Sophisticated distressed investors know the benefits of acquiring assets through a § 363 sale in a bankruptcy case. The primary benefit, of course, is acquiring assets free and clear of pre-existing liens, claims and interests. There are some occasions, however, where it is not practical for a buyer to request that a sale be run through a bankruptcy process, especially when the value of the assets and/or a sharp decline in the assets’ value does not justify the time and expense associated with a chapter 11 filing.
In circumstances such as these, a distressed investor may decide to consummate a sale outside of a bankruptcy filing. A key concern in these situations is guarding against the risk that the buyer will be subject to a claim that the asset sale was a constructive fraudulent transfer (because the assets were sold for less than a reasonably equivalent value). Due to some recent efforts by creative trustees, however, buyers should also consider whether the transaction may expose key vendors and suppliers to a preference risk as well.
Consider the following scenario. An auto parts manufacturer enters into an asset purchase agreement to sell substantially all of its assets to a buyer. Part of the consideration for the asset purchase includes an agreement by the buyer to assume all accounts payable to trade creditors that are unpaid at the closing date and are either reflected in an interim balance sheet or were incurred in the ordinary course of business. Approximately one month later the seller files a petition for relief under chapter 7 of the Bankruptcy Code. Two years after that the chapter 7 trustee files a number of lawsuits against the seller’s trade creditors, asserting that the buyer’s assumption and payment of the trade debt constituted a voidable preference.
This scenario is a summary of what transpired in the consolidated chapter 7 cases of In re Meridian Automotive Systems, Inc., et al., Case No. 09-12806 (MFW), which were filed in Delaware in July of 2009. In August of 2011 the trustee filed the above-mentioned actions against a number of trade creditors, all of which appear to have settled without the Delaware Bankruptcy Court ever having ruled on the merits of the trustee’s allegations or legal theory supporting the action.
At first glance it would appear that there would be no basis to file a preference action in these circumstances. The Bankruptcy Code clearly states that a trustee can only avoid “any transfer of an interest of the debtor in property…” 11 U.S.C. § 547(b). No such transfer appears to exist here, as the buyer assumed and then paid outstanding trade debt, not the debtor. The adversary complaints filed in these cases, however, make clear that the trustee was relying on a little-known line of cases that seem to support this position.
The seminal case relied upon by the trustee is Warsco v. Preferred Tech. Grp., 258 F.3d 557 (7th Cir. 2001). The facts in this case are incredibly complex, but the key facts can be summarized as follows. In 1998 an entity called PTG sold its assets to the future debtor in exchange for a $2 million unsecured note. Financial difficulties quickly followed, and by April of 1999, the future debtor began negotiating a sale of its assets to a new buyer. The asset purchase agreement required certain parties to consent to the sale, one of whom was PTG. PTG initially took the position that it would not consent unless it was paid $500,000 on its unsecured note. This was resolved when the buyer agreed to purchase PTG’s note for $500,000, conditioned on the sale closing. The sale closed in May of 1999. The Buyer’s consideration for the sale consisted of: 1) $3.425 million in cash; 2) assumption of certain trade debt; 3) $750,000 of debt forbearance on the note the buyer purchased from PTG; and 4) a post-closing payment subject to adjustment based on the value of the seller’s working capital at the time of closing (of which ultimately nothing was paid due to adjustments). About one month later an involuntary bankruptcy petition was filed against the seller. Unsecured creditors ultimately recovered nothing in the chapter 7 case.
The chapter 7 trustee later sued PTG, alleging that the buyer’s purchase and payment of its note constituted a voidable preference. The Bankruptcy Court granted summary judgment to PTG on the grounds that no transfer of an interest of the debtor in property had occurred, and that there was no proof that any payment it received was on account of an antecedent debt. The Seventh Circuit Court of Appeals reversed the granting of summary judgment on the grounds that there was insufficient evidence in the record to support the lower court’s finding. In doing so, however, the Circuit Court opined that consideration given for an asset sale could involve a transfer of an interest of the debtor in property:
If the funds the third party used to pay the creditor were consideration for the debtor’s sale of its assets, then those funds would have been part of the debtor’s estate and would have been available for distribution had they not been transferred to the creditor. On the other hand, if the funds used to pay the creditor were not part of the sale price for the debtor’s assets, then it is unlikely that the payment diminished the debtor’s estate. Instead, the transaction between the third party and the creditor likely was an independent transaction that did not affect the property in the debtor’s estate available for distribution.
