The Bankruptcy Code, the Uniform Commercial Code (UCC) and fiduciary duty laws do not proscribe the sale of a distressed company's assets to an insider. Nonetheless, a proposed sale of a struggling company's assets to its directors, officers or shareholders often results in long and critical inspection by unsecured creditors and bankruptcy trustees, and sometimes by courts. The reason for this scrutiny makes sense: An insider² of a struggling company presumably possesses a wealth of information about the company that outsiders do not, and hence may be in a position to take advantage of that information and acquire the company's assets—and potentially escape the company's liabilities—for less than the price the assets may garner in the marketplace.

Even though this fear may be well-founded, it is precisely because of the wealth of information about the company that an insider is often in the best position to deliver the best value for the assets of the distressed company, particularly in middle-market and closely held corporate transactions where finding potential outside purchasers or investors can be time-consuming, costly and difficult. However, recognizing a potential risk of unfairness, which primarily inures to the detriment of the distressed company's creditors, the law governing the disposition of distressed assets has created certain standards that, if met, can protect the economic interests and satisfy the legal obligations of all parties. Notwithstanding the additional costs or time required for strict compliance with these standards, parties involved with insider transactions—the company, the company's creditors and the insiders themselves—are usually well-served to make the effort.

Regardless of the forum used to dispose of the distressed corporation's assets, the corporation itself must consider the duties imposed by corporate law with respect to interested party transactions. Delaware law provides a good benchmark in determining to what standards corporate transactions will be held.³ Section 144 of the Delaware General Corporate Law provides that a transaction between a corporation and its directors or officers (or a company in which such directors or officers have a financial interest) is permissible if (1) after full disclosure, a majority of disinterested directors of the board ratifies the transaction; (2) after full disclosure, a majority of the shareholders, in good faith, approves the transaction; or (3) the transaction is fair to the corporation.⁴ While these requirements seem straightforward, a closely held or smaller corporation may not have any disinterested directors or shareholders.⁵ In such circumstances, the corporation must rely on the third disjunctive requirement: The sale transaction to the corporation's insiders must be fair to the corporation. Under Delaware law, the burden of proving the fairness of the transaction falls on the defendants (i.e., the insiders standing on both sides of the transaction).⁶ The insiders must establish that the transaction was the product of fair dealing and resulted in a fair price.⁷ By fair price, the Delaware courts require a showing that the price accepted was the highest value reasonably available under the circumstances.⁸

These standards do not mandate that every corporation seeking to sell its assets to insiders vigorously seek other bidders. Sometimes, cost concerns and timing will preclude such steps. However, no matter how dire the circumstances giving rise to the sale, a corporation should always do something beyond simply accepting the insider's bid.

The Code Requires that the Purchaser Acquire the Assets in Good Faith

Alternatively, a corporation may prefer to have the insider sale transaction approved in connection with a bankruptcy proceeding. In such instances, prior to approving the insider sale transaction, the bankruptcy court must make findings including that the sale is necessary, within the sound exercise of the debtor's business judgment and in good faith.⁹

Selling assets in a bankruptcy can provide substantial protection for the purchaser (whether an insider or otherwise), including the opportunity to purchase assets free and clear of liens, claims, interests and encumbrances. Also, the purchaser has the comfort of a court order that, if not appealed, binds every party with notice. Even if there is an appeal, however, the sale may still be valid. The Code provides that an asset sale cannot be invalidated if the purchaser acquired the assets in good faith.¹⁰

Courts will find a lack of good faith in situations of collusion between the purchaser and other bidders and/or collusion between the purchaser and the debtor, if the purchaser or trustee attempts to take a grossly unfair advantage over the process or other bidders, or if the purchaser pays less than fair value for the assets.¹¹ Parties to an insider sale transaction must make sure to avoid even the appearance of these elements of bad faith. For example, all parties (the debtor, purchaser and various creditor constituencies) should be represented by separate counsel, all of whom engage in open negotiations. Ensuring the presence of noninsider bidders can also be helpful. Ultimately, the court will be more likely to approve an insider sale transaction if there is evidence that the price paid is commensurate with the market value for such assets.

The UCC Requires Asset Sales to Be Commercially Reasonable

The UCC contains several provisions that permit a secured creditor to dispose of its collateral upon default. Both private and public sales are permissible, and the sales can take place at any time and on any terms.¹² However, every aspect of a sale must be "commercially reasonable"—including the method, manner, time and place thereof.¹³ The UCC also provides forms of the appropriate notices that must be sent to certain parties, and the timing, form and content of such notices.¹⁴ However, the remaining aspects of the sale are reserved to the discretion of the selling secured creditor—subject, of course, to challenge by any dissatisfied party.

