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"The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger—but recognize the opportunity." John F. Kennedy, speech in Indianapolis, Indiana, April 12, 1959.
As a result of the contraction of the capital markets, it has become increasingly difficult for distressed corporate borrowers to refinance their existing debt facilities, recapitalize their businesses or even obtain the debtor-in-possession financing necessary to reorganize through bankruptcy. As a result, distressed sales—both inside and outside of bankruptcy—have become commonplace. Most distressed M&A transactions are structured as asset sales, rather than corporate mergers. By purchasing the assets of a distressed business, the purchaser is able to extricate and unburden the operating assets from the debts and liabilities of the distressed seller. The exigent circumstances surrounding distressed sales, the often-precarious relationship between the seller and its lenders, and the lack of meaningful strategic alternatives available to the seller place downward pressure on the purchase price and create the opportunity for value.
Commensurate with the opportunity for greater value, distressed M&A transactions also present greater risk, particularly execution risk. In many instances, the purchaser is dealing not with a willing seller, but with a coerced seller that is being forced to liquidate by its senior lenders. The purchaser may find the seller's principals to be recalcitrant, making it more difficult to get the deal done. Moreover, the distressed seller's creditors (most particularly, junior lien holders) may attempt to interfere with or scuttle the sale in order to gain leverage in their negotiations with senior lenders. Each of these risks can, of course, be managed, but any purchaser evaluating a distressed acquisition should be mindful of the following five traps.
1. Selecting the Right Process for the Acquisition
One of the most important decisions that a purchaser must make in connection with a distressed M&A transaction is how to implement the sale. Because every transaction is unique, a purchaser should give careful thought to the proper procedural approach. The decision may be driven by a myriad of factors, including (i) the nature and complexity of the business and its assets, (ii) the seller's need for and access to operating capital in the interim period prior to a closing, (iii) the extent and priority of the existing liens, (iv) the level of acrimony among creditor constituencies and (v) the time available to complete the transaction. Choosing the wrong approach may jeopardize or complicate the execution of the transaction.
Potential implementation options include (i) a bankruptcy sale pursuant to Section 363 of the U.S. Bankruptcy Code, (ii) a secured creditor disposition pursuant to Article 9 of the Uniform Commercial Code (UCC), and (iii) a receivership or assignment for the benefit of creditors (ABC). Each option has relative benefits and detriments. Although it is beyond the scope of this article to address the intricacies of each approach in detail, a broad overview the three basic approaches is helpful.
- Bankruptcy Sale. Bankruptcy sales provide a number of benefits that cannot be obtained outside of bankruptcy. The most significant benefit is that the assets are generally transferred to the purchaser free of all claims, liens and encumbrances, pursuant to Bankruptcy Code Section 363(f). The purchaser is given clean title and the benefit of a federal court order insulating the purchaser from successor liabilities and other claims and liens previously associated with the assets. In addition, the court is generally authorized under Section 365 of the Bankruptcy Code to effect an assignment of the debtor's executory contracts and unexpired leases to the purchaser even if they contain provisions purporting to prohibit assignment. However, compared to the alternative approaches discussed below, a bankruptcy sale can be tremendously expensive, somewhat unwieldy and relatively slow to implement.
- UCC Article 9 Disposition. A distressed asset sale can also be implemented through a secured creditor disposition under Article 9 of the UCC. The UCC authorizes a secured creditor to dispose of personal property by public or private sale. This is a non-judicial method of foreclosure and generally has the effect of discharging any junior liens and security interests on the assets, but it does not provide the breadth of protection conferred by a bankruptcy court "free and clear" order. An Article 9 disposition can be implemented relatively quickly (in a matter of weeks) and is cost effective in comparison to a Section 363 sale in bankruptcy. However, in some instances, going concern value may diminish during the foreclosure process based upon the reaction of the seller's employees, vendors and customers.
- Receivership or Assignment for Benefit of Creditors. A receivership generally involves a judicial proceeding whereby the receiver is placed in control of the seller and its assets. An ABC is a non-judicial proceeding whereby the debtor assigns all legal and equitable title to its assets to a trust for the benefit of its creditors. The "assignee" (or trustee) is empowered to administer the trust estate for the benefit of the debtor's creditors. In each case, the receiver or assignee collects and liquidates the assets of the estate and distributes the proceeds to the appropriate creditors in accordance with their priorities. Generally speaking, neither a receivership sale nor an assignment discharges liens or security interests, but they can be used to sell assets under circumstances where a secured creditor consents to such sale, and the sale must be accomplished in a relatively short time period.
2. Multi-Party Negotiations
Unlike a "healthy" M&A transaction, a distressed asset sale is not a transaction between the seller and the purchaser alone. This is especially true of a sale in bankruptcy. A purchaser in a distressed sale is often required to negotiate with and/or placate multiple constituencies, including (i) senior and junior lien holders, (ii) trade creditors, (iii) an unsecured creditors' committee, and (iv) a bankruptcy judge. Each of the seller's various creditor constituencies may have its own agenda, which may or may not be consistent with the purchaser's objectives in the transaction. Dealing with intransigent creditors requires both flexibility and resiliency on the part of the purchaser.
3. Rights of Senior Lien Holders; Credit Bidding
Of all the creditor constituents involved in or affected by a distressed sale, the most important from the standpoint of the purchaser is the seller's senior lien holders. It is critical that the purchaser reach an agreement with the senior lenders regarding the sale terms, and involve them in the process. Absent the consent and support of the senior lenders, the transaction is unlikely to succeed. In many instances, the seller cannot continue to operate pending a sale without the interim financing provided by the senior lenders. Furthermore, with respect to an Article 9 disposition, it is the senior lien holders who initiate the process. Even in the context of a bankruptcy sale, the Bankruptcy Code recognizes the right of a secured creditor to "credit bid" its debt at the auction.
4. Stalking Horse Protections
In most instances, distressed sales—both inside and outside of bankruptcy—are market tested and subject to higher and better bids. Accordingly, it is tremendously advantageous for a purchaser to act quickly at the outset and negotiate to become the stalking horse. Serving as the stalking horse gives a purchaser the inside track. The purchaser will generally be able to shape the auction procedures governing the sale. Those procedures not only protect the stalking horse's interests in the event it loses the transaction to another bidder (by providing a break-up fee and/or expense reimbursement, for example), the procedures can also provide the stalking horse with a strategic advantage.
5. Limited Due Diligence; Fewer Contractual Protections
In contrast to a "healthy" M&A transaction, a purchaser in a distressed sale is often given very little time to conduct due diligence and has substantially fewer contractual protections. Due diligence must be executed efficiently and expediently, focusing primarily on the mission critical aspects of the transaction. Also, under the typical distressed asset purchase agreement, the purchaser is not given meaningful rights of indemnification. The representations and warranties made by the seller are fewer and more narrowly tailored than in a healthy M&A transaction. Moreover, there is often no hold-back or escrow provided to the purchaser to protect against a subsequently revealed breach. In some cases, distressed asset sales are conducted on an express "as is, where is" basis with no representations at all.
For all of these reasons, it is incumbent upon the purchaser to factor the additional transaction risk into the purchase price offered to the seller, thereby striking the proper balance between "danger" and "opportunity."
(This article was originally published in the July/August 2011 issue of Inside M&A.)
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.