Uncertainty
The projections as to the near- and medium-term future of oil and gas prices are mixed – to say the least. Irrespective of the direction prices ultimately go, industry is faced with significant uncertainty and companies in all industry sectors are evaluating their businesses and how they can best manage the uncertainty. Opportunities are surfacing for companies to strategically reposition themselves resulting in acquisition and divestiture activity. In this paper we consider special considerations when buying and selling assets of companies experiencing financial distress. We only address assets being divested outside of bankruptcy. Both the buyers and sellers will want to bring transactions to closing – understanding special issues will facilitate this mutual objective.
Selling or Acquiring Distressed Assets
When considering the acquisition of assets from a company experiencing financial distress, appropriate thought must be given to the structure of the purchase. The general legal principle is that a buyer is not required to assume corporate liability when it acquires the assets of a company. There may be risks associated with an asset purchase if the level of "distress" is approaching insolvency. Some of the post-closing insolvency risks that should be considered include: liens that may run with the asset; laws that void "fraudulent transfers" when the interests of the seller's creditors are at risk; and the fiduciary duties to which officers and directors of the seller are subject, which run not only to the shareholders but also to the creditors when the seller company is in the zone of insolvency. Forming a special purpose entity to effect the purchase of distressed assets better shields the buyer against unknown liabilities that may run with the asset. A board of directors of a company nearing the zone of insolvency should retain independent counsel and advisors to assist and advise in the sale transaction.
Due Diligence
Due diligence takes on a special focus when acquiring distressed assets. Consideration must be given to the "insolvency effect" of the contemplated sale. How will the seller's financial position change upon completion of a proposed asset sale? What credit arrangements are in place and what impact will the sale have on these arrangements? What tax liens, judgment liens and lawsuit filings exist? How will existing material contracts be impacted? Does the seller have lingering liability for environmental law violations that may affect the pre-closing solvency determination? If the acquisition involves an E&P company, what are the plugging and abandonment liabilities that will be assumed? Does the board include insiders? If so, are there sufficient independent directors to approve the transaction without the insiders? Are employee lay-offs planned and will the WARN Act be considered? What material executive employment contracts exist? Is there an employee stock ownership plan? Will there be changes made to medical and/or workers' compensation plans? Thinking through these issues upfront will go a long way in preventing surprises at or after closing.
Safeguards Against Fraudulent Transfer Claims
It is imperative that parties to a transaction create a transparent record of a reasonable and defendable sale process (i.e., one undertaken in good faith and resulting in an arm's length transaction). Interaction with the creditors on an appropriate level is key to this process and should reduce the risk of fraudulent transfer claims. Optimally, consent will be given by the creditors to the proposed transaction. The obligations assumed by seller will also serve to reduce risk. Ideally the seller will provide a covenant and some form of financial assurance that the seller will apply the proceeds from the sale to existing creditor claims. A buyer should also understand and, to the extent appropriate, provide for payment of secured claims. Claims can be identified by conducting a lien search, including a UCC-1 search on the seller. A buyer may want to make certain any secured debts are either paid or assumed under the sale. The agreement should require that no proceeds are paid to equity or insiders before all creditors are paid.
In addition, the seller should represent and warrant compliance with all applicable state and federal law and provide an indemnity against violation of either federal or state law. Coordinating with third party experts brings impartiality to the process. A distressed company or buyer should seek a solvency opinion, capital adequacy/surplus, or valuation opinion or some combination of such opinions from a qualified independent expert. Such opinions will support that the buyer is paying fair market value for the transferred assets and should reduce the likelihood that the transaction is set aside post-closing as a "sweetheart deal." No opinion, however, could guarantee the outcome of a challenge claiming a fraudulent transfer. For this reason, purchasers at times will insist that a distressed company file a "prepackaged" bankruptcy and condition the sale on court approval. Representations and warranties provided by the seller may be of limited value when the acquisition is transacted under distressed circumstances. Holdbacks, letter of credit, and escrows provide sound security to cover post-closing liability and indemnities. Post-closing holdbacks, escrows, or letters of credit should include sufficient contingency to account for creditor liability. Buyers are able to obtain holdbacks that are substantially higher than those for non-distressed assets. Creditors may resist holdbacks as it reduces the amount of cash they can be certain to receive from the sale.
Advantages and Disadvantages
There are tradeoffs when negotiating with a distressed seller outside of a bankruptcy proceeding. There are a number of advantages: (i) The transaction will proceed to closing at a much quicker pace if it is handled outside of the bankruptcy proceeding. (ii) Often times there is less scrutiny and possibly even less competition for the buyer. (iii) When working outside of bankruptcy the seller is often motivated and provides a more robust set of representations and warranties. (iv) Typically both the seller and buyer value the avoidance of hassle that is involved in formal bankruptcy proceedings. There are definite risks comprising the disadvantages of transacting outside of the proceedings: (i) Often times the buyer has less deal certainty, especially if there are non-consenting creditors involved. (ii) Buyers are often faced with limited ability to "cure" seller defaults under the purchase and sale agreements. (iii) Buyers may be faced with successor liability and certainly are confronted with an overall higher risk deal. (iv) The sale may be challenged as a fraudulent transfer and be subject to a court order unwind.
Conclusion
Volatile and unpredictable commodity markets present opportunities in the area of acquisition and divestiture. Bankruptcy proceedings are complex and time consuming and not conducive to completing acquisitions in the normal time frame. Transacting with a distressed seller outside of bankruptcy may be the best path forward under defined circumstances. Moving forward with insight as to the pitfalls, a proper structure, a plan for due diligence, and safeguards in place will help ensure that the deal will survive post-closing.