It is precisely because of this discretion that the secured creditor must see to it that, in sales to insiders, every step must be commercially reasonable. Otherwise, a challenge to the sale not only will impact the buyer, but the secured creditor as well.

One potential way to enhance commercial reasonableness is for the lender to engage an investment banker to value the assets and shop them to various potential, noninsider bidders. This step can be expensive and time-consuming, and the commercial reasonableness standard does not require such formality. Indeed, a private sale to an insider with requisite notice is not expressly prohibited under the UCC. However, the latter approach may be riskier in terms of a later challenge to the sale process. In selling assets to an insider, the corporation and the lender should endeavor to do as much as is cost-effective to ensure commercial reasonableness. For example, opting for a public sale with publication notice in relevant newspapers and trade publications is more commercially reasonable when the proposed buyer is an insider. A public sale is one where outside interest has been sought and the lender holds an auction that is open to all bidders and that takes place on the record (i.e., it is transcribed by a court reporter). Publication notice is also a wise option, especially if such notice is geographically and industry targeted to garner the most interest. Many industries have their own trade publications, and publishing notice in these publications evidences a concentrated effort to reach parties with a potential interest in the assets. Such notice should also make clear that the current high bidder for the assets is an insider of the corporation. Mentioning this fact can protect the lender from the allegation that it did not disclose all matters about the environment in which bids would be submitted.

These steps are not an exhaustive list of methods to conduct a commercially reasonable sale. However, they show that the lender, as well as the buyer and the seller, must put appropriate thought (and costs) into ensuring that the sale to an insider is as open and fully disclosed as possible. Expending less effort may be cheaper, but it may result in a sale that is subject to challenge.

Once an insider acquires the assets of a distressed company and crests the hurdles put in place by corporate laws, the Code and the UCC, an additional issue remains to be considered: successor liability.

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Insider sale transactions, if performed in an informed and deliberate manner, may be the best alternative available to maximize the value of the assets of the corporation.

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Successor Liability Is Not Automatically Precluded

Simply because a court concludes an asset sale was commercially reasonable under the UCC does not automatically exempt the purchaser from successor liability. Consider Continental Ins. v. Schneider Inc.,¹⁵ in which the assets of a distressed company were sold by the company's secured creditor under the UCC to a new company formed by the old company's shareholders, officers and directors. An unsecured creditor of the old company sought to impose successor liability on the buyer, and the Pennsylvania Supreme Court concluded that the cause of action should not be dismissed and remanded the case for trial. The court held:

neither the UCC itself nor the policy underlying it demands the imposition of an absolute bar to an unsecured creditor's assertion of a successor liability claim against an entity that has purchased the debtor's assets in a §9-504 [now §9-610] foreclosure sale. Rather, we conclude that such claims may proceed, and if the unsecured creditors can establish that one of the exceptions so the general rule against successor liability applies, it may collect the predecessor's debt from the successor.¹⁶

In Continental Ins., the unsecured creditor asserted successor liability because the buyer operated substantially the same businesses serving the same clients and had the same employees working in the same offices with a continuity of ownership and control.¹⁷ This is known as the "mere continuation" or "de facto merger" exception to the rule against successor liability. Two other exceptions are when the buyer obtained the assets through a transaction (1) in an effort to avoid liability; or (2) for less than adequate consideration and no provisions were made for the predecessor's creditors.¹⁸

Continental Ins. sounds a warning to insiders—particularly insiders with equity in the predecessor company—wishing to acquire the assets from a distressed company and, in essence, take over where the old company left off. In such a scenario, the identity of the business, at least vis-à-vis customers and unsecured creditors, is not meaningfully different between the purchaser and its predecessor. Furthermore, the risk of successor liability is heightened if the ownership of the corporation undergoes little change after the asset sale.

One way to potentially avoid successor-liability problems is to sell distressed assets through a bankruptcy. In a bankruptcy proceeding, the predecessor (debtor) and the purchaser can effect an asset sale through a §363 sale or a reorganization plan. Through these methodologies, the parties' negotiations and sale process is subjected to the scrutiny of the debtor's creditors, the U.S. Trustee and the bankruptcy court. Also, a sale order and a reorganization plan can have res judicata effects on all parties with notice such that subsequent challenges will be substantially more difficult. Finally, in connection with a reorganization plan, the debtor, its creditors and purchaser can negotiate the manner in which the purchase price for the assets will be allocated among the debtor's creditors and, at the same time and under the right circumstances, negotiate a release for the debtor, the lender and the purchaser. If the plan is confirmed, the plan becomes a binding contract that can bar an action for successor liability by an unsecured creditor of the predecessor.¹⁹

