When Challenges Arise, Opportunities Follow
Corporate & Finance Alert
February 3, 2009
“Problems are the price of progress. Don’t bring me anything but trouble. Good news weakens me.”
(Charles F. Kettering, Inventor)
While a downturn in the economy presents its challenges for some (or in this economic downturn, for most, if not all), it creates opportunities for buyout funds, strategic buyers, and the professional services firms having expertise dealing with distressed companies. In the past twelve months we have experienced, and continue to experience, a global financial and economic crisis of historic proportion. A company in financial distress has many challenges, but the distressed situation also gives rise to opportunities — opportunities to restructure a non-performing asset into a performing asset, to acquire a strategic piece of the market or a critical supply line, or to buy in to an existing business at a below market cost. This article discusses the investment rationale behind investments in distressed companies, and some of the alternative methods by which potential acquirers may take over a distressed company or its assets.
This article discusses the investment rationale behind investments in distressed companies, and some of the alternative methods by which potential acquirers may take over a distressed company or its assets.
Rationale for Investing in a Distressed Company
Investors look at distressed companies for a variety of reasons. A strategic buyer (an acquirer who operates in the same industry as the target) generally has the same motivation when targeting a distressed company as it does when targeting a healthy company — gain market share, control or reduce supply costs, or eliminate competition, for example. A financial buyer (e.g. a private equity firm) or institutional investor may be looking at a distressed company as an opportunity to obtain valuable assets at a fraction of the cost.
However in each case circumstance has created an opportunity that might not otherwise have existed. Owners of a distressed company may be more likely to sell, or in fact may be forced to sell to preserve what equity may remain or to get out from under loan guarantees. A competitor or supplier may not have the resources to keep its customers. Owners may no longer have the capital (or desire) to fund ongoing company losses. As 2009 gets underway, companies who have fought to stay afloat through 2008 may fall into one of the above categories, as holiday revenues decrease, “lender fatigue” rises to a boiling point, or owner optimism wanes and reality sets in.
This article is not intended to resonate in any negative way, or to infer that companies in distress are lost causes. To the contrary, in many cases these companies have strong assets or potential, which may include unique or necessary products or intellectual property, human capital in the form of a loyal, well trained labor force, or high sales volumes. Businesses become insolvent for a variety of reasons and insolvency does not necessarily indicate a flaw in the fundamental business. Sometimes companies expand too quickly, leaving the business highly leveraged and more susceptible to suffer losses if the revenues do not maintain the growth rate. A slight dip in sales for a company in this category would wreak havoc with the company’s financial situation. Problems are compounded as the reduction in sales may lead to a financial covenant default, which in turn can cause the company’s lender to tighten or freeze a credit line. Tighter credit means less ability to buy inventory. Less inventory could translate to less sales, and so on into a downward spiral. Such events could leave what recently may have been a thriving business vulnerable to competitors and suppliers, and could even force a bankruptcy. The current financial crisis and tightening of the credit markets clearly has been the last straw for a number of businesses. In the first 9 months alone in 2008, nationwide business bankruptcy filings were 38,651, an increase of almost 10,000 filings for the full 12 months of 2007.1
Many investors, however, instead of running from such situations, view a distressed company as an opportunity. These investors pump new equity into the company, making it easier to obtain credit and withstand downturns, or combine the business with another in a strategic acquisition. Strategic investors can reduce costs through economies of scale, or possibly by upgrading existing technology at below market value through an acquisition of a distressed company. Although financing these acquisitions carry their own challenges in today’s difficult economic environment, those with the access to capital to make acquisitions are looking to take advantage of distressed situations, and capitalize on opportunities created by the challenges facing distressed businesses.
From the seller’s perspective, the sale of a distressed business may also present an opportunity for principals of the seller. Although the principals may lose their existing equity in the business, depending on the severity of the situation, there may be no equity to begin with. Even if the principals receive no payment on account of equity, they may gain other benefits in connection with a sale. These benefits can include relief from personal guarantees, continuation of a management position or consultant job with the successor, payment of consideration in exchange for a non-compete, and a possible equity position going forward.
Methods of Acquiring a Distressed Business
Potential investors in a distressed company can consummate their investment in a variety of ways. Aside from traditional merger and acquisition techniques (mergers, stock or asset purchases), investors increasingly are looking to utilize non-traditional or alternative methods to acquire a distressed company or its assets. While the base structure of these alternative acquisition methods are generally asset acquisitions, the transaction process and negotiation is far different from a traditional asset purchase. The alternative techniques are intended to preserve the value of the target’s assets and give the buyer the most benefit from the target’s distressed situation, for example by extinguishing unsecured obligations of the target.
