During the course of the most recent bull market, merger and acquisition (M&A) activity generally remained robust. We increasingly saw competitive auctions for desirable companies, some of which also had the ability to pursue an initial public offering instead of a sale. In the years since the 2008 financial crisis, many acquisitive companies have become accustomed to pursuing target companies with solid balance sheets and bright prospects.
With the COVID-19 crisis, we suddenly find ourselves, once again, in an extremely challenging economic environment, one that many companies are unprepared to face. Many will not survive the economic fallout from the pandemic. Many others will persevere, some perhaps even thrive. They will have the opportunity to strengthen and expand their own footprints by salvaging promising companies that now find themselves in distress. Those deals will look dramatically different from the deals to which most strategic acquirers have become accustomed. For a buyer, adjusting to the rules of the road in the world of distressed M&A may be the most challenging part of a transaction with an insolvent company.
While 2020’s crisis is caused by different factors than 2008’s, the resulting increase in distressed M&A activity may ultimately be strikingly similar. Buyers should prepare for this change in the M&A landscape and be ready both to accept the challenges and seize the benefits of the various types of transaction structures for acquiring distressed assets. Understanding the risks and benefits of distressed company M&A and how to use structuring to achieve the right balance will help buyers navigate an unfamiliar road to what just might be a very beneficial transaction.
Distressed company M&A involves risks that don’t exist in a non-distressed situation, and the buyer often can’t avail itself of the otherwise standard contractual protections, such as indemnification provisions, it would have in a typical transaction. On the other hand, depending on how the transaction is structured, acquirers may find that the protections afforded by the bankruptcy code present a better mechanism for avoiding the assumption of unwanted liabilities than is available in a non-distressed deal.
Key Differences in Purchasing Distressed Assets
Fraudulent Transfer and Successor Liability Risks
When a buyer is considering purchasing assets from an insolvent company outside of the bankruptcy process, it must pay particular attention to avoid inadvertently assuming unwanted liabilities — a much more difficult proposition in transactions with insolvent companies. For buyers used to purchasing assets from solvent companies, a distressed transaction may be their first introduction to the concept of “fraudulent transfer” or “fraudulent conveyance.” In a nutshell, a creditor of an insolvent company may be able to invalidate a sale of the company’s assets, or seek recourse against the buyer of the assets, in the event of a fraudulent transfer. This is, of course, one of the risks a buyer hopes to avoid by opting for an asset purchase in the first place.
The concept of fraudulent transfer appears in both the bankruptcy code and in the laws of each state. While the elements of such a claim vary depending on the jurisdiction, as a general matter, if the seller does not receive reasonably equivalent value for the assets and was insolvent, became insolvent as a result of the transfer or the remaining assets of the seller were unreasonably small in relation to the business, then creditors will have a basis to bring a fraudulent transfer claim. Such a claim raises the possibility that the buyer will have to satisfy liabilities to creditors that it did not agree to assume — and may have in fact expressly provided were to remain with the seller — in the transaction.
Similarly, in a distressed environment, the buyer may face enhanced risks of being subjected to additional, un-bargained-for liabilities through claims brought against the buyer on a successor liability, de facto merger or similar theories. By case law and, in some instances, by statute, buyers that are “successors” to the business are deemed to have assumed certain liabilities regardless of any assertions to the contrary in the purchase agreement. Liabilities for taxes, product liabilities, environmental and employee claims are the most fertile ground for successor liability claims.
Limited Contractual Recourse
Unfortunately, notwithstanding these increased risks, it is typical that the buyer has relatively limited recourse for unwanted liabilities under the purchase agreement. It is uncommon for the purchaser of assets out of bankruptcy, for example, to receive any significant representations and warranties, let alone any post-closing recourse. Even in structures that fall short of a bankruptcy, representations and warranties, as well as post-closing recourse, are more limited than transactions involving healthy companies. A mixture of factors contributes to this, among others: (1) the buyer’s desire to quickly close the transaction before employees find other employment, customers leave, the business disintegrates and the value of the transaction is lost; (2) a discounted purchase price; and (3) given the discounted purchase price, the relatively small amount reasonably available for escrow and indemnification. Representation and warranty insurance may be an option, but that comes with its own costs and shortfalls. However, as discussed below, the bankruptcy code affords certain protections to a buyer in lieu of traditional contractual recourse.
