Note: This article was originally published on 6/5/2020 and was last updated on 10/15/2020.

Ordinarily, when commercial landlords are confronted with a tenant’s nonpayment of rent, the landlord’s recourse is the (relatively) swift and effective remedy of unlawful detainer (i.e., an eviction proceeding). The COVID-19 crisis has disrupted the traditional calculus. In response to the financial impacts of COVID-19, governmental bodies in California have implemented multiple layers of legal barriers to the initiation and prosecution of unlawful detainer proceedings. The net effect of these barriers is to completely block for the time being the landlord’s ability to prosecute an unlawful detainer action and thus recover possession of leased premises following a tenant’s monetary default. In this article, we briefly summarize the current COVID-19 related impediments to commercial evictions in California.

First, on April 6, 2020, early on in the COVID-19 crisis, the Judicial Council of California adopted Emergency Rule 1 which, among other things, prohibited California trial courts from issuing summons on complaints for unlawful detainer.  On August 13, 2020, the Judicial Council voted to sunset Emergency Rule 1 (along with Emergency Rule No. 2, freezing judicial foreclosures) at midnight on September 1, 2020, “to provide the Governor and Legislature more time to develop policy proposals and solutions to deal with the potential impacts of evictions and foreclosures during the COVID-19 pandemic.”  On the last day of the legislative session, the Legislature passed Assembly Bill 3088, known as the “Tenant, Homeowner, and Small Landlord Relief and Stabilization Act of 2020” to protect residential tenants, but this bill does not address commercial tenancies. Therefore, as of September 2, 2020, for commercial tenancies only, California trial courts are once again authorized to issue summons on all unlawful detainer actions, enter defaults and issue writs of execution when appropriate, and set trial dates on request, subject to Code of Civil Procedure section 1170.5.  The ability of the courts to process an anticipated tsunami of unlawful detainer filings in accordance with the statutory deadlines is a matter of some doubt.  Further (and as discussed below), in many cities and counties, emergency tenant protection ordinances that are still in force may limit or bar entirely commercial eviction proceedings based on pandemic-related nonpayment of rent.

Second, many California cities and counties have adopted moratoria on evictions within their borders.[1] While the terms vary from jurisdiction to jurisdiction, and some moratoria apply only to residential tenancies, many also place restrictions on commercial evictions, with such protections often limited to “small businesses” and nonprofits. Jurisdictions which have enacted such moratoria include the cities of San Francisco, Oakland, Los Angeles, and San Diego, as well as Alameda, Santa Clara, and Los Angeles counties. The terms of the various ordinances vary substantially, and determining landlord and tenant rights will require careful review of both city and county ordinances, if applicable.

Third, many California state courts (which are administered at the county level) have adopted local rules staying all unlawful detainer matters, including those involving commercial tenancies. For example, the Alameda County Superior Court issued a blanket stay on evictions on March 16, 2020, and has subsequently extended the stay multiple times, most recently on August 14, 2020. Per the Court’s press release and amended local rules, the Court’s stay on execution of writs of possession has been extended to December 31, 2020, and no new unlawful detainer complaints will be accepted for filing, unless necessary to protect public health and safety, or subject to an exception stated in a local ordinance. Similar stays or restrictions on unlawful detainer actions have been put in place by several local courts, including San Mateo County Superior Court (limited through October 2, 2020) and Santa Clara County Superior Court (end date uncertain, at least through September 30, 2020). However, some courts, such as Contra Costa County Superior Court, began accepting new commercial unlawful detainer filings as of September 2, 2020.

Finally, California Code of Civil Procedure section 715.020 permits only a “levying officer” (typically the county sheriff) to evict a tenant through service of a writ of possession. Many California sheriff’s departments have adopted formal or informal policies declaring that they will not serve writs of possession during the COVID-19 emergency. Examples include the San Francisco Sheriff’s Department, San Mateo County Sheriff’s Office, and Alameda County Sheriff’s Office. Thus, even if the commercial landlord is able to prosecute an unlawful detainer and obtain a judgment for possession, as a practical matter it may at present prove impossible to have the tenant physically removed from the leased premises.

The current restrictions on evictions in California have, for the time being, significantly altered landlord and tenant rights relative to the payment of rent. However, in some jurisdictions, we are beginning to see a return to normal with respect to commercial unlawful detainer actions. Nonetheless, depending on the terms of a given lease, applicable city or county ordinances, and the particular tenant’s circumstances, there may be steps that landlords and tenants can take to enhance their legal position going forward. Our Commercial Lease Dispute & Resolution attorneys are available to help guide commercial landlords and tenants alike through these challenging times.

[1] The authority for local governments to limit commercial and residential evictions was recently extended through September 30, 2020 by the Governor’s Executive Order N-71-20.

Neiman Marcus, Gold’s Gym, JC Penney and Hertz – the list goes on of large American companies that have declared bankruptcy during 2020. If you are a landlord with a commercial tenant that files for bankruptcy protection, what happens next? This article provides a brief overview of the assumption/rejection process for a commercial tenant after the tenant files a voluntary petition under Chapter 11 of the Bankruptcy Code and the landlord’s rights and remedies based on the tenant’s decision to assume or reject. This article solely focuses on the procedures following a Chapter 11 (Reorganization) filing and not a Chapter 7 (Liquidation) bankruptcy.

Assumption or Rejection of Commercial Lease by the Tenant

In a Chapter 11 bankruptcy case, all unexpired leases become property of the bankruptcy estate and the debtor may assume or reject them as part of its reorganization efforts. 11 U.S.C. §541(a)(1), 11 U.S.C. §365(a). If the tenant debtor assumes a lease, the lease will remain in effect. If the debtor rejects a lease, the rejection constitutes a breach immediately before the date of the filing of the bankruptcy petition (unless the lease was previously assumed) and the breach entitles the landlord to a claim for damages. 11 U.S.C. §365(g).