Alternative methods of acquiring a distressed business may include the following:
- Acquisition pursuant to a Bankruptcy Code § 363 sale
- A secured party sale of assets under Article 9 of the Uniform Commercial Code
- Acquisition of the secured debt of a distressed company
- Asset acquisition coupled with a negotiated discount of secured debt or a composition agreement with creditors
In addition, given the tight credit markets, some potential acquirers act as debtor-in-possession lenders in order to attempt to gain a competitive advantage over other buyers at a bankruptcy auction sale.
Following is an overview of some of the alternative methods of structuring the acquisition of a distressed business.
§ 363 Sales
If a distressed business has already filed for bankruptcy, the landscape changes and transactions involving the distressed company – now referred to as the “debtor” in the bankruptcy proceeding – generally require approval of the bankruptcy court. An acquisition under §363 of the United States Bankruptcy Code is one of the traditional methods of acquiring a bankrupt company, and was commonly utilized in the 1980’s and 1990’s. Amendments to the Bankruptcy Code in 2005, which shorten the time for a debtor in bankruptcy to terminate or assume real estate leases to 210 days, and the scarcity of debtor-in-possession financing to fund inventory and working capital during a bankruptcy, will likely cause an increase in sales of bankrupt businesses under § 363 in the current downturn. Secured lenders today are not willing to incur the substantial expense and delay in allowing a debtor to propose a reorganization plan and as a result, debtors are forced early after a bankruptcy filing to make a decision whether to sell their assets under § 363.
Although not without risks, a sale under § 363 provides certain benefits in connection with the sale of a business that are not available under a UCC Article 9 secured party sale or in another sale outside of a bankruptcy. Of greatest benefit of a § 363 sale is that the buyer can acquire the assets of a business free and clear of most liens and encumbrances. In addition, there is no requirement to obtain shareholder approval. Even a § 363 sale however does not eliminate the potential assumption by the buyer of the target’s products liability and certain employment and environmental claims, so due diligence in these areas is particularly important.
The Bankruptcy Code permits a debtor to determine which of its contracts it wishes to assume and assign to the buyer of its assets. An assignment of a debtor’s contracts, however, requires the buyer (because the debtor is usually unable to do so) to cure all payment defaults under the assigned contracts and provide adequate assurance of future performance under the contract. Therefore, a buyer of a debtor’s assets must carefully choose the contracts to be assumed and assigned. Additionally, a debtor is not authorized to assume and assign all of its contracts. A debtor cannot assign a contract if, under applicable non-bankruptcy law, the non-debtor party would be excused from accepting performance under the contract from any person or entity other than the debtor. These would include patent licenses and government contracts. Real estate leases where the debtor is the tenant may be assumed and assigned, notwithstanding a non-assignment clause in the lease, provided the lease is assumed within 210 days from the bankruptcy filing.
Aside from the requirement of obtaining court approval, another detriment to a § 363 sale is that it subjects the target to an auction sale, which could result in the buyer losing the target to another bidder. Before bringing a motion to sell its assets under § 363, a debtor generally locates a “stalking horse” buyer. The debtor then files a motion to approve the sale to the stalking horse buyer, subject (as is required under the Bankruptcy Code) to higher and better offers. Motions for the sales under § 363 typically seek two hearings. The first is a hearing on bidding and sale procedures. Those hearings are often held on shortened notice. At that hearing the bankruptcy court may be asked to enter an order (a) prohibiting the debtor from shopping the assets; (b) setting the time for and manner of submitting competing bids; (c) setting forth the required minimum terms of competing bids; (d) setting a date for an auction of the debtor’s assets; and (e) setting a final hearing on the sale. The court may also be asked to approve a break-up fee to compensate the stalking horse buyer, in the event that its bid is not the winning bid, for the expenses it has incurred and the efforts it has undertaken in becoming the stalking horse buyer. Bidding procedures and break-up fees or topping fees have generated substantial litigation because they tend to chill bidding at a sale. Rulings of the applicable bankruptcy courts and appellate courts on bidding procedures and break up fees generally allow, as a rule of thumb, a break-up or topping fee of no more than 3% of the total consideration paid for the debtor’s assets.
