As the global battle with the novel coronavirus pandemic (COVID-19) rages on, destabilized markets and deepening economic turmoil have investors in private companies considering how best to manage portfolio companies that are or may become distressed in the coming months.
Investors in privately owned businesses may not be in a position to continue funding cash or revenue poor, highly leveraged and/or high-risk portfolio companies. As current market realities limit the options to pursue asset sales, investors may need to work with boards of directors and managements to explore other options. New financings in the current environment might carry an unacceptable level of risk, while an asset sale may fail to obtain the real amount of the business’s potential future value. In light of such realities, investors in a portfolio company with significant debt may consider turning over assets cooperatively to the company’s creditors. While the fiduciary duties of directors and officers may require this eventual outcome, the transaction could also be an economically prudent choice for investors, providing an opportunity to secure releases from creditors and thereby cut off future liability. Depending on the circumstances, this type of asset transfer may be accomplished in a private transaction or as part of a bankruptcy process.
Outside of bankruptcy, the transaction, assuming a creditor has a security interest in substantially all of the company’s assets, can take the form of a strict or consensual foreclosure under the Uniform Commercial Code (in which a secured creditor takes possession of its collateral in full or partial satisfaction of debt) or a similar alternative contractual arrangement. Creditors may take over the investors’ equity stake in the company, or the transaction may be structured as an assignment of the underlying assets. A non-judicial proceeding provides flexibility for the transacting parties to tailor the deal terms to their needs and to move expeditiously. As creditors protect their economic interests by taking ownership of the company’s assets, investors can use the ownership transfer as an opportunity to escape future capital inflow requirements, other obligations and potential liability.
If investors cooperate with creditors to consummate a quick transfer of ownership that promotes the preservation of a business’s value for the creditors’ benefit, those investors may use the occasion to seek, and creditors may be more amenable to, the broadest possible release provisions in the transaction documents, absolving investors from any and all liability, known or unknown, that may potentially arise from the continued operation of the distressed company or from any of the underlying transferred assets, or for actions taken prior to the transfer. Investors who sit on the company’s board should also seek releases in their capacity as directors, in acknowledgement of their fulfillment of their fiduciary duties to the company and its stakeholders.
For some companies with a more complex capital structure, an out-of-court transaction may prove impossible. In such cases, a bankruptcy filing may be a useful tool for providing recoveries to creditors while securing releases for the company and certain of its affiliates. One of the primary rehabilitative features of the Bankruptcy Code is the debtor’s discharge from liability upon confirmation of a plan of liquidation or reorganization. In a chapter 11 bankruptcy (in which the debtor’s management retains control of the debtor’s estate while the case is pending), confirmation of a plan of reorganization or liquidation discharges the debtor from any debt that arose before the date of such confirmation, subject to certain exceptions. A chapter 7 liquidation (conducted by a court-appointed trustee) grants the debtor a similar discharge.
While the Bankruptcy Code provides statutory relief for debtors, the same is not true for directors or other interested parties, such as guarantors and other non-debtor entities or control parties who may continue to face liability following the conclusion of the bankruptcy for actions taken operating the business prior to the bankruptcy. However, chapter 11 debtors may negotiate with creditors, plan sponsors and asset sale counterparties to obtain additional releases for non-debtor stakeholders, including investors, officers, directors, parents, guarantors, or sureties, whose support for the proposed plan may be critical to the success of the confirmation process.
Courts generally approve third-party releases as binding on creditors when creditors provide express affirmative consent by opting into the release. However, courts have differed on the issue of what constitutes consent. Additionally, courts are divided on whether, and in what circumstances, non-consensual third-party releases may be approved as part of a chapter 11 plan.
A minority of federal circuits1 have taken the position that, with the exception of asbestos cases (which are explicitly provided for in Section 524(e) of the Bankruptcy Code), non-consensual third-party releases are not permissible under any circumstances. These courts have taken the view that Bankruptcy Code section 524(e), which provides that the “discharge of a debt of a debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt,” prohibits third-party releases.
