Bulk Sales Law: A Possible Trap for the Unwary Buyer of a Business

Buyers of businesses should be aware that California, like some other states, has a “bulk sales” law. Its official name is Uniform Commercial Code—Bulk Sales. The bulk sales act is designed to protect the creditors of a business by giving them notice of a “bulk sale” (sometimes called a bulk transfer).

What Is a Bulk Sale (and Who Cares Anyway)?

In general, a bulk sale is a sale to a buyer of all or most of the assets of the business outside the ordinary course of business. The object of the act is to reduce the prospect that the owner of a business will sell all or most of the assets of a business and then disappear with the money, leaving the creditors unpaid. In most cases, when a transaction is a bulk sale, creditors have to be given notice of the transaction. In some cases, the bulk sales law requires the purchase price to be put into an escrow so that the seller’s creditors can submit claims into the escrow and be paid.

The general rule is that a purchaser of assets or a buyer of a business is not liable for a seller’s obligations unless the buyer agrees to assume those obligations, but there are a number of laws that create successor liability, also known as transferee liability, for the purchaser of a business. The bulk sales law is one of them. Even though it creates no liability for the seller of a business, the seller of a business should consult with counsel to avoid an expected snag in the closing of the transaction. Of course, it is of more concern for the buyer.

If the transaction is subject to the bulk sales law and the buyer doesn’t make sure that transaction complies with the law, the buyer may be liable to the seller’s creditors to pay the seller’s debts to the extent of the consideration the buyer paid the seller (or if the assets were sold for a value below their value, to the extent of the value of the assets acquired). Of course, a buyer who gets stuck paying the seller’s debts when that is not part of the deal is entitled to be reimbursed by the seller, but if the seller’s creditors haven’t been paid by the seller, the likelihood is high that the seller is a deadbeat. Thus, in most cases, the buyer will want to make sure that that the purchase of a business subject to the bulk sales law complies with that law.

California’s bulk sales act is contained in Division 6 of the California Commercial Code, which is based on the Uniform Commercial Code drafted by the National Conference of Commissioners on Uniform State Laws (sometimes referred to as the U.S. Uniform Law Commission). Because the Uniform Commercial Code was adopted in all 50 states (though only partly in Louisiana), almost every state had a bulk sales law. The operation of the law would vary from state to state, but the existence of the law was fairly universal. Most of the states have now repealed their bulk sales laws for the simple reason that the bulk sales law doesn’t do much to protect creditors. There is talk of proposals for California to repeal its bulk sales act, but for now, the law is in full force and effect.

Sales Subject to the Bulk Sales Law

First, California’s bulk sales act applies only to certain sellers. In California, the bulk sales act applies only to a seller whose principal business is the sale of inventory from stock, including those who manufacture what they sell, or that of a restaurant owner. Thus, a service business is not subject to the bulk sales act.

Second, the seller must be located in California. If a seller has more than one place of business and some of them are not in California, the seller is deemed located in California if its chief executive office is in California. Thus, if a corporation or LLC is formed under Nevada or Delaware law but has its chief executive office (or its sole place of business) in California, a sale by it is subject to California’s bulk sales act.

Third, the sale must be of more than half (in value) of the seller’s inventory and equipment. So a sale of, say, one-third of a seller’s inventory would not be a bulk sale, even if the other criteria for a bulk sale are met.

Fourth, the sale must be not in the ordinary course of the seller’s business. Naturally, this is the case when the seller sells his business to a buyer; such a sale is not in the ordinary course. On the other hand, a retail shop is not conducting a bulk sale when it sells its goods to its customers in the ordinary course of business (no matter how much it sells at any one time).

In addition to the traditional negotiated sale of a business, the bulk sales law can apply to a sale by auction or a series of sales conducted by a liquidator on the seller’s behalf, but the focus of this blog post is on the acquisition of a business, either as a going concern or in liquidation.

By the way, the bulk sales law is not the only law that can make a buyer liable for the seller’s debts (even though the buyer has expressly disclaimed assuming any of the seller’s debts). See the links at the end of this post.

Bulk Sales Notice

To comply with the act, there are two steps that are essential.

First, the buyer has to prepare a notice of bulk sale that provides:

  1. A statement that a bulk sale is about to be made.
  2. The buyer’s name and business address.
  3. The seller’s name and business address.
  4. A list of any other business names and addresses used by the seller during the three prior years (the buyer is to obtain this list from the seller).
  5. A general description of the assets and their location.
  6. The place of the bulk sale.
  7. The anticipated date of the bulk sale.
  8. A statement whether the bulk sale is subject to the escrow requirements of the bulk sales law, and if so,
    (a)   the name and address of the person with whom claims must be filed and
    (b)   the last date for filing claims (one business day before the anticipated date of the bulk sale set forth in the notice).