The deadline to assume or reject a lease of nonresidential real property is the earlier of (i) 120 days after the date of the filing of the bankruptcy petition or (ii) entry of the plan confirmation order. 11 U.S.C. §365(d)(4). The debtor, by motion, may request a 90 day extension of this period “for cause.” Any further extensions require the written consent of the lessor. If the debtor does not timely assume or reject the lease, it is deemed rejected. 11 U.S.C. §365(d)(4).

Until the nonresidential real property lease is assumed or rejected, the tenant debtor is required to perform all the obligations under the lease. 11 U.S.C. §365(d)(3). The court may “for cause” extend the time for performance arising within the first 60 days of the case, but the time for performance may not extend beyond the 60-day period.  Prior to assumption or rejection, if the tenant remains in possession of the nonresidential real property and does not pay rent, the landlord can: (i) file a motion to compel immediate assumption or rejection; (ii) file a motion to compel payment of rent; or (iii) move to dismiss the Chapter 11 bankruptcy case, appoint a Chapter 11 trustee, and/or seek to convert the case into a Chapter 7 (Liquidation) case.

Rent Incurred Post-Petition Prior to Assumption or Rejection

As discussed above, if a bankrupt tenant remains in possession of the nonresidential real property, it is required to perform all the obligations under the lease until the lease is assumed or rejected. Until a lease is assumed or rejected (or premises are surrendered), a landlord is entitled to an administrative claim for all amounts arising under the nonresidential real property lease. 11 U.S.C. §365(d)(3). Administrative claims are paid before general unsecured claims.

If the Tenant Assumes a Lease

The assumption of a lease is subject to court approval. 11 U.S.C. §365(a). If there has been a default, at the time of assumption the tenant must “promptly” cure all existing defaults. 11 U.S.C. §365(b)(1). This generally means all monetary defaults must be cured and certain non-monetary defaults will also need to be cured by the debtor (to the extent they are curable). 11 U.S.C. §365(b)(1)(A). Tenant must also compensate the landlord for “any actual pecuniary loss” resulting from the default, and provide “adequate assurance of future performance.” 11 U.S.C. §§365(b)(B)-(C). The lease will continue in full force and effect if (and only if) the tenant assumes the lease, and any claims for subsequent defaults by the tenant will be entitled to administrative priority (i.e., paid before general unsecured claims) and will not be subject to the statutory cap on damages discussed below.

If the Tenant Rejects a Lease

If the debtor tenant rejects a non-residential real property lease (or the lease is deemed rejected), the tenant must “immediately surrender” the property to the lessor. 11 U.S.C. §365(d)(4). The rejection is deemed a breach of the lease immediately before the date of the filing of the petition (unless the lease was previously assumed). 11 U.S.C. §365(g)(1). Once the lease is rejected, the debtor has no ability to reinstate the lease and the landlord is entitled to a claim for damages arising from the rejection of the nonresidential real property lease. The resulting claim is a general unsecured claim with the same priority as the other general unsecured claims (behind priority claims).

The landlord’s rejection damages claim includes two types of damages. First, it includes all unpaid rent due on the earlier of (i) the Petition Date or (ii) the date the nonresidential real property was repossessed or surrendered by the lessee. 11 U.S.C. §502(b)(6)(A). This type includes all rent due for periods before the bankruptcy filing.

Second, the landlord’s rejection damages claim includes all “rent reserved” (future rent) that would be due under the lease. 11 U.S.C. §502(b)(6)(A). The Bankruptcy Code caps the “rent reserved” claim to the greater of (i) one year’s rent or (ii) 15% of the rent due for the balance of lease, not to exceed 3 years. 11 U.S.C. §502(b)(6). Like the first type of rejection damages, the “rent reserved” is measured from the earlier of the (i) petition date or (ii) the date the landlord repossessed, or lessee surrendered, the nonresidential real property. 11 U.S.C. §502(b)(6)(A). Parties sometimes litigate what is included in “rent reserved” (e.g., operating expenses, other additional rent, etc.).

Advanced Issues: Letter of Credit and Security Deposits

If the landlord holds a security deposit or letter of credit, it may apply either to all of its claims – although the security deposit or letter of credit should first be applied against the amounts of landlord’s capped general unsecured claim (and not administrative claim unless the bankruptcy estate is insolvent). Both a security deposit and a letter of credit are subject to the capped general unsecured claim. A landlord should not apply a security deposit without court authority. Although a letter of credit can generally be drawn on without court authority, if it requires notice to the debtor the notice can be construed as a violation of the automatic stay.

Process if Tenant Fails to Vacate

If a debtor tenant does not surrender the nonresidential real property after rejecting the lease the landlord will need to seek relief from the bankruptcy court. After a valid rejection, some courts will issue an enforceable order requiring tenant to surrender the premises. Other courts may require a motion for relief from the automatic stay and, after obtaining such relief, the landlord may commence and pursue an unlawful detainer action in state court to regain possession of the premises.

Dan Myers is a partner in the Real Estate Practice Group and Lisa Lenherr and Mark Bostick are partners in the Insolvency, Restructuring and Creditors’ Rights Practice Group at Wendel Rosen LLP in Oakland, California.  They can be reached by phone at (510) 834-6600 and by email at dmyers@wendel.com, llenherr@wendel.com and mbostick@wendel.com.

Note: This article was originally published on 6/5/2020 and was last updated on 6/26/2020.

Update: On June 18, 2020, the Senate Appropriations Committee did not remove SB 939 from the Suspense File, effectively killing the bill for this Legislative Session.

Update: At the June 11, 2020 hearing, the Appropriations Committee, per a 7-0 vote, placed SB 939 on its Suspense File.

Senate Bill 939’s Potential Impact on Commercial Leases

As many in the Commercial Leasing field in California have most likely read or heard, on May 29, 2020 Senate Bill 939, titled “COVID-19: Commercial Tenancies: Evictions,” which was introduced by Democratic State Senators Scott Wiener and Lena Gonzalez, was approved by the California Senate Judiciary Committee 5-1, with 3 NVRs (“no votes recorded.”). Those approving the Bill were Democratic Senators Hannah-Beth Jackson (District 19), Lena A. Gonzalez (Dist. 33), Maria Elena Durazo (Dist. 24), Bill Monning (Dist. 17), and Bob Wieckowski (Dist. 10); the lone no vote was Republican Brian W. Jones (Dist. 38).  Those not recording a vote were Republican Andreas Borgeas (Dist. 8) and Democrats Henry I. Stern (Dist. 27) and Thomas Umbeg (Dist. 34). The Bill is now scheduled for a fiscal review hearing with the Senate Appropriation Committee on June 9, 2020.

