It is common for companies in distress to undertake a sales process of assets to alleviate cash flow or debt repayment issues. Often this course of action is the last resort after all other lines of credit have been exhausted or creditors have stopped providing extended terms of trade. Companies should not take such decisions lightly, especially if the sale will impact the underlying business or forecasts. However, ultimately creditors’ demands and survival instincts result in action being taken (often too late and to the detriment of the company).
Companies in distress include: those with diminishing cash positions, disproportionate exposure to fluctuating commodity markets, those operating within an oversaturated or competitive market, those that are overleveraged or experiencing soft pressure to repay debt from their financiers, or those with an increasing number of unpaid creditors or where there has been a pattern of slippage in terms of trade. The most extreme version of a distressed sale is one of insolvency where the company is no longer under the control of its directors, be it through administration, receivership or liquidation.
Summary of concerns - Distressed Seller versus Insolvency Regimes
For prospective purchasers, distressed asset scenarios represent an opportunity to acquire potentially valuable assets below market price. It may also allow a competitor to consolidate itself in the market, or opportunistically build its profile and business. Such sales do not come without risk however, especially in the context of an insolvency sale. Purchasers also need to mindful that undue commercial pressure may in fact cripple both the sale and the seller.
Outlined in this article are some of the issues that may arise in a distressed sale and, at a high level, in an insolvency sale.
Management of Perception
The first issue to consider is the perception in the market of the sale, and the ultimate impact this may have on the price realised for an asset and on underlying business post-sale. Proprietary companies will have an advantage in this area as they are not encumbered with the continuous disclosure requirements of public or listed companies.
Generally speaking, unless the sale process is stringently run, and the rationale for it kept under wraps (including though strict confidentiality protocols), the success of the process, and the price realised for the assets may be drastically reduced. Engagement of savvy and trustworthy advisors during this process will assist, as well as the decision to start the process well before news of the sale filters into the market (especially, as noted above, for a public or listed company). The seller may also look consider whether it is appropriate to run a full sales process as opposed to approaching targeted purchasers. Again the clear issue here is time versus recovery. Arguable a full-scale sales process may produce a more financially advantageous result, however the business of the company may be put under too much pressure during the process. Sellers in such situations must balance their requirement for ongoing funding in the short term (to meet trade creditors etc…) against pricing its assets too high or too low. A higher sale price may prompt purchasers to take more time to consider their position and conduct fuller due diligence investigations on the assets. Too low a price may give the impression that the sale is one of last resort, prompting purchasers to seek further concessions. For these reasons, it is in a seller’s best interest to offer its assets at a reduced price, but not so low as to become uncommercial.
Walk to your own beat
Due to the financial pressures a distressed company is facing, all elements of the sale process may need to move faster than in a non-distressed transaction. This can create a level of tension for both the seller on the one hand, who is trying to apply pressure to get the sale away as quickly as possible with limited liability and, the purchaser, on the other hand, who wants to perform appropriate due diligence, have appropriate claims recourse to the sellers and is under no timing constraints.
The seller’s paramount concern is likely to be the underlying financial distress and how to manage or alleviate that. A balance needs to be struck between an expedient outcome (including certainty of the transaction completing and security for payment) and not spooking the purchaser or flagging to the market the extent of distress. That being said, if the seller’s accounts are publicly available, the purchaser and the market could of course infer such distress.
Interestingly however, a seller should also be alive to the potential for the company’s finances to begin to stabilise during the process. For example, if a company is undertaking multiple distressed asset sales or is investigating other means of resolving its financial issues, then it is possible that a resolution to its financial distress could crystallise prior to finalising the remaining asset sales. If this occurs, then the seller should consider either raising the price of the asset or ending the sale process. If the seller continues to negotiate with the mindset of a company in distress, the sale price achieved will most likely be below the appropriate market value of the asset.
Due to the limited time imposed by the sale process and the discounted price for the asset, a purchaser may need to take a commercial view and determine, on an exceptions basis, what key investigations and protections are required in order to secure the asset while avoiding unnecessary costs and time on diligence and immaterial issues. The most important information to be diligenced will be clear and encumbered title to the sale assets. Legacy security interests over sale assets can be extremely difficult to release (given creditors are understandably loath to release security over the assets of a distressed seller). This is especially the case when a seller subsequently enters into insolvency.
