Originally published in Blakes Bulletin on Business Law, October 2007
The acquisition of an insolvent target will usually involve a court process. A corporation may be insolvent on either an asset-value test, where the value of its assets is less than its liabilities, or a cash-flow test, where it has insufficient liquidity to meet its liabilities generally as they become due, regardless of the value of its assets. A court process will be necessary to convey to a purchaser assets that have a value that is less than the liabilities of the seller. The court process allows the purchaser to acquire the assets free and clear of those liabilities, with the proceeds of the sale distributed under court supervision to those entitled in accordance with the priority of their claims.
Companies with mergers and acquisitions experience may, nonetheless, be new to the distressed marketplace and unfamiliar with a sale process run by the court in either a restructuring or receivership. Buyers knowledgeable about mergers and acquisitions activity in the distressed market will have an advantage over those who do not and will be better able to respond quickly, assess the opportunity and pursue the insolvent target.
This article is intended to provide a brief guide to the uninitiated as to the court-supervised sale process for insolvent enterprises in Canada. The articles above have discussed the trends in the Canadian distressed marketplace, including the influence of a North American economy on insolvency proceedings. The increased number of cross-border insolvency filings over the last several years, and the increased participation of U.S. interests, as owners, financiers and potential buyers of Canadian businesses, have lead to U.S. influences on the sales processes for Canadian insolvent entities. It is therefore important for potential buyers in the Canadian distressed marketplace not only to understand the typical sales process for an insolvent Canadian business, but also to be familiar with the typical U.S. sales process under Chapter 11 of the U.S. Bankruptcy Code and how it may influence or dominate the Canadian sale.
The Companies’ Creditors Arrangement Act (CCAA) is the principal statute in Canada for the reorganization of large insolvent corporations. A more streamlined restructuring process is available under the Bankruptcy and Insolvency Act (BIA), which is suitable for smaller, less complex corporate restructurings. Both are court supervised.
While the CCAA process is intended to provide the debtor with an opportunity to restructure and present a plan of arrangement to its creditors, it is most frequently used as a vehicle for the sale of a business, particularly for large or cross-border enterprises. The CCAA is often preferred for the sale of a business enterprise over a receivership sale for various legal reasons noted in the preceding article, but also because of public perception. In CCAA, the debtor remains in possession of its assets and broadcasts its intention to continue to carry on business, as a restructured entity or a sold entity. Receivership telegraphs to the marketplace that management has been deposed (perhaps a good thing) and a court-appointed officer, the receiver, is in possession of the assets with one objective – to liquidate the business. Rightly or wrongly, receivership conveys a more negative message to customers, suppliers and employees, although the goal is the same as a sale in CCAA.
Receivership can be a useful mechanism in very special circumstances to convey assets, previously marketed by the insolvent company outside of court protection, to a designated purchaser immediately upon the receiver’s appointment, a so-called "quick flip receivership sale." The court must be persuaded that no better value could be generated by a court-approved and supervised sales process. The company and the purchaser take the risk that the court, and other stakeholders who have not been involved in the out-of-court process, may disagree. If successful, a "quick flip receivership sale" achieves the objective of a court-approved conveyance of assets to the purchaser, free and clear of the seller’s liabilities, and avoids the negative message of a receivership and the potential damage to the value of the company operating in receivership during a sale process.
Even in the case of a court-approved and supervised sale process in either CCAA or receivership, the timetable for the sale of the insolvent enterprise must be a fast one. The process must balance the needs of the potential purchasers in the industry-specific marketplace, who must be notified of the opportunity and given adequate time to conduct due diligence and submit an offer, against the financial strain on the insolvent target. The time needed to generate good offers (rather than deeply discounted prices if the potential purchasers have inadequate time for due diligence) must be balanced against the needs of the debtor after the filing, its available financing for the duration of the sale process, and the risk that customers, employees and suppliers may start to migrate. Time is of the essence to accomplish a sale before value evaporates. How fast is too fast is a question for the company, its advisers and its senior lenders, who are going to have to fund the company through its process and will have to commit to the timetable needed to achieve a sale and exit for the senior lenders.
The sale process in both CCAA and receivership is generally approved by the court in advance to avoid any stakeholder complaint over procedural matters at the time a sale agreement is brought forward for approval. The usual court-approved CCAA sale process for a large business enterprise involves the following steps:
- Company retains an investment bank or financial adviser to run the process. If not required in the circumstances, the company runs the sale process itself with the assistance of the monitor appointed in the CCAA process
- Data room prepared and ready to go for purchaser due diligence
- Advertising in appropriate newspapers or industry specific journals
- Summary information package and confidentiality agreement distributed to identified prospective purchasers
- Deadline for completion of due diligence and site visits
- Deadline for letters of intent or binding offers
- Deadline for definitive agreement
- Deadline for court approval and closing
In some cases, there is a second-round process, where a short list of potential buyers who submit attractive letters of intent are selected for a further round of negotiations with the company, particularly for more complex acquisitions.