The Bill proposes to add sections 1951.9 and 1951.10 to the Civil Code, relating to commercial tenant evictions.

Specifically, SB 939 places a temporary moratorium on all evictions/unlawful detainer actions against any qualifying commercial tenants, defined as Eligible COVID-19 Impacted Commercial Tenants,[1] until 90 days after the COVID-19 State of Emergency issued by Governor Newsom on March 4, 2020 (“State of Emergency”) is lifted or repealed. (Proposed, Civ. Code § 1951.9(a) and (b).)  It also allows all Eligible COVID-19 Impacted Commercial Tenants one (1) penalty free year of rent deferment for any accrued rents during the State of Emergency from the date the State of Emergency ends. (Id. at §§ 1951.9(i) and (j).)

It also provides that small (not publicly traded, under 500 employees, “not dominant in its field of operation,” and with its principal office in and officers domiciled in California) restaurants, bars, places of entertainment, and performance venues, which meet certain additional requirements,[2] can unilaterally demand “good faith” re-negotiations of existing leases and, if a re-negotiated agreement cannot be reached within 30 days, these qualifying tenants can terminate their existing leases with capped recoverable damages (a maximum of  three (3) months of rent accrued during the State of Emergency plus any additional rents incurred and unpaid outside of the State of Emergency).  (Proposed, Civ. Code §§ 1951.10(a)-(d).)  Additionally, these specified tenants would have one (1) year from the termination of the lease to pay the penalty-free recoverable damages, and any third-party guaranties associated with the lease would be unenforceable. (Id. at § 1951.10(d).)  This section, however, would only be operative until December 31, 2021, or two (2) months after the State of Emergency ends, whichever is earlier. (Id. at § 1951.10 (h).)

SB 939 also creates civil remedies for all commercial tenants, whether they are Eligible COVID-19 Impacted Commercial Tenants or not, for conduct of a commercial landlord deemed to be willfully harassing, intimidating, threatening, or retaliatory against a commercial tenant with the intent to terminate the tenant’s commercial occupancy. The remedies available to the commercial tenant include: the tenant’s actual damages, up to $2,000, with a minimum of $250, for each violation; the prevailing tenant’s attorney’s fees; and other remedies provided by Business and Professions Code section 17000, as well as any other State law. (Id. at §§ 1951.9(n), (o), (p) and (q).)

Both of these sections would go into effect immediately upon being signed into law by the Governor.

SB 939 still has many roadblocks to clear before becoming law. First, at its June 9, 2020 hearing, the Senate Appropriation Committee could amend the bill or send it to another committee for further review. From there, it will have to pass, via a super majority (2/3 vote), in both the Senate and Assembly, and, assuming it is approved by both houses, it would then proceed to Governor Newsom’s desk, where he may or may not sign it into law. Numerous heavyweights in the real estate industry have lined up in opposition to the Bill, including: Building Owners and Managers Assoc. of California (BOMA); California Assoc. of Realtors (C.A.R.), California Retailers Assoc. (CRA), California Business Properties Assoc. (CBPA), California Chambers of Commerce, International Council of Shopping Centers (ICSC), etc., arguing that this bill would “push many [commercial landlords] into foreclosure” and that it unconstitutionally “undermines all real estate contracts in the state.” (Senate Judiciary Committee Bill Analysis, Comment 6.)

Specific Bill Provisions for Reference

Section 1: Civil Code, §1951.9

(a)…

           (5) “Eligible COVID-19 impacted commercial tenant” means a commercial tenant that operates primarily in California, that occupies commercial real property pursuant to a lease, and that meets one of the following criteria:

                      (A) It is a commercial tenant that has experienced a decline of 20 percent or more in average monthly revenue over the two most recent calendar months…

                      (B) It is a commercial tenant that was prevented from opening or required to delay opening its business because of the state of emergency.

                      (C) It is a commercial tenant that has suffered a decline of 15 percent or more in capacity due to compliance with an official public health order or occupational health and safety guideline for preventing the spread of the coronavirus COVID-19.

(b) Until 90 days after the state of emergency is lifted, it shall be unlawful for a commercial landlord to serve a commercial tenant with a notice pursuant to paragraph (2) of Section 1161 of the Code of Civil Procedure if both of the following apply:

            (1) The notice requires payment of rent that accrued during the state of emergency.

            (2) The commercial tenant has served written notice on the premises’ landlord affirming, under the penalty of perjury, that the commercial tenant is an eligible COVID-19 impacted commercial tenant as defined by this section.

…

(i) The failure of an eligible COVID-19 impacted commercial tenant to pay rent that accrues during the state of emergency shall not be grounds for an unlawful detainer action. The unpaid balance of any rent that accrued on the commercial tenancy of an eligible COVID-19 impacted commercial tenant during the state of emergency shall be due at the end of the month containing the date 12 months after the end of the state of emergency, unless the tenant has reached an agreement with the person, business, or other entity to pay off the balance at a later time.

(j) Notwithstanding any lease provision to the contrary, late fees shall not be imposed for rent that accrued on the commercial tenancy of an eligible COVID-19 impacted commercial tenant during the state of emergency unless that rent remains unpaid after it becomes due pursuant to the terms of subdivision (i).

(k) Notwithstanding Section 1479, a landlord shall apply any rental payment made by an eligible COVID-19 impacted commercial tenant after the state of emergency is lifted toward the current month’s rent before applying any residuals to any unpaid balance corresponding to rent that came due during the period of the state of emergency.

(l) Written notice of protections afforded by this section shall be provided to tenants of commercial real property within 30 days of the effective date of this section. If the commercial landlord customarily communicates with the commercial tenant in a language other than English, the commercial landlord shall provide the written notice required by this section in that other language.

