The COVID-19 pandemic has dramatically changed the business landscape, with some businesses thriving as a result (e.g., Amazon, Walmart and Zoom) and others seeking bankruptcy protection (e.g., Neiman Marcus, Hertz and J. Crew). Many businesses – particularly in industries like hospitality, transportation and retail – have witnessed negative impacts from the COVID-19 pandemic and its effects. While they may have been able to rely on governmental assistance and existing banking relationships to weather the storm so far, experts predict that many of them will end up in a distressed situation. And this is where opportunity lies for investors. Many investors, including private equity sponsors, have been preparing to invest in distressed assets and are looking for opportunities to acquire assets at bargain prices. But those investors need to know that distressed transactions can be very different from traditional deals. Outlined below are some of these key differences.
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Key Differences Between Traditional And Distressed Transactions
Fraudulent Conveyance And Successor Liability Issues Must Be Considered
There are multiple ways to structure distressed transactions. A large number of distressed transactions are structured as “Section 363 sales,” which is a sale of assets of an organization under Section 363 of the U.S. Bankruptcy Code. A bankruptcy court has to approve the sale and the parties must follow a specific process, including entering into a purchase agreement that addresses the terms of the sale and potentially competing with other bidders and participating in an auction where the winning bidder determines who will ultimately acquire the assets. Some buyers prefer the Section 363 structure because it allows buyers to acquire assets free and clear of creditor and successor liability claims, among other reasons, but this structure does potentially subject the original “stalking horse” bid to higher bids.
Investors who have a higher risk tolerance and more confidence in their diligence of the business being acquired may be comfortable remaining outside of the bankruptcy court process, but they need to keep in mind that, if the acquired company was insolvent at the time of the sale, a creditor may subsequently be able to invalidate the transaction or allege a fraudulent conveyance. The potential result of this would be that the buyer will have to pay a higher price or satisfy liabilities that it may not have agreed to assume in the transaction.
More Parties Are Involved In Making Distressed Transactions Happen
One of the most striking differences in distressed transactions is the number of interested parties involved. In addition to (and oftentimes instead of) negotiating with business owners and their representatives, buyers may find themselves having to negotiate with creditors (secured or unsecured), landlords, vendors, customers, employees and a bankruptcy trustee.
Additionally, if the transaction is structured as a Section 363 sale, bankruptcy court approval will be required, so the views of the bankruptcy court will need to be taken into account, as well as its schedule and availability. The bankruptcy court approval required for Section 363 sales can take a significant amount of time (oftentimes from 60 to 150 days, except in unusual circumstances). Buyers need to plan for these potential delays and consider how delays in timing would affect the purchase price that they would be willing to pay for the assets (i.e., if this is a “melting ice cube” situation, the buyer may consider tying the purchase price to the timing of bankruptcy court approval and consummation of the transaction).
In A Bankruptcy Sale, Counterparty Consents To Assignment Are Generally Not Required
The U.S. Bankruptcy Code provides that certain contracts can be assumed and assigned to a buyer without counterparty consent even if they require consent to assignment (subject to cure and some exceptions). This allows for a smoother path to closing as the parties do not need to spend time and energy seeking counterparty consent. The parties typically negotiate who is responsible for cure amounts, which in some cases can be significant. Buyers will need to be careful about agreeing to cure amounts without a specified cap. Many times, cure amounts end up higher than the estimates provided by the debtor in the diligence process.
Due Diligence Is More Important Than Ever
In a typical non-distressed transaction, a seller is incentivized to disclose all potential issues to the buyer, thereby minimizing the seller’s exposure to post-closing indemnification claims. In a Section 363 sale, after the transaction closes, the bankruptcy estate will likely be the only one standing behind representations and warranties included in the purchase agreement, and the buyer may find that the bankruptcy estate may have distributed most or all of its available cash to the creditors, which makes it nearly impossible to recover for any breaches of representations and warranties. This amplifies the importance of a buyer’s due diligence, making it imperative for the buyer to fully understand and vet the assets they are acquiring. Some buyers also obtain representations and warranties insurance, which provides protection from a third party insurer in the event that seller’s representations and warranties turn out to not be true.
Purchase Agreements In Section 363 Transaction Are Generally Similar To Regular Asset Purchase Agreements, With Some Notable Exceptions
Section 363 purchase agreement will have typical provisions describing the assets being acquired and liabilities being assumed, representations and warranties, covenants, conditions to closing and termination rights. From time to time, the buyer will be able to include a diligence out in the purchase agreement, allowing it to complete its due diligence over a certain period of time. The purchase agreement will not be binding on the seller until it is approved by the bankruptcy court. Another bidder could submit a winning bid – so the buyer who is the initial party to the purchase agreement (also called the “stalking horse bidder”) does not have the ability to lock up the deal. Even so, the stalking horse bidder will have some protections under the purchase agreement, such as the break fee (typically around 3.5% of the purchase price) and expense reimbursement. More often than not, these protections allow the stalking horse bidder to win the deal.
Conclusion
As investors continue to prepare for the anticipated increase in distressed opportunities, they must understand the key differences between traditional and distressed transactions. Understanding these differences will help investors to avoid unpleasant surprises, anticipate potential issues, and ultimately achieve better results. If you have any questions about this article or distressed transactions in general, please contact the author.
About the Author
Tatjana Paterno is a member at Bass, Berry & Sims PLC. She helps private equity funds and their portfolio companies, strategic acquirers and multinational publicly traded corporations to structure, negotiate and consummate acquisition transactions. Tatjana can be reached at [email protected].
