Buying Distressed Assets
May 1, 2020
Our current economic slowdown is threatening the viability of businesses in numerous industries. Owners may be considering the liquidation of discrete assets to enhance their liquidity to preserve their core operations. Or, they may be considering a sale of the going concern in order to preserve the business, and jobs of employees, under a new, better capitalized owner. Today’s economy presents strategic buyers with opportunities to acquire solid businesses that are distressed due to circumstances beyond their control, on terms more favorable than would have been offered just a few months ago. This article discusses key considerations for buyers of distressed assets, and the four most common scenarios for distressed asset acquisitions.
While the business owners normally set the stage for terms of a proposed sale, a buyer often can have significant influence over the terms and conditions of sale. Some buyers may prefer a sale outside of a formal proceeding, which may eliminate the risk of competing bids, and may include representations and warranties frequently not found in court-supervised transactions. In contrast, court-approved sales may provide additional protections to buyers that cannot be achieved in a private sale, including findings that the assets are sold free and clear of existing liens and liabilities, or that the buyer shall not be considered a successor of the seller, which minimizes the risk of successor liability claims. Buyers should consult with their advisors regarding the best platform to achieve their specific goals.
An acquisition of a distressed business or its assets outside a court-supervised process is no different than the acquisition of a sound company. The terms of the purchase agreement negotiated by the parties will define the transaction. The deal can proceed as quickly as the parties are prepared to move.
- Quick and, Relatively, Inexpensive
A private asset sale can be consummated as soon as the parties are ready to close. Management may remain focused on running the business, and consummating the sale, without the distractions caused by a bankruptcy filing. The expenses of buyer and seller are limited to the costs of the deal – negotiating and documenting the sale terms and conducting related diligence.
- Representations and Warranties
The buyer may negotiate for standard representations and warranties from the seller, including as to ownership of the assets, conveyances free of encumbrances, and as to the financial condition of the business and the condition of the assets being acquired.
- No-Shop Provisions
The buyer may negotiate for a provision that precludes the seller from soliciting other offers while the buyer is under contract, eliminating any risk of getting out-bid.
- Avoids Negative Publicity
A private sale transaction minimizes the risk that the value of the business or assets is adversely affected by publicity that the seller is in financial trouble.
Distressed asset sales outside of a court-supervised process present numerous risks to buyers.
- The cooperation of lenders and key contract counterparties is essential.
If the purchase price offered is less than the payoff owed to secured lenders, their consent to the sale and the release of their liens is mandatory, unless the buyer and lender can agree to terms for the buyer’s assumption of the debt. Most contracts prohibit their assignment without the consent of the other party. If there are leases contracts, licenses, or other contracts that are vital to the business, securing the consent of the other party to the assignment is critical.
- Representations and warranties in the purchase agreement may have little true value; buyers must do their own diligence.
If the buyer is buying substantially all of the seller’s assets, the seller likely will cease all further operations and dissolve, whether formally or informally, after closing of the sale. Even if the buyer discovers meaningful misrepresentations, or failure to disclose relevant information, after closing, the buyer may have no meaningful recourse to recover damages it suffers as a result. The buyer should conduct its own due diligence and independent investigation into the seller’s business operations and financial condition, rather than simply relying on the accuracy of the information provided by the seller. An alternative is to negotiate for an escrow or reserve of a portion of the purchase price for some period post-closing, to give the buyer time to assess the condition of the business and assets once it’s in control.
- The buyer may find itself liable for undisclosed or unanticipated obligations of the seller.
If the buyer buys substantially all of the assets of the seller, the buyer may find itself exposed to successor liability claims under state or federal law. In addition, a variety of tax liens and assessments may attach to the seller’s assets under state or federal law, and follow those assets into the hands of the buyer. Those obligations may not easily determined through public records searches and may not appear in the seller’s books and records. The buyer should conduct an independent investigations to determine the extent of its potential risk to these types of claims and its willingness to buy the assets subject to that risk.
- The terms may be second-guessed if the seller subsequently files bankruptcy.
If the buyer has paid less than fair value for the assets acquired, the terms of the sale may be challenged as a fraudulent transfer in a subsequent bankruptcy filing by the seller. Buyers sometimes secure fair value opinions from valuation experts to provide a potential defense should the terms be challenged later, but these opinions can be expensive and time-consuming to obtain. Even if the buyer wins, it may incur significant costs in defending against the claims.
- If the deal includes post-closing obligations of the seller, the seller may be able to walk away from those obligations in a subsequent bankruptcy.
The purchase agreement may impose post-closing obligations on the seller, whether an intellectual property license, a shared service agreement, or a transition agreement. If the buyer files bankruptcy after the sale is consummated, the buyer may be able to reject the contract creating these post-closing obligations, leaving the buyer with less than it bargained for.
