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.