The auction sale of the debtor’s assets will occur after the bidding and sale procedures hearing. It typically takes place in the office of the debtor’s counsel. However, if there is sufficient interest in the debtor’s assets, the auction may take place in a public venue, such as the bankruptcy court, although bankruptcy judges typically are not present at the auction. The auction may, however, take place before the bankruptcy judge at the final hearing. Such auctions are more likely to happen at the sale of smaller debtors or only units of a debtor’s business. If there is competitive bidding, a back-up bidder may be chosen in the event that the successful bidder cannot or does not consummate the sale.
Most debtors need some type of financing to function in bankruptcy, even if the debtor plans to liquidate and needs only to operate long enough to consummate a sale of its assets. Since debtor-in-possession financing is tight, in some instances stalking horse bidders are serving as the source of debtor-in-possession financing, especially in smaller cases. This has the effect of maximizing the stalking horse bidder’s leverage and likely success in purchasing the debtor’s assets since its post-petition loan will have to be paid in full by any successful bidder for the debtor’s assets.
At the hearing on the bidding and sale procedures, the bankruptcy court will generally set a final hearing to approve the sale. That sale can be heard on the same day as the auction if one is held, or it may be later. At the final hearing, assuming that all of the requirements of §§ 363 and 365 and any other applicable provisions of the Bankruptcy Code have been satisfied, the sale will be approved.
The § 363 sale process may move very quickly, although the process must take at least twenty (20) days from the filing of the initial motion. This short time period may make presenting a competing bid difficult. There will be little time for due diligence and obtaining financing. Under such tight time constraints, it may be difficult or even impossible to obtain regulatory approvals. A potential competing bidder generally has no standing to challenge bidding procedures. As with any other transaction in bankruptcy, the parties to § 363 sale must act in good faith and collusive bidding is prohibited. Parties guilty of collusive bidding that depresses the sale price of the debtor’s assets may be liable for damages.
One important factor in a § 363 sale is that either the debtor or, if one has been appointed, the trustee, must consent to the sale and, in fact, must be the party bringing the sale motion. As the law currently stands, creditors cannot compel a debtor to file a § 363 motion. Another drawback of a § 363 sale is that it must be subject to higher and better offers and accordingly a stalking horse buyer could lose a bid. Given the benefits available to the successful bidder for a debtor’s assets and the relative speed at which a § 363 sale can be held, financially distressed debtors and their creditors may consider such a sale as a means of maximizing a recovery of at least the amount owed to debtor’s secured creditors. For a buyer, early involvement with a debtor, specifically prior to filing the bankruptcy petition, presents a valuable opportunity to acquire a distressed company with protection from claims by the debtors’ creditors in a very timely fashion.
Secured Party Sale
Distressed companies often attempt to avoid filing for bankruptcy for a number of reasons, including the expense of a filing and the burden of the administrative costs of the bankruptcy, and the difficulty in obtaining debtor in possession financing to finance operations or a bankruptcy reorganization sale. If the distressed company is looking to sell its business, the principals of the company will most likely lose their equity and any possibility of receiving consideration for the sale, and a potential buyer may or may not want to deal with the possibility of competing bidders in a bankruptcy auction. In addition, a bankruptcy filing could negatively impact the company’s customers, vendors and key employees, all factors a potential buyer would wish to avoid.
As an alternative to a costly and court managed bankruptcy sale, a secured creditor, in cooperation with a buyer, may arrange a sale of a business utilizing provisions of Article 9 of the Uniform Commercial Code (sometimes referred to as “Article 9 sales”, “secured party sales” and “friendly foreclosures”). Although a secured party sale does not afford the same level of protection to a buyer with respect to potential claims of creditors of the target company as does a sale under § 363, a properly structured Article 9 sale can give the buyer greater protection from claims of unsecured creditors of the distressed company than if the assets were purchased in a traditional manner. Other benefits of a secured party sale include lesser expenses compared to a § 363 sale, the speed in which a transaction can be concluded, and a more simplified transaction than a § 363 sale (no court approval is required).
Not all of the target company’s assets may be eligible for a secured party sale. Real property, whether owned or leased, assets which are not the subject of a lien by the secured party, and other assets that are not covered by Article 9 of the Uniform Commercial Code, may need to be addressed separately with the target company or other third parties.
There are two mechanisms for carrying out a disposition of assets by a secured party under Article 9 of the Uniform Commercial Code in effect in the State of New Jersey (the “UCC”): (1) disposition of the collateral by sale or other means under N.J.S.A. 12A:9-610 through N.J.S.A. 12A:9-613; and (2) retention of the collateral in full or partial satisfaction of the obligation under N.J.S.A. 12A:9-620 through N.J.S.A. 12A:9-622. Method (1) requires the secured party to conduct the sale and all aspects thereof (including the manner, time and place) in a “commercially reasonable” manner. Although the sale is not subject to court approval or confirmation, a sale under this method is still subject to what amounts to an auction, conducted by the secured creditor, or an auctioneer or other sales professional. This article discusses the second method, which, in commercial transactions involving a cooperative target company, does not require compliance with the conditions of a commercially reasonable sale.
