As banks and other traditional sources of capital find their balance sheets reflecting more and more under-performing assets, lending standards continue to tighten, leading to the well-publicized lack of commercial credit. Alternative sources of capital, such as private equity financings or the public securities markets are also out of reach for many companies.  As a result, an increasing number of companies find themselves facing a significant liquidity crisis, with many seeking protection in bankruptcy proceedings.

The Administrative Office of the U.S. Courts reports that over 43,000 businesses filed for bankruptcy during 2008, while the American Bankruptcy Institute reports over 14,000 bankruptcy filings by businesses during the first quarter of 2009, an increase of approximately 30% on an annualized basis.

Similarly, all Indian banks in its Q3 FY10 results have shown a substantial increase in both gross and net NPA.   They all have separate department under General manager to deal with issues arising out of NPA and also the authority to sell such assets to Asset Reconstruction companies.

Although the current economic climate poses challenges to distressed businesses, it may also provide opportunities for more economically sound companies to acquire key assets or lines of business at bargain prices. But are these deals too good to be true? Unfortunately, there is no “one-size-fits-all” answer, but here are some key questions to ask when contemplating a transaction with a distressed company:

Have you considered the costs beyond the purchase price?

Acquisition of Distressed Assets can be time-consuming and expensive, both in terms of management attention and outside counsel fees. For these reasons, many directors assume that purchase of a healthy business is preferable to buying Distressed Assets because it involves lower transaction costs and requires less time to close.Once the transaction costs of legal proceedings and additional compliance to acquire NPA from ARC or bank directly,  are factored in, the bargain price a purchaser thought it was getting may not be so attractive.

Is it a deal or a steal?

If the Potential purchaser follows the advice of management and negotiates a purchase of key assets from a distressed competitor without taking control of the whole company, there are other issues to consider. While the purchaser can, and should, use the negotiating leverage provided by the target’s financial distress,  but at the same time, the deal must provide reasonable value for the assets being acquired. This is because it should get free and future ligation-free title to assets acquired and possibility of any creditors or other stakeholders to claim that transaction was mala-fide /fraudulent and price paid was not based on commercial value considering all the circumstances. Key Questions for Directors occurred, regardless of whether there was any intent on behalf of the parties to defraud creditors. There is no single definition of “reasonably equivalent value,” but courts will often look to the fair market value of the assets acquired, with adjustments deemed appropriate given the circumstances surrounding the transaction. Even if the fraudulent conveyance claim fails, defending against such a claim of could result in significant costs

Who are the target’s creditors? When dealing with a distressed company, a potential purchaser must understand the target’s creditor base, including the scope and nature of the indebtedness involved. If the company has debt secured by its assets, it will be impossible to acquire those assets free and clear of the lien outside of debt recovery tribunal without either paying the secured debt in full or making another arrangement with the secured creditor.  Another option is to arrive at the settlement with secured creditors and make them confirming party to the transaction.

 Even if a company does not have any secured creditors, a potential purchaser should also consider the trade and other unsecured creditors of the target company. Trade creditors often consist of suppliers or service providers who are critical to the operation of the target’s business. If the value of the acquired assets depends on the continued goodwill of these unsecured creditors, the purchaser must carefully consider how those creditors will be treated in the transaction. If the unsecured creditor base is disorganized and dispersed, the purchaser may have more success in striking individual deals that maintain good relations with those creditors after the closing. If instead, the creditor base is tightly-knit and organized, the purchaser will have to deal with the creditors as a group, which may prevent the purchase from striking a deal on as favorable terms as it would like.

Finally, there is always a risk that the target’s creditors will file an involuntary bankruptcy petition, forcing the target company into bankruptcy. Understanding the company’s creditor base in advance will help directors better assess which creditors have the most to gain from such an action.

Are you protected after the purchase?

A final consideration when dealing with a distressed company is the potential for successor liability after the purchase and what, if any, indemnification will be available to the buyer. Although the buyer should seek to structure the transaction to limit the liabilities assumed by it, A potential buyer is exposed to potential claims from frustrated creditors— primarily that by purchasing the assets of the distressed company, the buyer also took on the liabilities of that company. Contractual indemnification may provide little comfort in these situations, as the distressed company may be in no position to honor any indemnification obligations under the purchase agreement, particularly if the company has gone into bankruptcy following the purchase.

Structuring of the transaction in a way that a buyer acquires assets and does not take over any liabilities is very important. But such a structure may not be tax efficient and generally does not permit a buyer to adjust past tax credit available to a seller and also generally involves payment of much stamp duty on such sale. Regardless of whether a transaction with a distressed company is with attached liabilities or not, a buyer will seek a post-closing escrow or purchase price holdback to secure any indemnification obligations of the seller. As a practical matter, the funds escrowed or held back will likely be the only funds available to address damages suffered due to breaches of the seller’s representations and warranties. Evaluating a transaction with a distressed company involves a number of practical and legal considerations. Directors must analyze these considerations to avoid getting more than they bargained for. Nonetheless, through careful analysis and negotiation, economically sound companies may find good opportunities to acquire key assets or lines of business at bargain prices.

Conclusion

 In acquiring distressed assets, one should not look for a steal. Further structure of the transaction is very important from the point of view of unanticipated liabilities and getting favorable tax treatment. The agreement for purchase must provide for post-closing escrow.

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