Distressed M&A – bargains to be had or damaged goods?

• Over the past few years the global commodities crash has led to significant distress across the natural resources sector. However, since early 2016, the commodities sector has started to show signs of life, particularly in mining. Iron ore has led the charge with over six weeks of rallying prices. The oil sector also seems to be turning with both Brent and WTI ending their continuous period of decline.
  
  
• With a sustained period of stabilisation, valuations will become more readily agreeable leading to both buyers and lenders having more confidence in commodity prices and a resultant surge in acquisitions and lenders taking more aggressive action to deal with defaulting borrowers.
  
  
• Investors looking at acquisitions, and banks looking at their borrowers’ distressed assets, need to look at deal structures that protect them from the liabilities of potential targets. Transactions can be structured to mitigate the legal risk associated with the restructuring of companies that later become insolvent.
  

Introduction

In September 2008 Norton Rose Fulbright conducted a client survey entitled “Credit Crisis: the long term implications of a turbulent market”. As part of the survey respondents were asked when they thought the effects of the global financial crisis would dissipate. 74.6% responded one to five years, 11.9% responded five to ten years, and only 5.2% responded that the effects would be permanent.

Almost eight years later and the global financial crisis of 2008 is still having a considerable impact. The US Federal Reserve changed its policy to put an end to quantitative easing in October 2014 but only increased interest rates for the first time in December 2015, with some analysts now seeing the sell-off in global reserves leading to quantitative tightening and a reduction in market liquidity. The European Central Bank is still looking at measures to further stimulate growth. In terms of the Far East, Japan moved to negative interest rates in January 2016, while the economy in China is actually slowing and the country’s stock markets remain temperamental. Any economy with strong links to commodities (particularly hydrocarbons) is facing serious difficulties.

However, are we starting to see some form of light at the end of this tunnel? Since its all-time low in February 2016, the Baltic Dry Index has been in a period of gradual but consistent growth. The price of iron ore, oil, corn, wheat and cocoa has also become increasingly more stable. With stabilising commodities prices and more certainty surrounding forward prices for commodities, after a year or more of declines it would be usual to expect M&A in the commodities sector and the wider economy to increase.

In the context of this commodity price stabilisation, for investors looking at acquisitions in 2016 restructurings and distressed M&A are likely to remain the norm. Doing deals in a distressed environment carries its own risks and benefits and requires decisions to be made to identify the asset to be acquired, agreeing the deal structure, and negotiating the necessary contractual protections for each party. Below we examine the issues that buyers, sellers and lenders need to consider during a distressed sale/acquisition in a private M&A context. Many of these issues will also be relevant for listed companies.

Structure – asset sale or share sale?

Once a company has decided on an acquisition there is often a question mark over the appropriate structure for the transfer, taking into account the general market conditions and the distressed status of the target and/or its parent company. Unsurprisingly, in a distressed market where both parties are keen to minimise their exposure to risk, buyers prefer to acquire the target’s assets and sellers prefer to sell the target’s shares.

Share sale

Share sales tend to be simpler and faster to execute, particularly given the potential tax liabilities and the range of third party consents that tend to arise from asset sales in many jurisdictions. Often in a commodities sector transaction there will be regulatory or licencing concerns that prevent an asset sale or at least make it unattractive. In a share sale, the buyer will buy the shares of the target, pay the purchase price to the seller and, where relevant, pay stamp duty and/or transfer taxes on the shares to the tax authorities. Because only one type of asset – the shares – is actually being transferred, the transfer documentation can be much simpler than the documentation for an asset sale. With an asset sale each class of assets will need to be transferred and this may require a third party consent (such as a counterparty approval to assignment or the consent of a regulatory authority). For a distressed seller, the relative simplicity of execution, speed and ability to transfer the liabilities in the target company make a share sale much more appealing.

Asset sale

By contrast, an asset sale is attractive to buyers as it provides the buyer with a clean start. The buyer can cherry pick the assets that it wants and can isolate itself from the liabilities of the target company. The buyer generally pays the purchase price for the assets to the target itself and the taxes due are likely to differ from asset to asset (depending on the jurisdiction). The key advantage for a buyer is that in an asset sale the buyer only acquires the assets it wants and there is less risk in assuming potential unknown or contingent liabilities contained in a distressed target company.

Buyers should be aware that where a buyer is purchasing part or all of the assets of a business as a going concern then, depending on the jurisdiction, it is possible that by operation of law the employees of the business will also be transferred to the buyer.

Due diligence

Due diligence, whilst important in any M&A transaction, becomes particularly important when acquiring a distressed asset. A seller in a distressed situation may have operated the business in a fashion which causes additional liability to a buyer, such as utilising working capital in a non-standard way, or deferring capital expenditure or maintenance. Key contracts will also need to be reviewed to ensure that the target has not breached their terms. As a distressed sale usually means that indemnities and warranties are limited, a buyer will need a full picture of the assets being bought prior to the acquisition.