Under N.J.S.A. 12A:9-620, a secured party may accept collateral in full or partial satisfaction of an obligation it secures. This structure can be utilized if the distressed company and the potential buyer agree on terms of sale that are approved and consummated through the distressed company’s secured lender. A secured lender in a distressed situation may be seeking an exit strategy, and may be willing to act as a conduit for the sale to the buyer, sometimes even financing the acquisition. If the parties agree to go forward, once the proper process is followed, the secured party accepts the collateral and sells it to the buyer. A buyer in this transaction may look to obtain representations and possibly indemnities from the target company or its owners, as the secured party likely will not make any representations regarding the collateral.
If the secured party is willing to accept collateral from its debtor and act as a conduit for the sale, the first step is for the secured party to prepare a proposal describing the terms on which it will accept the collateral (more particularly described below). Under N.J.S.A. 12A:9-620, the secured party must send the proposal to:
- any person from which the secured party has received, before the debtor consented to the acceptance, an authenticated notification of a claim of an interest in the collateral;
- any other secured party or lienholder that, 10 days before the debtor consented to the acceptance, held a security interest in or other lien on the collateral perfected by the filing of a financing statement that:
- identified the collateral;
- was indexed under the debtor’s name as of that date; and
- was filed in the office or offices in which to file a financing statement against the debtor covering the collateral as of that date;
- any other secured party that, 10 days before the debtor consented to the acceptance, held a valid security interest in property in which the filing of a financing statement was not necessary to perfect a security interest2; and
- any secondary obligor3 (if secured party is accepting collateral as partial satisfaction).
The failure to comply with the above notification requirement does not render the acceptance of collateral ineffective; however, a person to whom the required notice was not sent has the right to recover damages.
A “proposal” is a record authenticated by a secured party which includes the terms on which the secured party is willing to accept collateral in full or partial satisfaction of the obligation it secures. N.J.S.A. 12A:9-102(a)(66). A proposal need not take any particular form as long as it sets forth the terms under which the secured party is willing to accept collateral in satisfaction of the obligations secured by the collateral. N.J.S.A. 12A:9-620, Comment 4. A proposal should, however:
- specify the amount (or a means of calculating the amount, such as by including a per diem accrual figure) of the secured obligations to be satisfied;
- state the conditions, if any, under which the proposal may be revoked, and
- describe any other applicable conditions.
Id. A conditional proposal generally requires the debtor’s agreement in order to take effect. Id.
The parties who are entitled to receive notice are typically identified through due diligence and UCC searches (which must be updated close to closing).
A secured party may not accept collateral in full or partial satisfaction of the obligation if it receives an effective notification of objection from a party to which a notification of proposal must be sent or any other junior interest holder, within the time frames required by Article 9. N.J.S.A. 12A:9-620(a).
In addition to notifying third parties, the debtor (target company) must also consent to the transaction by following the procedures of Article 9. Failure to obtain debtor consent renders the acceptance of collateral ineffective.
After compliance with the UCC and the above procedures, the next step is for the secured party to receive the collateral and to close its sale with the buyer. N.J.S.A. 12A:9-620 does not impose any formalities or identify any steps that a secured party must take in order to accept collateral once the proposal notification and debtor consent conditions are satisfied. As a matter of good business practice, a secured party may wish to memorialize its acceptance by notifying the debtor that such acceptance under this section is effective or by placing a written record in its files. The secured party and the debtor typically will enter into a release and surrender or similar agreement, and the secured party and the buyer will enter into a simple purchase agreement or bill of sale, each of which will be executed simultaneously, along with other ancillary closing documents. As stated earlier, the buyer may also receive a representation letter from the debtor or its owners.
Under the right set of circumstances, a secured party sale may be a cost-effective method for a distressed company to dispose of its assets expeditiously. For companies on the verge of bankruptcy, a secured party sale could enable the company’s assets to retain more of their value than may be obtained through a bankruptcy sale. Unless other interested parties seek to slow down or stop the sale, a secured party sale could be concluded in less than sixty (60) days.
