The current economic turbulence and the onset of recession in many countries will result in an increase in the number of distressed sales and insolvencies globally. This will create significant opportunities for those Middle Eastern investors who are fortunate enough to be in the market as buyers, but equally there are significant traps for the unwary. This briefing examines some of the key issues which should be considered by prospective buyers of businesses in financial difficulties which are not in formal insolvency proceedings.
Due diligence and preparing for the purchase
Disaffected employees, customers reluctant to pay and impatient creditors are all likely to contribute to a messy and confused picture for a prospective buyer. The business in financial difficulties will not be a business packaged and made ready for an orderly sale. Reliable warranty or indemnity cover is not likely to be available. Accordingly, whilst undertaking due diligence is clearly of paramount importance, doing so may present considerable challenges, not least in getting reliable and current information. A buyer should expect the actual position to be worse than the position revealed by, or even known to, the seller. In addition to the need for as much detailed financial due diligence as possible, some of the key areas for legal due diligence (which may be required in a number of jurisdictions if a target group has operations in more than one country) are likely to be:
Ownership of assets
Understanding the basis on which key items of equipment or stocks are used by the business will be important. If there are significant retention of title, rental, security or other similar arrangements, then the buyer should clarify (ideally in discussion with the relevant counterparties) how these arrangements will be affected by the new ownership and in particular whether retaining or securing title to the assets will involve the buyer in significant expense.
Time may not permit extensive investigation of title to real estate so if significant financial or operational value is attributed to any properties then the deal value should reflect this uncertainty. In addition, key leasehold properties may be at risk of forfeiture for payment or other defaults under the lease.
Key supplier and customer contracts may be in jeopardy and may even have been terminated in consequence of the company’s financial difficulties. Where possible, a buyer would be well advised to hold discussions with important customers and suppliers to assess the current position.
If the business carries on activities requiring it to be licensed, the terms of the licences (including, in the case of financial institutions, the requisite regulatory capital) and any recent dealings with the regulating authority should be investigated.
The purchase of a business in financial difficulties often represents an opportunistic prospect for a buyer. It may be interested in picking up key assets and/or contracts but it may not wish to acquire the entire undertaking of the company concerned and in particular all or large parts of the workforce. In consequence, a key part of due diligence often involves calculating whether the economics of the transaction support those employee costs and ultimately any severance costs which may be required. This will be a relevant area of diligence whether or not the transaction is structured as a purchase of the shares or the business of the target company.
If the target company’s employees participate in a final salary pension scheme, then legal and actuarial due diligence will be required to determine how best to deal with this issue. The buyer could agree to take over the pension scheme by becoming its principal employer although the consequence of it inheriting significant liabilities in doing so (including the possibility of inheriting the funding liabilities of other participating employers and the obligation to meet the full buyout cost of the benefits should the scheme be wound up) are likely to make this unattractive. Accordingly, the most likely scenario is a transfer of employees to an existing scheme of the buyer or the establishment of a new scheme. Employees’ benefits are usually left behind in the target company’s scheme, the employees becoming deferred members of that scheme. Whether any approach will need to be made to a Pensions Regulator (in the light of its ability to issue contribution notices or financial support directions) also needs to be considered.
Reliance on the retained group
In the circumstances of a “normal” sale, the buyer’s due diligence would identify services provided centrally by a selling group with a view to negotiating the basis on which such services will continue for a period following the sale until the target achieves operational independence. If the future of the retained group is in doubt, such arrangements may not be practicable. If the business to be acquired has taken assignments of rights under contracts from the retained group, the later insolvency of the retained group is also likely to give rise to termination events under those contracts.
Searches of relevant registries and registers should be undertaken to establish what security exists over the assets to be sold (and indeed to ensure that no winding up petition has been presented). An early approach to lenders and holders of security is recommended to establish any conditions on which they will release the assets to be sold.
Structuring the sale
In tandem with due diligence, the buyer will need to consider its preferred transaction structure. Whilst the purchase of the business and assets of a company is more complicated than the purchase of its shares, principally because of the need to convey the component assets and liabilities of the business, this is likely to be the buyer’s preferred structure in circumstances where the target is in financial difficulties. This is because, this structure enables the buyer to buy selectively and not inherit all of the historic liabilities of the business. However, the prospective buyer should be aware of the following:
Identifying the assets and liabilities to be transferred
The individual assets and liabilities being sold/assumed will need to be identified, ideally by way of detailed schedules.
