Transactions with distressed companies: key questions for directors.

As banks and other traditional sources of capital find their balance sheets reflecting more and more under-performing assets, lending standards continue to tighten, leading to the well-publicized lack of commercial credit. Alternative sources of capital, such as private equity financings or the public securities markets, are also out of reach for many companies. The unprecedented government spending packages sponsored by the Bush and Obama administrations have made funds available in certain key industries and to companies deemed "too big to fail," but many businesses are either unable to take advantage of the government programs or unwilling to accept the strings attached to the funds being offered. As a result, an increasing number of companies find themselves facing a significant liquidity crisis, with many seeking protection in bankruptcy proceedings. The Administrative Office of the U.S. Courts reports that over 43,000 businesses filed for bankruptcy during 2008, while the American Bankruptcy Institute reports over 14,000 bankruptcy filings by businesses during the first quarter of 2009, an increase of approximately 30% on an annualized basis.

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Although the current economic climate poses challenges to distressed businesses, it may also provide opportunities for more economically sound companies to acquire key assets or lines of business at bargain prices. But are these deals too good to be true?

Suppose that you are approached by your management team with an opportunity to acquire the assets of a competitor at an attractive price. Management advises that the deal will need to close quickly, as the competitor does not anticipate having sufficient liquidity to satisfy its outstanding obligations. If the asset sale does not close soon, the competitor will have no choice but to file for bankruptcy and seek to sell its assets off under the supervision of the bankruptcy court.

As a director evaluating this situation, one of the most important decisions to be made is whether your company is better off purchasing the assets offered outside of bankruptcy or allowing the target company to file before seeking to acquire the assets. Unfortunately, there is no "one-size-fits-all" answer, but here are some key questions to ask when contemplating a transaction with a distressed company:

Have you considered the costs beyond the purchase price?

Bankruptcy can be time-consuming and expensive, both in terms of management attention and outside counsel fees. For these reasons, many directors assume that a private sale is preferable to buying through bankruptcy because it involves lower transaction costs and requires less time to close. Further, a potential buyer in a bankruptcy context may spend time and money negotiating with a target, just to find that it is the "stalking horse" in a bankruptcy auction and may be outbid. A buyer in bankruptcy will also be at the mercy of the schedule of the bankruptcy court, which can be quite different from the timeframes involved in a typical corporate transaction. Once the transaction costs of a bankruptcy proceeding are factored in, the bargain price a purchaser thought it was getting may not be so attractive.

Is it a deal or a steal?

If the board follows the advice of management and negotiates a purchase of key assets from a distressed competitor outside of bankruptcy, there are other issues to consider. While the purchaser can, and should, use the negotiating leverage provided by the target's financial distress, the deal must provide reasonable value for the assets being acquired.

A buyer that engages in a purchase of assets with a distressed company outside of bankruptcy risks that creditors in a subsequent bankruptcy will claim that the amount paid for the assets was too low. If the target company's creditors successfully argue that the target was insolvent at the time of the acquisition (or was rendered insolvent by the acquisition), and that the price paid was less than the "reasonably equivalent value" of the assets acquired, the court may find that a fraudulent conveyance occurred, regardless of whether there was any intent on behalf of the parties to defraud creditors. There is no single definition of "reasonably equivalent value," but courts will often look to the fair market value of the assets acquired, with adjustments deemed appropriate given the circumstances surrounding the transaction. If a claim of fraudulent conveyance succeeds, the bankruptcy trustee can seek to have the transferred assets (or their fair value) returned to the bankruptcy estate to be distributed to creditors. Even if the fraudulent conveyance claim fails, defending against such a claim of could result in significant costs that may outweigh any savings recognized by proceeding outside of bankruptcy. Purchasing assets through bankruptcy does not eliminate the possibility of a fraudulent conveyance claim, but should substantially minimize the risk that a claim will be brought or succeed.

Who are the target's creditors?

When dealing with a distressed company, a potential purchaser must understand the target's creditor base, including the scope and nature of the indebtedness involved. If the company has debt secured by its assets, it will be impossible to acquire those assets free and clear of the lien outside of bankruptcy without either paying the secured debt in full or making another arrangement with the secured creditor. On the other hand, in a bankruptcy, the bankruptcy court's order will generally allow a buyer to take the target's assets free and clear of most liens, including the liens of secured creditors.

Even if a company does not have any secured creditors, a potential purchaser should also consider the trade and other unsecured creditors of the target company. Trade creditors often consist of suppliers or service providers who are critical to the operation of the target's business. If the value of the acquired assets depends on the continued goodwill of these unsecured creditors, the purchaser must carefully consider how those creditors will be treated in the transaction. If the unsecured creditor base is disorganized and dispersed, the purchaser may have more success in striking individual deals that maintain good relations with those creditors after the closing. If, instead, the creditor base is tightly knit and organized, the purchaser will have to deal with the creditors as a group, which may prevent the purchaser from striking a deal on as favorable terms as it would like.

Finally, there is always a risk that the target's creditors will file an involuntary bankruptcy petition, forcing the target company into bankruptcy. Understanding the company's creditor base in advance will help directors better assess which creditors have the most to gain from such an action.

Are you protected after the purchase?

A final consideration when dealing with a distressed company is the potential for successor liability after the purchase and what, if any, indemnification will be available to the buyer. Although the buyer should seek to structure the transaction to limit the liabilities assumed by it, proceeding outside of bankruptcy exposes a buyer to potential claims from frustrated creditors--primarily that by purchasing the assets of the distressed company, the buyer also took on the liabilities of that company. Contractual indemnification may provide little comfort in these situations, as the distressed company may be in no position to honor any indemnification obligations under the purchase agreement, particularly if the company has gone into bankruptcy following the purchase.

Acquisitions through bankruptcy may allow the buyer to more effectively limit the liabilities it assumes in the transaction, but won't generally offer anything more in the way of indemnification. Purchase transactions in bankruptcy typically involve limited representations and warranties from the seller, often focusing on fundamental matters such as organization and title to assets, and otherwise take the form of "as is, where is" sales with limited post-closing indemnification. Regardless of whether a transaction with a distressed company takes place inside or outside of bankruptcy, a wise buyer will seek a post-closing escrow or purchase price holdback to secure any indemnification obligations of the seller. As a practical matter, the funds escrowed or held back will likely be the only funds available to address damages suffered due to breaches of the seller's representations and warranties.

Evaluating a transaction with a distressed company involves a number of practical and legal considerations. Directors must analyze these considerations to avoid getting more than they bargained for. Nonetheless, through careful analysis and negotiation, economically sound companies may find good opportunities to acquire key assets or lines of business at bargain prices.

Matthew M. McDonald is a partner and Jennifer J. Kolton is an associate in the Corporate and Securities Group of the law firm Drinker Biddle & Reath LLP (www.drinkerbiddle.com).

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