In this article, we explore some of the key considerations, and legal issues, associated with distressed mergers and acquisitions (M&A) transactions.
Distressed M&A
Distressed M&A – as opposed to conventional M&A – involves the sale and purchase of a business or a company confronted with financial difficulty. It is a subset of M&A that presents parties with a unique set of risks and opportunities.
The ‘distress’ in question can range from a company needing to engage in early-stage discussions with lenders and financiers, to restructuring negotiations through to the need to appoint insolvency specialists.
At the time of writing, New Zealand is grappling with historically high interest rates and inflation, rising wage and labour costs, a widespread labour shortage, commodity price hikes, a declining housing market (and also the impact of a foreign war and disruption in the US and European banking sectors). Such recessionary triggers are presenting challenging market and financial conditions for individuals and businesses alike. Q4 2022 metrics have confirmed a significant retracement in a number of key New Zealand industries, including manufacturing, exports, agriculture, accommodation and retail. Business confidence, generally, is in the balance and the sentiment seems to be that we are in for some choppy seas in 2023.
Some will stand to benefit from this economic environment; for the savvy investor looking to deploy capital towards quality assets, businesses with depressed valuations offer up attractive investment opportunities.
Comparison with conventional M&A
There are a number of key features of distressed M&A. When compared to a conventional M&A scenario, the distressed M&A timeframe is generally truncated, as is the suite of information generally made available to prospective purchasers. Separately, distressed M&A transactions usually proceed on a “buyer beware/as is, where is” basis, meaning purchasers will typically have the benefit of fewer contractual protections, most notably as regards warranties. To the extent warranties are given, the veracity of such protections may be called into question, in the event a claim arises. (With administration-driven sales, purchasers will usually also be asked to indemnify the administrators from any liabilities arising in connection with the sale.)
This highlights the need for a purchaser to be able to ‘price in’ key risks into a transaction, undertake targeted due diligence and act swiftly in order to best leverage the opportunity before it. It also reinforces the importance of having experienced advisors on hand to advise on the unique complexities of the deal in question.
Naturally, a distressed company’s financial state will determine the nature and type of any corporate action undertaken. The owners of a business feeling the beginnings of financial strain may elect to sell the business through a typical auction process. Creditors of a company with more pressing financial concerns may request that the company’s debt be restructured; selling the company may not generate enough to repay company debt and so a restructuring may yield better returns, rather than allowing the company to formally enter into insolvency.
Generally speaking, stakeholders will have varying motivations in a distressed M&A scenario. For example, insolvency practitioners ordinarily have a duty to obtain the maximum sale price they can under a distressed sale, whereas a lender’s focus will likely be more around ensuring the money obtained under the sale can service outstanding debt.
Distressed businesses may offer greater opportunities for investors to acquire debt (as opposed to shares or assets) at a discounted value; for investors ultimately looking to assume control of a business, acquiring debt may provide critical access to company information and, arguably, a strategic advantage over other investors.
In terms of the purchase price, sellers of distressed businesses are unlikely to agree to any form of completion account-type adjustment; anything which protracts the process, imposes possible liability on the seller or introduces further uncertainty will be of little appeal to sellers in such circumstances. The most commonly-agreed approach appears to involve the payment of a fixed price (subject, in some circumstances, to the use of escrow provisions as a hedge against any identified risks).
Due diligence
In distressed M&A transactions, bidders typically encounter limited (and, often, sub-standard) information. In practice, this means there is generally limited time for comprehensive legal due diligence and (generally) no vendor legal due diligence. In many respects, this is a product of the compressed timeframe and the target’s resource constraints. Early identification of potential problems is vital and so it is imperative that prospective purchasers undertake targeted due diligence on critical issues and significant risk areas. For all intents and purposes, they mirror those found in a conventional M&A process, but a purchaser may place more significance on knowing that it will obtain clear title to the target or assets and that material customer or supplier contracts are durable and will remain afoot (and any change of control provisions, and their implications and requisite consents, are identified and addressed).
Where time is of the essence, as with most distressed M&A deals, the use of legal technology and AI (particularly in the context of document reviews) may help streamline processes and it is something we expect to see increasingly in New Zealand.
Transaction structure
Early consideration of deal structure is crucial in any transaction, no less so than in a distressed M&A deal.
A potential purchaser of a distressed company will usually favour either a business and assets sale (as it enables the purchaser to selectively choose desirable assets) or a ‘hive-down’ (whereby specific assets are transferred to a newly-formed target company). These approaches reduce the risk of the purchaser inheriting unknown liabilities. Conversely, a seller may be more inclined to favour a share sale, from a tax perspective, and in terms of the process being generally less onerous and disruptive.
Parties to distressed M&A should appreciate the fact that if the deal is found to be an ‘insolvent transaction’ under the Companies Act 1993, a liquidator could ‘unwind’ the transaction and ‘claw back;’ assets. An ‘insolvent transaction’ is a transaction that occurs when a company is unable to pay its debts which allows another person to receive more towards the satisfaction of a debt, owed by the company, than that person would otherwise receive in the company’s liquidation. The risk of this happening is mitigated where a purchaser acquires a distressed company from an insolvency practitioner or through a formal insolvency process.
W&I Insurance
To mitigate the lack of contractual protection in a distressed M&A transaction, a purchaser may wish to explore warranty and indemnity (W&I) insurance. The type of policy would be one in which the insurer (as opposed to the seller) provides warranties to the purchaser in the policy itself. For the purchaser, it provides a safety net for any losses that could arise from misrepresentations. For the seller, it may help ensure that the transaction actually gets off the ground.
Directors’ Duties
Directors of distressed companies need to be mindful of their duties under the Companies Act 1993, in particular in relation to acting in the best interests of the company (section 131), the duty to avoid reckless trading (section 135) and the duty not to agree to the company incurring an obligation unless the director believes, on reasonable grounds, that the company will be able to perform the obligation.
Penalties may apply if directors are found to be in breach of these duties.
Regulatory concerns
Foreign investment
If foreign investors are involved, then – depending on the nature of the assets being acquired – parties need to be mindful of the fact that the Overseas Investment Act 2005 and its regulations (OIA) ‘could’ apply and that the transaction ‘could’ be subject to approval from the Overseas Investment Office (OIO).
The OIO also has the right to require certain information in connection with the transaction (for example, the reason for the distress, the potential impact on the target company’s employees, and the investor’s plans for the distressed asset). This information may need to be provided in short order and can add to the complexity of the process. The OIO can also impose strict investment conditions, such as requiring the investor to protect the environment, provide employment opportunities for New Zealanders, or commit to investing in the country’s infrastructure.
Penalties may apply for non-compliance with the OIA.
Competition
For distressed M&A deals, the New Zealand Commerce Commission (ComCom) may be particularly vigilant in reviewing the transaction’s impact on competition under the Commerce Act 1986. Distressed assets may be attractive to buyers seeking to consolidate their position in a market or to eliminate a competitor. ComCom can examine whether the acquisition would result in a dominant market position for the purchaser, and whether the transaction would lead to higher prices or reduced choice for consumers.
ComCom can also consider the impact of the transaction on the target company’s employees, suppliers, and customers; distressed companies may have a weaker bargaining position in negotiations, and so ComCom may be concerned about the potential for exploitation or abuse of market power. ComCom has the right to require the purchaser to commit to maintaining jobs, contracts, or prices, or to make other undertakings to address these concerns.
Again, penalties may apply for non-compliance with the Commerce Act 1986.
