Securing disinvestments from distressed businesses

Therefore, a reasonable assumption would be that, provided that adequate information is given to the purchaser, the seller will incur no risk if the purchaser fails to resolve the business difficulties and eventually files for insolvency. However, such assumption is misleading since case law regularly shows that sales of distressed businesses may carry high risks for sellers if the takeover fails and the transferred business is eventually the subject of insolvency proceedings.

This update sets out:

• the key risks associated with the divestiture of distressed businesses; and
• the actions to take in order to mitigate the risk that the seller may subsequently be blamed for the purchaser's failure.

Risks associated with sale of distressed businesses

High-risk scenario

From a practical standpoint, failures of takeovers of distressed businesses put sellers at risk when insolvency proceedings are opened within 36 months of the sale. The key elements of these failed takeovers are well known and often combine several operating factors such as:

• the loss of existing clients transferred by the seller;
• the failure to generate new business volumes; and
• the inability to take appropriate restructuring measures to address the situation while the company still has funding.

In such scenarios, the company often enters insolvency proceedings at a point when it no longer has sufficient cash to continue operating during the time necessary to find satisfactory solutions either to restructure the business or sell it at the end of an orderly bidding process. This often results in the business being sold as part of the insolvency proceedings at a very low price, leaving many unsettled liabilities and dismissed employees behind.

A recent Supreme Court decision^[3]  is yet another example that such circumstances pave the way for actions against the seller from two categories of claimant:

• the court-appointed liquidator seeking to increase liquidation proceeds in order to repay creditors; and
• dismissed employees seeking compensation in addition to severance payments received from the insolvency estate.

Risks in insolvency court

In case of insolvency, the seller becomes the ideal culprit to be held responsible for the failure of the business and from which to seek compensation.

Experience shows that it is all but too common that the management which took over the business argue during the insolvency proceedings that the seller is to blame in an attempt to dilute their own liability. Before any claims are made in court, and without the seller having the chance to challenge these allegations at that stage, the narrative of the seller's responsibility in the failed takeover may therefore already be instilled and adopted by a liquidator keen on finding a solvent debtor to bear the burden of the unsettled liabilities.

In such cases, the liquidator's action against the seller may be based on either:

• the specific regime governing the liability for mismanagement in an insolvency situation (Article L651-2 of the Commercial Code) if the liquidator claims that despite the sale, the seller remained the director of the business and, in such capacity, mismanaged the company in a way that contributed to the insufficiency of assets to settle liabilities; or
• tortious liability (Article 1240 of the Civil Code) where the liquidator claims that the seller was negligent in selling the business to a purchaser that had no capacity to ensure the continued operations of the business, or even fraud if the liquidator's contention is that the sale was a sham designed for the seller to avoid the costs of closing down the business.

Risks in employment court

When a large number of employees are made redundant as a result of liquidation of the company, dismissed employees may be prompt to bring actions in court against the seller to obtain additional compensation for the loss of their jobs. Such claims used to be based on the concept of co-employment and stated that the seller remained the employer in spite of the sale. Since 2014 the Supreme Court has limited, to a large extent, the scope of this legal ground^[4] and actions of dismissed employees are now increasingly based on tortious liability, arguing that the seller committed a civil wrong by selling the business, as such decision was dictated only by its own interests and was contrary to the interests of its former subsidiary and its employees.

Securing sale of distressed businesses

The litigation risks identified above are reminders that sales of distressed businesses are not standard M&A transactions. Accordingly, specific precautions must be taken both to prevent the risk of the takeover failing and evidence the seller's diligence in the conduct of the process in the event of subsequent litigation.

The key principle to remember is that the less solid the financial situation of the purchaser, the more essential the seller's precautions are for managing the risks of the transaction.

Key role of due diligence

The purchaser's business plan must be at the heart of the seller's concerns because in hindsight, the failure of the takeover will be analysed based on the business plan and the reasons why the purchaser failed to implement it.

This means that the seller must be particularly vigilant that:

• the business plan is prepared by the purchaser with its own legal and financial advisers, not by the seller;
• the business plan and its underlying assumptions are serious and realistic, as determined by an independent business review;
• the purchaser has obtained the necessary financings to implement the business plan; and
• the seller's role after the sale must be extremely limited in scope and not extend in any way to participating in the implementation of the business plan.

Evidencing management of transaction to anticipate potential litigation

As sales of distressed businesses carry litigation risks, the conduct of the transaction must be driven by the need to evidence the conditions of the transaction in case of subsequent litigation, from the process conducted to find purchasers to the formal presentation of the business plan by the purchaser to the seller and the employees' representatives and its review by an independent auditor.

When the success of the takeover appears particularly uncertain, further security may be provided by the use of out-of-court restructuring processes (whether ad hoc mandate or conciliation).

The ad hoc mandate and conciliation procedures share common characteristics:

• Both processes involve the company's management applying, on a strictly confidential basis, for the appointment a third-party mediator (whether an ad hoc agent or a conciliator) whose mission is defined by the order of the presiding judge of the commercial court appointing him or her on the basis of the management's request.
• They are fully confidential^[5].
• They are informal and flexible and do not affect the management of the company.
• In the context of a distressed sale, the presence of the ad hoc agent or conciliator will build evidence of:
• the distressed context in which the transaction was entered;
• the seriousness of the purchaser's business plan; and
• the seller's conduct of the process.

In addition, the transaction entered into in conciliation (whether requested directly or by way of the conversion of a previous ad hoc mandate) offers increased legal security if the parties decide to request its formal approval by the commercial court. This is because formal approval of the transaction requires the court to be satisfied, based on the insolvency practitioner's reporting, that:

• the debtor company is not (or, as a result of the conciliation agreement, ceases to be) insolvent;
• the agreement is such as to ensure the solvent continuation of the business; and
• the transaction does not prejudice the interests of those creditors that are not parties thereto.

In other words, the formal approval will warrant that at the time of the transaction, it was analysed by all parties involved as offering serious chances of success.
Should the takeover fail, the review of the insolvency practitioner and the formal approval of the transaction will prove valuable to deter or challenge claims that could be made by the liquidator or dismissed employees.

1. See Law 2014-856 of July 31 2014 "relating to a social and solidarity economy".
2. See Law 2014-384 of March 29 2014 "aiming at winning back the real economy", also known as the 'Florange Law' in reference to the blast furnaces operated by ArcelorMittal in Eastern France that were mothballed in April 2013. The law provided fines for owners of industrial sites that decided to close them without complying with the newly created obligation to look for a purchaser first. However, this emblematic system was censored to a large extent by the Constitutional Council as infringing the freedom of trade and the property right (Constitutional Council, March 27 2014, 2014-692 DC).
3. Supreme Court, Employment Court, May 19 2016, 15-13603 15-13604 15-13609.
4. Supreme Court, Employment Section, July 2 2014, 13-15208 et alt.: Bull V 159.
5. Confidentiality even binds journalists – for further details see "Supreme Court rules confidentiality of out-of-court restructurings prevails over freedom of press".