Buying a Financially Troubled Company
© 2010 Cohn Whitesell & Goldberg
Will the deal of a lifetime turn into the headache of a lifetime? What are the key differences between buying a solvent and an insolvent business? As the buyer, how can you protect yourself from the seller's creditors? What are the advantages and disadvantages of requiring that the seller file under Chapter 11? If the seller is in Chapter 11, should you buy in a Section 363 sale or under a Chapter 11 plan?
Interested in buying a financially troubled company? It's not for everyone. A common perspective is that making a smart acquisition - then doing a good job of running it or integrating it with an existing operation - poses plenty of challenges without piling on problems arising from the seller's financial distress. Another perspective is that the financially distressed company represents an irresistible opportunity because the price will usually be a bargain based on traditional metrics such as cash-flow multiples. Still other potential buyers, while viewing financial distress as a negative, will consider acquiring a troubled company when there's a significant strategic need or benefit. Whether reluctant or enthusiastic, if you are going to consider acquiring a troubled business, you need to understand the critical differences from acquiring a financially healthy company. From a legal standpoint, there are three important differences: (1) consequences of a seller default, (2) risks posed by unpaid creditors of the seller, and (3) opportunities presented by purchasing through the bankruptcy court.
Consequences of a Seller Default
Apart from the price, the most heavily negotiated portions of an agreement to buy a non-distressed business will often be the representations and warranties. From the buyer's perspective, well-drafted representations and warranties - backed by a strong indemnification clause and perhaps even by an escrow - are a way to limit risk. These provisions induce the buyer to supply correct and complete information about the business, provide a monetary remedy for misinformation, and in some cases even allocate to the seller the risk of known or unknown problems such as environmental contamination. In most transactions it is expected and agreed that a financially capable party - the seller itself or, if substantially all assets of the seller are being sold, then the seller's corporate parent or equity sponsor - will stand behind the representations and warranties.
In the case of a distressed business, certain representations (for example, that the seller is paying its debts as they become due) will be unavailable because they will not be true. But even more fundamentally, there will typically not be a financially capable party to stand behind the representations. If sale proceeds will be insufficient to pay even the seller's creditors, the corporate parent or equity sponsor will ordinarily have no incentive to put its assets on the line. Placing sale proceeds in escrow would be a theoretical solution. But if the sale proceeds are destined for creditors of the seller, these creditors may be extremely reluctant (especially if the buyer is perceived to be paying a rock-bottom price) to leave funds in escrow to backstop representations whose reliability the creditors may feel even less able than the buyer to assess. So while breach of a representation will permit the buyer to walk from the deal before the closing, the buyer of a distressed company must typically accept that representations will provide little or no protection once the closing has taken place. How does the buyer protect itself? Due diligence, an important component of any acquisition, is especially important in distressed deals. An escrow may be available, albeit with severe limitations in amount and duration. But most importantly, the buyer should negotiate a price that properly accounts for the risks.
Risk from Seller's Creditors
When a non-distressed business is sold, the buyer has limited concern with the seller's liabilities. These will typically be paid in full, either because they remain with the corporation (in a stock sale), are assumed by the buyer (in an asset sale), are satisfied with sale proceeds, or will be paid when due from the seller's remaining operations or assets. The buyer will expect and receive protection against liability for obligations of the seller other than those specifically allocated to the buyer under the deal.
When a distressed company is sold and liabilities of the seller remain unpaid, the buyer must evaluate the risk of being sued by the seller's creditors. This risk will be non-trivial even where the buyer takes the obvious precautions of buying assets rather than stock, and disclaiming liability for all obligations not expressly assumed. Creditors of the seller may seek to collect their debts from the buyer under the doctrine of successor liability. The seller's creditors (or a subsequent bankruptcy trustee) may attack the sale as a fraudulent transfer. If the sale represented a breach of fiduciary duty by the seller's directors and officers, liability may even be imposed on the buyer for aiding and abetting the breach. These legal risks will in some situations be so severe that they can be managed only by insisting that the sale be accomplished through a bankruptcy or receivership. To learn more about the legal risks of buying an insolvent business, and how to minimize these risks, click here.
Opportunities for the Buyer in a Bankruptcy Purchase
In addition to the defensive purpose of reducing legal risk, bankruptcy sales will in some instances provide affirmative benefits to the buyer. For example, suppose the buyer wishes to assume valuable contracts of the seller, but the other party to the contract refuses its assent, imposes unacceptable conditions, or (whether for business or legal reasons) cannot be approached before announcement of the transaction. In many such situations, the bankruptcy court has the power to compel the other contract party to accept the buyer's assumption of the contract. Similarly, the buyer may have concerns about the quality of the seller's title or rights that third parties might assert in certain assets of the seller. The bankruptcy court typically has the power to resolve this type of dispute, and even to preempt future attacks on the quality of the buyer's title. Or suppose the buyer has concerns about potential successor liability. Most bankruptcy courts will enter a sale order that bars successor liability claims against the buyer; however, it is important for the buyer to be well advised about the scope and limitations of the protection afforded by such orders.
Bankruptcy sales can be accomplished either under Section 363 of the Bankruptcy Code or as part of a Chapter 11 plan. The two procedures are quite different,and certain of the most important rules are unwritten. In general terms, the key differences between buying under Section 363 of the Bankruptcy Code and under a Chapter 11 plan relate to timing, bid competition, structure and the role of parties other than the seller. The Section 363 process tends to be quicker (in an emergency, a sale can be accomplished in a matter of days, although six to ten weeks after submission of the buyer's bid is more typical) and almost always involves the opportunity for competitive bidding, though the practical ability of competitors to bid varies greatly. The Chapter 11 plan process almost always takes several months at a minimum (although a prepackaged or pre-negotiated plan may be quicker), and does not need to involve competitive bidding. Concerning structure, most bankruptcy sales involve assets rather than stock; however, a Chapter 11 plan may effectively provide for the buyer to acquire the seller as an entity, free from liabilities. The bases for other parties to oppose the sale can be different under Section 363 and under a Chapter 11 plan, but whether opponents of the sale will have greater blocking power under one process or the other will vary depending on the situation. It is critical for any prospective buyer to understand the bankruptcy process and to develop a strategy best calculated to serve the buyer's goals. Back to resource center
This article provides general information concerning its topic. It is not intended to provide legal advice or to create an attorney-client relationship.