…

(n) In addition to the prohibitions contained in subdivisions (a) and (b) of Section 798.3, a commercial landlord shall not willfully harass, intimidate, threaten, or retaliate against a commercial tenant with the intent to terminate the occupancy. Any commercial landlord who violates this section shall be liable to the commercial tenant in a civil action for all of the following:

            (1) Actual damages of the tenant.

            (2) An amount not to exceed two thousand dollars ($2,000) for each incident constituting a violation. In determining the amount of the award, the court shall consider proof of those matters as justice may require; however, in no event shall less than two hundred fifty dollars ($250) be awarded for each separate cause of action. Subsequent or repeated violations, which are not committed contemporaneously with the initial violation, shall be treated as separate causes of action and shall be subject to a separate award of damages.

(o) In any action under subdivision (n), the court shall award reasonable attorney’s fees to a prevailing commercial tenant. In any action the commercial tenant may seek appropriate injunctive relief to prevent continuing or further violation of the provisions of this section during the pendency of the action.

(p) Willful violation of this section shall constitute an unlawful business practice and an act of unfair competition within the meaning of Section 17200 of the Business and Professions Code. The remedies and penalties provided by this section are cumulative to each other, the remedies under Chapter 5 (commencing with Section 17200) of Part 2 of Division 7 of the Business and Professions Code, and the remedies or penalties available under all other laws of this state.

Sec. 2: Civil Code, §1951.10

(a)…

            (2) “Eligible COVID-19 impacted commercial tenant” means a small business that operates primarily in California, that occupies commercial real property pursuant to lease, and that meets one of the following criteria:

                      (A) It is an eating or drinking establishment, a place of entertainment, or a performance venue that has experienced a decline of 40 percent or more of average monthly revenue over the two most recent calendar months…

                      (B) It is an eating or drinking establishment, a place of entertainment, or a performance venue that was prevented from opening or required to delay opening its business because of the state of emergency.

                      (C) It is an eating or drinking establishment, a place of entertainment, or a performance venue that has suffered a decline of 25 percent or more in capacity due to compliance with an official public health order or occupational health and safety guideline for preventing the spread of the coronavirus (COVID-19).

            (3) “Small business” means a business that is not dominant in its field of operation, the principal office of which is located in California, the officers of which are domiciled in California, and which has 500 or fewer employees..

(b) An eligible COVID-19 impacted commercial tenant who wishes to modify its commercial lease may engage in good faith negotiations with its landlord to modify any rent or economic requirement regardless of the term remaining on the lease.

(c) A commercial tenant that is an eligible COVID-19 impacted commercial tenant may serve written notice on the premises’ landlord affirming, under the penalty of perjury, that the commercial tenant is an eligible COVID-19 impacted commercial tenant as defined by this section and stating the lease modifications the commercial tenant desires to obtain.

(d) If the eligible COVID-19 impacted commercial tenant and the landlord do not reach a mutually satisfactory agreement within 30 days of the date the landlord received the negotiation notice, then within 10 days thereafter, the eligible COVID-19 impacted commercial tenant may terminate the lease by serving a notice of termination of the lease on the landlord. The tenant shall have 14 days from service of the notice to vacate the premises. Once the eligible COVID-19 impacted commercial tenant vacates the property, all of the following shall apply:

            (1) The lease shall terminate.

            (2) No further liability for any rent, fees, or costs shall accrue under the lease.

            (3) Any third-party guaranties associated with the lease shall terminate and shall no longer be enforceable.

            (4) In lieu of any other damages, the eligible COVID-19 impacted commercial tenant shall be obligated, within 12 months of vacating the commercial real property, to pay the landlord all of the following:

                        (A) Three months’ worth of the past due rent incurred during the state of emergency or a lesser sum as may be actually unpaid.

                        (B) All unpaid rent that accrued outside of the state of emergency.

….

(g) This section shall not apply to any publicly traded company or a company that is owned by, or is affiliated with, a publicly traded company.

(h) This section shall be inoperative on December 31, 2021, or two months after the declared state of emergency ends, whichever is later.

SEC. 4. This act is an urgency statute necessary for the immediate preservation of the public peace, health, or safety within the meaning of Article IV of the California Constitution and shall go into immediate effect. The facts constituting the necessity are: 

In order to mitigate the economic hardships to tenants of commercial real property, including businesses, nonprofit organizations, and eating or drinking establishments, resulting from the coronavirus (COVID-19), it is necessary that this act take effect immediately.

[1] Any commercial tenant that operates primarily in California and that: (1) experienced a 20% decline or more in average monthly revenue over the most 2 recent calendar months; (2) was prevented or delayed from opening its business because of the State of Emergency; or (3) incurred a 15% or more decline in capacity due to compliance with official public health or occupational health and safety guidelines associated with COVID-19.

[2] Any eating or drinking establishment, a place of entertainment, or a performance venue that: (1) has experienced 40% or more decline in average monthly revenue for the 2 most recent calendar months; (2) was prevented or delayed from opening its business because of the State of Emergency; or (3) incurred a 25% or more decline in capacity due to compliance with official public health order or occupational health and safety guidelines associated with COVID-19.

In Part 1 of this series of posts, we discussed how business owners must think beyond the near term and that certain Buyers may view this as an opportune time to acquire a company while certain Sellers may be thinking that the best path forward is to sell their companies.  In Part 2, we discussed some initial steps for Buyers and Sellers in preparing to buy or sell the struggling business.  In Part 3, we went over due diligence and structuring the transaction.  In Part 4, we outlined risks and risk mitigation.  In this final post of the series, we will discuss final considerations for both Buyer and Seller in a transaction involving a struggling business.

Transaction Point to Negotiate

There are many points to negotiate in crafting an agreement between a Buyer and a Seller.  With a struggling business, some of those points may be less negotiable.