Diligence Is Critical
As a result, diligence becomes of paramount importance. It is far preferable to avoid “buying” liabilities by discovering them in advance through diligence than to discover them following closing and have only limited recourse against the insolvent seller. In addition to the usual areas of diligence, the COVID-19 pandemic brings certain areas of inquiry to the forefront, such as
• exposure of the business (including its key counterparties, suppliers and customers) to jurisdictions highly affected by the epidemic
• supply chain risk and the availability of, and costs associated with, using alternative sources of supply
• potential employment law issues and compliance with relevant government health guidelines
• the legal basis under privacy laws, particularly the General Data Protection Regulation in the European Union/UK, to process health data on employees, visitors and customers and whether privacy notices cover processing for COVID-19 purposes
• whether the seller has any deferrals of tax, customs duties, taxes or fees, whether through newly adopted state, federal or foreign laws in response to the pandemic or otherwise
• regulatory, licensing and data privacy implications as a result of remote working arrangements, particularly in certain industries (e.g., financial services)
• the ability of the business or its counterparties to perform, suspend or walk away from obligations under assignable material contracts, including exercising force majeure or similar provisions — in particular, investigating scenarios where the nonperformance by the seller’s counterparty has the consequence of causing the seller (or buyer as assignee) to breach its obligations under other contracts
Additional Protective Actions
Buyers should consider going beyond their own usual diligence and obtaining a third-party valuation of the assets being acquired, seeking releases and waivers from third parties who might have claims against the seller and using deal mechanisms more directly involving the seller’s creditors, such as an assignment for the benefit of creditors (also referred to as an ABC) or a “friendly” foreclosure, discussed briefly below, which may provide some incremental protection against unwanted liabilities and claims of fraudulent transfer.
Different Fiduciary Duties Means a Different Dynamic
Finally, buyers should be aware that as a seller approaches insolvency, its directors’ and officers’ fiduciary duties may expand to include not only the interests of the company and its stockholders, but the interests of creditors as well. While the details of this shift, and when it occurs, vary by state, the general result is that the interests of creditors take on a much greater level of importance in these transactions than would be the case where the seller is not in distress. In many cases, creditors may be involved in the negotiation of the transaction.
The Opportunity of Bankruptcy Protection: A “363 Sale”
While distressed company M&A presents some unique challenges, it also offers a unique opportunity — the opportunity to use the chapter 11 process to more definitively leave unwanted liabilities behind.
“Chapter 11” Versus a “363 Sale”
Chapter 11 bankruptcies are well known as a mechanism by which an insolvent company may develop, pursuant to the bankruptcy laws and subject to the confirmation of the bankruptcy court, a plan of reorganization that allows the company to restructure its debts and contractual arrangements with its lenders, customers, suppliers, vendors etc., ideally with the goal of emerging from bankruptcy as a viable business. The chapter 11 plan, once approved by creditors and confirmed by the court, allows for virtually any type of reorganization or M&A transaction imaginable.
For distressed companies in bankruptcy seeking to conduct a sale of some or even all of their assets in order to repay creditors, such companies frequently conduct what are known as “363 sales,” a reference to a section in the bankruptcy code allowing the debtor to use, sell or lease assets outside of the ordinary course of business. After running a robust process intended to obtain the “highest or otherwise best” bid for the assets, often accomplished through an auction, the bankruptcy court approves the sale without requiring the extensive voting process associated with confirming a chapter 11 plan. As such, a 363 sale can typically be conducted more expeditiously and at a lower cost than the full chapter 11 plan process.
Perhaps the most attractive benefit of a 363 sale is that with only limited exceptions, assets are transferred to the buyer free and clear of liens and encumbrances and free from creditor and successor liability claims. This gives a buyer significant protection against acquiring unwanted liabilities. Other benefits include the ability to assume certain contracts even if they contain anti-assignment provisions (subject to some exceptions and provided that defaults are cured) and the fact that approval of the transaction by the seller’s stockholders is not required. Further, the purchase of the assets through a 363 sale eliminates the fraudulent transfer risk otherwise existing in out-of-court distressed acquisitions, as the purchase is blessed by a court order.