Id. at 565.
The Circuit Court went on to say that:
In those cases in which courts have held that a preference was given in the context of an asset sale, there is a fairly direct, traceable link between the consideration given for the debtor’s assets and the funds used to pay the creditor. For instance, a debtor may sell its assets to a third party, and, as part of the purchase agreement, the third party may agree to assume the debtor’s liabilities. When the third party subsequently pays a creditor of the debtor, courts have allowed the bankruptcy trustee to recover the payment as a preference. See In re Food Catering, 971 F.2d at 397-98; Sommers v. Burton (In re Conard Corp.), 806 F.2d 610, 611-12 (5th Cir. 1986). In such cases, the third party’s assumption of the debtor’s debt is consideration for the sale of the debtor’s assets. See In re Food Catering, 971 F.2d at 398. The debtor effectively transferred to the creditor its right to receive a portion of the sale price equal to the amount of the debt. See In re Conard Corp., 806 F.2d at 612.
If you focus on the above statements made by the Warsco court it is easy to see why the Meridian trustee found support for filing his preference actions. But the actual facts of the case in Warsco not only don’t address a buyer’s assumption of trade debt, but seem to undercut them. To begin with, it must be recognized that the Warsco trustee did not seek to avoid as preferential any payments the buyer made on account of trade debt it assumed. Indeed, in a footnote the court states that “We note in passing that, under the APA, [buyer] effectively assumed the debt [seller] owed to Extruded Metals. However, neither party has argued that this payment is a preference, and we therefore express no opinion on the matter.” Id. at 566, n.12. Moreover, it seems clear that the court viewed the outcome as unfair, especially since PTG conditioned its agreement to the sale upon some payment on its unsecured debt, and other unsecured creditors did not receive any distributions in the chapter 7 case. In short, Warsco could be read as a situation where bad facts make bad law.
Additionally, the Warsco decision appears to be out of sync with the realities of distressed asset sales. A distressed seller’s relationship with its key vendors and suppliers often constitutes a significant portion of the value of the assets being sold. Preserving this relationship by assuming unpaid trade debt not only maximizes the value of the assets being sold, it also preserves jobs and business of both the seller and vendor. This relationship only stands to be damaged if a trustee later sues trade vendors to recover a preference, which could also impact the buyer’s operations and financial performance, and buyers should be able to rely on the express provisions of the Bankruptcy Code when structuring transactions. Moreover, the alternative to most distressed sales is liquidation, which typically results in the destruction of value, and loss of business for the vendors and suppliers who now must find alternative arrangements.
The unstated assumption underlying cases like Warsco seems to be that courts should be skeptical of out-of-court distressed asset sales and take measures to ensure an “equitable” division of sale proceeds. Such an assumption, however, not only contradicts the express provisions of the Bankruptcy Code, but would also incentivize distressed buyers to only pursue asset sales in a bankruptcy case. This might be seen as good news for bankruptcy professionals, but would not benefit distressed businesses, or trade vendors, where the time and expense of a bankruptcy filing are simply not cost effective given the values at stake.
It remains to be seen if the rationale announced in Warsco will gain wider acceptance. To date, the only written opinion in the Third Circuit that addresses the issue is the unreported decision in In re M Liquidating Corp., et al., Case No. 03-49349, 2007 Bankr. LEXIS 4356, Dec. 27, 2007 (Bankr. D. N.J. 2007). Distressed asset buyers would be wise to consider the potential impact this line of cases may have on future transactions, even if they do not involve entities in the 7th Circuit.