Bankruptcy sales are court-supervised. Inevitably, they will take longer than the buyer would prefer; but they come with a level of buyer protection frequently unavailable in private transactions. Some buyers insist on acquiring assets from a bankruptcy proceeding in order to secure these additional protections.
- The sales price may be lower; transactional costs will be higher.
Because of the various risks to a buyer from a bankruptcy sales process, the ultimate purchase price the buyer may pay for the assets may be lower than the price it would pay in a private transaction. That savings may be offset by the additional professional fees that the buyer will incur in a court-supervised sale, and by the delay inherent in a court process.
- Sale orders can provide additional protections to the buyer.
The provisions of sale orders are frequently as heavily negotiated as the terms of the purchase contract itself. Because notice of the sale is given to all known creditors, consent of individual creditors to the sale is typically not required. Rather, the court may order that the assets are vested in the buyer free and clear of all known liens and claims. Except in limited circumstances, the court may approve the assignment of leases and contracts to the buyer, whether or not the counterparty has consented. The court may also find that the buyer is not a successor of the seller, for successor liability purposes. The buyer may end up with better title to the assets than the buyer can negotiate for in a private transaction.
- The buyer may serve as a “stalking horse,” receiving break-up protection and influence over the sales procedures.
If the seller is filing bankruptcy with the goal of achieving a sale of its business or assets, it typically prefers to be under contract with a lead buyer, the “stalking horse,” before filing. Except in exceptional circumstances, the court-approved sales process will require some form of competitive bidding or auction. The terms of the sales process are typically negotiated with the stalking horse buyer and set out in the purchase agreement. In addition, the stalking horse buyer may negotiate for breakup protection, such as expense reimbursement and a breakup fee, if it is ultimately outbid. The purchase agreement with the stalking horse buyer normally is the template to be used by competing bidders; the buyer may be able to include terms in its agreement that are beneficial to it, but problematic for competing purchasers. The typical stalking horse contract will eliminate all contingencies to closing other than court approval; putting pressure on competing bidders and leaving them with a narrow window to conduct diligence.
- Once approved by the court and consummated, the sale is generally immune from subsequent challenge.
The sale order normally includes a finding that the buyer is a good faith buyer. With that finding, the sale normally can’t be unwound later, even if an interested party appeals the sale order. Similarly, a bankruptcy court order should insulate the sale from a collateral attack in a different proceeding claiming that the sales prices was inadequate or otherwise challenging the sale terms.
- Absent extraordinary circumstances, the sales process will take several months.
The Bankruptcy Code requires notice to all creditors of a sale, and the opportunity to object. The process is normally four steps: a) approval of sale procedures, including any breakup protections negotiated with a stalking horse buyer; b) notice of the proposed sale to all interested parties and solicitation of competing bids; c) an auction, if competing bids are received; and d) if objections are filed, or the court has its own concerns, a sale hearing. A fast sales process will typically take 60 to 90 days, but it is common for the process to take much longer.
- Publicity about the bankruptcy filing could harm the value of the business.
A bankruptcy filing is a public process; information is accessible to members of the general public and notice of the process must be given to all known creditors. Publicity about the filing can result in the loss of customers or key suppliers, or have other adverse impacts on the value of the business while court approval is pending. While buyers can negotiate walk-away rights if there is a material adverse change in the business prior to closing, the buyer will also walk away from its significant investment of time and money in negotiating the deal in the first place.
- Creditors have leverage to attempt to secure better terms.
Secured lenders may have the right to demand full satisfaction of their claims and may oppose a sale at a lower price. In larger cases, an official committee of unsecured creditors may be appointed to act on behalf of all unsecured creditors to attempt to improve the sale terms for their benefit or to find a buyer willing to pay more. Even without a committee, any significant creditor has standing in a bankruptcy case to object to a proposed sale.
- The buyer may be outbid.
Courts will require evidence that the business has been appropriately marketed and typically require a post-bankruptcy competitive bidding process to attempt to assure the highest value for the assets is realized. Break-up protections for the stalking horse buyer frequently will not reimburse the buyer fully for its investment in diligence, or the value of the potential deal to the buyer, if the buyer is outbid. If the purchase price is insufficient to satisfy a secured lender’s claim, it may “credit bid” its claim and acquire the assets itself, unless the buyer is willing to match that credit bid with cash, and break-up protection may be more limited in the face of a credit bid.
- Diligence is everything.
