Distressed M&A—The Rules of the Road

Ricky Mason is partner, Amy Wolf is of counsel, and Joe Celentino is an associate at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell Lipton memorandum.

The topic of the complete publication (available here) is mergers and acquisitions where the target company is “distressed.” Distress for this purpose means that a company is having difficulty dealing with its liabilities—whether in making required payments on borrowed money, obtaining or paying down trade credit, addressing debt covenant breaches, or raising additional debt to address funding needs.

Distressed companies can represent attractive acquisition targets. Their stock and their debt often trade at prices reflecting the difficulties they face, and they may be under pressure to sell assets or securities quickly to raise capital or pay down debt. Accordingly, prospective acquirors may have an opportunity to acquire attractive assets or securities at a favorable price. This outline considers how best to acquire a distressed company from every possible point of entry, whether that consists of buying existing or newly issued stock, merging with the target, buying assets, or buying existing debt in the hope that it converts into ownership.

Some modestly distressed companies require a mere “band-aid” (such as a temporary waiver of a financial maintenance covenant when macroeconomic forces have led to a temporary decline in earnings). Others require “major surgery” (such as where a fundamentally over-levered company must radically reduce debt).

Before discussing the law and practice of distressed acquisitions, we undertake a review of corporate responses to debt crises, each of which can provide an important entry point for a would-be acquiror. Part I explores initial corporate responses to distress. For companies with adequate liquidity and no looming debt maturities, options for dealing with distress include negotiating forbearance agreements, waivers, and amendments of bank and bond debt. These responses are discussed in Part I.A.

Companies facing significant liquidity problems and impending debt obligations may be able to pursue non-bankruptcy solutions, but will likely need to respond to their distress in ways that dilute the existing equityholders’ ownership of the distressed company or its assets. Examples of such responses include asset sales, PIPE investments, rights offerings, debt repurchases or restructurings, exchange offers, and foreclosure sales. Such undertakings provide opportunities for a potential investor to acquire interests in, assets from, or control of the distressed company. However, dealing with a company facing this level of distress also entails numerous risks. Part I.B highlights the potential benefits and risks of working with a company on the verge of bankruptcy, and describes ways to mitigate risk and capture potential benefits.

Out-of-court transactions like those described in Part I.B tend to be less costly and time-consuming than in-court transactions, but they often require shareholder approval or creditor consensus—and non-consenting parties typically cannot be bound against their will to changes in their fundamental rights (e.g., a reduction of principal or interest or an extension of maturity of an obligation owed to a creditor).

By contrast, a transaction executed pursuant to the U.S. Bankruptcy Code can bind non-consenting parties and does not require shareholder approval. Therefore, in-court solutions are often imperative for firms experiencing acute distress.

Part II of this outline discusses hybrid approaches such as “prepackaged” and “pre-negotiated” bankruptcy reorganization plans. These plans are appropriate for troubled companies with sufficient lead time to engage in out-of-court bargaining prior to acute distress. They tend to result in cheaper, faster, less confrontational bankruptcies with less damage to the business (less impact on trade credit terms, less risk of outright loss of suppliers, less reputational harm with customers, fewer employee defections, etc.). Sometimes the mere fact that a borrower is prepared to file bankruptcy brings dissenting creditors into line and makes a fully out-of-court solution possible.

Part III of this outline discusses acquisitions of companies in and through bankruptcy. Asset sales in bankruptcy—addressed in Part III.A—may be consummated pursuant to section 363 of the Bankruptcy Code on an expedited basis. Although such sales (commonly referred to as “363 sales”) were traditionally disfavored by courts where the assets to be sold constituted a significant portion of a bankrupt company’s business, and time was not of the essence, more recently many business debtors have been allowed to sell substantially all of their assets despite having a lengthy liquidity runway. Another option is the acquisition of a bankrupt company, or a significant portion thereof, by creditors or outside investors through implementation of a reorganization plan. This scenario is addressed in Part III.B.

Part IV of this outline addresses specific considerations regarding trading in claims against distressed companies. Claims trading can be a strategy for obtaining control (e.g., by buying claims that can be used as consideration in a section 363 sale or that may receive ownership of the restructured company under a plan of reorganization) or an investment opportunity for the trader with a shorter-term horizon. For either class of investor, trading claims presents risks and opportunities that generally do not exist for acquirors of the debt of non-distressed companies.

Regardless of an investor’s ultimate point of entry, a good first step when considering a transaction with a distressed company is to hire counsel familiar with the process. Counsel will be able to review all relevant documentation, determine whether collateral has been properly secured and perfected, expose vulnerabilities, find opportunities, and safeguard against undue risk.

The complete publication, including footnotes, is available here.

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