Entering into Liquidation Agreements: A Comprehensive Guide

What is a Liquidation Agreement

A liquidation agreement is a type of agreement between a shareholder owning at least 75% of a company’s shares and a debtor company. Under a liquidation agreement, such shareholder agrees to pay all debts incurred by the company (the "Debtor") after a formal insolvency has commenced.
The liquidation agreement takes the protection afforded the individual debtor in personal bankruptcy and gives that same protection to shareholders of a company, subject to certain conditions and limitations. In doing so, a liquidation agreement ensures that creditors are not prejudiced, because the Debtor remains liable for all of its debts.
This article examines the elements of a liquidation agreement including establishing eligibility, the role of the shareholder, the composition of the Board, disclosure requirements, the process of dissolution and dissolution of corporate assets.
Many creditors of an insolvent company can take comfort in the knowledge that corporation law does not insulate shareholders from the debt incurred by the Debtor. Section 96 of the Saskatchewan Business Corporations Act , C.S.S. 2001, c. B-10 (the "BCA"), imposes personal liability on all shareholders, registered owners or allottees of shares in a corporation who have not fully paid for the shares.
The liquidation agreement was created as a means through which shareholders (who are required to meet the personal liability tests in the BCA) can take refuge from personal liability. Pursuant to Section 145 of The Bankruptcy and Insolvency Act, RSC 1985, c.B-3, as amended (the "BIA"), such refuge is only available to a person who is a shareholder owning at least 75% of the Debtor whereas B.C. and Alberta, have the lower threshold of at least 25%. In designing the requirements of a liquidation, the provinces of Canada have ensured that liquidation agreements are not abused as a means through which shareholders can escape liability while at the same time protecting creditors from an unfair shortfall.

Essential Elements of a Liquidation Agreement

An essential aspect of the liquidating procedure is a liquidation agreement that sets forth the terms by which the parties to the liquidation, i.e., the IRS, the debtor and the bankruptcy estate, agree upon how the liquidation will be carried out. These agreements can vary substantially based upon the characteristics of the subject debtor, what other parties are involved, etc. The most common term in these agreements is to set forth a time period for the liquidation. In many instances, the agreement can be entered into at any time during the bankruptcy, but is most commonly entered into shortly before any sale is to occur.
It is normal for liquidation agreements to also set forth any fees that are to be charged by the bankruptcy estate and/or trustee and/or any other third parties. Often, this can be a percentage that is measured based upon the value of the liquidation, receipts from the sale, etc. This allows the parties to have a third party review the liquidation and get comfort that the fee is appropriate. It also places some pressure on the seller to keep costs down with a third party on the job.
The third essential component of these agreements is to identify the assets that are covered, that is being sold off, in order to make sure that there is no conflict later over whether something is part of the liquidation. All too often, entities attempt to sell off all of their valuable assets in a single transaction all at once. This is not the case in most cases of liquidation, but do not assume it will not be possible in this case.
Last, under each liquidation agreement, there is a requirement that the debtor pay all of its taxes before the liquidation. With that said, it also has to be noted that liquidation agreements provide a good deal of leeway with regards to whether the debtor ideally pays all of its taxes. As with all contracts, the intent of the parties is what matters in terms of construction.

The Advantages of a Liquidation Agreement

From the DIP perspective, entering into a liquidation agreement at an early stage minimizes the DIP’s need to expend significant cost on a corporate search for bidders to purchase an entire business. Once it has a bid and made a decision on whether or not to accept it, the DIP can focus on addressing issues such as seeking evidence about the circumstances which led to the liquidation. The DIP can focus its resources on interviewing potential liquidators on the basis of the liquidation agreement. A DIP that has prepared a liquidation agreement is in a position to implement the transaction with minimal disruption. A DIP that has not prepared a liquidation agreement may: (i) be challenged by a party taking the DIP to task about a sale, (ii) be forced to engage in negotiations about the costs of the liquidation, and/or (iii) find that a proposal from a third party is not very advantageous.
An indemnity in favour of the DIP is often negotiated into a liquidation agreement. Indemnity will be claimed by a DIP as a guaranty that the DIP has either sold the assets free of encumbrances or at least delivered the assets to the liquidator free of charges except for agreed-upon purchase money charges (e.g., monies owed to a secured creditor to the extent of the value of the asset).
A liquidation agreement gives assurance to creditors that a liquidation will be completed in accordance with the proposal. A longer process creates uncertainty and increased cost for unsecured creditors. When a liquidation is lengthy, all classes of creditors are negatively affected in some way. For example, a lengthy liquidation will lead to higher legal fees that are deducted from distributions that would otherwise be made to creditors. A liquidation of an insolvent corporation will affect trade creditors who will face diminished odds of being paid for goods and services provided to the insolvent corporation. When an insolvent corporation was paying product suppliers and service providers, they had some means to manage their own affairs in relation to the shortfall in payment of what the larger customer owes them. Because the insolvent corporation is not paying amounts owed it, other than perhaps for goods in transit, the supplier or service provider has no hope for recovery since the insolvent corporation is not paying suppliers for current services. In this environment, a liquidation agreement gives a trade creditor a degree of assurance that it will receive payment from a liquidator if the trade creditor is owed the funds.