The benefits of a confirmation order are demonstrated in Mickowski v. Visi-Trak Worldwide LLC.²⁰ Mickowski is a case with complicated facts, but, in short, a judgment debtor in a large patent lawsuit filed for bankruptcy.²¹ The debtor confirmed a plan that provided for a sale to the judgment creditor of the stock of the reorganized debtor.²² The confirmation order effected a discharge of the debtor's debts, including the claim owing the judgment creditor.²³ However, the plan had specific predicates to effectiveness that, if not met, enabled the judgment creditor to move to vacate the plan.²⁴ The conditions of effectiveness were indeed not met, and after a motion and a hearing, the bankruptcy court vacated the plan but not the confirmation order.²⁵ After vacating the plan, the bankruptcy court approved a sale of the debtor's assets to former management of the debtors pursuant to §363. The judgment creditor then sought to impose successor liability on the purchaser of the debtor's assets on a mere continuation theory.²⁶

The Sixth Circuit made two alternative holdings: (1) because the confirmation order was never vacated, the discharge granted therein resulted in a discharge of the debtor's obligation owing to the judgment creditor, for whom a recourse was no longer available,²⁷ and (2) successor liability was inappropriate because the identity of the debtor's ownership changed when the purchaser acquired the assets.²⁸

Regardless of the method used to sell distressed assets to insiders, the parties to such sales should be prepared to do as much as possible to protect them against subsequent challenge. Even though it may take more time and money to take these additional steps, the alternative could be even more costly. Insider sale transactions, if performed in an informed and deliberate manner, may be the best alternative available to maximize the value of the assets of the corporation.

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Footnotes

¹ Brian I. Swett and Peter A. Siddiqui are attorneys in Jenner & Block's Chicago office and are members of the firm's Bankruptcy, Workout and Corporate Reorganization Practice. Mr. Swett, a partner at the firm, has represented senior secured lenders, other secured creditors, public and private companies (including debtors in possession), unsecured creditors, sellers, purchasers, shareholders and investors in all aspects of in-court and out-of-court workout, restructuring and reorganization matters. Mr. Siddiqui, an associate, has represented clients in bankruptcy cases and corporate reorganizations, including debtors in possession, secured creditors and trustees. Return to article

² The Code provides a broad definition of an "insider" of a corporation. See 11 U.S.C. §101(31)(B), (E), (F). Notwithstanding the applicability of this article to all insiders under the Code, the primary focus here is directed toward officers, directors and controlling shareholders of a corporation. Return to article

³ Courts often look to Delaware law if the state law applicable to any transaction has not been fully developed. See, e.g., Dynamics Corp. of Am. v. CTS Corp., 805 F.2d 705, 708 (7th Cir. 1986). Return to article

⁴ In re Walt Disney Co., No. Civ. A. 15452, 2004 WL 2050138, at *7 (Del. Ch. Sept. 10, 2004); see also Cede & Co. v. Technicolor Inc., 634 A.2d 345, 366 n.34 (Del. 1993). Return to article

⁵ If the corporation does have disinterested directors, the corporation can form a special committee of such disinterested directors to review the insider transactions. Return to article

⁶ Cede & Co., 634 A.2d at 361. Return to article

⁷ Id. Return to article

⁸ Id. Return to article

⁹ 11 U.S.C. §363. Disclosure by the debtor and the insider as to all elements of their transaction (i.e., process and price) is necessary to secure these findings. Return to article

¹⁰ Id. at 363(m). Return to article

¹¹ In re Lotspeich, 328 B.R. 209, 218 (BAP 10th Cir. 2005); see also In re Filtercorp., 163 F.3d 570, 577 (9th Cir. 1998) (applying same standard to insider sale transaction). Return to article

¹² See UCC §9-610(a)-(b). Return to article

¹³ Id. Return to article

¹⁴ See UCC §§9-611 - 9-614. Return to article

¹⁵ 873 A.2d 1286 (Pa. May 17, 2005). Return to article

¹⁶ Id. at 1294. Return to article

¹⁷ Id. at 1290. Return to article

¹⁸ Id. at 1290 n.5. Return to article

¹⁹ Mickowski v. Visi-Trak Worldwide LLC, 415 F.3d 501 (6th Cir. 2005). In Mickowski, the court held that a confirmation order granting a discharge in favor of the debtor precluded the imposition of successor liability notwithstanding the fact that the former management of the debtor owned the equity of the reorganized debtor. Id. at 509. Return to article

²⁰ 415 F.3d 501 (6th Cir. 2005). Return to article

²¹ Id. at 504. Return to article

²² Id. at 505. Return to article

²³ Id. Return to article

²⁴ Id. Return to article

²⁵ Id. at 506. Return to article

²⁶ Id. Return to article

²⁷ Id. at 509. Return to article

²⁸ Id. at 515. Return to article