Section 363 Sale1. Simplicity and speed.

2. Avoidance of corporate law requirements toobtain majority shareholder approval.

3. The right to sell property free and clear ofall liens, claims and other interests. Thepower of the Bankruptcy Court to free thedebtor’s assets of claims and interestsmakes it more attractive to a potentialbuyer.



4. The right to assume and assign executory contractsand unexpired leases of non-residential real propertypursuant to section 365 of the Bankruptcy Code thatare otherwise not assignable outside of bankruptcy.(However, as a general rule, patent licenses,government contracts, and personal service contractsare not assignable even in bankruptcy.)

5. The right to sell property despite contractual anti-bankruptcy provisions and similar sale restrictions.



6. The right to sell property co-owned by the debtor and otherperson(s) under certain circumstances.

7. The right to a good faith purchaser finding pursuant to section363(m) of the Bankruptcy Code.

8. Protection against the reversal or modification on appeal of aconsummated bankruptcy sale. The Bankruptcy Code providesthat an order approving a sale cannot be reversed or modifiedon appeal unless either the party bringing the appeal obtains acourt stay of the sale while the appeal is pending (i.e., usually byposting a significant bond) or the purchaser buys the assets inbad faith. In addition, the Third Circuit, amongst others, has avery strong equitable mootness doctrine on appeal.



9. Approval of the sale and appropriate findings by thebankruptcy court should prevent subsequentfraudulent conveyance, successor liability, or piercingthe corporate veil claims by creditors or otherdisgruntled parties.

10. Some courts find that successor liability is an“interest” subject to sale free and clear. Cases oftenturn on whether a particular claim is known and couldhave been brought into the bankruptcy and whether aparticular claimant receives adequate notice of a saleand bankruptcy proceeding. Providing notice toknown or potential claimants may defeat latersuccessor liability arguments.



B. Cons Section 363 Sale1. The section 363 sale process can be

somewhat time consuming and costly.

2. Potential for negative bankruptcy publicity,damaging the reputation of the business,and customer willingness to purchasegoods and services. Most, however, findthis concept to be incredibly overstated.

3. Distressed business may not be able tosurvive even a quick bankruptcy processwithout losing significant value.



4. Some Bankruptcy Courts will not allow a section 363 sale incircumstances in which only the secured lender benefits (i.e.,where no funds are going to unsecured creditors). A sellermust be prepared to deal with (i.e., provide a “tip”) todisenfranchised creditors.

5. Some courts disagree that successor liability is an “interest”subject to the sale free and clear.

6. Section 363 sales must be subject to an auction that willentertain higher and better bids (i.e., a “stalking horse” biddercould lose the bid to a competing party, yet the stalking horsebidder may be entitled to a “Break Up Fee”).



7. Creditors may try to obtain leverage byobjecting to the process and attempt toextract “holdup” concessions.

8. Secured creditors have rights to “credit bid”their secured debt amount pursuant tosection 363(k) of the Bankruptcy Codeagainst their collateral being sold. As aresult, buyers will normally negotiate withsecured creditors during the sale process.



UCC - ARTICLE 9 –“FRIENDLY FORECLOSURE”

� A UCC - Article 9 “friendly foreclosure” is a situation inwhich a troubled borrower cooperates with its lender(generally an undersecured lender) to facilitate aforeclosure sale. A friendly foreclosure will deliver titlefrom the borrower to the lender or a third-party buyer.



� Under the Uniform Commercial Code (“UCC”), inparticular UCC 9-610, a lender may sell collateral afterthe borrower’s default “at any time and place and on anyterms,” so long as every aspect of the transaction is“commercially reasonable.” The UCC allows aforeclosing lender to choose between a public and aprivate sale. The UCC requires a lender to send“reasonable” notice of an intended sale to the borrower,any secondary obligors, such as sureties or guarantors,and unless the collateral is consumer goods, any otherparty with a secured claim on the collateral that eitherhas perfected its claim by filing or has notified thesecured lender of that claim.



� In the usual friendly foreclosure, the lender, borrower,and buyer enter into a three-way foreclosure agreementsimilar to an asset purchase agreement. The agreementis intended to affect a quick transfer of the borrower’sassets to the buyer in an Article 9 foreclosure by privatesale. The borrower will normally confirm the value of theassets are less than the secured debt and affirm thelender’s right to foreclose in the manner specified in theagreement. A borrower also may make certainrepresentations to the buyer about its business that thelender may not be in a position to provide.



