Distressed M&A or the appeal of a new start.

 There is magic in every beginning and every end holds the appeal of a new start (very loosely based on Hermann Hesse).

Distressed M&A or the appeal of a new start.

In keeping with this aphorism from Hermann Hesse, the numerous corporate crises caused by the COVID-19 pandemic not only represent an end but also offer opportunities.

The acquisition of an insolvent company, whether in whole or in part, is generally referred to as distressed M&A and offers the buyer unique opportunities. This approach enables the buyer to expand its own market position, quickly gain access to new markets or acquire expertise and technologies at comparatively low prices. At the same time, this provides the company in crisis with the opportunity to revive the business outside of insolvency. This can also preserve jobs. Nevertheless, these opportunities also involve significant risks. Transactions of this nature take place under challenging conditions and require excellent preparation together with rapid action on the part of everyone involved.

Asset deal as the preferred transaction

The asset deal, i.e. the acquisition of all or certain operating assets or parts of this company, is generally the preferred method of acquiring distressed target companies. Compared to a share deal (acquisition of company shares), purchasers have the advantage of not being forced to take over the company as a whole in crisis situations. This would also force the buyer to purchase unprofitable or unnecessary areas along with the company’s concomitant liabilities and liability risks. Instead, the asset deal enables the buyer to focus those particular assets or parts of the business that retain their value.

However, this “cherry-picking” also has limits with regard to employees due to the transfer of operations, even if transfer or employment or qualification companies are a viable option. At the same time, the asset deal involves the risk of losing key employees. Moreover, alongside classic M&A issues, such as tax risks, cartel authority approval and clarification under foreign trade law, the risks arising from old liabilities which also exist in a crisis situation cannot be entirely avoided. In particular, these consist of liabilities arising from environmental pollution and the continuation of the company. The asset deal may involve a further disadvantage given that the purchaser does not automatically enter into the company’s existing contractual relationships but instead has to conclude separate contracts.

Possible acquisition times

The timing and time required for the acquisition is a key aspect of a distressed M&A. Specifically, the acquisition process consists of three separate time phases:

  • pre-insolvency, namely after a financial crisis has occurred but before there is a reason for insolvency,
  • after a reason for insolvency has occurred but before initiating insolvency proceedings (preliminary insolvency proceedings) and finally
  • the phase after initiating insolvency proceedings (transferring reorganization or “in-court sale”).

Acquisition before filing a request for insolvency

Avoiding the (alleged) stigma of insolvency along with a bidding competition are points favoring the pre-insolvency acquisition of a company. Furthermore, the supply chains frequently remain unburdened and the customer base intact. The negotiation foundation also differs from situations involving preliminary or existing insolvency proceedings. Given that as the number of negotiating parties (diverse creditors, the (preliminary) insolvency administrator, etc.) rises, the contract negotiations also become increasingly complex. During the phase before the company files for a request insolvency, the situation is (still) comparatively simple and the particularities of insolvency law largely remain a non-issue. Yet the disadvantage lies in the fact that the acquisition can become a “bottomless pit” if additional financing needs exist that were not identified beforehand.

Contesting insolvency as per Sections 129 et seq. of the German Statute on Insolvency (InsO)

An acquisition between the time at which the reason for insolvency occurs and the initiation of insolvency proceedings is generally not advisable. The insolvency administrator will doubtlessly contest the contract or the transfer of assets during this period.

This is due to the fact that the insolvency administrator may contest the asset deal as a whole or the acquisition of individual assets as per Sections 129 et seq. of the German Statute on Insolvency (InsO). This becomes an issue if insolvency proceedings have been initiated regarding the assets of the seller and the grounds for insolvency existed at the time of acquisition. In this context, the insolvency may be challenged as per Section 131 InsO in light of the disadvantage to the company’s creditors if the sale of the company took place below the market value.

Yet even in the case of a reasonable purchase price, the risk of the cover being contested as per § 130 InsO often arises. This occurs if the purchase took place within the last three months before proceedings were initiated and the purchaser was aware of the seller’s insolvency. Under certain circumstances, acquisition of a company can even be contested a number of years after the purchase, resulting in reversal of the contract. In turn, the buyer’s entitlement to repayment of the purchase price then becomes a mere insolvency claim and the buyer is only refunded a small amount as a consequence.