Structuring a “363 Sale”
Frequently, when a seller is approaching insolvency, it will embark on a process to find a buyer willing to enter into a “pre-negotiated 363 sale.” That is, before any filing is made with the bankruptcy court, the seller and the buyer enter into a negotiated asset purchase agreement (or APA). Thereafter, the seller files its chapter 11 petition along with a motion seeking approval of bidding procedures and bidding protections for the buyer. The negotiated APA will be attached to the motion, allowing other parties the opportunity to submit their own bids for the assets in accordance with the bid procedures. Additionally, because all filings in bankruptcy court are public, the general public will also have access to all the details of the proposed transaction.
On only the most superficial level, the APA is similar to what a buyer sees in the context of any other asset purchase. It provides for a list of particular assets to be purchased, liabilities to be assumed, liabilities to remain with the seller and a specified purchase price. The APA contains representations and warranties, pre-closing covenants, closing conditions and termination rights.
Within these high-level categories of provisions, however, there will be substantial deviation from the provisions contained in an APA involving a solvent company. As previously discussed, the representations and warranties will be very basic and limited. Pre-closing covenants will focus less on limitations on the seller’s operations between signing and closing and more on the bankruptcy process itself. Conditions that permit the buyer to walk away — for example, financing outs or diligence outs — are heavily disfavored.
Closing conditions and termination rights will be limited and fairly seller favorable. In fact, buyers new to 363 sales may be surprised to learn that the APA in a 363 sale is ultimately not binding on the seller until approved by the bankruptcy court. That approval can come only after a notice and an opportunity for an auction process during which creditors may challenge the terms of the proposed transaction and the seller must actively seek out other bidders for the assets.
Stalking Horse Bidders and Break Fees
A 363 sale APA thus, explicitly puts the buyer in the position of being the “stalking horse bidder” for the seller’s efforts to obtain a higher price for its assets in a public auction. It is common for the stalking horse bidder to receive a breakup fee if it is not the winning bidder in consideration for playing this role.
In general, these breakup fees are around 3% of the purchase price (typically not including the value of any assumed liabilities), plus expense reimbursements that are typically subject to a cap. The net result is similar to the typical breakup fee of around 3.5% of equity value that a jilted buyer in a public company purchase might receive in the event of a successful topping bid. Most important, the breakup fees and expense reimbursement offers a significant advantage to the stalking horse bidder if another entity steps forward and wants to bid at the auction. Because the goal of a 363 sale is to maximize the value of the assets and obtain the highest or otherwise best bid, the competing bidder must add the full value of the breakup fees and expense reimbursement to their topping bid. As a result, many times the stalking horse bidder is able to obtain the assets without other bidders coming forward — and therefore, without the need for an auction.
Nonetheless, potential buyers must consider whether the risk of the public bankruptcy auction is worth the protection a bankruptcy process can provide or whether a privately negotiated transaction not subject to approval by the bankruptcy court might be more desirable. If a bankruptcy process is deemed more advantageous, potential buyers must then decide whether it is better to be the stalking horse or to participate as a third-party bidder in the later auction. Each case will differ depending on the competitive landscape for the assets, the types of liabilities that may arise, the number of potential creditors and claimants involved and the importance to the buyer of securing the assets.
Other Regulatory Hurdles Still Apply
It is important to note that while there is a shortening of the waiting period required under the Hart-Scott-Rodino Act to 15 days (from 30 days) for 363 sales, the filing obligations remain the same.
Another common regulatory hurdle, at least for foreign buyers, also applies to 363 sales. A filing with the Committee on Foreign Investment in the United States (CFIUS) might be prudent, and possibly mandatory, when a foreign buyer takes possession of a bankrupt business or a foreign party acquires assets out of bankruptcy. CFIUS has jurisdiction to review the national security implications of transactions where a foreign party acquires a stake in a U.S. business that affords it certain governance or information rights or acquires real estate located in proximity to sensitive military installations. CFIUS has jurisdiction over transactions in any sector, but is particularly interested in investments in companies involved in technology, infrastructure, the collection of personal data or government contracts. Historically, CFIUS jurisdiction was limited to investments in which a foreign person acquired control of a U.S. business, and filings were voluntary. Recent legislation has expanded the scope of CFIUS jurisdiction to cover certain kinds of investments by foreign persons that confer rights in a U.S. business that fall short of control and has made filings mandatory in certain situations.