Possible Disadvantages and Issues to Look Out For

As with any other financial instrument, liquidation agreements can pose some disadvantages or challenges in practice. The most common issues that arise are: parties to the collateral trust deed becoming rigid in interpretation, and error, fraud and misrepresentation in issuance of the certificate. There is also the potential to lose:
(i) the junior notesholders whose consent is required for variations of the terms of the CMO; (ii) the senior noteholders in case of a default scenario if the position of the credit enhancements has altered in the meantime; and (iii) the value of the transaction when an insolvency event occurs, as this will cause the senior noteholders to demand redemption of the collateralized obligation.
Further, if one party to a liquidation agreement defaults on its obligations under the agreement, or becomes insolvent, this could trigger cross-default provisions, which could result in the forced liquidation of the transaction, resulting in losses to all parties involved.
Parties might also face challenges when interpreting the terms of the liquidation agreement. For instance, other than obvious typographical errors, what constitutes an error or fraud in a certificate of entitlement could vary. Legitimate claims for repayment could be rejected by other parties. A person aggrieved might have to pursue a claim for damages after the collapse.
There is no regulatory authority that adds a layer of security or oversight to the standardisation of liquidation agreements. As is often the case, the terms of a liquidation agreement may differ significantly and not follow any commonly accepted principles, which can lead to greater disputes, whether casual or material, between parties.
The liquidations are often done in a financially difficult environment, especially at the time of an insolvency of the issuer. For example, in 2013, Timeshare Resorts International (Bhutan) Ltd ("TRIBL") – an issuer of Bhutanese notes under a CDO structure – was unable to honour its obligations upon maturity. The collapse of TRIBL could therefore result in the liquidation of the CDO.

Drafting an Effective Liquidation Agreement

There are plain vanilla liquidation agreements, and then there are liquidation agreements that have been tailored to the specific needs of a business or dispute. The latter type of liquidation agreement generally involves a checklist of issues to be covered and the drafting process will involve the best and most reasonable effort you can give in addressing the issues on the checklist. Given the rewrite of Delaware’s LLC Act in 2013, the best and most reasonable outcome may be very different from what you have seen in the past.
A. Issues to Consider

1. Dissolution and Winding-up Clauses

The liquidation agreement should generally provide that it sets forth the manner for the dissolution of the business. The decision on when to dissolve can be made upon the recommendation of the Manager, with the consent of the board, or the confidence vote of 70% of the Members.
The default provisions for winding up in Section 18-803 may be inappropriate for your unique situation. You should discuss an agenda for winding up with the client and be mindful of issues under 18-208(b) and the consequences of merged entities that require compliance with the new requirements of 18-209 and 18-213. You must also consider whether to construct a wind down that is different than the default that is tractable to the marketplace.

2. Liquidation Preference

You should review contractual vehicles that memorialize the split of the proceeds among the various interest holders of the enterprise. You should consult with an individual who is experienced in non-judicial liquidation transactions to determine if the liquidity of the market for the asset warrants the use of preferred stock. For example, if the enterprise winds up in a foreclosure and the assets are liquidated, the members may have a liquidation preference that entitles them the first $500 million from the sale of the assets before the remaining proceeds are divided among the interest holders in accordance with their respective ownership percentages.

3. Wind down Process

The process for winding up must be considered in light of the preferred means of payment of the creditors . For example, if the majority of creditors will accept cash, then you should structure a process that provides for the use of cash rather than other means of winding up the business. This can vary based on whether the credit is non-recourse or secured.

4. Cohesiveness of the Members and the Management

The members of the enterprise must be able to work together to bring about the wind down of the entity together. A liquidation agreement should be reflective of how the members will work together to satisfy creditors and wind up the affairs. For example, an entity with a highly contentious management or member group may elect to wind up the entity through a third-party entity due the lack of cohesiveness between the members or between the management group and the members.

5. Relationship of the Members to the Liquidation

The relationship of the members to the enterprise will play a vital role in the wind up and liquidation of the entity. Typically, members and managers have an intimate knowledge of the affairs of the enterprise and can assist others with the final wind up of the entity. It is important to account for the members involvement in the liquidation within the terms of the liquidation agreement.

