Purchasing shares from a seller in financial distress

Doron Afik, Esq.
January 20, 2016

People in financial distress may sometimes acquires "financial oxygen" by selling holdings in companies which may also an opportunity for investors to purchase these shares at an attractive price. However, transactions with those standing at the edge of a financial cliff may later cancelled and it is important to exercise caution in such a case.

Section 98 of the Israeli Bankruptcy Ordinance (such provisions apply to companies as well as individuals) allows the cancellation of transactions carried out shortly before the bankruptcy. The aim of such provision is to prevent preference of creditors and ensure equitable distribution of assets of the insolvent. The provision requires four cumulative conditions for denying validity of a transaction due to the preference of creditors: a receivership order was given against an individual or a liquidation order against the company (or order a stay of proceedings), at the date of the transaction the person or company could not repay all due debts, the suspicious transaction was made to give preference to a particular creditor or under constraint or unlawful solicitation, and the transaction was done within the three months preceding the application for receivership, liquidation or stay of proceedings. Note that in some cases the "suspect period" may be longer.

When a person purchases shares in a company there is always the apprehension that if the seller enters insolvency proceedings a receiver or liquidator may later cancel the transaction. In such a case the purchaser will have to return the shares while the funds paid will not be able to be retrieved but instead, the purchaser will need to stand in line with the other creditors and hope that enough money will remain for distribution so at least some of the investment may be retrieved. For this reason, it is very important to make sure that the amounts paid to the seller will be sufficient to cover any debts and are paid to the creditors and not be used for other purposes. It is also important to draft the agreement in a manner that takes into account the risks involved in order to ensure that the transaction itself will not be deemed an illegal preference of creditors. Thus, for example, it was held that registration of a pledge in favor of a new debt could be considered as a transaction in preference of creditors.

We note that a similar issue (and perhaps more significant) exists also when instead of purchasing shares of a company an asset sales transaction is structured, in which all assets of the company are purchased leaving the company as an empty vessel. This transaction is sometime more tax efficient and may also better protect against unknown past liabilities and may ease a merger and acquisition when some shareholders oppose it. In such a case it is very important to ensure that the company that sold the assets received enough funds to pay all its creditors so that it will not enter insolvency proceedings and the transaction will be jeopardized.

It is important to emphasize that mergers and acquisitions is a very complex field and requires an understanding not only of contracts but of receiverships and liquidations and many other legal fields. If ordinarily it is advised to retain an attorney specializing in mergers and acquisitions rather than an "ordinary" lawyer, before the entry into a transaction with a person on the verge of bankruptcy, it is even more important to be accompanied by an attorney familiar with this field.