There are important issues and procedures to be considered when a foreign buyer seeks to purchase the assets of a U.S. entity that is distressed or subject to a U.S. insolvency proceeding and which is involved in business activities with a nexus to U.S. national security.1 This article will describe the various ways that a foreign purchaser can acquire assets from a distressed seller and also provides a brief overview of the procedures and steps that such buyer should consider in order to satisfy the regulations implemented by the primary national security regulatory body, i.e., the Committee on Foreign Investments in the United States ("CFIUS"), should the acquisition constitute a transaction that could result in control of a U.S. business by a foreign person (a "Covered Transaction") and which has a nexus to U.S. national security.
Part I - Acquisition of Distressed Assets
In the United States, parties that wish to acquire assets from a distressed or insolvent seller more often than not acquire such assets in the context of an insolvency proceeding commenced under chapter 7 or chapter 11 of the United States Bankruptcy Code. 2 (An entity that is subject to an insolvency proceeding in the U.S. is referred to as a "Debtor.") A chapter 7 proceeding facilitates a liquidation of a Debtor’s assets pursuant to an auction or a series of auctions conducted under the supervision of the Bankruptcy Court. A chapter 11 proceeding provides for a reorganization of a Debtor’s business pursuant to a plan of reorganization that is voted on by the Debtor’s creditors in accordance with certain voting requirements and approved by a United States Bankruptcy Court (a "Plan of Reorganization"). Debtors can also sell all or a portion of their assets in a chapter 11 proceeding; this type of proceeding is referred to as a "liquidating 11".
A sale of Debtor’s assets will be conducted in accordance with Section 363 of the U.S. Bankruptcy Code following the issuance of prior notice to interested parties and the convening of a public hearing. The sale itself is conducted as a public auction, subject to higher and better offers. The Debtor will establish certain sales and bidding procedures, which must be approved in advance by the Bankruptcy Court. A typical requirement is that all prospective purchasers must establish themselves as a "Qualified Bidder" in order to submit a bid by providing evidence of their ability, both financial and legal, to consummate the purchase. At auction, a Debtor will choose the highest and best bid, which does not always mean the highest purchase price. If a prospective bidder has offered the highest price but is less qualified than others to consummate the purchase, a Debtor is unlikely to approve that bid.
This standard is particularly relevant for sales that will constitute a Covered Transaction because a foreign buyer will need to demonstrate that it has, or will be able to, obtain CFIUS approval and be able to consummate a sale. If numerous foreign buyers are competing for the same assets, a foreign buyer that has obtained CFIUS approval will likely be considered a better buyer as compared to a foreign buyer that has not obtained CFIUS approval since the latter buyer will not be able to consummate the transaction without CFIUS approval.3 If bids are submitted before any CFIUS reviews have been completed, foreign buyers with a greater likelihood of CFIUS approval are likely to be viewed more favorably. If a foreign buyer is competing with a U.S. buyer for assets in a Covered Transaction, the foreign buyer will need to demonstrate likely CFIUS approval in order to be able to compete on equal footing with the domestic buyer.
"At auction, a Debtor will choose the highest and best bid, which does not always mean the highest purchase price."
In order to maximize value, Debtors conduct a public sales process prior to the auction in which the assets are marketed to third parties. Debtors are entitled to select a lead bidder from among several qualified buyers, which is known as a "stalking horse bidder." A stalking horse bidder is afforded certain protections, such as reimbursement of fees and expenses and the receipt of a break-up fee should another party outbid the stalking horse bidder at the 363 sale. Some studies have demonstrated that a stalking horse bidder is the successful bidder in over 70% of auctions conducted under Section 363.4
In instances where a Debtor has incurred loans beyond its ability to repay, a Debtor’s secured lenders may be in a position to use their loans to effectuate a purchase of the assets of its borrower through either a "Credit Bid" or "Loan to Own" strategy. The Credit Bid strategy arises where a Debtor’s assets are being sold at a 363 sale, and the Debtor’s secured lenders (whose loans exceed the value of the collateral being sold) determine to bid at the 363 sale using their debt as consideration. The amount that is credit bid by the lender is treated the same as cash funds offered by third parties.
