M&A Due Diligence: Issues in Purchasing Inventory of a Bankrupt Retailer

Part I and Part II of this three-part series discussed risks associated with purchasing inventory in conjunction with the acquisition of a retailer and the procedures a Buyer should consider performing as part of the due diligence process. This post will focus on issues specific to purchasing inventory through the acquisition of a retailer in bankruptcy.
There are various methods by which a bankrupt retailer can sell its inventory and/or its business as a whole through the bankruptcy process. What is referred to as a Section 363 asset sale is generally the most common means by which a bankrupt retailer sells its assets and it provides debtors with guidelines on how to effectuate a sale while in bankruptcy.

Retailers must first determine how to go about selling their assets, primarily inventory, which can be executed in the following ways:
  • Sale of the business to a new buyer, including all inventory, where management of the bankrupt retailer either continues with the new buyer or is replaced.
  • Conduct going-out-of-business (GOB) or store closing sales without a liquidator.
  • Sell inventory to a liquidator, which usually includes an auction sale to the highest bidder for all or part of the debtor’s inventory. Arrangements involving liquidators take two forms:
  • An outright sale of all inventory to the liquidator for a guaranteed amount, at which point the liquidator assumes the risk of selling the debtor’s assets; or
  • A consulting arrangement in which a liquidator is hired to manage and oversee the retailer’s inventory and asset sale process. These deals are typically structured as a sharing arrangement whereby the retailer and liquidator share in the sale proceeds based on a specified sharing formula.
When a bankrupt retailer sells its business outright to a new buyer there are various issues that can result in post-acquisition disputes. These issues include, but are not limited to, disputes related to alleged obsolete, excess or unsalable inventory, where the Buyer claims that it received inventory that was misrepresented by the Seller. Disputes related to the seller’s representations about its inventory sometimes result from information provided by former members of management that were hired by the buyer. These disputes can be tricky since the alleged issues typically involve transactions that occurred while these former members of management worked for the seller.  Other times, after the closing of the sale, the buyer makes changes to the business or mix of inventory that contributes to or causes the alleged inventory problem.

In cases where a liquidator is hired, reconciliation issues may arise during the GOB sale process. Reconciliation issues with the liquidator typically occur due to issues related to augmented or additional inventory, where the bankrupt retailer is entitled to share in a portion of the proceeds from the sale of inventory that the liquidator brings into the stores and sells during the GOB sale. Other issues that may arise relate to the sharing of liquidation expenses or the application of the lowest ticketed price in pricing the inventory. In addition, the parties may face issues arising when sale proceeds may not reach expected levels or fall short of guaranteed minimums. There are also situations where the bankrupt retailer or the liquidator miscalculate the actual inventory on hand, due to shrink or other issues, which typically are not known until after the end of the GOB sale process. These situations typically are not resolved until the parties come to an agreement on how to allocate any shortfalls in sale proceeds.

Have you been involved in a retail bankruptcy that resulted in a post-acquisition dispute?