Many companies are unprepared to face the tremendous economic challenges brought on by the pandemic. For buyers, navigating this new world of distressed M&A may be the hardest obstacle to overcome in transactions with insolvent organizations.
However, while these deals differ significantly from those that were commonplace during the recent bull market, there are opportunities among the challenges, and buyers seeking to seize what they view as bargain prices should understand five key issues.
Understand fraudulent transfer and successor liability risks
Bull market buyers have not often needed to consider “fraudulent transfer” or “fraudulent conveyance” risks — the possibility that a creditor of target company may be able to invalidate a transaction or have a remedy against the buyer. The elements of a fraudulent transfer claim differ by state, but generally allow creditors to make claims against a buyer in cases where the seller was not paid reasonably equivalent value for the assets and either is insolvent (or becomes insolvent as a result of the transaction) or is left with assets that are unreasonably small for the business. An acquirer may also be subjected to additional liabilities on a successor liability or similar theory. Such claims raise the possibility that the acquirer will have to satisfy liabilities to creditors that it did not agree to assume.
Recognize limited contractual recourse
Typically, a buyer will have limited recourse under the purchase agreement. When a distressed company sells assets without a bankruptcy proceeding, a buyer may be able to obtain a standard set of representations and warranties as well as indemnity provisions, but frequently these provisions will be more limited than where the seller’s business is robust, given that the sale proceeds in a distressed transaction are most frequently fully devoted to satisfying existing liabilities. Purchasers of assets out of bankruptcy often receive minimal representations and warranties and there is no ability to make claims against the seller after the closing. Buyers might consider obtaining representation and warranty insurance, though that may not put the buyer in the same position as having received fulsome indemnity provisions.
As a result of this limited opportunity for recourse, due diligence on a company’s liabilities becomes particularly important. Buyers should pay particular attention to liabilities specific to the pandemic, including employee-related liabilities, failure to comply with applicable government health and safety requirements and breaches due to failure to perform under customer contracts. Bankruptcy does have some advantages in that the bankruptcy code itself affords certain protections to a buyer against certain types of these unwanted liabilities, as discussed further below.
Know the benefits of “363 Sales”
A distressed company can sell its assets in order to repay creditors by conducting a “363 sale,” a reference to a section in the bankruptcy code. After running a process to sell the assets that is designed to obtain the “highest or otherwise best” bid, the sale is approved by the bankruptcy court. This often is done as a “pre-negotiated 363 sale” in which the company finds a buyer, enters into a negotiated asset purchase agreement with that buyer, and then files its chapter 11 petition along with a motion seeking approval of bidding procedures and protections for the identified buyer. The agreement is ultimately not binding on the distressed company seller until it is approved by the bankruptcy court. Before the court will grant that approval, the agreement, bidding procedures and protections are made public and other potential buyers will be permitted to bid on the assets being sold in accordance with the bidding procedures.
A 363 sale can typically be accomplished more quickly than a chapter 11 bankruptcy plan. With limited exceptions, in a 363 sale the buyer receives protection from the seller’s liabilities, buying the assets free from obligations to the seller’s creditor and successor liability claims.
Consider the pros and cons of being a stalking horse bidder
The buyer who enters into an asset purchase agreement in a pre-negotiated 363 sale is the “stalking horse bidder” against whom other bidders compete to acquire the target’s assets in a public auction conducted pursuant to the bankruptcy court approved bidding procedures. As consideration for playing this role, stalking horse bidders usually receive a break-up fee if they do not ultimately prevail as the buyer for the assets. These fees are around 3 percent of the purchase price, plus expense reimbursements, usually subject to a cap.
An acquirer considering purchasing assets from a distressed company must consider whether the risk of the public auction is worth the protection a bankruptcy process can provide and weigh that process against a privately negotiated transaction not subject to approval by the bankruptcy court. If a bankruptcy process is unavoidable, the acquirer should consider the pros and cons of being the stalking horse versus participating as a third party bidder in the later auction.
Evaluate benefits of alternative structures
If the bankruptcy process would be slower than is needed for the circumstances, but the buyer seeks greater insulation from fraudulent transfer and successor liability claims than in an out-of-court negotiated agreement with the seller, an assignment for the benefit of creditors (or “ABC”) or friendly foreclosure may be preferable. In an ABC, an independent third party runs the process to sell the Seller’s assets, with the proceeds going to the seller’s creditors. That third party is assigned the assets and is becomes the “seller” as a fiduciary for the creditors. It receives a fee for that role that reduces the proceeds distributed to the creditors. This process is intended to ensure that the sale process is fair to creditors, potentially reducing fraudulent transfer claims. Whether the ABC option is available as a transaction structure depends on the law of the applicable state, with states differing significantly as to the availability and details of this process.
In a friendly foreclosure, a secured creditor forecloses on the assets, obtaining title to the assets that can then be transferred from the creditor to a buyer. This is done with the agreement of the seller, hence the “friendly” moniker for this form of transaction. Because the secured creditor is not well positioned to make representations and warranties about the assets, these transactions are often done on an “as-is, where-is” basis. However, by virtue of the formal state law foreclosure process, the buyer in this structure may receive some protection against claims by unsecured creditors and successor liability claims.
The current environment brings both risks and opportunities for buyers. When considering acquiring distressed assets, a buyer should enter the process well-informed as to its structuring options, consider diligence and all other factors in choosing a structure, and focus on prioritizing its objectives relative to its risk tolerance.