Payment of Seller Debts and Obligations

Seller will presumably intend to enter into a transaction that provides enough cash to pay off all of its debts and obligations.  With a struggling business, Buyer will require that Seller’s debts and obligations be paid on or around closing in order to avoid some of the risks we discussed in our prior post.  Related to this point, Buyer also will seek to ensure that Seller does not file for bankruptcy after the closing, so as to avoid claims of fraudulent transfer.

Earn-Outs; Payments Over Time

A common way for a Buyer and Seller to come to an agreement on a purchase price is for Buyer to pay Seller via a post-closing earnout or in installment payments over time.  Continuing to operate the Seller’s business in the same manner post-closing in order for a Seller to achieve an earn-out could be risky to a Buyer with respect to successor liability claims.  In addition, a Seller will want payment up front to satisfy its debt and obligations.  Thus, earn-outs may be seen less frequently in sales of struggling businesses.

Indemnification Claims

Typically, Buyer will require in the purchase agreement that Seller indemnify the Buyer for claims arising post-closing that relate to the acquired assets and operation of Seller’s business pre-closing.  Indemnification means that Seller reimburses Buyer for Buyer’s costs and expenses in dealing with these claims. The problem is that if Seller has no money post-closing (because all the purchase price is used to pay existing debts and obligations), there won’t be funds available to indemnify Buyer.  Because of this, Buyer may conduct more lengthy and extensive due diligence pre-closing (to identify potential claims ahead of time) as well as require a large escrow or holdback of the purchase price at closing to ensure funds are available to cover indemnifiable claims.

Is This the Right Transaction for Buyer?

In contemplating the purchase of a struggling business, a Buyer will need to weigh the advantages of acting in a “buyer’s market” to acquire strategic assets versus the risks of a transaction with a struggling Seller.

Is This the Right Transaction for Seller?

The Seller of a struggling business will need to balance its current operating timeframe and cash flow needs with the timing to get a transaction completed.  The Seller will also need to negotiate the appropriate terms in order to ensure that its debts and obligations will be satisfied.  Finally, as we mentioned in Part 1 of this series, a Seller may want to ensure continued employment for all or some of its employees with the Buyer and Seller will need to advocate for that condition as part of the transaction.

While the current economy has severely affected many businesses, it may be an opportune time for Buyers to make strategic acquisitions at a reasonable purchase price.  For some businesses, a sale may be the best of limited alternatives.  In either case, Buyers and Seller of struggling businesses should consider some of the important issues that we have outlined in this series of posts.

Related Articles

Buying or Selling a Struggling Business (aka the “Distressed” Business) – Part 1

Buying or Selling a Struggling Business (aka the “Distressed” Business) – Part 2

Buying or Selling a Struggling Business (aka the “Distressed” Business) – Part 3

Buying or Selling a Struggling Business (aka the “Distressed” Business) – Part 4

In Part 1 of this series of posts, we discussed how business owners must think beyond the near term and that certain Buyers may view this as an opportune time to acquire a company while certain Sellers may be thinking that the best path forward is to sell their companies.  In Part 2, we discussed some initial steps for Buyers and Sellers in preparing to buy or sell the struggling business.  In Part 3, we went over due diligence and structuring the transaction.  In this post, we will discuss risks and risk mitigation.

Risks Relating to the Struggling Business

In our prior post, we mentioned that in a sale of assets by a Seller, the Buyer can affirmatively choose not to assume any debts or obligations of the Seller.  Sounds ideal for the Buyer of a struggling business, right? However, a Buyer may become liable for some of Seller’s debts or obligations even if the written agreement specifically states that Buyer does not assume those debts or obligations.

Successor Liability

Under State law, a Buyer may be deemed to be liable for the Seller’s debts or obligations under the concept of “successor liability” notwithstanding the terms of the written agreement.  In California, the determination of whether a Buyer is liable for the debts of Seller is fact specific: a court will look at whether Buyer “impliedly” assumed the obligations in the purchase agreement; whether the transaction constitutes a “de facto” merger; whether the business operated by Buyer is a “mere continuation” of Seller; or whether the transfer of assets to Buyer is fraudulent because the purpose is for Seller to avoid liability for its debts.  Buyer should consult with its experienced M&A legal counsel to understand if any of the above risks are present in a proposed transaction.

Fraudulent Transfer

In California a fraudulent transfer is called a voidable transaction.  A transfer of assets, such as in an asset sale by a Seller to a Buyer, may be considered fraudulent as to the Seller’s existing and future creditors if certain factors are met, in particular, if Seller did not receive “reasonably equivalent value” for its sold assets, and if Seller was insolvent at the time of the transaction or became insolvent as a result of the transaction.

Bulk Transfer Laws

In California these are called bulk sales.  Basically, bulk sales laws require notice to all creditors of Seller of a sale of the business or of substantially all of the assets by a Seller engaged in the principal business of selling inventory from stock, including manufacturers and restaurant owners.  There are some exemptions to the notice provisions including if the sale is valued at more than $5 million.  Buyer has the obligation to comply with the bulk sales laws, although Buyer frequently imposes contractual responsibility on Seller for any non-compliance.

Unpaid Sales and Use Taxes

In California, Buyer is required to withhold from the purchase price an amount sufficient to cover Seller’s sales and use tax liability until the Seller provides a receipt or certificate from the California Department of Tax and Fee Administration (CDTFA) showing no tax due.  Buyer is otherwise liable for Seller’s unpaid sales and use tax including from Seller’s historical sales prior to the transaction.  Buyer can request the certificate from the CDTFA.  Problem – it may take 60 days or more to obtain the certificate and may trigger an audit of Seller.  Thus the parties sometimes contract around this liability.  Seller should note that it must separately notify the CDTFA of the sale of its business or it continues to be liable for sales and use tax obligations of the sold business.

Unpaid Employment Taxes

In California, Buyer is also required to withhold from the purchase price an amount sufficient to cover Seller’s due or unpaid amounts relating to unemployment funds.  Either Buyer or Seller may request a Certificate of Release of Buyer from the California Employment Development Department (EDD) that no amount is due, but again issuance of the certificate takes time and thus parties sometimes contract around this liability.   The Certificate of Release of Buyer only protects Buyer; Seller should file properly completed final filings with the EDD upon sale of its business.