The second method is where the Debtor’s lenders acquire the Debtor’s assets by converting their debt into the equity of the reorganized Debtor, which entity succeeds to the ownership of the assets, pursuant to a Plan of Reorganization approved by the Bankruptcy Court. A debt-for-equity conversion can occur if the value of the Debtor’s assets are less than the aggregate debt held by the lender seeking to implement such conversion. There are many considerations involved in a debt-for-equity conversion, a discussion of which is beyond the scope of this article.
"A debt-for-equity conversion can occur if the value of the Debtor’s assets are less than the aggregate debt held by the lender seeking to implement such conversion."
Lenders will pursue these strategies if they believe their recovery will be greater if they own and control the assets rather than if they let the assets be sold to third parties for a low price. The distressed debt market in the United States and other developed countries has evolved to a point where sophisticated distressed debt investors acquire the outstanding debt of troubled companies, at a discount from the par value of the original face amount of the debt with the intention of converting that debt to a majority equity ownership position. This business strategy is known as a "Loan to Own Strategy." Distressed investors need to analyze the proper purchase price in order to achieve an appropriate return and, if the Debtor’s debt structure is multi-tiered, must also analyze the appropriate tranche, or level, of a borrower’s debt to acquire in order to effectuate this strategy. The senior-most level of debt that exceeds the value of the Debtor’s assets is called the "fulcrum" debt, and is generally the party in interest in a Debtor’s insolvency proceeding whose approval is needed to implement a debt-to-equity conversion. In certain circumstances, such fulcrum lenders can propose their own Plan of Reorganization. Since the value of a Debtor’s assets may rise and fall prior to, and during, the course of an insolvency proceeding, a Loan to Own Strategy is a high risk, but potentially high reward, method of acquiring assets.
There are other methods of acquiring a Debtor’s assets outside of a bankruptcy process, e.g. through private sales or a foreclosure of liens pursuant to state law. The principal benefits of using these methods are that they cost less money and often take considerably less time than a 363 sale or Plan of Reorganization process conducted pursuant to a bankruptcy proceeding. For reasons discussed below, however, they are not well suited for a purchase of distressed assets that implicates a CFIUS approval.
In summary, there are three principal ways to acquire the assets of a Debtor in an insolvency proceeding:
- by purchasing the assets as a third party bidder in an auction conducted pursuant to a 363 Sale;
- through a credit bid by a lender to the Debtor in an auction conducted pursuant to a 363 sale, i.e. the Credit Bid Strategy; and
- by acquiring and converting the debt owed by the Debtor into a majority controlling interest in the reorganized entity pursuant to a Bankruptcy Court-approved Plan of Reorganization, i.e. through a Loan to Own Strategy.
A tangible benefit of acquiring assets of a Debtor through a 363 sale or pursuant to a Plan of Reorganization is that once a Bankruptcy Court approves the sale or the Plan of Reorganization (in the case of a Loan to Own transaction) and the order of the Bankruptcy Courts becomes a final order, the purchaser obtains good title to the assets, free and clear of claims by other parties and prior liabilities of the Debtor (except where explicitly assumed by the Purchaser).
The foregoing is a simplified overview of what are complex and often contentious transactions. Different creditors and bidders may be competing for the same distressed assets, and differing views on value will affect the influence of parties who seek to acquire the assets through a Credit Bid or Loan to Own Strategy.
PART II – CFIUS Considerations
Under U.S. law, the U.S. President has broad authority to review all mergers, acquisitions, and takeovers that "could result in foreign control of any person engaged in interstate commerce in the United States."5 Following review, the President may suspend or prohibit a transaction that the President deems a threat to national security that cannot otherwise be addressed. The national security review process is administered by CFIUS, which is a multi-agency committee that includes the U.S. Secretaries of Treasury, Homeland Security, Commerce, Defense, State, and Energy, the U.S. Attorney General, the U.S. Trade Representative, the Director of the Office of Science and Technology Policy, and the head of any other executive department, agency or office determined appropriate by the President or the Secretary of the Treasury on a case-by-case basis, as voting members.6
"Following review, the President may suspend or prohibit a transaction that the President deems a threat to national security that cannot otherwise be addressed."