Downsides to a 363 Sale
While a 363 sale can be completed more efficiently than a chapter 11 plan, it nonetheless can be more time consuming than a typical asset purchase or other structures discussed below such as an assignment for the benefit of creditors, the friendly foreclosure or other variants of the same. It also exposes the buyer to the risk of being outbid at auction for the assets it desires to acquire. The auction process alone can be time consuming, and in the interim the seller could experience a loss of employees and customers — and much of the value that the buyer is hoping to attain in purchasing the company could be quickly eroded. In addition, while the stalking horse buyer may negotiate an APA that provides for, among other things, a limited time period in which the bankruptcy process and the auction must occur, the bankruptcy court must approve certain provisions in the APA such as requirements that must be satisfied for a third party to submit a “qualified” bid in the auction, the minimum amount by which third parties must “overbid” the stalking horse and each other and, of course, the amount of the breakup fee if the stalking horse is not the winning bidder. While experienced legal counsel can guide the client toward a generally accepted range for such provisions, ultimately the bankruptcy court has the final word on these matters.
Where circumstances warrant a greater degree of structural (as opposed to contractual) protection against fraudulent transfer and successor liability claims than a typical APA provides, but in a shorter time frame with less risk of third-party bidders than a 363 sale provides, an assignment for the benefit of creditors (or ABC) or friendly foreclosure may provide the right balance between the buyer’s competing concerns.
Assignment for the Benefit of Creditors
In an ABC, the seller assigns its assets to a third party (the assignee) who is then responsible for selling the assets and distributing the proceeds to the seller’s creditors (net of the assignee’s fee). ABCs are governed by state law and vary significantly from state to state. Depending on a given state’s law, an ABC may or may not be an option. In addition, the fact that an ABC typically requires stockholder approval may also rule out an ABC as an option. While no structure provides absolute protection from a fraudulent transfer allegation, because an ABC involves a sale of the assets by an independent third-party fiduciary, the purchase of assets through an ABC may reduce the risk that a creditor will view the sale process as having been unfair or inadequate and bring a fraudulent transfer claim.
In a friendly foreclosure, the secured creditor and the seller agree that the secured creditor will foreclose on the assets and then use its power as secured creditor to transfer title to the assets to a buyer. While the buyer should expect the secured creditor to seek to sell the assets on a purely “as-is, where-is” basis with little in the way of representations and warranties or indemnity, the structure may provide incremental protection against claims made by unsecured creditors and third parties asserting successor liability by virtue of the formal state law foreclosure process.
Dealing With Changed Circumstances
When evaluating acquiring a distressed company, buyers should be prepared for surprises. Frequently, in the course of due diligence, the liabilities will turn out to be greater than initially thought, accounts receivable will be more difficult to collect than represented and issues surrounding employees will be thornier than anticipated. This is sufficiently common in distressed company deals that while it should not necessarily be cause for undue alarm, it may well be cause for rethinking how the transaction should be structured. Where it may have initially seemed that the seller was more “troubled” than “distressed” and the buyer was willing to proceed with a more traditional stock purchase agreement, changed circumstances may lead to a conclusion that in fact, a 363 sale, ABC or friendly foreclosure may better balance the competing risks and benefits. Ultimately, the buyer’s objectives in terms of price, liabilities, timing, avoiding competing bids, keeping the employee and customer bases intact etc., will all have to be taken into account.
A buyer will need to remain flexible to preserve its ability to revise the proposed structure to take its diligence into account and to keep its eye on the ball in terms of what it wants to achieve. Similarly, as the larger economic picture continues to change and evolve, buyers should be mindful of any changing circumstances in their own business and whether a potential acquisition continues to be one that remains advisable.