Whether a bulk sale is subject to the escrow requirements of the bulk sales will be discussed later in this blog post.

Second, at least 12 business days before the sale takes place, the buyer must (1) record the notice of bulk sale in the county recorder’s office, (2) publish the notice in a local newspaper of general circulation, and (3) deliver the notice of bulk sale to the county tax collector. A “business day” is any day other than a Saturday, Sunday, or state holiday.

Delay Resulting from Notice Requirement

The notice requirement results in a two and one-half week period between giving the required notice and closing the transaction. In some cases, the notice period has no effect on the transaction because the time that the parties have scheduled between signing the contract and closing the transaction is longer than 12 days, and the giving of notice does not delay closing.

Often, however, the parties are negotiating the contract while the buyer is doing his due diligence, and they want to sign the contract and to close the transaction simultaneously with the signing. In that case, the notice period introduces an unwanted delay in closing the sale. In a number of cases, the parties are motivated to move as quickly as possible and any delay is unwelcome.

For example, in a distress sale, the seller may be selling because he has an obligation to make a payment by a certain date, and he intends to use the sales proceeds to satisfy that obligation. Or the seller may have an option to extend the term of his lease, but the seller does not want to exercise the option before closing because the seller does not want to commit to the additional term if there is no sale of the business. The buyer, of course, does not want to buy the business unless the buyer can extend the term. If the date parties must act by is before the twelve-day notice period expires, the notice requirement of the bulk sales law can present a serious problem.

Escrow Requirements of a Bulk Sale

In a bulk sale subject to the bulk sales law, there is no escrow requirement if the price is more than $2,000,000. There is also no escrow requirement if the price will be paid by consideration other than cash (or a promise to pay cash in the future). So, if the price will be paid by the buyer’s giving stock in the buyer exchange for the seller’s assets, there is no escrow requirement.

If the price is $2,000,000 or less and will be paid in cash or by a promise to pay cash in the future, whether or not set forth in a note (or a combination of the two methods of payment), then there is an escrow requirement.

Technically, the bulk sales act does not require an escrow, but because a purchase and sale of a business is often handled through an escrow, I refer only to the obligations imposed on the escrow agent. If there is no escrow, say, because the bulk sale is not the purchase of a business, then the duties that would be imposed on an escrow agent are imposed on the buyer, and references to the duties of the escrow agent are references to the duties of the buyer.

If there is an escrow, the buyer must deposit the full amount of the purchase price into escrow. If part of the purchase price is to be paid by a promissory note, then the note is deposited into escrow along with the cash portion. Thus, while the entire purchase price is to be deposited into the escrow, only a portion (or none) may be cash.

When a proper claim is timely submitted by a creditor into the escrow, the escrow agent must pay the claim from the cash in the escrow. A proper claim is one that is due and payable before the date of the bulk sale. A timely submittal is one that is made in writing and is received on or before the date for filing claims set forth in the bulk sales notice.

If the seller disputes the claim (either on the ground that it is not due and payable or that the amount is not correct), the escrow holder must withhold from any distribution to the seller 125% of the first $7,500 of the claim ($9,375 on a $7,500 claim) plus an amount equal to the balance of the claim. Thus, if the claim is for $5,000, the escrow agent must withhold $6,250 (125% of $5,000). If the claim is for $10,000, the escrow agent must withhold $11,875 ($9,375 + $2,500). The balance of the purchase price can be disbursed to the seller.

On or before the second business day after the disbursement of the purchase price to the seller, the escrow agent must send a notice to the claimant that the amount withheld will be paid to the seller unless the claimant files for and obtains a writ of attachment within 25 days of the mailing of the notice. After 25 days, any amount that is not subject to a writ of attachment must be disbursed to the seller.

Creditor Claims in Excess of Cash

What happens if the cash in the escrow is not sufficient to pay all claims?  Things get more complicated.

If the cash in the escrow is not sufficient to pay all claims, the distribution of the purchase price and the conveyance of title must be delayed for at last 25 days and no more than 30 days from the mailing of the notice to claimants.  The escrow agent must send out a notice to each claimant, stating:

  1. The total consideration deposited or agreed to be deposited in the escrow.
  2. The name of each claimant who filed a claim against the escrow and the amount of each claim.
  3. The amount proposed to be paid to each claimant,
  4. The new date scheduled for the passing of legal title.
  5. The date on or before which distribution will be made to claimants (no more than five days after the new date specified for the passing of legal title).