The CFIUS review process involves several steps that implicate timing considerations for a transaction. First, the parties must gather the information for the CFIUS filing, which is a joint notification that contains specific information about the foreign investor and its ownership, the U.S. business that is the subject of the transaction, and the transaction itself. After the draft CFIUS filing has been prepared, the parties are encouraged to "pre-file" the draft for at least five business days, which allows CFIUS an opportunity to provide some initial feedback before the statutory review period begins.
Upon receiving formal notice of a proposed acquisition, CFIUS conducts a 30-calendar-day initial review to determine whether national security considerations warrant a full-scale investigation. If not, the process ends with a notice to the parties that CFIUS has concluded its review and determined that there are no unresolved national security concerns with respect to the transaction. If CFIUS decides that the acquisition presents national security concerns, certain factors that trigger mandatory investigations are present, or CFIUS requires additional time, however, a 45-calendar-day investigation follows. If, after the 45-day investigation, CFIUS recommends the President stop a transaction, CFIUS cannot reach a decision regarding a transaction, or CFIUS requests a presidential decision, the President will make the final decision as to whether to allow the transaction to proceed. In such a case, the President has 15 calendar days to decide what action to take. Presidential reviews, however, are rare, and if at the end of a 45-day investigation period CFIUS requires additional time to complete its process (e.g., if it is negotiating mitigation requirements with the parties), the parties more typically withdraw and resubmit their filing, which restarts the initial 30-day review period. The majority of cases are resolved after the initial 30-day review, but approximately one third of all cases move to investigation. Accordingly, for transaction-planning purposes it is best to account for a full 45-day investigation following the initial review.
CFIUS review is generally a voluntary process, but avoiding it can carry significant risk. Any member of CFIUS can initiate a review of a proposed or completed acquisition if the agency believes that the acquisition is subject to CFIUS’s jurisdiction. CFIUS members may also contact parties about un-notified transactions to "invite" the parties to submit a filing, at which point filing is for all practical purposes mandatory. Acquisitions for which CFIUS does not receive notice remain forever open to Executive Branch scrutiny and potential divestment or the imposition of mitigation conditions. By contrast, once a transaction clears CFIUS review, it may not be reinvestigated unless the initial review was based on false or misleading information material to the review—or the parties omitted material information. Accordingly, even when a transaction is arguably exempt, it is prudent to notify CFIUS in order to vet the transaction.
"Acquisitions for which CFIUS does not receive notice remain forever open to Executive Branch scrutiny and potential divestment or the imposition of mitigation conditions."
CFIUS has broad jurisdiction to review transactions. As noted above, a key element for determining whether a transaction is a Covered Transaction is whether it will result in "control" of a U.S. business by a foreign person. Control is defined as "the power, direct or indirect, whether or not exercised, through the ownership of a majority or a dominant minority of the total outstanding voting interest in an entity, board representation, proxy voting, a special share, contractual arrangements, formal or informal arrangements to act in concert, or other means, to determine, direct, or decide important matters affecting an entity."7 Applying this broad standard, the determination of who has "control" of an entity turns not merely on the percentage of ownership, but also on who has potential decision-making power. Thus, a minority equity holder with veto power over certain key issues could be considered to "control" an entity for the purpose of CFIUS review.
Furthermore, CFIUS interprets its national security jurisdiction broadly, so it is critical to be aware of the various issues involved in a potential transaction to try to assess any national security implications. For example, CFIUS has objected to transactions that were substantively not clearly linked to national security but where it was determined there was a national security threat based on the U.S. target’s physical proximity to sensitive U.S. military assets. Moreover, just because a specific issue has been resolved by a single U.S. Government agency with independent jurisdiction does not mean that CFIUS will not want to conduct a full national security review. Finally, CFIUS jurisdiction applies to cases in which a U.S. business is being sold by a foreign owner to a new foreign buyer as CFIUS will assess the national security implications of the new foreign control.
