An out-of-court workout technique sometimes employed by a distressed business and its secured lender is the so-called "friendly foreclosure." By this procedure, the debtor and its secured lender arrange for a voluntary repossession of the debtor's assets by the secured lender and a pre-determined and substantially contemporaneous resale of the assets to a newly formed corporation, all under the auspices of Article 9 of the Uniform Commercial Code (UCC).
Although there are variations, two common features of the friendly foreclosure are: (1) the old owners or officers of the repossessed debtor often hold equity interests, either directly or indirectly, in the newly-formed corporation and (2) the assets of the debtor are purchased by the newly formed corporation with a loan from the repossessing lender approximating the amount of its loan balance with the debtor and secured by the purchased assets. The net effect of the transaction is essentially to leave the lender's position undisturbed, while the unsecured creditors of the distressed debtor are left behind and its old owners acquire interests in a new corporation that has no unsecured debt.
Can this be actionable, you might ask? While the answer might depend on which jurisdiction you are in, it certainly can be said that the friendly foreclosure carries some significant legal risks wherever it may take place.
Indeed, courts are becoming increasingly sympathetic to the plight of an unsecured creditor who is frozen out by this somewhat common work-out alternative. Specifically, a collection of relatively recent decisions holds that a friendly foreclosure, even though it complies with the strictures of Article 9 of the UCC, does not protect against a cause of action by an unsecured creditor of the debtor against the purchaser of the debtor's assets based on successor liability.[1] And there are cases where a transaction of this type has been successfully attacked as a fraudulent conveyance when it is shown that the purchase price for the assets did not constitute fair value,[2] although the Uniform Fraudulent Transfer Act would appear to insulate such a claim when it is based on constructive, as opposed to actual, fraud.[3]
While most courts hold that an Article 9 foreclosure will not, as a matter of law, preclude a successor liability claim, the claim must still be proven. In that regard, the general rule is that:
when a corporation purchases all or most of the assets of another corporation, the purchasing corporation does not assume the debts and liabilities of the selling corporation...except if (1) the purchasing corporation expressly or impliedly agrees to assume those liabilities; (2) the transaction amounts to a consolidation or merger of the corporations; (3) the purchasing corporation is a continuation of the selling corporation or (4) the corporations enter the transaction to escape liability.[4]
Thus, a claim for successor liability against a purchaser of a company's assets must be sustained under either of these four well-established exceptions.
Most courts analyzing whether a claim of successor liability can be sustained against a purchaser at an Article 9 foreclosure sale focus on the "mere continuity" or "de facto merger" exceptions.[5] The factors considered by the courts in analyzing each of these exceptions often overlap or at least have similar themes. They include: "identity of the officers, directors or shareholders, and the existence of a single corporation following the transfer,"[6] which probably means that the selling corporation must either be dissolved or rendered an empty shell, "continuity of management, personnel, physical location, assets, and general business operations ...[,] assumption by the successor of liabilities ordinarily necessary for the uninterrupted continuation of the business of the predecessor...and...continuity of ownership/shareholders."[7] Although the issue is open to question, it would appear that to satisfy both exceptions, the selling and purchasing corporation must have the same or common shareholders or directors,[8] so that simply employing one of the seller's principals would not be sufficient to establish successor liability.[9]
For those considering a friendly foreclosure who might wish to avoid the vagaries of successor liability law, the Bankruptcy Code may provide a more tolerable solution. Recent authority holds that a sale of assets under §363 of the Code can be made free and clear of successor liability claims, provided the underlying claim against the debtor is "connected to, or arise[s] from, the property being sold."[10] Since it would appear that most, if not all, unsecured claims incurred by a business would be "connected to, or arise from" the assets of the business, in the sense that they contribute to the business assets or arise from their use or application, it follows that, under this test, a §363 sale can have the effect of precluding most successor liability claims.
Although a §363 sale to an insider or company where the insider holds an equity stake is not per se prohibited,[11] it will be subject to heightened scrutiny.[12] In those instances where bankruptcy sales to insiders have been approved, they were fully and fairly disclosed,[13] the assets sold were extensively marketed with no higher bidders appearing[14] or--the insider is part of the purchasing entity--the negotiations over the sale were extensive, genuine and in good faith.[15]
Conclusion
Given the legal landscape concerning successor liability, a distressed business contemplating an Article 9 friendly foreclosure sale, particularly to a group including insiders, should give serious consideration to the alternative of a §363 bankruptcy sale. Although it opens the playing field to other prospective purchasers, the §363 sale can have the effect of "cleansing" the transaction and cutting off potential successor liability claims.
