July, 2003

Issue 7, July 2003    
President's Message
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ACG's New Look
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Dealing with the Dangers in Buying Distressed Assets
by Stephen A. Gould, Nutter McClennen & Fish LLP

Although the M&A market remains languid, purchases of distressed assets are emerging as a viable growth strategy. But companies tempted to jump at a bargain must keep “caveat emptor” firmly in mind, balancing the immediate appeal of an opportunity with a plan to minimize the risks. There are at least five ways to do so.

First, let’s assess the opportunity. For those accustomed to shopping at hip M&A boutiques, distressed asset shopping may seem akin to visiting a flea market on a Sunday afternoon. But the growth prospects are particularly attractive right now. On the supply side, corporate bankruptcy filings are still at very high levels and, as a result, there are potentially good deals to be found. On the demand side, because we are continuing to operate in a tight capital market and companies are reluctant to make large investments in an uncertain economy, buying distressed assets may be an attractive investment strategy, especially where they can be purchased for pennies on the dollar.

While companies that are in Chapter 11 would generally prefer to sell their companies as going concerns, that route is not always feasible, and the distressed company may choose to sell its assets piecemeal through a Bankruptcy Code Section 363 auction. Such assets could include property, plant, equipment, leases, and current assets (including accounts receivable and inventory). An increasingly valuable asset is a company’s intellectual property, including patents, trademarks, and copyrights.

The potential downside of purchasing the assets of another firm is that you may unwittingly purchase its problems as well. Acquiring distressed assets raises the issue of successor liability. While Chapter 11 permits distressed companies to reorganize and protects them from the demands of creditors, bankruptcy does not necessarily and completely wipe the slate clean of existing liabilities. For example, a company that purchases land may inherit the environmental liabilities associated with a contaminated site, while a company that purchases another’s intellectual property may be exposed to existing patent or trademark infringement claims.

Along with those risks comes the peril of the premium placed on speed. In a distressed-asset sale, the value of certain assets, such as customer lists, may depend on the ability of a company in Chapter 11 to keep operating as a viable concern. Moreover, there may be strong competition for a distressed firm’s assets that encourages prompt action. There are five key steps that a buyer can take to minimize those risks.

Implement a partial purchase plan. Buyers will often demand to hold back a portion of the purchase price for up to a year in order to address any claims that may arise during that period.

Ensure effective insurance coverage. For those deals where environmental liability poses a significant risk, buyers are increasingly looking to purchase environmental liability insurance policies.

Don’t short-cut “notice and drafting” practices. Such exposure can be further reduced to an absolute minimum by comprehensive notice and by careful drafting of the Bankruptcy Court’s sale approval order. The urgency of many distressed-asset sales can lead an offeror to give short shrift to proper notice and drafting. But if those steps are taken carefully, then a purchase out of bankruptcy is far and away the “freest and clearest” way to buy an insolvent’s assets and to neutralize successor-liability issues.

Play defense with “break-up” fees. The price for this “free and clear” aspect of a bankruptcy purchase is the necessity of subjecting oneself to the notice and counteroffer (a/k/a “auction”) requirements of the Bankruptcy Code and Rules. But even here, the initial offeror can protect itself by structuring the sale procedures to include a “break-up” or “stalking horse” fee. The initial offeror may be outbid, but at least it does not suffer the additional indignity of having to eat its out-of-pocket expenses incurred in negotiating its offer and bringing it before the Bankruptcy Court.

Stay true to due-diligence disciplines. Chastened by the experiences of the late 1990s, dealmakers have become more risk-averse, and M&A deals are typically taking months longer to complete as due diligence regains its importance. But the need for quick action on distressed deals can undercut that welcome trend. A shorter due-diligence period raises the risks that purchasers of distressed assets may later confront issues of successor liability.

In the end, taking precautionary steps can make distressed asset sales a win-win for both the seller and buyer. For the time being, there remain significant growth opportunities for companies to invest in assets that in better economic times would have been unavailable or too expensive.

Stephen A. Gould is a junior partner in the Boston law firm of Nutter McClennen & Fish LLP, concentrating on mergers and acquisitions, venture capital financings, joint ventures, and complex business transactions. He can be reached at 617.439.2710.


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