3. Pending Bankruptcy
Scenario: A vendor calls its attorney in a panic when its customer filed for bankruptcy. Must the vendor keep supplying? What about outstanding prebankruptcy obligations? Will the customer try to claw back prior payments? Can the vendor object to the assignment of its contract to a third party?
Vendors must understand the effect of a counterparty’s bankruptcy on their commercial relationship. If both parties to the contract have significant unperformed obligations remaining, the contract is likely “executory” and subject to the debtor’s assumption (or reaffirmation), rejection (or breach), or assignment to a third party. In most circumstances, the debtor need not decide whether to assume or reject the contract until a plan is confirmed at the end of its case, thereby leaving the vendor in limbo during the bankruptcy proceedings. If the vendor’s contract is rejected, all obligations under the contract will be relieved, leaving the vendor with a general unsecured claim.
With some limited exceptions, contract provisions purporting to condition assignment on consent of the nonassigning party are unenforceable. Absent consent of the nonbankruptcy party, however, the contract must be assumed in its original form. If the debtor assumes or assigns the contract, the debtor or assignee must cure (or pay) any outstanding defaults and provide “adequate assurance” of its ability to perform under the contract going forward. The assumption (or assignment) of a contract also insulates any 90-day payments from preference avoidance. Thus, when dealing with a debtor or assignee that wants to negotiate more advantageous contract terms, the nondebtor vendor should insist on the assumption and modification of an existing contract rather than the execution of a new supply agreement, which will result in the rejection of a prior agreement and possibly create preference exposure. Even if the vendor does not have the bargaining power to have its contract assumed and paid in full, a vendor subject to preference exposure may have enough bargaining power to, for example, have its contract assumed, but waive affirmative recovery on its claim, thereby protecting it from a preference attack.
Vendors may find themselves in no-man’s land where their contract has been neither assumed nor rejected, but a prebankruptcy payment default remains outstanding, and the debtor still seeks performance. In such a case, the vendor remains obligated to perform under the nonterminated contract so long as the debtor complies with its terms. Although the Bankruptcy Code mitigates further exposure by giving the vendor administrative-expense priority over even secured claims, payment is not guaranteed. Vendors in this situation should closely monitor the debtor’s post-bankruptcy performance and seek relief from the bankruptcy court if necessary. The Bankruptcy Code does not require creditors to incur unmitigated exposure.
Vendors faced with a customer’s bankruptcy should almost always file a proof of claim in the bankruptcy case before the claims deadline expires. Creditors should recognize that submitting a proof of claim likely will subject them to the bankruptcy court’s jurisdiction, which may lead to unintended results, such as waiving their right to a jury in avoidance actions and allowing themselves to be sued in bankruptcy court on other claims. Creditors may also decide not to file a proof of claim if they are wary of unwanted attention; however, failing to do so might subject a creditor to an absolute bar of its claim. Creditors should carefully consider the consequences before determining not to file a claim.
4. Mergers & Acquisitions
Scenario: A client has asked generally about the risks associated with the purchase or sale of a distressed company, both inside and outside of Chapter 11.
Distressed companies often are prime acquisition targets—buyers believe they can turn the business around; sellers are eager to cut their losses and move on. However, the sale of distressed companies implicates important bankruptcy considerations not present in other M&A deals.
These issues arise even when a company is sold in an arms-length transaction outside of Chapter 11. If the buyer ultimately fails to turn the business around and files for bankruptcy, the seller may be subject to a fraudulent transfer claim on the grounds that the buyer-debtor overpaid. Conversely, if the business improves post-sale, the seller or its equity holder may assert a fraudulent transfer claim, alleging that the buyer underpaid.
To mitigate that risk, parties should obtain a fairness opinion from a reputable third party to support the transaction value. Although not dispositive, a fairness opinion verified by thorough due diligence could provide a court with strong evidence that reasonably equivalent value was exchanged. In the leveraged buyout context, the Bankruptcy Code contains special safe-harbor provisions that might provide a defense to a fraudulent transfer claim asserted against the purchased entity’s shareholders. This continues to be a developing area, however, and litigation is time-consuming and costly.
In any event, if a party to a transaction files bankruptcy, there is a significant risk that the debtor or its creditors will seek to investigate the transaction, which also can be time-consuming and costly. Bankruptcy Rule 2004 provides a broad discovery opportunity for the debtor and creditors “fishing” for information and potential causes of action.
Purchasers enjoy greater protections when they acquire assets through formal bankruptcy proceedings. A sale in bankruptcy usually is subject to higher and better offers, and a bankruptcy court order approves the sale. The court order often contains findings of fact and conclusions of law that undermine the ability to make claims against the buyer. A bankruptcy sale also causes transfer of the assets free and clear of all liens, claims, and interests, which attach to the sale proceeds.
A “free and clear” order may reduce exposure to many types of successor claims, but will not fully insulate the buyer from the risk of all types of claims. Litigation over the scope of the free-and-clear language often arises in the environmental, employment, and personal-injury contexts, which means that, even if the free-and-clear order is upheld, the buyer might be forced to incur legal fees defending against the barred claim. Purchasers should also note that the debtor’s representations and warranties typically are worthless after the deal has closed. Indemnities are meaningless if the debtor lacks the funding to satisfy them. Accordingly, purchasers should insist that any indemnity be funded through an escrow with a reputable, financially stable third party pursuant to a negotiated escrow agreement.
In sum, insolvency-related risks accompany nearly every commercial transaction. Although the ramifications of a contractual partner’s bankruptcy can be alarmingly counterintuitive, companies can mitigate their exposure by taking the steps discussed in this article.