February 3, 2010

The current economic downturn has brought about a growing niche of opportunities in distressed mergers and acquisitions (M&A). In the past, only those with experience in finding, evaluating and navigating these unique opportunities would consider themselves players in the distressed M&A market. Now, middle-market businesses in all industries are finding themselves presented with strategic opportunities to acquire competitors, integrate key suppliers and combine with other financial or industry partners through distressed M&A activity.

These types of transactions come in a variety of shapes and sizes, including the sale or liquidation of assets, assignments for the benefit of creditors, Chapter 7 liquidations and Chapter 11 reorganizations. Based on the circumstances, the finer points of the deals can differ and the number of primary players can range from two parties in direct negotiations to as many as seven different stakeholders at a single negotiation table.

Sale or Liquidation of Assets

In this category of M&A transactions, a distressed business finds a buyer, and the two parties directly negotiate a going concern or liquidation sale of the assets of the company. The going concern or liquidation sale could take place in one transaction or in a series of transactions (e.g., selling accounts receivable to a factoring company, inventory to a competitor and vehicles to an auto auction). The decision to sell the assets of the distressed business may be part of an exit strategy of the ultimate stakeholders, or it may be motivated by demands for payment from the company's principal lender and other creditors. Typically, the distressed business and the buyer retain their own legal counsel and financial advisors to assist in negotiating and documenting the transaction, finding the parties to the deal and conducting due diligence investigations.

A going concern or liquidation sale of assets generally has two primary players at the negotiating table: the distressed business and the buyer, each accompanied by its respective legal counsel. Each player's motivations are likely transparent. The distressed business desires to maximize the purchase price and decrease the scope of and the risk associated with any representations, warranties and post-closing obligations. The buyer, on the other hand, seeks the exact opposite.

Assignments for the Benefit of Creditors

In an assignment for the benefit of creditors, also known as an ABC, a distressed business assigns all of its assets to an independent trustee, which then sells or liquidates those assets to a buyer. This approach involves two separate transactions: (1) the assignment of the assets from the distressed business to the trustee and (2) the sale or liquidation of assets by the trustee to the buyer. The trustee earns a fee for its service, and the balance of the proceeds from the sale or liquidation is used to satisfy amounts due to creditors and other liabilities. The decision to pursue an ABC, which may take place with or without state court supervision (depending on the jurisdiction), is typically motivated by demands for payment from the distressed business' creditors.

An ABC has up to four primary players (and possibly a fifth if the process is being supervised by the state court): the distressed business, its creditors, the trustee and the buyer, as well as their respective legal counsel. Each of these parties has its own goals for the negotiations. The distressed business, not having any assets left after the assignment and not likely to receive any of the proceeds from the sale or liquidation, may not have much at stake at the end of the ABC process. Each of the creditors hopes that the trustee will realize proceeds sufficient to repay all amounts owed to them, while the trustee works to generate the greatest amount of proceeds possible, with the goal of satisfying all amounts due to creditors. Finally, the buyer desires to minimize the purchase price and find parties to make and stand behind representations, warranties and post-closing obligations, although trustees do not generally make such representations and warranties as part of an ABC.

Chapter 7 Bankruptcy Liquidations

Bankruptcy, whether it is filed under Chapter 7 or Chapter 11 of the Bankruptcy Code, sets up another possible transaction in the distressed M&A market. A distressed business initiates a bankruptcy case through its lawyer by filing a petition for relief with the United States bankruptcy court. Chapter 7 liquidation cases are administered by a trustee who is appointed from a panel of private trustees consisting of lawyers, accountants and other qualified professionals. As in an ABC, the trustee collects and liquidates the assets of the distressed business, generally referred to as the "debtor." Much like an ABC, a Chapter 7 case involves two separate transactions: (1) the initiation and completion of the bankruptcy case and (2) the sale or liquidation of assets by the trustee to the buyer. The trustee earns a fee for its service, and the balance of the proceeds from the sale or liquidation is used by the trustee to satisfy the debtor's liabilities.

There can be up to five primary stakeholders involved in a sale under a Chapter 7 case: the bankruptcy judge and courtroom staff, the debtor, its creditors, the trustee and the buyer (along with their respective counsel). Following the model of the typical ABC, the trustee's goal is to realize the greatest value for the debtor's bankruptcy estate so that all amounts due to creditors can be satisfied. Likewise, the debtor generally does not have much at stake at this point, except a desire to liquidate the business assets and complete the bankruptcy case. The creditors still want the trustee to realize proceeds sufficient to repay all amounts owed to them, and the buyer still wants to minimize the purchase price and find parties to make and stand behind representations, warranties and post-closing obligations, which are not typically made by a bankruptcy trustee.

Chapter 11 Bankruptcy Reorganizations

In a Chapter 11 case, the debtor, generally referred to as the debtor-in-possession (DIP), remains in possession and control of its business and assets. The DIP is given the chance to reorganize its debts and emerge from the bankruptcy as a healthy company. As part of that process, the DIP usually contacts creditors to negotiate changes in the terms of their financing (e.g., decreasing interest rates, extending maturity dates and decreasing the size or frequency of payments). In addition, a Chapter 11 case may include the sale of all or a portion of the DIP's assets as part of the reorganization plan or under Section 363 of the Bankruptcy Code, sometimes referred to as a Section 363 sale or simply a 363 sale.

The office of the U.S. Trustee Program is often heavily involved in Chapter 11 cases. Some of these cases also have a committee of unsecured creditors, which is appointed by the U.S. Trustee, subject to court approval. The committee hires counsel and other financial advisors and has standing to be heard on all issues in the Chapter 11 case. The DIP's secured creditors are also generally involved in all aspects of the case, including a sale of assets as part of a reorganization plan or through a Section 363 sale. Third parties to executory contracts and unexpired leases that are to be assumed by a buyer as part of any final sale may also take active roles since they will have post-closing ties to the buyer.

In a Chapter 11 case, there can be as many as seven primary players involved in a Section 363 sale. In addition to some of the parties involved in a Chapter 7 case (the bankruptcy judge and courtroom staff, the debtor, its creditors and the buyer), a Section 363 sale involves the U.S. Trustee (in lieu of a Chapter 7 trustee) and the committee of unsecured creditors, as well as third parties to executory contracts and unexpired leases. The committee of unsecured creditors wants the DIP to realize proceeds from a sale sufficient to repay all amounts owed to them, while the third parties to executory contracts and unexpired leases want assurances that the buyer is capable of satisfying all obligations under the assumed contracts and leases going forward.

Success Factors

Clearly, opportunities in the distressed M&A market come in many shapes and sizes, and the playing field has opened significantly to include middle-market businesses and other newcomers hoping to take advantage of the fallout from the economic downturn. The ultimate success or failure of these types of transactions may depend on how well you understand the intricacies of the distressed M&A market, the final structure of your transaction, and the motivations and desires of all the key players. If you have questions or need assistance evaluating the opportunities before you, contact me or your Much Shelist attorney.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.