One of the unhappy duties of a venture investor is to wind down a portfolio company that has failed. The available options for this task differ in important ways. Both equity and debt investors are well served to understand the promise and pitfalls of the alternatives, including the potential gambits to protect themselves, especially from sharp strategic choices made by others in this process.
The easiest alternative, of course, is simply to walk away. As a recent Forbes column points out, however, that approach might well leave significant value on the table, especially if the company’s main assets are intellectual property. Some orderly method of responsibly liquidating the company’s assets and distributing value to creditors is preferable in many, if not most, cases.
As that same Forbes article noted, venture capitalists used to regard putting a portfolio company into bankruptcy as “an unthinkable breach of decorum,” but they are now increasingly perceiving the benefits of this more structured approach. Bankruptcy is a powerful mechanism for salvaging asset value and placating creditors who might otherwise militate for legal action against the company founder or venture sponsor.
A third and generally much less understood option is mentioned fleetingly at the end of the Forbes article: assignment for the benefit of creditors, more commonly known by its acronym, ABC. The article describes this as “a quieter state-law procedure” and notes that “it allows [sponsors and liquidating companies] to fly under the radar.” This provocative description neatly sums up the major pros and cons of the ABC alternative.
The precise rules for ABCs vary among the 50 state legal systems, but an ABC generally differs from a bankruptcy liquidation in only a few important respects. The process and result are fairly similar, as the company simply nominates a trustee (usually a law or accounting firm) to accept an assignment of all of the company’s assets, collect creditors’ claims, and liquidate and distribute those assets to identified creditors, net of a tidy administrative fee. An ABC process is often less expensive than a bankruptcy case, involves much less disclosure paperwork and little if any publicity, and so can be a smoother and cheaper alternative to bankruptcy liquidation.
The privacy advantage also has a darker flipside, which can be an intended disadvantage to creditors. Unlike in a formal bankruptcy case, an ABC has no creditors’ committee to investigate possible asset transfers at undervalue and other sources of recovery; e.g., lawsuits against the debtor-company’s founders, financial sponsors, lenders, and contract counterparties. Likewise, the trustee who accepts the ABC generally has no statutory power to investigate and reverse such prior transactions. And an ABC trustee is generally not supervised by either a court or other regulator, so while the ABC trustee is a fiduciary of all of the creditors, it is often unclear what rights any individual creditor might have to information or to goad the trustee into pursuing any potential legal rights against founders and other third parties.
While avoiding probing scrutiny of pre-liquidation conduct is an attractive advantage for company insiders, it is a decided disadvantage for company creditors. Once the trustee distributes the company’s asset value, the company will have nothing further to pursue on behalf of unpaid claims, and the company founders will be shielded by the company’s veil of limited liability.
Unhappy debt investors and creditors suspecting this intended-opacity strategy have at least two possible responses. One is to undermine directly the lack of transparency in an ABC by putting the debtor-company into a formal bankruptcy case. The appointed bankruptcy trustee will have both statutory power and a much greater interest in investigating questionable transactions and clawing value back into the estate from insiders and other recipients of fraudulent and preferential value transfers. In the U.S., unless the debtor has fewer than a dozen creditors, three must join together behind a creditors’ petition, but the appointment of an ABC trustee automatically provides a foundation for the initiation of an involuntary bankruptcy case.
The other potential response is to rely directly on fraudulent conveyance law, veil-piercing, and other legal actions against third parties. These laws, at least in the U.S., do not require a bankruptcy case, giving creditors direct standing to pursue recovery of fraudulent value transfers and other harmful transactions. Such lawsuits are directed not against the now-defunct company, but against the recipient of the questionable transfers or the perpetrator of the fraud, who is less likely to have been denuded of all assets. The current holders of those assets can be pursued before or even after the conclusion of an ABC, though with the attendant risk and expense of that separate litigation.
So, while company founders might choose an ABC because it is less expensive and faster than a bankruptcy liquidation, they might also make that choice to avoid scrutiny of pre-insolvency value transfers or other questionable conduct by those with insider connections. Whichever it is, savvy creditors have options, and those considering an ABC should consider the possible end game of this chess match, as well.