Nevertheless, the majority of jurisdictions2 have found that such releases may in fact be authorized by a bankruptcy court, albeit in limited and exceptional circumstances, by means of the broad equitable powers derived from of the Bankruptcy Code. Although the majority of circuits agree that circumstances may exist which warrant the granting of non-consensual third-party releases, no uniform standard has emerged to determine the specific conditions under which such releases may be issued. In the absence of a uniform standard, courts have applied fact-intensive analyses on a case-by-case basis to determine whether third-party release provisions are appropriate.
A five-factor test, developed by the Western District of Missouri in Master Mortgage3, has become one popular option for courts to employ in undertaking a fact-intensive analysis in this regard. The five factors outlined in Master Mortgage include whether 1) an identity of interests exists between the debtor and the third-party; 2) the third-party has contributed substantial assets to the reorganization; 3) the release is essential to the success of the reorganization; 4) a substantial majority of creditors, specifically, the impacted classes, agree to the release; and 5) the plan provides a mechanism to pay for substantially all of the claims of the classes affected by the release.
The Master Mortgage factors do not represent an exhaustive list of requirements but are rather intended to serve as a guide or tool for determining whether non-consensual third-party releases are justified. Numerous circuit courts that share the majority view have championed their own adapted version of the Master Mortgage factors. Parties wishing to obtain bankruptcy court approval of non-consensual third-party release provisions should enlist bankruptcy counsel with jurisdictional expertise and work closely with counsel to reach an acceptable outcome.
Minimizing Liability via an ABC
In some instances, investors in a distressed company can reduce potential liability through a state law liquidation vehicle known as an assignment for the benefit of creditors (ABC). In an ABC, a company assigns substantially all of its assets to a third party (typically a professional liquidator), who then liquidates the assets and distributes proceeds to the company’s creditors, acting as a fiduciary to the creditors. An ABC may be particularly useful where secured creditors are willing to cooperate but do not have the technical wherewithal, industry savvy, financial resources, or business desire to operate the company or liquidate its assets.
As a general matter, a key advantage of using an ABC as a liquidation vehicle, relative to selling assets through a regular negotiated sale conducted outside of bankruptcy, is that an ABC allows a third-party transferee to receive the assets of a troubled business free from any unsecured debt incurred by the transferor. While a heavy burden of unsecured debt can render a regular merger or acquisition of a distressed company infeasible, an ABC often provides a viable and potentially attractive option for both investors and secured creditors (via a designated third-party assignee) to liquidate distressed assets without undergoing the expense and procedural complications of a bankruptcy. An ABC also carries the relative advantage of avoiding some of the negative publicity and resource demands associated with a bankruptcy filing.
Despite these benefits, there are some limitations on the circumstances in which an ABC can be useful. Investors considering an ABC should note that this process requires secured creditor cooperation, as there is no ability to sell assets “free and clear” of liens and security interests without the consent or full payoff of lienholders. Additionally, unlike a bankruptcy filing, an ABC does not give rise to an automatic stay, meaning that creditors can continue trying to pursue actions against the company after the process has been initiated (although an assignee can often block judgment creditors from attaching assets). Investors should also be aware that proceeding with an ABC is typically a default under most contracts allowing termination, and as such should consider the effect of potential termination by counterparties on the value of the business.
The legal framework governing ABCs varies from state to state. California has a particularly well-developed statutory scheme governing ABCs, and ABCs are used there with particular frequency. In many states, including California, the assignment and subsequent liquidation are completed as private transactions without the approval of a court. For directors and managers of an insolvent company, an ABC can significantly limit potential liability, as the assignee is responsible for the liquidation and subsequent distributions to creditors.
The appropriate strategy with respect to a given company will depend on its capital structure, the relationships between its stakeholders, and other factors. Investors—together with the board and management—should work with restructuring counsel to evaluate the legal ramifications imposed by the current economic landscape and develop an approach that is well-suited for their respective needs and can provide potential protection from future liability.
 The Fifth, Ninth, and Tenth Circuits have adopted the minority view.
 The Second, Third, Fourth, Sixth, Seventh, and Eleventh Circuits have adopted the majority view.
 In re Master Mortg. Inv. Fund, Inc., 168 B.R. 930 (Bankr. W.D. Mo. 1994).