Up Next in the Series

In part 5, we will discuss final deal considerations when buying or selling the struggling business.

Generally, when a property owner in California wishes to terminate a commercial tenancy and reclaim the leased premises due to a tenant’s failure to pay rent, the owner must initiate an action for unlawful detainer to evict the tenant.  As a result of the COVID-19 Pandemic, however, the State of California and many local jurisdictions have enacted emergency measures that strictly limit, if not fully abrogate, a property owner’s right to evict a tenant for extended periods of time.  (See Wendel Rosen Commercial Lease Dispute & Resolution Team article on current barriers to commercial evictions here.)  However, California law provides another procedure that may allow a property owner to promptly terminate a tenancy and reclaim the leased premises, even during the Pandemic, when a tenant not only stops paying rent but also reasonably and genuinely appears to have abandoned the premises during the tenancy term.

Examples of circumstances that might provide a landlord with a reasonable basis to believe that a commercial tenant has abandoned the premises might include: terminated utility services, the accumulation of unopened mail, empty store or office shelves, the removal of furniture and equipment, as well as the tenant’s repeated failure to respond to the landlord’s phone calls, emails or letters.  A landlord would be well advised to keep detailed records of the circumstances that give rise to the landlord’s belief that the tenant has abandoned the premises, including records of the efforts the landlord made to get ahold of the tenant.

California Civil Code Section 1951.35 provides that commercial real property shall legally be deemed to have been abandoned by a tenant, and the tenancy shall terminate, if the landlord gives the tenant formal written notice of the landlord’s belief that the tenant has abandoned the premises in accordance with the procedures set forth below, and the tenant does not timely respond and rebut the landlord’s belief.  If the landlord follows these procedures, then in order for a commercial tenant to avoid having its tenancy terminated before the end of the lease term, the tenant must timely respond by giving landlord written notice that the tenant does not intend to abandon the premises, and the tenant must provide the landlord with an address at which the tenant may be served by certified mail in an action for unlawful detainer.  Civil Code Section 1951.3 provides a similar procedure for residential tenancies, but the focus of this article is on commercial tenancies.

Pursuant to Civil Code Section 1951.35(c), a landlord may give the tenant formal notice of the landlord’s belief that the tenant has abandoned the premises (“Notice”) only when the rent on the property has been due and unpaid for at least the number of days that are required for the landlord to declare a rent default under the terms of the lease, but in no case less than three days.  The landlord must also have a reasonable basis to believe that the tenant has abandoned the property, aside from the mere non-payment of rent.  The landlord must have the Notice personally delivered to the tenant, or send the Notice to the tenant by a “recognized overnight carrier,” or by first-class mail, at the lessee’s last known address.  The tenant’s last known address may be the leased premises itself, but that is not always the case.  If there is reason for the landlord to believe that the Notice will not be received by the tenant at the tenant’s last known address, then the landlord must also send the Notice to any other address that is known to the landlord where the tenant “may reasonably be expected to receive the notice.”  The Notice must be in substantially the same format that is spelled out in Civil Code Section 1951.35(e).

Once the landlord has duly delivered the Notice to the tenant, the tenant must respond on or before the deadline specified in the Notice by informing the landlord in writing that the tenant does not intend to abandon the premises.  The tenant must also provide the landlord with an address at which the tenant may be served by certified mail so that the landlord can file and serve the tenant with a lawsuit for unlawful detainer in the event that the tenant does not immediately pay the landlord the past due rent.  If the tenant does not timely provide the landlord with this information, then the tenant shall automatically and legally be deemed to have abandoned the premises, even if the tenant did not truly intend to abandon them.

Once the premises are legally deemed to be abandoned, the landlord may enter the premises and secure them by changing the locks and any security or alarm codes.  The landlord should then take the time to inspect the premises for damages caused by the tenant.  If the landlord discovers that the tenant has left inventory, equipment, supplies, and/or other personal property behind, under Civil Code Section 1993 and several related code sections, a commercial landlord is required to serve the former tenant with a Notice of Right to Reclaim Abandoned Property (“Reclamation Notice”).  A tenant has 15 days after the Reclamation Notice is personally served, or 18 days, if served by U.S. Mail at the tenant’s last known address, to reclaim the abandoned personal property and pay the landlord the reasonable cost of storage.  The landlord can prohibit the tenant from claiming the property until those costs have been paid.

If the tenant does not claim the personal property in time and the landlord reasonably believes that the abandoned personal property is worth less than $2,500, or an amount equal to one month’s rent and charges for the premises (whichever amount is greater), then the landlord may keep, sell, or destroy the abandoned personal property after the reclamation period expires, without giving further notice to the tenant.  If it is reasonably clear that the value of the abandoned property is above these thresholds, then the landlord must hold a public auction sale of the abandoned personal property after publishing the date, time, and place of the sale in a local newspaper with general circulation at least five days before the sale.  The tenant may still reclaim the personal property any time before the sale, but the tenant must pay for the costs of storage up to that point, as well as the landlord’s costs of advertising the sale.

California Code of Civil Procedure Section 1988 provides that, after the sale, the landlord may use the net proceeds of the sale as reimbursement for the costs of storing the property and advertising the sale, but the landlord must turn over any remaining money to the treasury of the county, where the tenant can claim the proceeds for up to one year.

In Part 1 of this series of posts, we discussed how business owners must think beyond the near term and that certain Buyers may view this as an opportune time to acquire a company while certain Sellers may be thinking that the best path forward is to sell their companies. In Part 2, we discussed some initial steps for Buyers and Sellers in preparing to buy or sell the struggling business. In this post, we will go over due diligence and structuring the deal.

Due Diligence

Due diligence is the process by which a Seller provides extensive information regarding its business to the potential Buyer, and the Buyer reviews that information and identifies issues or risks (that could affect how the transaction is structured or the amount of the purchase price). The due diligence process usually begins with Buyer providing a comprehensive written information request list to Seller, and Seller uploads all the requested information to an electronic data room.