Non transferable assets
Some assets of the business may not be transferable as they are in effect “personal” to the transferring company. The most obvious example would be operating licences. Unless the acquired business can continue to operate under the umbrella of licences already held by the buyer, the buyer will need to seek new licences and the logistics and timing of this will need to be considered at an early stage. In addition, important supply or customer contracts are unlikely to be transferable without the consent of the counterparties to them. The usual way of dealing with this would be to include a mechanism in the sale agreement for the buyer to assume the benefit and responsibility for performance of the contracts until they can be formally assumed by or novated to the buyer. However, the buyer may not be comfortable with a mechanism of this nature in the context of a selling company which may not be around long enough to see such an arrangement out. In addition, the insolvency of the retained group is likely to trigger termination rights under these contracts. Similar considerations would apply even if the contracts concerned are assignable because of the necessity of the continued existence of the assignor.
Even if these are on offer, they will be of questionable value given the financial state of the seller. Whilst some measure of security may be obtained by the use of a deferred consideration structure against which a warranty or indemnity claim may be set off, warranty insurance in such circumstances may not be available. In many cases, the only practical protection will be to discount the price to take into account the absence of warranty/indemnity cover.
The use of completion accounts to verify the Buyer’s pricing assumptions and the apportionment of creditors and debtors may be one way of removing some of the uncertainties and risks associated with incomplete due diligence. However, whether the seller will be in a position to honour any downwards adjustments may be questionable. In any event, the distressed seller is likely to be interested in a transaction which is a clean break and this may make the inclusion of a completion accounts provision unacceptable.
In European and other jurisdictions, employee protection legislation will apply if the transaction amounts to a transfer of a business, undertaking or part of a business or undertaking where there is a transfer of an economic entity that retains its identity. The effect of such legislation in normal circumstances is to transfer the contracts of employment of the employees engaged in the business to the buyer, give protection for employees against dismissal connected with the transfer and give rise to a duty to inform and consult with employees or the Unions or others who represent them.
If employee protection legislation applies to the transaction the buyer will, in most cases, be required to make contributions to a pension scheme in respect of the transferring employees. The type and amounts of such contributions will depend on whether the employees are members of an occupational pension scheme or have a personal pension. In certain limited circumstances, transferring employees may be able to claim that the buyer is required to provide a defined benefit pension to the transferring employees if they retire early (for example following redundancy). Whether any approach will need to be made to a Pensions Regulator, this is a risk which would normally be covered off by indemnity protection but where the seller is financially distressed the potential cost of this liability may instead need to be factored into the price.
Competition law requirements
Despite recent changes made to competition law in the context of financial institutions in financial difficulty, buyers should not assume the suspension of normal competition law rules in circumstances where the seller is in financial difficulties.
Insolvency law implications
If the seller goes into formal insolvency proceedings, for a short period thereafter, the insolvency practitioner can overturn transactions which took place at an undervalue in circumstances where the transferring company was insolvent at the time of or in consequence of the transaction. However, in practical terms, an arms’ length transaction achieving the best price reasonably obtainable in the circumstances is unlikely to be exposed to a successful challenge. That the directors of the selling company have so concluded should be recorded in the minutes of the seller’s board meeting approving the transaction.
Would it be better to wait until the company goes into insolvency proceedings?
In some circumstances, a prospective buyer may consider that there would be less risk and a cheaper price if it waits to deal with an administrator or other insolvency practitioner. The buyer will have to weigh such factors against the effect of formal insolvency on the Company’s goodwill and a worsening liability position. However, this damage may already be done so making the advantage of buying prior to insolvency illusory. The other risk associated with waiting for the company to go into formal insolvency proceedings is that the insolvency practitioner has a duty to ensure that he has obtained the best price for the business which may cause some additional delay and the possibility of a competing bid for the business emerging. In the context of a target group operating in several jurisdictions, significant additional complexity will arise in dealing with different insolvency regimes and the insolvency practitioners appointed under them.
An insolvency practitioner will accept no personal liability in selling the assets of the company. Equally, he will not agree to any contingencies or ongoing liabilities which will prevent the quickest realisation of the company’s assets and the return of the proceeds to creditors. On that basis, the sale documentation (which will be prepared by the insolvency practitioner’s lawyers) will contain no warranties or even normal covenants as to title to the assets being sold.