Subject to the level of competition to acquire an asset, a purchaser must also make a commercial decision about the timing to purchase. Under a distressed sale situation (should it be known), a seller is necessarily in financial difficulty, often resulting in a seller becoming subject to a formal insolvency process during the course of the sale negotiations. Given the potential for a change in effective control of the seller (i.e. no longer controlled by its directors), a purchaser must consider whether it would be preferable to wait until a formal insolvency process to pay a lower price for the asset, and whether in fact it is more beneficial to engage with the seller or an insolvency practitioner.
Selling the ‘Jewel in the Crown’
A key issue faced by companies in distress is which assets to sell and when. The temptation (often with financier or creditor encouragement) is to liquidate the most profitable asset (i.e. the ‘Jewel in the Crown’), which is likely to result in the biggest cash return to be used to pay down debt. However, sellers often fail to consider the long term implications for the seller of selling the ‘Jewel in the Crown’ (i.e. what cash generative assets remain post-sale to pay down the balance of the debt to assure the viability of the seller and avoid insolvency). Distressed sellers should also be conscious to ensure the realisation of such an asset is not just a short term fix that will only benefit certain creditors and may ultimately result in the business becoming unsustainable long term.
There are countless examples of distressed companies selling the ‘Jewel in the Crown’ only to enter into insolvency a short time afterwards. Particular caution should be paid to disposing of the cash generating assets in the business, and analysis done on the impact of their removal on long term business and cash forecasts. Retaining the ‘Jewel in the Crown’ may well allow the seller to trade out of distress, thus retaining some shareholder value.
For purchasers this is presents the perfect opportunity to acquire a profitable asset which would not otherwise be for sale (potentially at a discount) and the ability to advance or defend a competitive position in the market.
However, in an insolvency (as opposed to a distressed sale or restructure) this is less of a concern because all sales are generally geared towards maximising recovery for creditors, and less so on the survival or longevity of the business.
What can you give? What should you accept?
Liabilities, warranties and indemnities may vary significantly in a distressed asset sale when compared to a traditional asset sale.
A seller should realistically assess what level of warranties and indemnities it can in fact give in the circumstances and the level of liability for claims it is willing to accept and the price discount offered for the assets.
On the other hand, a purchaser must balance a request for market standard warranties and indemnities, with the discount offered for the asset, the knowledge that it may not be feasible for the seller to provide any such warranties and indemnities in a distressed situation or that the seller may not be in a financial able to meet any warranty or indemnity claims that may arise post sale (including because the seller may go insolvent). Given this scenario, a purchaser’s recourse is to reduce the purchase price to offset risk or seek other protections.
A useful tool to limit a seller’s liability is requiring a buyer to take out warranty and indemnity insurance policy. Typically, these policies are taken out in situations where sellers are reluctant to give meaningful warranty protection to a purchaser or a purchaser wishes to improve their competitive position in a sale process. In these circumstances, the seller would walk away with 100% of the purchase price (subject to any working capital adjustments) and would have no or minimal risk of a warranty or indemnity claim (except for fraud).
Another option is to quarantine part of the purchase price in escrow to act as an effective ‘claims pot’ for warranty or indemnity claims. The escrowed funds will only be transferred to the seller if there is no warranty or indemnity claims. This approach is not be ideal for the seller in a distressed situation as it potentially reduces the purchase price and delays payment.
In a formal insolvency situation, insolvency practitioners will only provide limited representations and warranties as to title and capacity. In a large part, this is due to the personal liability imposed under statute (for example on administrators) or the fact there has been limited interaction with or control over the asset, meaning that they are not in a position to provide such warranties and indemnities. It is not uncommon for an insolvency practitioner to push back on most market standard representations and warranties, and a purchaser will need to factor this into any purchase price.
Pesky third parties
In terms of the timing for any sale, the interaction with third parties who have interests in sale assets and over whom the seller has no control (e.g. security holders or from whom a consent to transfer assets is required) can create the most significant roadblocks and delays to a sale. In a distressed sale, such delays have the potential to be fatal to the sale process and the seller’s business. A well advised seller will, even before commencing the formal sale process, begin the process of engaging with such third parties. In practice, this may mean terminating or otherwise dealing with any contractual obligations which interfere with the sales process. In a non-distressed situation, parties may have the luxury of time to negotiate with third parties and work together to obtain consents or negotiate changes to allow the sale to proceed. However, due to the limited time available to a seller to negotiate and finalise the sale of an asset in distress, it is in the seller’s best interests that these issues be dealt with as quickly as possible by pre-emptively removing these considerations (if possible) to streamline the process. For purchasers, it is important to identify third party interests in value attached to the assets and to move quickly to engage with them (following consent from the seller). The imperative is often on the purchaser to get the third party over the line, lest the seller ends up in insolvency
It should be noted that third parties can often be dealt with swiftly in an insolvency scenario. Insolvency practitioners will look to terminate or cram down on unprofitable third party contracts, especially if the continuation of such a contract will reduce the value of the asset sale.