� A lender may warrant to the buyer that it is entitled to conveytitle to the collateral in good faith, but it usually disclaims mostwarranties and representations that customarily accompany anon-distressed sale. The buyer agrees to take the collateral inits current condition. In some sales the lender may not makeany warranty of good title, thus imposing all the risk on thebuyer. The buyer also may assume some of the borrower’sspecified liabilities, but usually excludes most of the borrower’sobligations, including taxes, employee benefits, trade debts,contracts, and tort liabilities. The buyer’s recourse to thelender, if any, almost always is contractually limited to theamount of consideration paid by the buyer. The lender maychoose to finance a portion of the purchase price by specifyingin the agreement that the buyer is taking title subject to aportion of the existing debt held by the lender.



� Assuming the lender who brings the friendlyforeclosure is the most senior securedlender, the sale of the borrower’s assetsunder an Article 9 foreclosure will wipe outthe interests of all other junior creditors (whoreceived notice of the sale).



Pros To “Friendly Foreclosure”1. Often faster and less costly than a section

363 bankruptcy sale.

2. Creditors have less opportunity to extract“holdup” concessions from a lender duringa sale process.

3. Parties are not subject to Bankruptcy Courtreview and procedures.



4. Article 9 requires notice to a smaller groupof entities than does bankruptcy. (Vendorsand customers usually need not be notified,which may make it easier to maintainoperating a borrower’s business than in abankruptcy.)

5. Article 6 “Bulk Transfer” laws are exemptedfrom transactions that settle liens, includingfriendly foreclosures. See UCC 6-103.



Cons To “Friendly Foreclosure”1. If lender is not undersecured, there is a likelihood

that the foreclosure may be challenged by othercreditors (as a fraudulent transfer, successorliability, or veil piercing).

2. Lender and borrower will usually disclaimwarranties. Typically occurs as an “As Is, WhereIs” Transaction.



3. Failure of lender to send a commercially “reasonable”notice of intended sale to the borrower, secondaryobligors and other lienholders may taint the sale andcause such parties to seek to challenge the sale. Thesale price, the efforts to find alternative buyers, and thelender’s good faith in maximizing the value of thecollateral are all considered by courts whendetermining “commercial reasonableness.” In actionsinvolving a deficiency or surplus after the sale, thelender may have the burden to prove the sale wascommercially reasonable. Unsecured creditors mayseek to prove the sale was not commerciallyreasonable in aid of a successor liability or fraudulenttransfer claim.



4. Article 9 sale will not wipe out any security intereststhat are senior to the foreclosing lenders.

5. There is no established “safe harbor” (via a courtreview) for Article 9 foreclosures like there is in abankruptcy section 363 sale.

6. There is no bankruptcy stay against third parties.Thus, there is a threat of creditor adverse action (i.e.,notice of UCC sale could prompt creditors to file aninvoluntary petition against the debtor or create thepotential that the UCC sale could be challenged andavoided as a fraudulent transfer).



7. A UCC Article 9 foreclosure does not apply to realestate sales, and thus is not a great vehicle forsale of an entire business if the business hassignificant owned real estate. The real estate mustbe transferred via other means, including a shortsale, deed-in-lieu related transaction or structuredforeclosure sale.

8. Inability to assign leases and other contractscontaining non-assignment clauses unlike asection 363 bankruptcy sale.



9. Creditors of the seller could challenge the transactionon “successor liability” grounds.


Assignment for the Benefit of Creditors

A general assignment provides a means of liquidating the assets of adebtor in an orderly, controlled manner. A general assignment is avehicle used for the sale or liquidation of a business. It is not used tofinancially rehabilitate or “turn the business around”.

Assignments are either common law or statutory, and the law variesfrom state to state as to which form of assignment is utilized. Generally,states will follow one of two approaches to the assignment process.One approach requires court supervision of the assignment and theassignee (e.g., Delaware, California, New Jersey to name a few); theother permits the assignments to proceed without court supervision, butrequire that the assignee follow state laws applicable to and governingthe liquidation of a business and its assets.

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� It is easy to think of a common law assignment as similarto Chapter 7

� All assets of the Assignor is transferred to the Assignee

� The Assignee liquidates the property

� An Assignee may have the power to pursue preferencesand fraudulent conveyances depending on state law inwhich the Assignment takes place

� Distributions are made to creditors according to statutorypriority and based on claims

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The Assignee is generally someone who is not related to or directlyinvolved in the management or the day-to-day operations of the debtor(i.e. a disinterested third party).