1 Ed Peters Jewelry Co. Inc. v. C&J Jewelry Co. Inc., 124 F.3d 252, 267 (1st Cir. 1997) ("existing case law overwhelmingly confirms that an intervening foreclosure sale affords an acquiring corporation no automatic exemption from successor liability."); EEOC v. SWP Inc., 153 F. Supp. 2d 911, 924 (N.D. Ind. 2001) ("[t]he mere fact that the transfer of assets involved foreclosure on a security interest will not insulate a successor corporation from liability where other facts point to continuation."); Glynwed Inc. v. Plastimatic Inc., 869 F. Supp. 265, 275 (D.N.J. 1994) (purchase of assets at a secured party sale does not preclude a finding of successor liability); Continental Insurance Co. v. Schneider Inc., 810 A.2d 127, 133 (Pa. Super. Ct. 2002) ("we hold that a sale pursuant to §9-504 of the UCC does not, as a matter of law, preclude a creditor's claim against the purchaser based upon successor liability,") appeal granted, 573 Pa. 690, 825 A.2d 639 (June 5, 2003).
2 See e.g., Voest-Alpine Trading USA Corp. v. Vantage Steel Corp., 919 F.2d 206 (3d Cir. 1990).
3 UNIF. FRAUDULENT TRANSFER ACT §§ 8(e)(2), 4(a)(2), 5 (1984).
4 Schnoll v. Acands Inc., 703 F. Supp. 868, 872 (D. Or. 1988). See also Cargo Partner AG v. Albatrans Inc., 207 F. Supp. 3d 86, 94 (S.D.N.Y. 2002); Ricciardello v. JW Grant & Co., 717 F. Supp. 56, 57 (D. Conn. 1989); Cargill Inc. v. Beaver Coal & Oil Inc., 424 Mass. 356, 676 N.E. 2d 815 (1997). Courts have recognized that the law on successor liability is essentially uniform throughout the country. See Glynwed Inc. v. Plastimatic Inc., 869 F. Supp. 265, 270 (D. N.J. 1994) (citing Luxliner P.L. Export v. RDI Luxliner, 13 F.3d 69, 74 n.5 (3d Cir. 1993)).
5 Ed Peters Jewelry Co. Inc. v. C&J Jewelry Co. Inc., 124 F.3d 252, 268 (1st Cir. 1997); Glynwed Inc. v. Plastimatic Inc., 869 F. Supp. 265, 275-76 (D. N.J. 1994); Continental Insurance Company v. Schneider, Inc., 810 A.2d 127, 134-35 (Pa. Super. Ct. 2002), appeal granted, 573 Pa. 690, 825 A.2d 639 (June 5, 2003).
6 Continental Insurance Co. v. Schneider Inc., 810 A.2d 127, 134-35 (Pa. Super. Ct. 2002), appeal granted, 573 Pa. 690, 825 A.2d 639 (June 5, 2003) (court described these factors as "the primary elements of the continuation exception.")
7 Glynwed Inc. v. Plastimatic Inc., 869 F. Supp. 265, 275-76 (D. N.J. 1994) (court described these factors as those that most courts consider for the continuation exception). Compare Continental Insurance Co., 810 A.2d at 135 (court described same factors attributed by Glynwed to the continuation exception as factors courts consider for the "de facto merger" exception).
8 Cargo Partner AG v. Albatrans, Inc., 207 F. Supp. 2d 86, 96-114 (S.D.N.Y. 2002) (containing an extensive analysis of this issue under New York law).
9 Id. at 113 (stating that "a purchaser's employment of one or more of the seller's officers is not sufficient to show continuity of ownership.")
10 In re Trans World Airlines Inc., 322 F.3d 283, 289 (3d Cir. 2003). See also In re Medical Software Solutions, 286 B.R. 431, 447 (Bankr. D. Utah 2002) (assets may be sold free and clear of successor liability claims under §363(f)). But see Kuney, George W., "Misinterpreting Bankruptcy Code §363(f) and Undermining the Chapter 11 Process," 76 Am. Bankr. L.J. 235, 262 (2002) (arguing that successor liability claims should not be eliminated on a §363 sale).
11 In re Andy Frain Services Inc., 798 F.2d 1113, 1125 (7th Cir. 1986); In re Wilde Horse Enterprises Inc., 136 B.R. 830, 842 (Bankr. C.D. Cal. 1991).
12 In re Bidermann Industries U.S.A. Inc., 203 B.R. 547, 551 (Bankr. S.D.N.Y. 1997).
13 Polvayr. B.O. Acquisitions, Inc. (In re Betty Owens Schools Inc.), No. 96 Civ. 3576 (PKL), 1997 WL 188127 at *1 (S.D.N.Y. April 17, 1997).
14 In re Medical Software Solutions, 286 B.R. 431, 445 (Bankr. D. Utah 2002).
15 In re Apex Oil Co., 92 B.R. 847, 870-71 (Bankr. E.D. Mo. 1988).