For acquisitions or debt-to-equity conversions where foreign ownership is involved, it is critical to assess the need for a CFIUS filing, anticipate issues that may arise in the course of a review, and work to begin the CFIUS process as early as possible to provide the greatest flexibility for closing. These considerations are especially relevant in an auction as they may impact the Debtor’s assessment of the bids. Moreover, as part of the CFIUS analysis, it is important to anticipate potential sensitivities with respect to the buyer and/or U.S. business, including whether CFIUS-based mitigation requirements may be required. Mitigation is not required in most CFIUS reviews, but when imposed, it can impact the relationship between the buyer and the target post-closing, such as the buyer’s ability to access and manage the U.S. business.
"CFIUS interprets its national security jurisdiction broadly, so it is critical to be aware of the various issues involved in a potential transaction to try to assess any national security implications."
There are other national security considerations that may be relevant to an acquisition of distressed U.S. assets, such as foreign ownership, control or influence ("FOCI") mitigation requirements if an investor with foreign ownership acquires interests in a U.S. company holding a facility security clearance and performing on classified contracts. Such issues are important to understand independently as well as in the context of a CFIUS review, but are beyond the scope of this article.
PART III – Managing The Process In A Distressed Acquisition Subject To CFIUS Approval
Foreign (or foreign-owned) entities seeking to acquire the assets of a distressed entity which would require CFIUS approval have to manage and coordinate two distinct processes, i.e., the acquisition of the assets themselves and the procurement of the approval by CFIUS. It is important for the potential buyer to have a thorough understanding of each process and to develop a plan and a timeline that maximizes the probability of acquiring the assets.
The potential foreign buyer should retain professionals who are well versed in distressed acquisitions and related national security regulatory considerations. As noted above, a foreign purchaser of distressed assets in a Covered Transaction will need to work with counsel to assess the issues and sensitivities involved in the transaction and work with counsel to develop an appropriate CFIUS strategy. (Although beyond the scope of this article, if a foreign buyer (or a U.S. buyer with foreign ownership) is going to acquire a cleared U.S. company, the parties will need to propose a FOCI mitigation plan to the U.S. Department of Defense’s Defense Security Service in connection with the transaction.)
There are tangible benefits to being proactive in informing CFIUS about a potential acquisition, and there may be significant negative consequences if CFIUS is informed too late in the process, or is not informed at all. Potential risks include a forced divesture of the acquired assets or the imposition of mitigation requirements that the parties may find unacceptable and/or contrary to the buyer’s rationale for the transaction.
As noted, a buyer can acquire the distressed assets through a 363 sale as a third party or can acquire a controlling amount of the target’s outstanding debt and either credit bid at a sale of such assets (using the debt) or convert the debt into a controlling interest in the reorganized entity that will own the acquired assets through a Plan of Reorganization in the distressed entity’s bankruptcy proceeding. There are many legal and business issues and risks involved in a distressed acquisition, and local knowledge is essential in order to be a serious and successful bidder. If the potential bidder wishes to be a stalking horse bidder and the U.S. company is willing to join a CFIUS filing, it should seriously consider obtaining CFIUS approval in advance so that the Debtor and other interested parties will know that the stalking horse bidder will be a Qualified Bidder and be able to consummate the acquisition. CFIUS approval will be a key part of determining whether a foreign buyer can consummate the acquisition.
The same principle applies if the potential buyer wishes to acquire the assets through a Credit Bid strategy or a Loan to Own Strategy. The Debtor may not agree to enter into a Credit Bid Sale or a Plan of Reorganization which implements a Loan to Own Strategy if the buyer has not obtained—or agreed to seek—CFIUS approval. In the case of a Loan to Own Strategy, the potential purchaser will have more lead time to address any CFIUS approval than in a 363 sale scenario. For 363 sales, prospective purchasers will need to seek approvals and generally address the CFIUS issues much sooner.
Given that CFIUS approval may well be a condition to proceeding with an acquisition, it is advisable for a foreign buyer of distressed assets in a Covered Transaction to first develop the best method of acquiring the assets, e.g. through a 363 sale, a Credit Bid Strategy or a Loan to Own Strategy, and then develop and implement a CFIUS strategy before committing to acquire the assets.