Assignee is usually an individual experienced in the process ofliquidating businesses; however, an the Assignee may also be acorporate entity with such experience.

An Assignment is consummated when the Assignee accepts theAssignment Trust "contract,” or Deed of Trust from the Assignor.

Upon acceptance of the assignment “contract,” all of the Assignor’sright, title and interest in its assets is “transferred” to the Assignee forthe purposes of liquidation.

The Assignee then becomes a fiduciary on behalf of any and allcreditors of the Assignor, as well as for the Assignor and, ultimately, itsowners/shareholders.

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� The Assignee must preserve the assets for the benefit ofcreditors.

� The Assignee must liquidate and administer assets fairly.

� The transfer of assets is subject to any and all existingliens, and the assignee is bound to honor all valid,perfected and enforceable liens.

� General assignments do not typically give a debtor adischarge, as discharge of debts can only be achievedthrough a bankruptcy case.

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Receivership

� Equitable proceeding in which a courtappoints a disinterested person, thereceiver, to receive, preserve andprotect designated assets or property

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Receivership: Federal vs. State

� Advantages of Federal Receiverships over StateReceiverships– National jurisdiction; solves diversity of jurisdiction

problem over supervision and control of assets– “Free and clear” sales– Incorporation of bankruptcy concepts

� Advantages of State Receiverships over FederalReceiverships– Statutory authority for appointment of a receiver in a

variety of contexts; see e.g., California code of CivilProcedure Section 564

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Receivership: Common Purposes

� Facilitating injunctive relief� Taking custody of and managing property� Preserving assets and business books and records� Obtaining an accounting of assets, income and use of

proceeds� Locating hidden assets� Uncovering fraud and misappropriations� Exposing criminal enterprises� Involuntarily dissolution� Enforcing a judgment

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Receivership: Factors for Appointment

� Probability that fraudulent conduct has occurredor will occur to frustrate opponent

� Imminent danger that property will be concealed,lost or diminished in value

� Inadequacy of other legal remedies� Lack of less drastic equitable remedy� Likelihood that appointment of receiver will do

more good than harm� Contractual consent to appointment upon default

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Receivership: Common Types

� Custodial Receiver� Liquidating Receiver� Interim Operating Manager, status quo� Provisional Director� Fiscal Agent� Post-Judgment Receiver

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Receivership: For the Benefit Of:

� Secured Lender� Judgment Creditor� Deadlocked corporate directors, LLC members or partners� Oppressed minority shareholder, member or partner� Creditors or equity holders seeking to take custody or:

– Bring and defend lawsuits; seek injunctive relief; issue subpoenas to obtaindocuments

– Compel testimony and the production of documents and things� Notify customers and tenants of any change in name of payee or mailing address

for payments� Change locks and security codes� Intercept and redirect mail� Evict tenants� Obtain permits as needed, such as for managing real estate projects� Pay, where permitted, “pre-receivership” expenses

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How the Receiver is Selected:

� By secured lender

� By court

� By creditor’s or debtor’s counsel

� In all events, court approval is required

The Receiver’s Relationship With Other Parties:

� Officer of the court

� Qualified fiduciary role with respect to debtor/company

� Allegiance to secured lender by virtue of authority and purpose

� Duty to subordinate creditors and equity interests

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Receivership


Receivership: The Receiver’s Duties

� Locate and preserve assets� Provide accounting to the court� Fulfill purpose as stated in court order

establishing the receivership

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Receivership: Types of Powers of a Receiver

� Take possession of and mange assets, as specified in court order,including cash in bank accounts, goods, rights and credits

� Take possession, custody and control of licenses, documents,books and records, emails in possession of accountants, attorneysand other third parties

� Administer business operations as though the receiver were theowner or president

� Borrow money similar to bankruptcy’s DIP loans, granting a super-priority lien; i.e. “receiver certificates” similar to DIP financing

� Manage bank accounts, change signature cards, open newaccounts

� The Receivership Order can, and should, be tailored to fit whateverpowers and duties the Receiver may need in their appointment.

