Buying a distressed competitor may be a smart business move. However, the means used to buy the business can have legal consequences.
This case involved a distressed Texas based glove maker that was a formerly a public company. A competitor wanted to buy the company and had been talking to the company since 2007 or 2008, but without success.
In late 2014, the company obtained a revolving credit facility from its lender, secured by substantially all of the company’ assets. Between November 2016 and April 2017, the lender agreed to waive defaults when the company breached the debt service coverage ratio covenant of the loan agreement. On April 11, 2017, the lender agreed to replace the debt service coverage ratio covenant with a 12-month trailing adjusted EBITDA covenant. In May 2017, the lender demonstrated it was willing to work with the company through financial difficulties when it extended the loan’s maturity date to July 2018.
On July 6, 2017 the company filed a Form 8-K Report with the Securities and Exchange Commission disclosing accounting irregularities that resulted in inflated revenue figures on the company’s financial statements, the termination of the employment of the company’s chief executive officer and chief financial officer, and the appointment of new individuals to those positions.
Days later, on July 10, 2017, the competitor wrote the company to say the competitor did not want to wait for the financial reports to be restated and upped its offer price. Meanwhile, the competitor purchased the loan from the company’s lender on July 25, 2017. The competitor had never acted as a commercial lender.
The next day, on July 26, 2017, the competitor sent the company a letter declaring the company in default under the loan due to the previously disclosed misstated financial reports, accelerating the loan, and demanding immediate payment of the $3.7 million outstanding balance in full.
The competitor knew the company could not pay off the loan since the company’ last financial statements filed with the SEC showed a cash balance of less than $300,000. Over the next four weeks, the company negotiated with several prospective lenders to either replace or supplement the existing debt, but the competitor did not allow that to happen. Instead, the competitor agreed only to two one-week forbearances—one signed August 1, the other signed August 14—even though the company told the competitor they needed two to three weeks to arrange financing. Meanwhile, the competitor continued to make offers to purchase the company.
The competitor began sweeping cash from the company’ bank accounts on August 24, 2017. The company could not operate without cash and so filed for bankruptcy protection under chapter 11 in a California bankruptcy court on September 8, 2017.
In bankruptcy the company entered into a stalking horse asset purchase agreement for the company assets with the competitor, but a higher bidder ultimately purchased the company’s assets.
The company’s shareholders sued the competitor in the bankruptcy proceeding for depriving them of a better deal by illegally forcing their company into bankruptcy.
The competitor defended itself by claiming that all its actions were legal. The court agreed with the competitor but gave the shareholders the right to amend their complaint.
The court said that applicable Texas law would have prohibited the competitor from threatening to accelerate the note in bad faith but that the competitor did not threaten to accelerate the note; it simply declared that the note was in default (which it was) and exercised its right to be paid off under the loan agreement’s acceleration provision.
However, the court suggested that the company could amend its allegations that the notice of acceleration of the debt implied a threat that the competitor was going to sweep the company’s cash. That might be illegal under Texas law if not done in good faith. The action would be in good faith if done to protect the competitor’s legitimate interest as a creditor, but not done in good faith if done to force the company to sell the business to the competitor. The court said that whether good faith is required under Texas law when threatening a cash sweep would be an issue to be decided by the California bankruptcy court if the shareholders amend their complaint.
This case is referred to In Re ICPW Liquidation Corporation, Lead Case No. 1:17-bk-12408-MB, Jointly Administered With 1:17-bk-12409-MB, Adv. Proc. No. 1:17-ap-01101-MB, United States Bankruptcy Court, C.D. California, San Fernando Valley Division, (March 11, 2019).
It is a common plot in film and television for the ruthless businessman to buy the troubled ranch loan to force the rancher to sell the ranch to the businessman. But as this case illustrates, there may be legal risks involved when this tactic is used.
By John McCauley: I help businesses minimize risk when buying or selling a company.
Telephone: 714 273-6291
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