One of the effects of the current economic problems in the Eurozone, when combined with the ongoing global economic downturn, is likely to be an increase in the number of distressed sales. For those who are fortunate to be in the market as buyers, there may be considerable opportunities but equally there are significant traps for the unwary. This briefing examines some of the key issues which should always be considered by prospective buyers of businesses in financial difficulties which are not in formal insolvency proceedings. It also considers what additional issues arise where such businesses have operations, or material exposure, in jurisdictions which are at risk of being adversely affected by the Eurozone crisis and any consequences that this may have (or which may arise from the seller being situated in such a jurisdiction) for the sale and purchase documentation.
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Due diligence and preparing for the purchase
In any distressed sale scenario, disaffected employees, customers reluctant to pay and impatient creditors are all likely to contribute to a messy and confused picture for a prospective buyer. The business in financial difficulties will not be a business packaged and made ready for an orderly sale. Reliable warranty or indemnity cover is unlikely to be available. Accordingly, whilst undertaking due diligence is clearly of paramount importance, doing so may present considerable challenges, not least in getting reliable and current information. A buyer should expect the actual position to be worse than the position revealed by, or even known to, the seller.
In addition to the need for as much detailed financial due diligence as possible, some of the key areas for legal due diligence (which may be required in a number of jurisdictions in the context of a target group with operations in a number of countries) are likely to be:
- Ownership of assets - Understanding the basis on which key items of equipment or stocks are used by the business will be important. If there are significant retention of title, rental, security or other similar arrangements then the buyer should clarify (ideally in discussion with the relevant counterparties) how these arrangements will be affected by the new ownership and in particular whether retaining or securing title to the assets will involve the buyer in significant expense.
- Real estate - Time may not permit extensive investigation of title to real estate so if significant operational or other value is attributed to any properties then the deal value should reflect this uncertainty. In addition, there may be significant title, lease and/or environmental liabilities which will have to be considered.
- Key contracts - Key supplier and customer contracts may be in jeopardy and may even have been terminated in consequence of the company’s financial difficulties. Where possible, a buyer would be well advised to hold discussions with important customers and suppliers to assess the current position.
- Licences - If the business carries on activities requiring it to be licensed, the terms of the licences (including, in the case of financial institutions, the requisite regulatory capital) and any recent dealings with the regulating authority should be investigated.
- Employee issues - The purchase of a business in financial difficulties often represents an opportunistic prospect for a buyer. It may be interested in picking up key assets and/or contracts but it may not wish to acquire the entire undertaking of the company concerned and in particular all or large parts of the workforce. In consequence, a key part of due diligence often involves calculating whether the economics of the transaction support those employee costs and ultimately any severance costs which may become payable. This will be a relevant area of diligence whether or not the transaction is structured as a purchase of the shares or the business of the target company.
- Pensions issues - If the target company’s employees participate in a final salary pension scheme, then legal and actuarial due diligence will be required to determine how best to deal with this issue. The buyer could agree to take over the pension scheme by becoming its principal employer although the consequence of it inheriting significant liabilities in doing so (including the possibility of inheriting the funding liabilities of other participating employers and the obligation to meet the full buy-out cost of the benefits should the scheme be wound up) are likely to make this unattractive. Accordingly, the most likely scenario is a transfer of employees to an existing scheme of the buyer or the establishment of a new scheme. Employees’ benefits are usually left behind in the target company’s scheme, the employees becoming deferred members of that scheme. However, whilst most rights under occupational pension schemes do not transfer to the buyer on a business sale, where employees have entitlements to enhanced benefits on redundancy or other early retirement rights under the seller's scheme, such liabilities may transfer to the buyer. Whether any approach will need to be made to the Pensions Regulator (in the light of its ability to issue contribution notices or financial support directions) also needs to be considered.