The sale order may provide certain protections, including confirming that the seller has good title to the assets and can convey them free and clear of liens and claims. But, sellers typically disclaim most standard representations and warranties, including as to the accuracy of financial information provided to the buyer or condition of the assets. Indemnification provisions are rare and may be worthless anyway. Thus, it is vital that the buyer conduct thorough diligence.
- Cash is king.
It is a rare bankruptcy sale that provides for seller carry-back financing. In addition, it is an unusual sales process that permits a financing contingency for a stalking horse buyer or competing bidder. If a buyer is unable to pay cash at closing, it should have its financing lined up before signing the contract.
- Notice to all interested parties is essential.
The bankruptcy sales process requires that notice be given to all interested creditors. A creditor that does not receive notice of, or have actual knowledge of, the bankruptcy filing and the proposed sale may be permitted to pursue its claims against the buyer. This is of particular concern with claims of taxing and regulatory authorities, who often don’t appear on a seller’s list of creditors. Sophisticated buyers typically engage in independent research to confirm that notice is given to all potential creditors; notice by publication in appropriate newspapers or trade journals may be required in larger transactions.
Most loan documents permit a secured lender to seek appointment of a receiver over its collateral if the borrower defaults. A receiver is a neutral party acting at the direction of the receivership court. The receiver’s authority is defined by the order of appointment, which typically itemizes in some detail the receiver’s authority.
While many receiverships are commenced to preserve the lender’s collateral pending its foreclosure on them, sometimes the secured lender prefers that the receiver sell the business. Except as defined or limited by the order appointing receiver, the receiver has significant discretion in developing a marketing strategy to try to realize the highest and best value for the assets. The receiver may run a formal auction process, may hire an investment banker or broker to market the business, or may use the receiver’s own contacts and knowledge of the industry in finding the best buyer.
The purchase agreement will be subject to receivership court approval, and creditors and other interested parties are typically given notice of the proposed sale and the opportunity to object.
Receiver’s sales come with no representations or warranties of substance from the receiver, but various protections can be built into the order approving the sale.
There are few statutes that govern receiver’s sales. This presents advantages and disadvantages, when contrasted with a bankruptcy sale.
Sales may move relatively quickly. The receiver may adopt a sales process uniquely suited to the particular assets or industry. There may be no formal auction or competitive bidding process.
A state receivership court does not have nationwide jurisdiction over all creditors and a sale order may not be binding on a creditor who has not been made a party to the proceeding. The parties may need to secure the consent of secured creditors and affirmative release of their liens, and the consent of counterparties to the assignment of key contracts. Creditors may be able to pursue their claims against the buyer under certain circumstances.
Another way to acquire distressed assets is through a lender’s foreclosure sale. Foreclosure sales of real estate are fairly common. The sales process is public and laid out in detail in state statutes. A buyer can obtain title to distressed real estate by submitting a bid at the sale, and after waiting out any applicable redemption periods. Title to the real estate is confirmed in a public trustee’s deed issued to the buyer. The buyer will take title free of all liens junior to the lien being foreclosed, and will take subject to any senior liens. A buyer will want to coordinate insurance from a title company in connection with its bid.
A lender may also foreclose on personal property business assets, including inventory, accounts receivable, equipment, intellectual property, and goodwill, serving as collateral for its loan. The Uniform Commercial Code adopted in substantially similar form in all fifty statues provides the framework for a sale. A secured lender may sell the assets in a private sale negotiated with one buyer, or may opt for a public auction; in some circumstances a public auction may be required. The sales process adopted by the secured lender must be commercially reasonable.
UCC foreclosure sales may move very quickly – only ten days’ notice of a proposed foreclosure sale is required to interested parties, and only the borrower and other creditors with liens on the assets being foreclosed are entitled to notice. UCC foreclosure sales are a potentially efficient and cost-effective way for a strategic buyer to acquire assets, but they typically come with few to no representations and warranties. Again the buyer must be comfortable with its own diligence.
UCC foreclosure sales are a less effective way to acquire a going concern because the secured lender is not in control of the operating business and the borrower may cease operations as soon as it receives notice of the proposed foreclosure. [Secured lenders who believe the going concern has more value than the value of the individual assets will typically seek appointment of a receiver to preserve that value.] In addition, if the business has real estate and personal property assets, coordination of the sales of both can be challenging, given the different statutes and procedures that govern sales of each. “Friendly” foreclosures can sometimes be coordinated, with the cooperation of the borrower and secured lender, to preserve a going concern.
With businesses of all sizes reeling from the effects of government-ordered shutdowns to control coronavirus and a looming recession, strategic buyers may be presented with unique opportunities to acquire distressed assets on favorable terms. Given the rapid timelines of some distressed transactions and limited due diligence periods, strategic buyers should be giving consideration now to potential acquisition targets and their preferred acquisition strategy.