The statute provides a distribution scheme that sets forth priorities of various types of creditors. Thus, some types of creditors may get paid in full, and others may share pro rata share of the balance remaining (or receive nothing at all).

Noncompliance with the Act

Many times, however, parties proceed with a transaction that falls within the act but knowingly don’t comply with it. Often, a buyer can do that, either with complete safety from any claim under the act or with relative safety.

Transactions That Are Exempt

First, the California version of the bulk sales act contains two express exemptions. It does not apply to a sale of assets having a value of more than $5,000,000 on the date of the bulk sale agreement or to a sale of assets having a value, net of liens and security interests, of less than $10,000.

What if value falls within those two amounts? Quite often, the purchase and sale of a business is structured in a way that the transaction does not fall within the act even if the value falls within those two amounts.

Transactions Not Subject to Act

The act does not apply to the sale of an interest in a business entity, even if the entire interest is owned by one person and the entire interest is being sold. Thus, the act does not apply to the purchase and sale of stock in a corporation, even if there is only one shareholder and all the stock is being sold. Likewise, it does not apply to the sale of a membership interest in a limited liability company (LLC) or a partnership interest.

For this reason, the bulk sales act typically does not apply to a buy-sell transaction between partners in a partnership or co-owners of a corporation or LLC. In those cases, the remaining owner is not buying the assets from the business but is instead purchasing the partnership interest or stock or LLC membership interest.

The also does not apply to a merger of a corporation or LLC into another entity, even though the result is that all the assets of the party who would be considered the seller are transferred to the party who would be considered the buyer.

Intentional Noncompliance

Finally, many purchasers of a business intentionally don’t comply with the act, though the purchaser will ordinarily protect himself otherwise against the claims of creditors. Here are two typical scenarios applicable to the acquisition of a business subject to the act.

In one scenario, the asset purchase agreement provides that the purchaser is not assuming any liabilities, and the seller promises to pay the existing liabilities. (Of course, the whole point of the bulk sales act is that when a transfer falls within the act, third-party creditors have rights against the buyer independently of any agreement to assume liabilities. So an agreement that the purchaser takes the assets free and clear of any liabilities does not limit the creditors until the statute of limitations for claims by creditors expires).

Another typical scenario is that the seller represents and warrants to the purchaser what the liabilities are, the purchaser expressly assumes those liabilities, and the seller promises to pay any liabilities not expressly assumed by purchaser. In this scenario, the purchaser is already liable to the third-party creditors who have been disclosed so the bulk sales adds no exposure as to those creditors.

In either scenario, the purchaser is exposed to risk. What if the seller doesn’t pay the creditors whose claims the purchaser has not agreed to assume?  If the act applies and if there is no exemption, then the purchaser is on the hook to creditors.

But in these types of transactions, the purchaser typically owes the seller a portion of the purchase price, either in the form of a post-closing escrow or express hold-back of the purchase price for a specified period (which in either case can protect the purchaser against hidden claims), or in the form of deferred payment of the purchase price (typically a promissory note). It is standard for a purchaser to retain the express right to offset against the deferred payment of the purchase price any claims that the purchaser has against the seller, including a claim that the seller misrepresented liabilities or failed to pay liabilities that the purchaser did not assume. Thus, through a combination of due diligence and careful structuring of the transaction, a purchaser can avoid complying with the bulk sales act with relative, and sometimes absolute, impunity.

Conclusion

To avoid inadvertently becoming liable to the creditors of a seller, a purchaser should be advised by a California lawyer experienced in the acquisition of a business. One of the most valuable services a lawyer can provide a client in a business purchase is helping to structure the transaction.  The prospective acquirer of a business would do well to consult with counsel before making any kind of offer, including a proposed letter of intent.

For information on possible buyer liability for the seller’s liability to the Board of Equalization (for sales taxes) (whether or not the bulk sales act applies), see  https://richardburtlaw.com/boe-tax-clearances/

For information on possible buyer liability to the Employment Development Department (for the seller’s state payroll tax obligations) (whether or not the bulk sales act applies), see https://richardburtlaw.com/edd-tax-clearances/

For information on possible buyer liability for the seller’s liability to the Franchise Tax Board (whether or not the bulk sales act applies), see https://richardburtlaw.com/franchise-tax-board-tax-clearance-certificates/

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