Lately, we bankruptcy lawyers seem to be more popular with our Corporate and M&A colleagues. As default rates and fuel prices rise and as the malls seem a little or a lot less crowded, more transactional lawyers are finding their clients being interested in companies or business lines that are underperforming, negotiating covenant amendments or waivers with lenders, or projecting weakening results over the next 6 to 12 months. Strategic and financial investors are seeing more deals cross their desks that are being valued at less than the amount of the secured debt on the business. More investment bankers are circulating information memoranda which refer to the prospect of consummating “363 sales” in bankruptcy, seeking “stalking horses” or running a sale process governed with court-approved bidding procedures.
What does all this mean for the investor – the potential acquirer – that finds its target is a troubled company? The investor is faced with a different set of transaction options, some of which may involve the target’s expected Chapter 11 bankruptcy or the transaction needs to be assessed in consideration of a possible unexpected bankruptcy filing by the target. While certain investors have already spent the last few years spending quality time in the world of insolvency and distressed mergers and acquisitions, these numbers are now increasing as more and more strategic and financial investors are considering, and being presented with, deals for distressed businesses. Some of these deals may implicate the target’s Chapter 11 bankruptcy filing, but the bankruptcy option may not be the right option for every deal involving a troubled company. How does an investor approach a distressed deal in 2008? When should an investor consider having its deal consummated through a target’s bankruptcy? What should an investor do when its target insists that it must pursue the deal through a Chapter 11 bankruptcy?
Common Distressed Deal Considerations
The structure of a distressed transaction typically will hinge on how the investor and target prioritize a number of important concerns, including:
- The target’s debt and capital structure, including the presence of a single class or multiple classes of secured debt, and a determination of which class of debt is the likely “fulcrum debt”;
- The immediacy and extent of target’s financing needs – how quickly must a transaction close before the target runs out of liquidity, or its liquidity needs exceed its resources?;
- The potential costs and timing exigencies of the proposed transaction – how long can the target maintain its relations with key employees, customers and suppliers?;
- Consent rights of third parties (e.g.., lenders, landlords, equipment lessors, key customers);
- The timing of critical events such as loan or bond defaults, payments due under critical agreements, production schedules;
- Considerations arising from a potential auction process, including the investor’s willingness to participate in an auction, and the perceived and actual liability risks facing target’s directors over issues of value; and
- Does the target have businesses and assets outside of the United States, and do these other foreign jurisdictions have laws and insolvency processes that are friendly to the investor’s chosen sale process?
As assessment of these factors, in turn, will dictate the deal structure. The most common methodologies include:
Out-of-Court Sale: A traditional sale pursuant to an asset purchase agreement may turn out to be the best option for the parties if the target has a simple debt structure, third party and governmental consents are not needed or are readily obtainable, and the target’s fiduciaries see little risk of liability to themselves in approving a sale. Under these circumstances, an out-of-court sale may permit the parties to minimize transaction costs, limit business disruption and close quickly.
UCC Article 9 Sale: Where the target has a relatively simple debt structure, with a single class of secured debt, the parties may be able to negotiate a consensual foreclosure by the secured creditor in conjunction with the creditor’s sale of the assets to the investor. This approach has the advantage of permitting the investor to acquire the assets free and clear of liens in a relatively quick and inexpensive transaction. However, the more complex the business being acquired, the more disruptive this approach will be to the target’s business. The parties may perceive that they are constricted in the amount of pre-sale planning in which the investor can be engaged. Further, unhappy creditors may counter an Article 9 sale with an involuntary bankruptcy filing, and seek to challenge the sale on fraudulent transfer grounds. Also, in the face of hostile junior creditors, the secured creditor may view this approach as presenting it with exposure to lender liability-type claims.
Loan to Own: Where the target needs financing but has not yet decided to put itself up for sale, or where the investor is not yet sure about the prospects of ownership, the investor may decide to make a loan to the target at the level of debt perceived by the investor to be the “fulcrum debt.” Often, the “fulcrum debt” will be a junior lien or senior unsecured debt position that is permitted by the target’s existing financing or consented to by the existing creditors. While the investor will have less control over the target than in an outright acquisition, the investor may be able to use loan covenants to dictate financial or operational performance parameters for the target. This approach more likely will be used by a financial investor who is less concerned about integrating the target’s business into another, existing business.
Debt Acquisition: Depending on the circumstances, an investor may be able to acquire the target’s existing “fulcrum debt” for a purchase price less than par or, with the cooperation of the target, in a restructuring of the existing debt on terms more favorable to the target. Indeed, an investor may acquire the target’s debt even without the target’s prior knowledge. By controlling the target’s “fulcrum debt,” the investor will expect to be able to exert great influence, if not effectively control, the target’s efforts to restructure its balance sheet and operations. Depending on the discount to par represented by the purchase price, the investor may choose to hold the target’s debt, or seek to take over the target by exchanging debt for the target’s equity or by including all or a portion of the debt as a credit bid for the target.
Bankruptcy Sale: The Bankruptcy Code Section 363(b) sale process provides a target, creditors and bidders with a stable and battle-tested auction environment. While the bankruptcy process presents the greatest transaction costs and requires the longest lead time prior to closing, it provides a court-authorized framework for obtaining assets free and clear of liens and claims, circumventing most consent rights or other assignment or sale restrictions (except, most notably, with respect to restrictions on intellectual property rights), and minimizing potential deal risks such as an investor’s fraudulent transfer risk and the risk of litigation claims being brought against a target’s directors.