Acquisition of Debt of a Distressed Company
Potential acquirers may acquire the target company in stages, first by acquiring secured debt of the company. Debt could be acquired from the secured lenders of the target, often times at a discount. Assuming the debt is in default, the buyer could exert pressure on the company to hand over its assets pursuant to one of the Article 9 secured party sale methods referred to above, or through a judicial foreclosure. Buying debt is different than buying direct assets, and involves a somewhat different due diligence process. Among other things, the buyer will want to confirm that the lender has a perfected security interest and conduct lien searches to verify the position of the lender’s liens.
Acquiring debt can be an attractive structure to a buyer if the lender is willing to sell the debt at a discount. It may also be used to gain leverage over a recalcitrant seller. In some circumstances it will help to keep the assets from being acquired by a competitor. Distressed companies and their owners may be able to benefit from this transaction structure by receiving relief from obligations under personal guarantees and possibly gaining temporary access to financing in order to conclude a more orderly liquidation of assets.
In addition to acquiring debt of a distressed company, a strategic buyer may extend secured credit to the target over a period of time, ultimately foreclosing on the underlying security for the credit extended. Such transactions however need to be carefully reviewed and documented so as to minimize the avoidability of the transaction if the target were to file for bankruptcy.
Asset acquisition coupled with a negotiated discount of secured debt or a composition agreement
As a means of avoiding a potential costly bankruptcy filing, a potential buyer of a distressed company could propose an agreement that is approved by the company’s secured lender and an unofficial committee of the company’s unsecured creditors. By handling a liquidation of the company outside of bankruptcy, aside from saving the expense of a bankruptcy filing, the parties can obtain greater value for the company’s assets and a greater return for creditors, than might be obtained in a fire sale of the assets. The buyer also has greater comfort that the company’s relationships with its customers, vendors and employees may be preserved.
In this structure a typical asset purchase agreement is negotiated. The consent of the company’s secured creditor is required and the creditor may be asked to continue to finance the company for some additional time period or to permit the company to use its cash collateral. The secured and unsecured creditors each agree to a compromise to accept a fixed or contingent amount in exchange for a release of their respective outstanding claims. Escrows are established to negotiate with non-responsive or non-consenting creditors.
This can be complex process and it must be well thought out and carefully planned with the company, its secured lender, and its major unsecured creditors. Utilizing this structure may be beneficial to the principals of the distressed company, as it may be possible for the principals to continue in a management role with the buyer and also receive an equity interest in the buyer.
For a company in distress, there are several alternative sale structures which can be utilized to retain the existing enterprise value and minimize deterioration of assets due to a non-orderly liquidation sale or a long, drawn-out negotiation and closing process. As in any acquisition or disposition, the parties must carefully consider a myriad of issues and their impact on the transaction. When acquiring a distressed company, buyers will also want to carefully analyze credit agreements, corporate structures, bankruptcy, insolvency, tax and creditors rights issues. A potential acquirer needs to conduct specialized due diligence to determine what risks may be hidden and which could become a liability of the acquirer post closing. Each of the structures discussed above has different nuances and risks that must be fully analyzed and addressed as part of the transaction.
Once the risks and issues have been thoroughly analyzed, a properly negotiated and structured transaction may yield substantial benefits to not only the acquirer, but also to the seller and its owners in such a transaction. As quoted above “problems are the price of progress.” Opportunities abound in these challenging times, and progress is the reward for those who have the acumen and ability to identify and implement the strategies necessary to take advantage of the possibilities.
This article provides a summary description of various alternative means of acquiring the assets or business of a distressed company. All those interested in acquiring or disposing of distressed businesses are strongly encouraged to discuss their particular circumstances with legal counsel and other professional advisors.
* Portions of the discussion contained herein regarding Bankruptcy Code Section 363 are reprinted from prior Gibbons Corporate and Finance Alert entitled “Distressed M & A: Bankruptcy Code Section 363 Sales” dated December 23, 2008 by Frank B. Reilly, Jr., Director, Corporate Department and David N. Crapo, Counsel, Financial Restructuring and Creditors’ Rights Department.
1 As reported by U.S. Bankruptcy Courts.
2 See N.J.S.A. 12A:9-311 (i.e. federal law, treaty or rule pre-empting state filing requirements, certificate of title statutes, and the New Jersey motor vehicle certificate of ownership law and Boat ownership certificate act).
3 Means an obligor to the extent that: (a) the obligor’s obligation is secondary; or (b) the obligor has a right of recourse with respect to an obligation secured by collateral against the debtor, another obligor, or property of either. N.J.S.A. 12A:9-102(a)(71). Secondary obligors are also referred to as being a surety to a principal obligor (borrower). Id. at Comment 2a.