How Do You Buy Assets From a Bankrupt Company?

by Scott Edward Walker on November 17th, 2010

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

 

Question

One of our competitors just filed for bankruptcy under Chapter 11, and we think we can buy their IP and other valuable assets at bargain prices.  We were wondering if there are any issues we need to focus on.  We don’t know a lot about the bankruptcy process and are a little worried we might be getting in over our heads.

Answer

Welcome to the world of distressed M&A.  Indeed, I started my legal career in the corporate departments of two major New York City law firms and handled a number of these types of deals.  In short, this is very tricky stuff.  Below are five key tips.

Tip #1 — A Section 363 Sale is Usually the Way to Go.  The purchase of assets of a Chapter 11 debtor may be consummated either pursuant to Section 363 of the Bankruptcy Code (a “Section 363 Sale”) or as part of the debtor’s overall plan of reorganization.  A Section 363 Sale is the recommended method because it is faster and cheaper and therefore minimizes the risk of a decline in enterprise value and/or a shortage of working capital.

From the buyer’s perspective, a Section 363 Sale is often more attractive than a non-bankruptcy acquisition for a number of significant reasons, including: (i) in most cases, the bankruptcy court will approve the sale of the assets “free and clear” of all liens and liabilities (other than those liabilities that the buyer expressly agrees to assume and, arguably, certain “successor” liabilities such as environmental and product liabilities claims); (ii) the approval of the bankruptcy court should bar any subsequent fraudulent conveyance challenge; (iii) the buyer will be able to cherry-pick assets and contracts in ways not possible in the non-bankruptcy context and assumed contracts will generally be “cleansed” of non-assignability or change-of-control provisions; and (iv) State shareholder approval laws and bulk transfer laws generally do not apply to a Section 363 Sale.

Tip #2 — It May Pay To Be the Stalking Horse.  A Section 363 Sale is subject to bankruptcy court approval after notice to interested parties and a hearing.  To ensure that the debtor has obtained the “highest and best” price for its assets, an auction will usually be conducted under the supervision of the bankruptcy court.  Accordingly, the threshold question for a prospective buyer is whether it should play the role of the “stalking horse” bidder (i.e., be the initial party to execute a purchase agreement with the debtor) — or just wait to see the final sale terms approved by the bankruptcy court and then decide whether to make a higher bid (assuming it has such an opportunity).

There are a number of advantages to being the stalking horse, including: (i) more opportunity to conduct an adequate due-diligence investigation; (ii) the ability to set the threshold price and terms of the sale; and (iii) the ability to negotiate certain deal protections and bid procedures, as discussed below.  The major risk to being the stalking horse, of course, is bidding too high — i.e., locking into a deal that may not look so good at the time of the auction.

Tip #3 — Negotiate With All of the Relevant Constituencies.  In the non-bankruptcy context, a buyer generally negotiates solely with the distressed target’s management and need not deal with its creditors (except where the buyer is seeking amendments to debt documents or waivers, etc.).  In a Section 363 Sale context, however, there are a number of different constituencies — often with disparate interests — with which the buyer must deal, including perhaps secured creditors (e.g., first-lien and second-lien holders), unsecured creditors, equity holders (e.g., preferred and common stockholders), bondholders, landlords, indenture trustees, etc.

Indeed, it is imperative that the buyer understand the debtor’s capital structure and the dynamics of the various pieces and then keep all of the relevant constituencies “on board” throughout the negotiation process.

Tip #4 — Focus on the Bidding Procedures in the Purchase Agreement.  If the buyer is willing to be the stalking horse, it must bear in mind the context of the transaction and the competitive environment discussed above (i.e., the likelihood of a subsequent auction).  The purchase agreement that the stalking horse executes must be approved by the bankruptcy court and will serve as the bid document against which other parties will submit their proposals.  Accordingly, it makes strategic sense to keep the agreement as simple as possible and for the buyer to rely on its due diligence and the order of the bankruptcy court for protection rather than comprehensive representations and warranties and indemnification provisions (which will significantly discount its bid).

The most effective use of the stalking horse’s leverage is in connection with the negotiation of bidding procedures, including: (i) a bid deadline and an auction date, (ii) qualified bidder criteria provisions (e.g., no financing conditions), (iii) overbid requirements and matching rights, (iv) a termination fee and expense reimbursement provisions and (v) auction rules.

Tip #5 — A “Pre-Pack” May Be a Good Alternative.  Time is often the buyer’s biggest (and least predictable) risk in connection with purchasing distressed assets in the bankruptcy context.  The debtor’s filing may, for example, trigger protracted negotiations among the various constituencies, unexpected claims, litigation, etc.  Accordingly, “prepackaged” Chapter 11 plans (“Pre-Packs”) — which may include a Section 363 Sale — are becoming more prevalent  (particularly in light of the increased costs and the difficulty of existing management to control the bankruptcy process under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005).

Where a company has a sound business model, but is overburdened by debt, a Pre-Pack may be particularly appealing to avoid the risks of purchasing distressed assets in the non-bankruptcy context, coupled with the lower approval thresholds of Chapter 11.  You must, however, “catch” the target company before it files.

Conclusion

I hope the foregoing was helpful (and not too complex).  This may sound a bit serving, but you definitely need to retain strong M&A counsel to help you through the process.  Good luck.

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