COVID-19, without a doubt, has imposed incredible financial difficulties upon many businesses in the United States. Certain industries such as retail, hospitality, leisure, and foodservice have been most directly impacted, but the damage has extended, indirectly, into manufacturing, business services, and other sectors, as well. At this point, it seems that no part of the economy will be left untouched. In the face of such difficulties, liquidity-strapped companies may look to sell certain non-core assets or portions of their business (e.g., divisions or product lines) in order to raise capital to fund their remaining operations. In addition, companies that are staring down an imminent bankruptcy filing may also choose to sell assets in an attempt to maximize proceeds for the bankruptcy estate.
This could present attractive buying opportunities for companies and investors that remain well-capitalized during the downturn. However, the purchase of distressed assets presents unique issues under the federal bankruptcy code that buyers should keep in mind when conducting their due diligence on such assets.
If a distressed business sells assets and then ultimately declares bankruptcy following the sale, the bankruptcy trustee may examine certain transactions that occurred leading up to the bankruptcy filing under Section 548 of the U.S. Bankruptcy Code. If those transactions are found to be fraudulent, the court may avoid the transactions and attempt to bring the assets back into the bankruptcy estate or otherwise make the bankruptcy estate whole.
There are two types of fraudulent transfers or fraudulent conveyances that a trustee may seek to recover in a bankruptcy proceeding – those where there was actual fraud on the part of the debtor, and those where the bankruptcy court determines that the transfers were constructively fraudulent. Actual fraud involves the actual intent to defraud creditors. Constructive fraud, on the other hand, is defined under Section 548(a)(1)(B) of the Bankruptcy Code as a transfer of assets that was made in exchange for less than reasonably equivalent value and one in which the debtor was insolvent at the time of transfer or was rendered insolvent as a result of the transfer. In assessing whether a transfer was constructively fraudulent, intent is irrelevant. Rather, assuming the courts have determined that the debtor was in fact insolvent at the time of the transfer or was rendered insolvent as a result of the transfer – and, given that the debtor has declared bankruptcy, this should not be a difficult hurdle to clear absent an extraordinary change in circumstances between the transfer date and the bankruptcy filing – the court will then turn its attention to whether the transfer was made for less than reasonably equivalent value at the time it occurred.
If the court determines that reasonably equivalent value was received in exchange for assets that were transferred pre-bankruptcy, it will ostensibly find that there was no constructive fraud (after all, the bankruptcy estate, and therefore its creditors, have presumably not been harmed if the value received by the company in the transaction was reasonably equivalent to the value given up by the company). If the opposite is true, however, then a finding of constructive fraud is possible. This then begs the question – how exactly does one measure reasonably equivalent value?
Unfortunately, there is no easy answer to this question. The U.S. Bankruptcy Code does not define reasonably equivalent value. Rather, Congress left it up to the courts to determine its meaning. In making this assessment, the courts have generally considered “reasonably equivalent value” and “fair consideration” to have effectively the same meaning and have often adopted fair market value as a starting point in its analysis, where fair market value is defined as the price paid in an arm's length transaction between a willing buyer and a willing seller. The parties to the bankruptcy litigation may look to independent valuation experts to help them put forth their arguments regarding the fair market value of the assets or business that were transferred. These valuation experts, in turn, will likely utilize commonly accepted valuation methodologies in valuing the assets. These methodologies may include the Income Approach, the Market Approach, and the Asset Approach.
The Income Approach measures value by projecting the future economic benefits (e.g., earnings or cash flow) that the owner of the assets may expect to receive by virtue of their ownership, and discounting those benefits back to a present-day value at a rate of return that is commensurate with the assets’ risk. If applying the Market Approach, the valuation expert would review the prices paid for similar assets or businesses, either in the public markets or in M&A transactions for comparable companies. Lastly, the Asset Approach looks to the cost to replicate or replace the assets individually, rather than the future economic benefits that may be derived from operating the assets together. At their discretion, the valuation expert may apply all of these methodologies in estimating value or select only those that it deems to be applicable given the facts and circumstances surrounding the business or assets that were transferred.
Importantly, since the overriding purpose of Section 548 of the U.S. Bankruptcy Code is the preservation of value for unsecured creditors, the courts have made it clear that the fair market value of the assets or business transferred should be analyzed from the creditor’s point of view. Moreover, value should be measured as of the date of the transfer, not after, and should exclude any subsequent depreciation or appreciation of value. Therefore, any buyer-specific synergies that may have impacted the buyer’s perception of value at the time of the transfer or that may have affected value since the transfer (such as the buyer’s ability to reduce corporate overhead costs as part of a larger organization, or increase revenues by selling products through a more robust distribution network) should not be part of the fair market value analysis. Similarly, any intangible assets (e.g., patents or know-how) that only have value in the hands of the debtor should not be considered, either.
Ultimately, the court is interested in whether the fair market value of the assets transferred is roughly equal to the purchase price or consideration that was received by the debtor in return. The comparison of values need not be strictly equivalent, however. Rather, any large or significant disparity between the fair market value of what the debtor gave up and what the debtor received in return may preclude a finding of reasonable equivalence.
The finding of a constructively fraudulent conveyance by the bankruptcy court could result in a number of unwelcome consequences for the buyer of the assets or business in question. Theoretically, the court could order the transaction in question to be unwound, and the buyer could be forced to return the assets to the bankruptcy estate in exchange for the price it paid for those assets. Practically, however, this may be difficult to do if the buyer has already begun to integrate the acquired business into its own operations. Alternatively, the buyer can be forced to pay the difference between the price it paid and the court’s determination of the fair market value of the assets. Ultimately, the court’s objective is to place the debtor back into the same position that it was in, financially speaking, before the transfer in question was made. In either case, however, it is an outcome that the buyer of the assets would, presumably, very much prefer to avoid.
A fair market value opinion from a qualified appraiser will assist the buyer of distressed assets in supporting an argument of reasonable equivalence if a transaction is ultimately contested on these grounds. It should be noted that this may not, in and of itself, provide complete evidence of reasonably equivalent value under the bankruptcy code. There is no fixed mathematical formula or bright line rule used to determine reasonable equivalence. Rather, the courts will determine on a case-by-case basis whether the value received in exchange for the transfer of property by the debtor is reasonably equivalent. In doing so, they will review the totality of the circumstances and may consider not only the tangible economic benefits that the debtor received in the exchange, but also factors such as whether the transaction was conducted at arm's length, whether the parties demonstrated good faith, and other intangible or indirect benefits that are not always easily measured (such as the debtor’s enhanced ability to borrow following the transfer or the impact on the debtor’s ability to retain an important source of supply or an important customer). Thus, reasonable equivalence may not be entirely synonymous with fair market value. However, there seems to be no doubt that an educated assessment of fair market value is an important starting point for the court’s review and is a critical factor in its ultimate determination of reasonable equivalence.