- Reliance on the retained group - In the circumstances of a “normal” sale, the buyer’s due diligence would identify services provided centrally by a selling group with a view to negotiating the basis on which such services will continue for a period following the sale until the target achieves operational independence. If the future of the retained group is in doubt, such arrangements may not be practicable. If the business to be acquired has taken assignments of rights under contracts from the retained group, the later insolvency of the retained group is also likely to give rise to termination events under those contracts.
- Security - Searches of relevant registries and registers should be undertaken to establish what security exists over the assets to be sold (and indeed to ensure that no winding up petition has been presented). An early approach to lenders and holders of security is recommended to establish any conditions on which they will release the assets to be sold.
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Structuring the sale
In tandem with due diligence, the buyer will need to consider its preferred transaction structure. Whilst the purchase of the business and assets of a company is more complicated than the purchase of its shares, principally because of the need to transfer the component assets and liabilities of the business, this is likely to be the buyer’s preferred structure in circumstances where the target is in financial difficulties. This is because, subject to employee liabilities passing under the provision of the Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE), this structure enables the buyer to buy selectively and not inherit all of the historic liabilities of the business. However, the prospective buyer should be aware of the following:
- Identifying the assets and liabilities to be transferred - The individual assets and liabilities being sold/assumed will need to be identified, ideally by way of detailed schedules.
- Non-transferable assets - Some assets of the business may not be transferable as they are in effect “personal” to the transferring company. The most obvious example would be operating licences. Unless the acquired business can continue to operate under the umbrella of licences already held by the buyer, the buyer will need to seek new licences and the logistics and timing of this will need to be considered at an early stage. In addition, important supply or customer contracts are unlikely to be transferable without the consent of the counterparties to them. The usual way of dealing with this would be to include a mechanism in the sale agreement for the buyer to assume performance of the contracts until they can be formally assumed by or novated to the buyer. However, the buyer may not be comfortable with a mechanism of this nature in the context of a selling company which may not be around long enough to see such an arrangement out. In addition, the insolvency of the retained group is likely to trigger termination rights under these contracts. Similar considerations would apply even if the contracts concerned are assignable because of the necessity of the continued existence of the assignor.
- Warranty/indemnity protection - Even if these are on offer, they will be of questionable value given the financial state of the seller. Whilst some measure of security may be obtained by the use of a deferred consideration structure against which a warranty or indemnity claim may be set off, warranty insurance in such circumstances may not be available. In many cases, the only practical protection will be to discount the price to take into account the absence of warranty/indemnity cover.
- Completion accounts - The use of completion accounts to verify the Buyer’s pricing assumptions and the apportionment of creditors and debtors may be one way of removing some of the uncertainties and risks associated with incomplete due diligence. However, whether the seller will be in a position to honour any downwards adjustments may be questionable. In any event, the distressed seller is likely to be interested in a transaction which is a clean break and this may make the inclusion of a completion accounts provision unacceptable.
- Employment issues - TUPE will apply if the transaction amounts to a transfer of a business, undertaking or part of a business or undertaking where there is a transfer of an economic entity that retains its identity. The effect of TUPE in normal circumstances is to transfer the contracts of employment of the employees engaged in the business to the buyer together with rights and liabilities in relation to those employees, give protection for employees against dismissal connected with the transfer and give rise to a duty to inform and consult with employees or the Unions or others who represent them. TUPE can however operate more beneficially for the transferee where the transferor is subject to insolvency proceedings since, depending upon the nature of the insolvency proceedings, certain liabilities remain with the transferor following the transfer and changes to employees’ terms and conditions of employment may be made in certain circumstances.
- Pension issues - If TUPE applies to the transaction the buyer will, in most cases, be required to make contributions to a pension scheme in respect of the transferring employees. The type and amounts of such contributions will depend on whether the employees are members of an occupational pension scheme or have a personal pension. In certain circumstances, where transferring employees have entitlements under the seller's scheme to early retirement benefits (for example, enhanced rights on redundancy or early retirement with or without employer consent), these liabilities may pass to the buyer. This is a risk which would normally be covered off by indemnity protection but where the seller is financially distressed the potential cost of this liability may instead need to be factored into the price.
