With continued headwinds that include rising interest rates, high inflation and the general sentiment of a recission that is always right around the corner, the outlook for merger and acquisition activity generally – and for the retail industry in particular – seems likely to include more transactions with distressed targets than in recent years. Here is a brief summary of some unique considerations for deals involving distressed targets to help you brush up your playbook for potential transactions as the U.S. and world continue to navigate a challenging macroeconomic environment:
- Transaction Structure – Given the general ability to pick-and-choose what assets a purchaser wants to acquire, and what liabilities a seller is willing to assume, distressed transactions frequently are structured as asset sales rather than equity sales or mergers. The benefits to a buyer of being able to select the assets it purchases and the liabilities it assumes, and tax benefits of the step-up in basis that the buyer can receive by purchasing assets, typically outweigh the burden of additional third-party consents associated with asset deals. It is critical for buyers in an asset deal to ensure that the purchase agreement is clear on the assets being purchased to ensure that the scope includes everything the buyer intends to purchase and the liabilities that it is (and is not) assuming to avoid taking on unintended obligations from a seller.
- Successor Liability – While the general rule in an asset sale is that the buyer only assumes the liabilities it expressly assumes from the seller, there are general exceptions to that rule such as the de facto merger doctrine and fraudulent transfer exception under state laws. Certain federal and state laws also can impose liabilities on buyers that are not expressly assumed in a transaction, including unpaid taxes or under labor, employment or benefit statutes, including the National Labor Relations Act and the Fair Labor Standards Act. Buyers in distressed transactions therefore should be cognizant of these potential unbargained-for obligations when evaluating the target business, and they should not ignore known issues relating to the target business assuming that an asset structure and disclaimer of the assumption of a particular liability will be effective against an aggrieved third party under all circumstances.
- Indemnity – Acquisition transactions commonly include some level of indemnity protection provided by the seller for breaches of representations and warranties relating to the target business. Representations and warranty insurance (RWI) has become a common tool in many transactions to limit sellers’ exposure for breaches of representations and warranties in acquisition agreements. Sellers in distressed situations, however, often cannot be counted on to satisfy any indemnity protections they might agree to when the time comes for the buyer to assert a claim. As a result, if a buyer’s purchase price does not account for the risk that the seller might not be able to satisfy its post-closing indemnity obligations, RWI might be the only reliable means to protect a buyer from that risk. Given that distressed transactions frequently have compressed timeframes, if RWI is desired, it is critical to start working with a broker very early in the process to be able to perform sufficient diligence to satisfy an insurer and obtain policy of meaningful scope.
- Other Post-Closing Dependencies – In addition to a potential inability to satisfy post-closing indemnity obligations, buyers in distressed transactions should be cognizant of any other post-closing dependencies on a seller that the seller might not be able to satisfy if the seller ceases operations or goes bankrupt. For example, any services agreed to be performed by a seller under a transition services or supply agreement might not be fulfilled for the full contractual term. Buyers who need some post-closing services from a distressed seller therefore need to account for that risk in their purchase price and/or have a contingency plan ready at the time of closing the transaction.
- Bankruptcy and Insolvency – Finally, buyers in distressed transactions should be aware that a deal is not necessarily safe once it is closed. Under the Bankruptcy Code, a company may avoid transfers it made or obligations it incurred prior to the bankruptcy filing date if the transfer was made or obligation was incurred within two years before the filing date with actual intent to hinder, delay, or defraud creditors. A transfer made or obligation incurred during that two-year period also may be avoided as a “constructive” fraudulent transfer if the company received less than “reasonably equivalent value” in exchange for the transfer, and the seller (1) was insolvent at the time of the transfer or became insolvent as a result of the transfer, (2) was engaged in a business or transaction for which any property remaining with the company was “unreasonably small capital,” or (3) intended to incur, or believed that it would incur, debt beyond its ability to pay as the debt matured. The Bankruptcy Code therefore presents a risk that a court looking back several years after a transaction closed could, with the benefit of hindsight, find that the purchase price paid by the acquiror was less than “reasonably equivalent value” and invalidate the sale. This risk of having a sale invalidated years after the fact, as well as risks discussed above relating to successor liability, can be dealt with by purchasing assets in a transaction under section 363 of the Bankruptcy Code, which is an option available if a distressed seller cannot complete a sale out of court, as a result of any of the potential issues buyers might have discussed above or otherwise.
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