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Receivership: Types of Powers of a Receiver

� Utilize receivership entity’s tax identification number forall transactions

� Hire professionals such as attorneys, accountants,appraisers, and auctioneers

� Expend funds for the preservation of assets, such asrepair, maintenance, insurance, licenses, taxes, utilitiesand other operating expenses

� Buy and sell assets� Enter into contracts obligating receivership assets� Market and sell receivership property; sale usually

requires court approval

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Receivership: Powers of the Receiver

� Bring and defend lawsuits; seek injunctive relief; issue subpoenas toobtain documents

� Compel testimony and the production of documents and things

� Notify customers and tenants of any change in name of payee ormailing address for payments

� Change locks and security codes

� Intercept and redirect mail

� Evict tenants

� Obtain permits as needed, such as for managing real estate projects

� Pay, where permitted, “pre-receivership” expenses

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COMPARISON OF CERTAIN AVAILABLE DISTRESSED SALE ALTERNATIVES

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Topic Chapter 11 Chapter 7 Receiver Assignment

Procedures Detailed Code, rules and US Trustee involvement

No formal court rules Streamlined; with or without court (State

specific)

Company Involvement May still operate as DIP and attend 341

hearing

Must attend 341 hearing

None or TBD Debtor consensual conveyance of the property; ongoing role limited/TBD

Publicity Public forum with all pleadings and financial results available to the media

and public

Fewer reporting requirements but

pleadings available

Publicity minimized; public filings are

limited (subject to specific State laws)

Court Federal Federal Federal or State State (if applicable)

Oversight US TrusteeJudge,

Committees

US TrusteeJudge

Judge Depends on State, Judge or creditors



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Financing the Process DIP Lending provisions attract capital, process to

use cash collateral

Asset Sale Proceeds

Potentially financed by Senior Creditor;

no process to secure use of cash

Asset Sale Proceeds, use of secured creditor’s

collateral

Process Costs Expensive; cost benefit analysis

should be undertaken

Could be less expensive; but asset values

could = liquidation value or less

Less Expensive Potentially least Expensive

Cost Drivers Committee Counsel and FA

US Trustee Rigorous Court

Process

No CommitteeNo US Trustee

No CommitteeNo US Trustee Fewer reporting

requirements

No CommitteeNo US TrusteePotentially no

supervision. Speed of ability to liquidate

assets

Time Detailed Code, rules and US Trustee involvement=slow with statutory delays

Federal or State; no formal court rules=fast

State; streamlined with no court process=fast



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Flexibility of the Process

Specific Law; Federal

Jurisdiction

Vague and Open; State laws vary, could be Federal

Vague and Open; dependent on State

law

Sales are “as-is, where-is” so up to

buyer to be clear as to liens on

purchased assets

Assignment or Rejection of Contracts/Leases

Yes - landlord claim limited pursuant to 502(b)(6)

No (opportunity with Receiver Order and

Court approval)

No

Ability to Position Operating Asset for Best Value

Use Code to restructure operations

NA Operating Receiver; limited ability

Limited

Creditor Composition/ Impact on Forum

Best Option for complex capital structure/multi

state

NA Best Option for creditor

concentration; single State

TBD; the less other interested parties

the better

Other Considerations Ability to pursue claims and causes of actions or other Code based creditor

recovery strategies

No Federal; State Law may have

basis

State law specific


What is on the horizon for 2015?

A. More non-bankruptcy asset sales

B. Focus on Distressed Health Care and Energy Sector Transactions

C. Increased use of receiverships


Contact Information

Polsinelli PCwww.polsinelli.com

Jim Bird – Kansas City (Practice Group Co-Chair)[email protected]

Chris Ward – Delaware (Practice Group Co-Chair)[email protected]

Randye Soref – Los [email protected]

Jerry Switzer – [email protected]


Polsinelli, a national law firm ranked among the Am Law 100 with over 740attorneys located in 19 offices, deliberately seeks constant improvement in allthat we do. At its inception more than forty years ago, the firm established aculture of openness and entrepreneurship that still pervades today. As thefastest growing U.S. law firm for the past six years as ranked by The AmericanLawyer*, the firm’s growth has been fueled by the recruitment of like-mindedattorneys from top law firms across the country.

Polsinelli attorneys successfully build enduring client relationships by providingpractical legal counsel infused with business insight, and with a passion forassisting General Counsel and CEOs in achieving their objectives. The firmfocuses on healthcare, financial services, real estate, life sciences andtechnology, and energy and business litigation, and has depth of experience in100 service areas and 70 industries.

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