Caveat Emptor: Distressed M&A (legal perspective)

Since the 'hot' area of M&A has become distressed companies, I thought it would be apropos to make a post on the topic. This post comes courtesy of a recent Cooley Godward article.

Risks to BuyCo

1. Indemnification Largely Ineffective. By its nature, BuyCo in a distressed sale cannot avail itself of the Definitive Agreement's indemnification provisions. Practically speaking, BuyCo must "get it right" when the deal is struck because there is little opportunity to cry foul if/when the deal goes sour. TargaCo won't be around!
2. Fraudulent Transfer: Trap #1 that BuyCo may find itself in. If BuyCo's purchase is structured incorrectly, then the creditors of TargaCo may be able to "reach through" the transaction and sue BuyCo for its accounts receivable. The actual Minnesota law on the subject says a transfer made by a debtor is fraudulent if the debtor made the transfer "with actual intent to hinder, delay, or defraud any creditor of the debtor." s513.44(a)(1). The law prescribes a laundry list of 11 factors to determine "actual intent". s513.44(b)(1-11). More generally, if a transfer makes the seller insolvent, then creditors may pursue BuyCo to satisfy their claims against TargaCo. Importantly, the existence of a fraudulent transfer trumps indemnification provisions. Thus, BuyCo may be held liable even though BuyCo and TargaCo expressly provided otherwise in their Purchase Agreement. The fraudulent transfer doctrine is an attempt by courts to prevent corporations from evading their actual debts.
   
3. Successor Liability: Trap #2 that BuyCo may find itself in. The general rule in M&A is that successors aren't responsible for the actions of their predecessors. But exceptions exist - especially in the distressed company setting. One such exception is the generic merger. In a merger, BuyCo is assumed to have taken on the liabilities of TargaCo. This is the primary reason why lawyers never structures M&A transactions as a plain-vanilla merger (but instead use a subsidiary and either a reverse or forward triangular merger). This is true even when the words of a purchase agreement state that it is not a merger -- courts look to the circumstances of a transaction, rather than its title, to determine whether a de facto merger has in fact occurred. *** In some states (though not MN), a successor may find itself liable if the court finds that there has been a "continuity of the enterprise." *** The bigger danger is the "product line" exception. Under this rule, a successor is liable if BuyCo acquires all or substantially all of the manufacturing assets of another company, and undertakes essentially the same functions as the predecessor company. Ray v. Alad Corp., 560 P.2d 3 (Cal. 1977). *** If BuyCo is found liable as a successor, it may be required to pay for the taxes, environmental claims, employee claims, or product liabilities of its predecessor.
   
4. Result of the Risk: Due Diligence must be Excellent. Because the reps & warranties are not meaningful in a distressed setting, the legal (and financial) due diligence must be excellent. There is no room for error. Careful buyers should consider obtaining releases from creditors of TargaCo.
   

Benefits to BuyCo

1. Low Price AND Low Liability. When structured well, BuyCo can purchase a company for a great price and avoid assuming liabilities that would otherwise be impossible to avoid.
2. s363 Sale. 363 sales are a method of purchasing a company through Section 363 of the Bankruptcy Code. It is faster, less expensive, and carries less risk than buying a company out of a Chapter 11 plan. Most importantly, the transfer is blessed by the court. Thus there is no risk of liens/encumbrances/fraudulent transfers/successor liability. A s363 does not require approval by TargaCo's shareholders. *** s363 sales are always done through an Asset Purchase Agreement, since APAs allow buyers to pick-and-choose which liabilities they will assume.
3. Other Options. There are other options in the distressed setting, including the Assignment for the Benefit of Creditors (ABC) and a Friendly Foreclosure. Like anything else, there are goods and bads to each option.