The end result is a motion before the court on notice to the principal stakeholders for (a) approval of a purchase agreement recommended by the debtor and the monitor and (b) a vesting order, which vests title to the purchased assets in the purchaser free and clear of all right, title and interest of the debtor, and all claims, liens and encumbrances.
At the approval hearing, the court will not, apart from exceptional cases, entertain overbids from unsuccessful bidders or latecomers to the bidding in order to protect the integrity of the sale process and the interests of the winning bidder.
The CCAA sales process has been influenced in some recent Canadian filings by the "section 363 sale process" under Chapter 11 of the U.S. Bankruptcy Code, a full-blown auction process for a company’s assets, which generally operates as follows. The company identifies a "stalking horse" or initial bidder, usually after a marketing process of some kind, and enters into a definitive agreement to purchase the company’s assets with the understanding that the agreement will be shopped around to other prospective purchasers, who will be solicited to top its deal. The U.S. bankruptcy court is asked to approve the stalking horse bid, the date for the auction and the bidding procedures. The bidding procedures will set the rules for the auction, and often include the following terms and built-in protections for the stalking horse that provides the threshold bid:
- minimum bidding increments, set at a meaningful level in the context
- an approved form of purchase agreement for competing bids
- standard bidder qualifications
- a negotiated "break fee," which is paid to the stalking horse if it is outbid at auction or otherwise not the successful bidder
- expense reimbursement for the stalking horse if it is outbid
The U.S. bankruptcy courts are generally prepared to approve break fees in the range of one per cent to three per cent of the purchase price, although the practice is not without controversy. Bidding incentives (or overbid protections) are reasonably required by the stalking horse to compensate it for its costs and the arguable disadvantage of coming forward to establish the transparent baseline for the auction process. The break fee protects the stalking horse and is also intended to generate an attractive initial bid, rather than a deeply discounted offer, which then sets too low a baseline for the auction process.
There are those who argue against the break-fee protection on the basis that it is a disincentive to other bidders, who must outbid the stalking horse offer plus the amount of the negotiated break fee, and diminishes the recoveries to stakeholders by the amount of the break fee that has to be paid to the stalking horse if there is a successful overbid. While there is much academic debate on the topic, the usual 363 sales process includes a break fee as part of the overbid protections to the stalking horse.
There have been recent examples in Canadian insolvency proceedings where a stalking horse style process has been used from the outset or adopted later on in the process. With no statutory provisions to establish a stalking horse process at the beginning, there have been some purchasers and prospective purchasers who have complained that the process changed or migrated toward an auction, with the court entertaining the participation of late bidders. If the rules are not clearly established at the beginning, the purchaser that thought it had the winning bid may not have negotiated protections, such as a break fee or expense reimbursement, which are typical in the U.S.
There have been recent examples in Canadian insolvency proceedings where the Canadian business has been sold in a full-blown 363 sales process. Cross-border insolvencies are on the rise, reflecting the increased cross-border commercial activities of both U.S. and Canadian enterprises. If the U.S. enterprise is the dominant business, then the Chapter 11 process may well prevail and be utilized in the sale of the North American enterprise, including the Canadian business. The co-ordination of a cross-border sale may involve a 363-style auction process approved by the Canadian court for the Canadian enterprise, in tandem with the 363 sale process for the U.S. enterprise supervised by the U.S. bankruptcy court. Canadian and U.S. courts have been quite willing to co-operate in cross-border protocols and recognition orders, with the shared objective of maximizing value for creditors on both sides of the border. Amendments to the U.S. Bankruptcy Code and proposed amendments to the CCAA would entrench such cross-border co-operation even further.
Whether or not the stalking horse process generates more value is a matter of some debate among U.S. and Canadian insolvency practitioners. However, flexibility is required and Canadian insolvency practitioners by necessity are knowledgeable about the U.S. process. Buyers in the distressed marketplace must also be knowledgeable about practice on both sides of the border in order to act on opportunities.
For a prospective purchaser, insolvency presents an opportunity for the acquisition of a target business, which, if privately held, may not have been offered for sale but for the fact of its financial distress. Further, it may present an opportunity for a going-concern acquisition at a discounted price. Some prospective purchasers, while active in mergers and acquisitions, have no interest in wading into the insolvency arena. Others may be deterred by a shorter time frame than they are used to for completing due diligence and submitting a binding offer, and the absence of any representations and warranties that would be expected in a sale transaction outside of the insolvency context. This leaves less competition for those willing to learn and participate in the opportunities of the distressed markets.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.