The bankruptcy sale process is often viewed as potentially the most disruptive of all of the sale methodologies, although parties often seek to minimize the potential for disruption by soliciting bids and negotiating a stalking horse bid, with an asset purchase agreement, prior to the target’s Chapter 11 filing. Often, the complexities of the target’s capital structure, or the presence of statutorily created consent rights from non-cooperative parties, will dictate the target’s sale through Chapter 11. It is important to note that, with rare exceptions, the Chapter 11 process requires the target to solicit competing bids and to conduct an auction to determine the highest and best bid. As a result, some investors may seek to avoid the bankruptcy sale process if at all possible, while others may seek to be the stalking horse in order to gain the earliest possible entrée into the company, and to recoup their time and expense investments through a break-up fee and/or expense reimbursement. In some cases, an investor that is unsure of the target’s value or unwilling to invest considerable time in a deal that may not close may wait until the target discloses its stalking horse offer and commences the process for soliciting competing bids.
A typical 363(b) Sale timeline looks like this:
|Initial submission of bids||Day 1|
|Selection of Stalking Horse||Day 3 – 14 (time period depends on target’s distress)|
|Negotiation of Asset Purchase Agreement; Filing of motion to approve bidding procedures, break-up fee and related sale matters||Day 7 – 21 (time period depends on target’s distress)|
|Bankruptcy court approval of bidding procedures, etc.||Requires 20 days’ notice to creditors and interested parties; time period can be shortened for “cause” |
|Auction for overbids against stalking horse bid – conducted by debtor’s investment banker or broker, outside
|Typically 20 days after bankruptcy court approves bidding procedures|
|Sale Hearing||Typically 1 – 3 days after Auction |
|Closing||10-day appeal period can be waived by court to permit closing as soon as sale order is entered on the case docket.|
Chapter 11 Plan: In certain cases, the investor may seek to acquire the target by co-sponsoring the target’s Chapter 11 plan of reorganization. A Chapter 11 plan would be voted on by the target’s classes of creditors, and must be approved by at least one class of creditors that is impaired under the plan. Through a Chapter 11 plan, the investor may seek to avoid the competitive bidding process inherent in the Section 363(b) sale process, since under Chapter 11 a debtor has an exclusive right to propose a Chapter 11 plan for the initial 120 days after its bankruptcy filing (which period may be extended up to 18 months from the bankruptcy filing).
A sale under a Chapter 11 plan also enables the avoidance of transfer taxes which in certain deals can be of a significant benefit to the creditors of the target. However, even a Chapter 11 plan may be subject to competitive bids if, for example, a creditor or a class or group of creditors is successful in contesting the valuation of the target represented by the plan. In addition, the Chapter 11 plan process likely will have the greatest transactional costs and longest time period prior to closing. However, the Chapter 11 plan process may be useful to or necessary for the investor who is seeking to merge with the target, or who seeks to raise additional capital for the reorganized company through a rights offering to the target’s existing creditors and/or equity holders.
In our current economic environment, troubled businesses are increasingly presenting strategic and financial investors with potentially attractive opportunities. The world of distressed investing presents a different range of transaction options than investors would consider in acquiring relatively healthier businesses. The bankruptcy Chapter 11 auction sale process is significant among these options, since it very much is the standard against which the other options are to be assessed, in terms of transaction costs and timing, ability to close with or without third party consents, potential exposure to the investor and target, and the ability to acquire assets free and clear of liens and claims.
Investors interested in troubled companies are well-advised to consult with counsel and other advisors having both M&A and insolvency expertise at the earliest possible stage of their consideration of a potential investment. We in Dorsey’s M&A and Financial Restructuring and Bankruptcy practice groups have considerable experience in advising investors pursuing transactions with troubled businesses and would be happy to speak with you about your opportunities.
 Section 363(b) of the US Bankruptcy Code, 11 U.S.C. Sec. 363(b), requires a company in Chapter 11 bankruptcy to obtain bankruptcy court approval of all transactions that are outside of the debtor’s ordinary course of business, including sales of business divisions, product lines, or substantially all of the company’s assets. Chapter 11 of the US Bankruptcy Code enables a company, as a debtor-in-possession, to reorganize under the bankruptcy protections from creditors while remaining in control of its business and assets. Accordingly, bankruptcy as discussed in this article as a transaction option refers to the target’s sale or restructuring under Chapter 11.
 A “stalking horse” is a bidder for the target’s assets whose offer is then used to by the target to solicit competing offers, usually in an auction process run by an investment banker or other broker. The stalking horse typically will be protected against an overbid by negotiating a break-up fee and/or expense reimbursement.
 A bankruptcy sale process will be governed by procedures approved by the bankruptcy court that provide for notice to creditors and interested parties, the form and content of competing bids (including whether a deposit will be required, the bidding increments, and, where groups of assets or business are being sold, whether bids will be entertained in part or in whole), and the scheduling of an auction and court hearing on approval of the “highest and best” offer resulting from the sale and auction process
 The “fulcrum debt” of the target will be the point in the capital structure where the target’s liabilities exceed the value of the target’s business and assets: e.g., the debt that could control or greatly influence the bankruptcy process.
 A class of creditors will be found to have accepted the Chapter 11 plan if the plan has been accepted by creditors in that class holding at least two-thirds in amount and more than one-half in number of the allowed claims.