The insolvency administrator’s right to choose performance

Even when a company acquisition contract has not yet been fully executed, there is also a risk that the insolvency administrator will refuse the execution of the company acquisition contract (Section 103 InsO) after insolvency proceedings have been initiated regarding the assets of the seller or the legal entity of the company. In this case, the purchaser is also only able to assert its claim for repayment of the purchase price and possible compensation for damages as insolvency claims pursuant to § 38 InsO. This often equates to a total financial loss for the purchaser.

Minimizing the risks

In view of these circumstances, precautionary measures are essential to minimize the purchaser’s risk of contested insolvency and refused performance. Obtaining an expert assessment prepared by an independent third party regarding

  • the appropriateness of the purchase price (e.g. by means of a fairness opinion),
  • the absence of insolvency at the time of the conclusion of the contract and
  • the existence of a promising restructuring concept prior to concluding the acquisition agreement can help to refute the accusation that creditors have been disadvantaged.

In particular, obtaining a fairness opinion creates opportunities for a balanced acquisition process. Ultimately, simultaneous signing and closing is recommended in order to ensure a rapid transfer of the contractual object.

Acquisition after initiating insolvency proceedings

As a rule, company disposals do not take place after filing for insolvency and preliminary insolvency proceedings have been initiated. The provisional insolvency administrator will frequently consider the option of preparing the disposal in order to then sell the company after initiating proceedings as the “actual” insolvency administrator. After initiating insolvency proceedings, the power of disposal over the company’s assets no longer lies with the owners, but rather with the insolvency administrator. This gives rise to additional particularities compared to the classic M&A transaction.

After initiating the insolvency proceedings, the opening assessment of the insolvency administrator is available in addition to the information obtained from the due diligence. Restructuring goals can often be achieved more easily and efficiently under the aegis of insolvency law, in particular with a view toward labor law. However, there are other parties involved in this process. In addition to the insolvency administrator and the purchaser itself, the involvement of the shareholders and, above all the creditors, is mandatory. In most cases, it is in the insolvency administrator’s interest to sell specific parts of a company’s operations in an orderly process. This also eliminates the risk of these transactions being contested prior to the acquisition process. In turn, this reduces the risks for the buyer. Insolvency proceedings create good opportunities for buyers for whom the company represents a strategically viable target and who deliver an effective restructuring concept that they might not have in a competitive market even with a healthy company.

The insolvency administrator as the seller

In addition to the insolvency-proof nature of the acquisition, the existing liability exclusions for taxes and from the going concern are further points in favor of concluding an asset deal at this stage. The liability risks for the purchaser associated with the transfer of the business under labor law are also significantly lower after initiating proceedings. Accordingly, the purchaser is only liable for liabilities that have arisen after initiating proceedings. Only the liability for environmental contamination persists.

It is important to note that the insolvency administrator generally does not provide any or only very few guarantees. As a consequence, thorough due diligence on the part of the buyer is essential. When negotiating the purchase price, both identified and unidentified risks from the due diligence need to be taken into consideration and a purchase price adjustment mechanism should be included in the company acquisition contract (see below).

Creditors entitled to separation and separate satisfaction

The assets that comprise the asset deal are often secured in favor of individual creditors. These may also be wholly owned by the creditor without being collateral. Creditors are often entitled to rights of separation and/or separate satisfaction and these may have a significant influence on the transaction. These frequently impair the smooth acquisition of ownership and the correct assessment of the acquisition price.

Creditors with the right to separate satisfaction are entitled to demand the surrender of an asset from the insolvency administrator. As a consequence, the purchaser needs to know which items are subject to the right to separate satisfaction. The purchaser cannot effectively acquire these items from the insolvency administrator. Acquisition price adjustment mechanisms in the contract provide protection in this regard. The purchase price is reduced in the event of non-existent assets, assets which are not owned by the insolvency debtor contrary to expectations and/or defective assets. If the purchaser is interested in these assets, it is worth contacting the creditor entitled to separate satisfaction at an early stage. Often, the creditor is also interested in selling to the purchaser.

Overall, acquiring a company in crisis and during insolvency offers purchasers unique opportunities yet also involves significant risks. The right timing is essential. Particularly when making an acquisition of this nature, purchasers need to ensure very thorough due diligence. If risks can be assessed or actively reduced, an acquisition before opening insolvency proceedings offers extensive freedoms. In the case of an advanced company and financial crisis, the transferring reorganization represents the safer course to safeguard the transaction. This enables the purchaser to take full advantage of insolvency law. Ultimately, choosing the best time to conclude the company acquisition contract or to acquire the company in the crisis depends on each specific case. The individual circumstances always have to be considered.

Distressed M&A transactions are complex. They can involve critical timing along with liability risks. Legally-supported transactions.