The mind of the Company
Directors, as opposed to the company under distress, are in our experience well advised to take independent counsel in times of distress, whether during a sales process or otherwise. Given the extensive personal liability regime under the Corporations Act 2001(Cth)for insolvent trading, directors need to be mindful of their personal liability positions in light of the company’s ongoing financial circumstances. During the course of a sale process, especially when prolonged, directors need to be constantly vigilant about the company’s cash position and creditor base.
Should the company become insolvent (that is, unable to pay debts when due and payable) and absent the reasonable expectation of a solution (noting a sale could satisfy this if there is certainty of execution), directors will likely appoint voluntary administrators to protect themselves.
This is an all too common outcome, and an ill-informed or advised purchaser can be a significant contributing factor to this should it apply pressure recklessly.
Insolvency is often, quite wrongly in many instances, associated with the role of undertaker when it comes to companies in distress. Should a company enter into insolvency it can in fact be the best outcome for creditors or the company if the process is used to restructure the business (for example, through a deed of company arrangement). Whereas a company in distress will have specific considerations as outlined above, companies subject to formal insolvency processes will also have a number of other nuances which both purchasers and insolvency practitioners should be aware of. This paper has not sought to go into detail, however outlined below are some key issues for further consideration:
- Personal liability for the insolvency practitioner when completing the sale (under the corporations legislation or at general law) and how best to avoid/mitigate it;
- Obligations on a sale (for example, a receiver’s obligations under section 420A of the Corporations Act 2001 (Cth) to obtain the best price possible or market value);
- Asset control (identifying and understanding where the asset is located and how, and if, title can be transferred);
- Representation/Warranties (as noted above what representations and warranties can be given) and how this may impact a purchaser’s appetite;
- Long-term liabilities under contracts and how that dovetails into timing or creditor consent; and
- Pre-appointment sale contracts (what changes need to be made to ensure such contracts can be completed without the insolvency practitioner ‘adopting’ the contract, and therefore assuming personal liability).
Companies undertaking asset sales in a distressed scenario need to be mindful of the timing, cash position post-sale and more importantly long term impact of the proposed sale. Directors of such companies also need to be mindful of their personal positions during this process and ensure that they are not exposing themselves to additional liability. It is fruitless for a company to expend money and undertake a sales process only to realise that it has deleveraged momentarily but cannot meet the reduced debt payments or pay ongoing creditors. It is also clear that the more stringent the sales process and the faster it moves to market, the less likely a seller is to see dramatically reduced price realisation or long term reputational or commercial damage.
As part of any consideration on a sale from a seller’s perspective is the internal conflict that may exist within the stakeholders of the company in distress itself. For example the board of directors and management team may be attempting to ensure the company remains solvent to ensure they comply with their ongoing duties and to avoid personal liability, and indeed to ensure continued employment. Shareholders will almost certainly be concerned with maintaining value for equity in the business, and this is clearly eroded should the company enter into insolvency. Creditors on the other hand, especially secured creditors, may simply want to see a return in the short term (i.e. a reduction in debt) especially if they have lost faith in management. Whereas trade creditors may see some value in the business continuing to trade, but this may very well depend on how out of the money they are.
Purchasers in a distressed sale scenario have in many respects more negotiating leverage than they otherwise would. Key and valuable assets can be acquired for under value and in a timely fashion. Further, purchasers who become aware on the nature of the sale, and the state of the seller, may exert significant pressure through the process absent competition for the sale asset from other purchasers. This can result in a bargain for the purchaser but does need to be balanced with the ultimate tipping point (i.e. insolvency). However, in some sale scenarios dealing with an insolvency practitioner with a clear agenda and mandate may be easier and more efficient.
Insolvency sales have their own unique issues, but the agenda is always clear - maximise return to creditors. This may play out differently depending on the type of appointee (be it receivership or administration). However, in almost all instances an incoming purchaser will receive little comfort on the state of the asset or have little recourse post-sale. This is ultimately reflected in the price paid and the respective parties’ appetite for risk.