- Competition law requirements - Buyers should not assume the suspension of normal competition law rules in circumstances where the seller is in financial difficulties, but will need to undertake the usual review of whether the transaction could raise competition law issues and whether it may need to be notified for clearance to any competition authorities.
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Insolvency law implications
If the seller goes into formal insolvency proceedings, for a short period thereafter, the insolvency practitioner can overturn transactions which took place at an undervalue in circumstances where the transferring company was insolvent at the time of or in consequence of the transaction. However, in practical terms, an arms’ length transaction achieving the best price reasonably obtainable in the circumstances is unlikely to be capable of successful challenge. That the directors of the selling company have so concluded should be recorded in the minutes of the seller’s board meeting approving the transaction.
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Would it be better to wait until the company goes into insolvency proceedings?
In some circumstances, a prospective buyer may consider that there would be less risk and a cheaper price if it waits to deal with an administrator or other insolvency practitioner. The buyer will have to weigh such factors against the effect of formal insolvency on the company’s goodwill and a worsening liability position. However, this damage may already be done so making the advantage of buying prior to insolvency illusory. The other risk associated with waiting for the company to go into formal insolvency proceedings is that the insolvency practitioner has a duty to ensure that he has obtained the best price for the business which may cause some additional delay and the possibility of a competing bid for the business emerging. In the context of a target group operating in several jurisdictions, significant additional complexity will arise in dealing with different insolvency regimes and the insolvency practitioners appointed under them.
An insolvency practitioner will accept no personal liability in selling the assets of the company. Equally, he will not agree to any contingencies or ongoing liabilities which will prevent the quickest realisation of the company's assets and the return of the proceeds to creditors. On that basis, the sale documentation (which will be prepared by the insolvency practitioner’s lawyers) will contain no warranties or even normal covenants as to title to the assets being sold.
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Issues if target group companies and/or the seller have connections to a jurisdiction at risk of being adversely affected by the Eurozone crisis
Where there are potential Eurozone exposures, the buyer will need to investigate the extent to which the target group has operations and/or material exposure in Eurozone jurisdictions and the buyer will then need to consider any consequences that this may have (and/or which may arise from the seller being situated in such a jurisdiction) for the sale and purchase documentation.
- Analysis of target group’s exposure to Eurozone events - The buyer’s investigation into the target company’s vulnerability to adverse Eurozone events is likely to include consideration of: the extent to which the target group has operations in a country at high risk of being affected by the Eurozone crisis (and the consequences for, among other things, the business continuity of such operations in the case of a Eurozone exit); the extent to which the target group’s business relies on ongoing contracts with third parties situated in any such high risk jurisdiction (and the likelihood/consequences of such contracts being terminated or amended and/or the relevant counterparty becoming insolvent and/or the payment obligations under such contracts being redenominated); any other dependence by the target group on euro revenue streams generated from within such jurisdictions (and the likelihood/consequences of such revenue streams being halted or redenominated); and the extent to which the target group’s financing arrangements may be affected by adverse Eurozone events (e.g. event of default triggers in financing documents).
- Sale and purchase documentation - Where there is a delay between signing the sale and purchase agreement and completion (for example to obtain regulatory or shareholder consents), the buyer may wish to consider including an appropriate termination right and/or condition in the agreement which would enable the buyer to terminate the agreement and not proceed to completion in the case of adverse Eurozone events.
Where the seller is situated in a member state which is at risk of exit from the Eurozone, the buyer may be particularly concerned about the seller’s ability to meet warranty or indemnity claims following the acquisition. This concern may in part be addressed by a parent company guarantee (from a substantive company in the seller’s group located outside the relevant member state) or a retention of a portion of the purchase price to satisfy future claims (with the retention account being held outside the relevant member state).
In all cases, thought should also be given to the currency of payment obligations under the sale and purchase agreement. A buyer may require the payment obligations to be in a currency other than euro (with the governing law and jurisdiction, where possible, being the law and jurisdiction of a country outside the Eurozone).
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