For a struggling business, it is important that Seller prepare in advance to provide all the information that may be requested. While we always encourage a Seller to assemble information in advance, this becomes particularly important for the struggling business.

Timing

By having information organized and ready, a Seller can provide the information quickly and efficiently particularly if there is more than one potential Buyer. For a struggling business with dwindling cash or prospects, moving quickly is imperative.

Risk Management

As mentioned in our first post, in acquiring a struggling business, a Buyer may encounter more risk than in a normal course transaction. If Seller can identify and explain risks and propose solutions immediately, it may facilitate negotiations with the Buyer.

Tip to Sellers

Be sure to clarify with Buyer all the due diligence that will be needed.  Often a Buyer will request preliminary financial and business information and Sellers think they are done!  In fact, Buyer may engage internal and/or external resources who will be requesting in-depth information on every aspect of a Seller’s business: financial; legal; people/benefits; sales; real estate; intellectual property; and so on.

Deal Structuring

There are a few ways to structure a purchase and sale of the company, and the choice of the structure depends on the type of entity of each of Buyer and Seller (LLCs or corporations, for example), tax advantages or disadvantages to each, contract provisions, and payment terms. However, for a transaction involving a struggling business, an asset sale is the usual choice.

Asset Sale

As the name suggests, in an asset sale, the Buyer identifies those assets of Seller that it wants to acquire, and Buyer can specifically choose not to assume any liabilities of Seller. Buyer can, in essence, pick and choose the Seller assets it wants while avoiding the debts and obligations that Seller has (with some risk and limitations, which we will address in our next post). In addition, Buyer receives a step up in the basis of the assets acquired, to the extent the asset’s value has increased, which is beneficial for Buyer.

An asset sale is generally less favorable to the Seller: Seller is stuck with its debts and obligations; the receipt of the purchase price is generally not taxed at a more beneficial capital gains rate (as it would be in the sale of stock by Seller’s stockholders, for example); and it may be left with unsaleable assets.

If the Seller has valuable contractual relationships that can’t be assigned to a Buyer without the consent of the contract party, Seller may have the ability to negotiate for a sale of its stock or a merger transaction. In view of the risks around a struggling business, however, a Buyer may choose not to proceed with any transaction if an asset transaction is not possible.

Up Next in the Series

In part 4, we will discuss risks and risk mitigation in the purchase and sale of a struggling business.

Note: This article was originally published on 4/30/2020 and was last updated on 6/1/2020.

Recognizing the impact of the current COVID-19 pandemic and social distancing on individuals’ and local governments’ abilities to adhere to statutory, filing, and regulatory deadlines under the California Environmental Quality Act (CEQA), on April 22 Governor Newsom issued Executive Order N-54-20 immediately suspending several CEQA deadlines for a period of 60 days, as well as revising certain noticing requirements.

Specifically, the Governor’s Order provides that the following deadlines are all suspended for 60 days from April 23, 2020:

• The public filing, posting, notice, and public access requirements set forth in Public Resources Code sections 21092.3 [preparation of an environmental impact report (EIR) or negative declaration] and 21152 [notices of determination], and California Code of Regulations, Title 14, sections 15062(c)(2) and (c)(4) [public inspection of notices of exemption]; 15072(d) [notices of intent to adopt negative declarations or mitigated negative declarations]; 15075 (a),(d), and (e) [notices of determination for negative declarations or mitigated negative declarations]; 15087(d) [notices of availability of draft EIRs]; and 15094(a), (d), and (e) [notices of determination], for projects undergoing, or deemed exempt from, CEQA review. Note, however, this suspension does not apply to provisions governing the time for public review of CEQA documents.
• The timeframes in Public Resources Code sections 21080.3.1 and 21082.3, within which a California Native American tribe must request consultation and the lead agency must begin the consultation process relating to an EIR, Negative Declaration, or Mitigated Negative Declaration under CEQA.

Local agencies are generally required to file notices of determination or notices of exemption within five days of approval of a project with the county clerk of each county where the project takes place, and the clerks are usually required to post these notices within 24 hours and for at least 30 days. However, per the Governor’s Order, agencies that would have been required to publicly post or file materials concerning a project or otherwise make such materials available to the public, must now do all of the following:

• Post the materials on the agency’s or the applicant’s public-facing website for the same period of time they would otherwise be required to be posted by the county clerk;
• Submit these materials electronically to the State Clearinghouse’s CEQA Webnet Portal; and
• Engage in outreach to individuals and entities known by the agency or applicant to be parties interested in the project in the manner contemplated by CEQA and the CEQA Guidelines.

Local agencies and applicants are also encouraged to pursue additional methods of public notice and outreach as appropriate for particular projects and communities.

On a related note, although the Governor’s Executive Order does not expressly relate to any “statutes of limitation” under CEQA, on April 6, 2020 the California Judicial Council issued 11 Emergency Rules, including Emergency Rule 9, which tolled all statutes of limitation for “civil causes of action” for the period between April 6, 2020 and 90 days after the Governor declares the end of the state of emergency regarding the COVID-19 pandemic.

However, after receiving numerous comments from multiple cities, counties, building associations, and land use practitioners, on May 28, 2020 the Judicial Council approved a revision to its Emergency Rule 9 to distinguish between those statutes of limitations of more than 180 days from those that are 180 days or less. Specifically, the newly amended Emergency rule 9 does the following:

• Tolls from April 6, 2020, until October 1, 2020, the statutes of limitation and repose for civil causes of action that exceed 180 days.
• Tolls from April 6, 2020, until August 3, 2020, the statutes of limitation and repose for civil causes of action that are 180 days or less.

The Judicial Council also added an advisory committee comment clarifying that this amended rule is broad and applies to all civil causes of action, including those brought pursuant to CEQA and the Planning and Zoning Law. The usual statutes of limitations under CEQA are 30 days to challenge an environmental impact report or negative declaration for which a valid notice of determination was filed; 35 days to challenge an exemption determination for which a valid notice of exemption was filed. Similarly, there is a  60-day statute of limitation to challenge a determination under the California Coastal Act. As none exceed 180 days, all of these statutes of limitation are now tolled until August 3, 2020 per the amended Emergency Rule 9.