6. Disputed Claims

If the entity has members that are highly litigious, you must account for the potential litigation that might arise within the liquidation agreement. For example, while the liquidation agreement will provide for a specific claims procedure, some members will not observe the terms of the claims procedure and may seek to overturn the business judgment of the managers regarding the payment or satisfaction of a particular claim. It should be your goal to provide for a settlement of all disputed claim within the terms of the liquidation agreement.

7. The Pay out of the Proceeds

Every liquidation sale can potentially yield a different result, therefore the liquidation agreement should provide for a springing clause that sets forth any payment disputes that may arise. For example, if the members cannot agree on the value of the proceeds, the liquidation agreement should provide for a formula to use for the distribution of the proceeds if a dispute arises.

Legal and Regulatory Requirements

When entering into or negotiating a liquidation agreement, there are important laws and regulations that must be followed. These range from legal formalities in the document to broader compliance issues that may arise with state or industry-specific laws and regulations. For instance, as an outline for these considerations, if a business is dealing with an individual, there may be securities law requirements under federal and state securities laws, as well as issues under state consumer protection statutes in certain circumstances. If dealing with an entity, there may be antitrust issues and various corporate and commercial law requirements.
An important thing to keep in mind (as is the case with many similar agreements) is that there may be provisions in other relevant agreements concerning additional formalities. So the first step when considering entering into a liquidation agreement should be to review all of your pertinent agreements and to consult with an attorney about the relevant disclosure requirements.

Common Myths Surrounding Liquidation Agreements

Many misconceptions exist about liquidation agreements. One common myth is that a liquidation agreement for a business will always be honored so long as the requirements of Section 6.5 of the Solicitors’ Accounts Rules are met. This is not true. Certainly, any liquidation agreement must comply with Section 6.5. However, compliance does not make it valid. A liquidation agreement not based on a proper legal ground, such as negligence or conversion, may not be honored regardless of whether the other requirements of Section 6.5 have been satisfied. Compliance with Section 6.5 also renders the agreement much more likely to be honored because of the increased level of scrutiny from the Law Society of Scotland.
A related misconception is that, provided a liquidation agreement was properly entered into, i.e. in compliance with Section 6.5, the agreement is binding. This may not be true if the underlying factual foundation of the claim does not give rise to a liquidated claim, e.g. if the claim is for negligence or breach of contract. Liquidation agreements are binding only if the person entering into the agreement has a liquidated claim under the practice rules and that is not the case in every instance. It is a misconception to think otherwise.
Another misconception is that the Law Society of Scotland is bound by liquidation agreements entered into at the request of third parties. In fact, the Law Society will not consider itself so bound when considering disciplinary proceedings against a solicitor. These risk factors are particularly real for the solicitor’s insurer and insureds and it is not always possible to obtain insurance coverage in respect of the risks involved in entering into a liquidation agreement.

Case Studies and Practical Examples

Examples of Liquidation Agreements in Action
To illustrate the use of the aforementioned clauses, consider the following hypothetical examples:
Example 1:
A small software company recently purchased a competitor with proprietary software for $5 million. At the time of the deal, both parties were optimistic about a bright future as synergies were identified and additional software products added to the larger suite of products offered by the combined companies. Unfortunately, two years after the acquisition, the larger, combined company was unable to sustain its business and ultimately filed for bankruptcy. As one of the creditors, the original software company sought to enforce the clawback provision. The point of contention became whether the clawback needed to be requested prior to the sale of the smaller unit or whether the clawback became void upon the sale of the unit. As outlined above, a clawback may become void if the smaller company is sold in a bona fide, arms-length transaction. A significant factor was whether the product line was independently salable.
Example 2:
A real estate company consisting of five single family homes is preparing to sell all of its properties to a developer. Unfortunately, the company has no written liquidation agreement . Of the five single family homes, two were purchased from the same developer who is once again purchasing the same two homes. As part of the flexible clawback clause, the seller will be entitled to recoup the price of these two homes plus interest.
Example 3:
Company A produces a popular product in the U.S. Company B signs on to distribute the product in Canada. Company A’s distribution in Canada has caused the Canadian division to grow from under $1 million in sales to almost $50 million in the first year. Under the liquidation agreement, Company A would be entitled to recoup its initial investment in the product division as well as any money expended to enhance the value of that division. In the event of a litigation dispute and the subsequent initiation of a clawback provision, the clawback amount would be increased by a percentage under the nearly always voluntary provision (i.e. voluntary clawbacks likely are 125% – 130%). Company A made out well because they had a very successful licensing agreement. If they were unsuccessful in closing a licensing agreement, they could have had to write off the value of the Canadian division as the clawback agreement could only be obtained if the Canadian division does not result in any profit.