In an asset sale the focus of the buyer’s due diligence will be on the assets to be acquired. As a consequence the due diligence process can, in many cases, be streamlined. In a share sale of a distressed target, the focus will be the full business of the target company. As such, unless the buyer is willing to accept the risk (which may be the case if the buyer already knows the business of the target), the due diligence will need to be detailed and look at all aspects of the target and its operations.

Nevertheless, the cost of an asset acquisition and the restructuring that may be required can in some cases outweigh the benefits. At the end of the day the decision to proceed with an asset or a share acquisition will come down to a cost benefit versus risk analysis.

Restructure – hive down?

The best of both worlds may be the hive down. In a hive down, the seller transfers assets into a new company within the seller’s group as part of a wider restructuring and the new company is then sold to the buyer. While this may take time, often a seller is better placed to transfer assets and contracts as many agreements permit the transfer or assignment of assets to ‘affiliates’ (usually defined as companies within the seller’s group) but not to third parties. For a seller the orderly restructuring of the business and sale of a clean new company is likely to maximise the value. Change of control or other transfer/assignment consents can then be dealt with subsequently within the context of a clean new company and a known buyer. In some jurisdictions, the seller may have the ability to retain tax losses in the old company and use them to its benefit in future operations. For a buyer, completing due diligence on a clean entity (including the manner in which selected assets have been transferred to it) is preferable to the complex due diligence required when dealing with a distressed target company with liabilities the buyer does not want to take on or only discovers after completion.

Key to any hive down is ensuring that the transfers are completed in a way that protects the buyer and seller from any issues arising under any subsequent insolvency of the seller or the seller’s group.

Insolvency law

Under English law there are three core areas that are of immediate relevance to a distressed M&A situation. These three areas, in one form or another, are common to most insolvency regimes worldwide, including both common and civil law jurisdictions.

Transaction at an undervalue

The first area to be conscious of is the potential for claw back or unwinding of the transaction. Under the Insolvency Act 1986 (of England and Wales) (the Insolvency Act), a transaction made at an undervalue in the two years before the commencement of the administration or liquidation of the company can potentially be set aside if at the time of the transaction the company was, or became as a result of the transaction, unable to pay its debts as they fell due.

Creating a preference

The second area to be aware of is the possibility that a transaction could be set aside, if that transaction is entered into with the purpose of putting assets out of the reach of the creditors or the transaction otherwise prejudices the interests of creditors. Under the Insolvency Act, the company need not be insolvent at the time. In addition, the Insolvency Act allows the court to reverse any preferences made by the company to specific creditors.

Wrongful trading

The third area impacts on directors. Directors need to be aware of their obligations and liabilities when managing a potentially insolvent company as insolvency legislation in many jurisdictions contains personal penalties on directors for wrongful trading. These provisions are aimed at protecting a company’s creditors from reckless directors who continue to trade despite the risk of insolvency. Under the Insolvency Act, if a director concludes or should have concluded that there is no reasonable prospect of the company avoiding an insolvent liquidation or administration, they have a duty to take every step which a reasonably diligent person would take to minimise potential loss to the company’s creditors. ‘Director’ is widely defined in the Insolvency Act and includes ‘de facto’ or ‘shadow directors’, including persons in accordance with whose directions or instructions the directors are accustomed to act.

If, after the company has gone into insolvent administration or liquidation, it appears to the court that a ‘director’ has failed to comply with this duty, the court can order the director to make personal contributions to the company’s assets. Consequently, any sale of a distressed company or its assets (including through a restructuring or hive down) is an area where company directors will need to exercise caution. Regular board meetings should be held to ensure that the actions of the directors, as well as the reasons behind those actions, are recorded. Often it is prudent for directors to receive independent legal advice on their personal obligations. If there is any risk that a person will be considered a shadow or de facto director, that person should also act in accordance with the duties of a director and be aware of the potential liabilities.

Mitigating the risk of transactions at an undervalue

Many jurisdictions have similar provisions to those found under English law, allowing for transactions to be annulled/avoided or unwound. A hive down or indeed any restructuring transaction can be structured to mitigate the legal risk associated with companies in danger of insolvency. The contribution in kind of assets in exchange for newly issued shares is probably one of the simplest techniques to avoid transactions at an undervalue. Ensuring that the old company continues to be supported by its shareholders should mean in most cases (where the shareholder is itself solvent) that the old company will not be unable to pay its debts as they fall due. The issue of the creation of a preference will still need to be carefully examined on a case by case basis within the contractual matrix of the particular seller group.

Debt to equity swap

Often the reason for a distressed sale is the target’s inability or decreasing ability to service debt. In a restructuring a debt to equity swap can provide a borrower with the ability to continue to operate without the burden of debt or at least reduce the burden.