Wendel Rosen LLP’s Land Use attorneys will update this post as any further clarification regarding the impact of these orders and emergency rules is provided, and our attorneys are available to answer any questions you may have regarding these changes to CEQA deadlines and noticing requirements.

In Part 1 of this series of posts, we discussed how business owners must think beyond the near term and that certain Buyers may view this as an opportune time to acquire a company while certain Sellers may be thinking that the best path forward is to sell their companies.  In this post we will go over some initial steps for Buyers and Sellers in buying and selling the struggling business.

Finding the Potential Buyer or Seller

A potential Buyer may already have identified a target Seller to approach, or a Seller business may know of potential Buyers for its business.  Frequently this is a result of a business’s usual business development methods, such as identifying new channels or products it would like to add to its business, keeping tabs on competitors, and meeting other business leaders at conferences or industry events.  Or, a Buyer or Seller may need assistance in locating the potential transaction party.  In either event, a Buyer and a Seller may turn to business brokers, or investment bankers or M&A advisors for help in both identifying the potential transaction party and negotiating terms. (M&A means mergers and acquisitions, which includes the different ways to structure the purchase and sale of a company and the financing of the transaction.)

Although there is overlap with other advisors, business brokers generally work with small transactions, frequently (but not always) with values less than $1 million.  An advantage to a business broker is that, subject to licensing and other factors, a business broker can often represent both the Buyer and the Seller in the transaction which could be more cost-effective for the parties to the transaction.  See https://cabb.org/ for some information.

Investment bankers or M&A advisors are engaged by only one party to a transaction, so a Buyer and a Seller may each have their own M&A advisor.  Because a transaction to buy or sell a business involves a lot of steps, such as valuation and structuring the transaction as well as negotiating many terms, each party may find it helpful to have its own M&A advisor.  There are many M&A advisors available with different specialties.  Contact us for some referrals.

Sellers Should Prepare Prior to Speaking with a Potential Buyer

Advisors

Although a Seller may feel squeezed for cash, it is especially important that Seller has the right set of advisors ready to help it with any transaction.  These advisors will ensure that Seller receives the optimal deal in a transaction and mitigates the many areas of risk the Seller has.  In addition to potentially engaging an M&A advisor, a Seller should engage an experienced M&A attorney as well as an accountant familiar with M&A transactions.

Sellers

The person or firm that prepares the company’s annual tax returns may or may not have the knowledge needed to advise you in a purchase and sale transaction.  Ask them now if that is an area of expertise for them.

Debts and Obligations

A struggling company looking to sell should prepare a schedule of all of its debts and other obligations with information on:  payment due dates and interest accrual; security interests and other liens securing the debt; personal or other guaranties; and prepayment or termination penalties.  This information will be essential to negotiating how a potential transaction is structured and the purchase price is to be paid.

Evaluate Your Business

A struggling company should also work with its advisors to evaluate the business:  is it more valuable sold as a whole?  Or are certain business lines or products more profitable and could be more easily sold to a potential Buyer separately?

Up Next in the Series

In part 3, we will discuss due diligence and deal structuring.

Current events are having a very negative effect on many businesses, but business owners must think beyond the near term to fully assess their business prospects.  For some companies, this may be an opportunity to use accumulated cash to acquire businesses in a desired channel, market, or competitive space (Buyers). For other companies, the struggle to return to success and profitability is daunting, if not impossible, and they should think about selling their business (Sellers).

In a five part series, we will discuss some factors for both Buyers and Sellers to consider when buying or selling a struggling business.

What is a “distressed” business? 

A common definition is that the price to sell the assets of a distressed business is less than the value of those assets.  Often, a distressed business is insolvent and is or should contemplate options under federal bankruptcy and related laws (such as a Chapter 11 reorganization or an assignment for the benefit of creditors).  My colleagues in our insolvency and restructuring practice group are very experienced in this area of the law.

What is a “struggling” business?

For our purposes, we will be discussing non-bankruptcy related sales, and so using the term “struggling business” seems more appropriate than “distressed business”.  A struggling business is still able to operate and make payments on most of its obligations, however, the future prospects are dim and perhaps a significant infusion of cash is the only way the company will ultimately survive.

What are the advantages and disadvantages for a Buyer?

The obvious advantage to a Buyer acquiring the struggling company is valuation – the purchase price for the struggling business will be lower .  The other advantage is leverage – the Buyer will have more leverage to negotiate terms than the Seller, who probably needs to act quickly and thus can’t afford to negotiate at length.  The main disadvantage for a Buyer is risk – there is a higher risk of post-closing claims such as for successor liability or fraudulent transfer (which we will discuss in a future post).

What are the advantages and disadvantages for a Seller?

An advantage to a struggling Seller is that a sale may yield more purchase price for Seller’s assets than going through a bankruptcy proceeding.  Another advantage is that Seller may be able to satisfy all outstanding obligations with the right purchase price and deal structure.  And, a Seller may be able to ensure that its employees have continued employment with Buyer post-closing.  The main disadvantages to Seller are the advantages to Buyer:  Seller must sell at a lower valuation than if the company were successful, and has less leverage to negotiate terms.  Another challenge for a Seller is timing.  It is optimal to sell an operating company with revenues that is not insolvent.  Sellers should forecast their cash flow needs and act before they run out of cash.

Tips to Sellers

1. If you are running out of cash, don’t stop paying compensation to any W-2 employees (including owners) with a promise to pay later. There are complicated tax laws and state laws regarding payment of wages and deferred compensation and violations may entail penalties. Call us for advice on wage reductions or employment termination.
2. Be sure all payroll taxes, sales taxes, use taxes, and similar taxes are timely paid. If not, the person responsible at the company for ensuring taxes are paid may become personally liable for the unpaid taxes.

Up Next in the Series

In part 2, we will discuss the initial steps for Buyers and Sellers in buying and selling the struggling business.