As well as being a debt restructuring tool, a debt to equity swap can create an alternative acquisition structure. An investor who can see the potential of a target company may look to acquire debt to give it a dominate role in any restructuring and ultimately ability to be able to take over the company. Market standardised loan documentation (for example LMA in England) will often allow the holder of the majority of the debt (in some cases this can be as little as 25%) to control or at least have negative control over any restructuring which may ultimately result in a debt to equity swap.

For an investor in a listed company, a debt to equity swap may trigger a mandatory offer which would deliver the entire target or a least a majority to the investor. In a private company context, the acquisition of the majority of the debt of a target company may provide a purchaser with a number of alternative acquisition routes. Under English law these include a simple agreed dilution of the majority shareholding through a swap and/or introduction of new money, a pre-pack administration or a court sanctioned scheme of arrangement. Similar provisions exist in other jurisdictions.

Insolvent target – opportunity or complication?

A potential option for a buyer is acquiring a target which is already the subject of insolvency proceedings. Assuming that formal insolvency proceedings have commenced, buying an insolvent target can be advantageous. If a buyer is dealing with an insolvency practitioner rather than a seller then the transaction to acquire that company is less likely to be the subject of a challenge under insolvency legislation. Dealing with a formal insolvency process also means more certainty. The buyer will be dealing with a heavily regulated process and will not be as vulnerable to the whims of the seller as in a regular sale.

There is a school of thought that buying a target which is the subject of insolvency proceedings means a cheaper price, and in some instances this is true. However an insolvency practitioner can often drive a much harder bargain. In most jurisdictions the insolvency practitioner is under a duty to achieve the best possible price for the company. In many civil law jurisdictions the sale process is required to be by way of a formal court sanctioned auction process, while in many common law jurisdictions the process of sale by the insolvency practitioner is less proscriptive.

An insolvency practitioner is unlikely to be able to provide any protections in the form of warranties, indemnities or other covenants. When buying an insolvent target it will therefore be a case of buyer beware. Where the target is the holding company of a group, the complexity of an insolvency, particularly one involving assets in multiple jurisdictions, may slow down the acquisition process and create an increased level of complexity and risk for any buyer. The potentially accelerated process for buying a target which is the subject of insolvency proceedings can also mean that, although the potential risks connected with the target are higher, the time for due diligence is substantially reduced.

The role of the lenders

Although insolvency and the breach of financial covenants are standard events of default in any facility agreement and are likely to give the lender the right to accelerate the loan, during this recession many lenders have recognised that, as creditors, they can often achieve better returns through supporting an orderly restructuring of a company’s debt than through forcing the company into formal insolvency.

The longer the solvency of a target remains open to question the greater the risk of the target’s position worsening. Prolonged insolvency can lead to creditors refusing to extend further credit, a reduction in the value of the company’s goodwill, debtors refusing to pay out, the termination of material contracts and the loss of key employees. For this reason, lenders will often prefer to restructure the debt, often entering into a restructuring agreement or a standstill agreement, which protects the company from insolvency proceedings while it negotiates with its creditors. During this time the lenders will take an active role in negotiations and will put together a restructuring plan, which can often require the company to dispose of subsidiaries and key assets. Sellers should be aware that while lenders are generally motivated to reduce the seller’s liabilities, the lenders’ key objective is to recover their debt and they are therefore likely to be particularly risk averse. Equally, the lender’s involvement in a sales process can be beneficial to buyers, as the lender, in trying to accelerate the sales process, may try to compel the seller to accept terms that he may not otherwise agree to.

Material adverse change provisions

For a seller of a distressed asset one of the most important factors is deal certainty. Where there are multiple potential buyers, deal certainty, and not price, may be the determining factor for the seller. This means that the seller will resist termination rights that may be typical on non-distressed sales where there is a split signing and completion, including rejecting the right of the buyer to terminate on a material adverse change or breaches of pre-completion covenants, and requiring that any consents are accepted regardless of any conditions imposed. For the buyer this means that risk will effectively transfer on signing and not on completion.

A buyer of a distressed asset is likely to seek assurances that certain events will not happen between signing and completion, and will typically seek a right to walk away (terminate) on the occurrence of those events. Triggers for these termination rights often include any steps taken towards insolvency, a loss of any key licenses, customers or contracts or a default under any borrowings. Whether the buyer will succeed in negotiating these walk-away rights will depend on the relative bargaining power of the parties. In our experience we have seen that for sellers of distressed assets walk-away rights are often deal breakers, and sellers may typically require a non-refundable deposit, break-fee or other security to ensure that the buyer does not walk away.

Closing thoughts

In general, within the context of the recovery from the global financial crisis and the potential for growth in the price of commodities, companies are starting to consider M&A, distressed or otherwise, as a means of expansion or diversification. In a market which is recovering from recession it is therefore crucial to structure the deal wisely and to be aware of the potential pitfalls.