By Kevin T. Lamb, Corporate Law Senior Counsel and Hanna B. Rubin, Intern, 2020 Summer Associate Program
In a year that has come to be defined in large part by a global pandemic, many businesses have faced challenges they were not prepared to weather. As a result, mergers and acquisitions involving distressed companies (commonly known as “distressed M&A”) have increasingly attracted the attention of legal and financial industries. Entities that “thrive” amidst the challenges “will have the opportunity to strengthen and expand their own footprints by salvaging promising companies that now find themselves in distress,” but the M&A process may begin to look unfamiliar to all involved.
In the United States, distressed M&A may occur through an out-of-court sale or under a bankruptcy court’s supervision. Within the category of bankruptcy proceedings, a buyer may purchase a distressed company through a Chapter 11 plan of reorganization or through a Section 363 sale. The former involves just what the name indicates: a detailed plan that a bankruptcy court must approve with respect to reorganizing the distressed company. Such a plan of reorganization may provide for the sale of some or all of the distressed company’s assets.
A Section 363 sale, on the other hand, typically involves a public auction, with the starting bid set by a potential buyer who has assumed the role of the “stalking horse.” Parties often prefer this route, as it tends to be more “expeditious” than obtaining confirmation of a plan. A Section 363 sale also allows the buyer to select which, if any, liabilities it will assume.
Regardless of how distressed M&A occurs, a buyer must engage in due diligence to avoid surprises regarding which assets are being purchased. Prior to the onset of the pandemic, “sufficient” due diligence could take different forms depending on the industry involved, the nature of the transaction, the identities of the parties, and many other factors. Often, though, due diligence required extensive investigation into such issues as the liabilities a buyer may wish to assume versus the liabilities that would be excluded from the sale; any relevant third-party liens or other encumbrances; the distressed company’s reliance on intellectual property subject to third-party licenses or rights; and the likelihood of major customers of the distressed company continuing to do business with the buyer. For example, a buyer’s assumption or rejection of leases and contracts may very well affect the value of a distressed company to the buyer. A Section 363 sale allows a buyer significant leeway to select the contracts the buyer wishes to acquire with the distressed company.
Now that COVID-19 has changed the economic landscape, due diligence necessities have changed with it. A prudent purchaser will not only investigate all of the issues involved in pre-pandemic due diligence, but will also adjust methods and add inquiries into new areas of concern associated with the pandemic.
For one, there are many liabilities that are either new or newly prevalent and important due to COVID-19. One author lists several “areas of inquiry” on which COVID-19 has increased focus: “exposure of the business…to jurisdictions highly affected by the epidemic”; “supply chain risk…”; “potential employment law issues and compliance with relevant government health guidelines”; “the legal basis under privacy laws…to process health data on employees, visitors and customers…”; “whether the seller has any deferrals of tax, customs duties, taxes or fees…”; “regulatory, licensing and data privacy implications as a result of remote working arrangements…”; and “the ability of the business or its counterparties to perform, suspend or walk away from obligations under assignable material contracts.”
COVID-19 has also impacted due diligence methodology. Buyers now have a heavily reduced ability to engage in activities like attending in-person meetings with the target’s officers and critical employees and accessing physical sites, existing inventory, and non-digital documents. “In distressed tech company acquisitions,” for example, “buyers still need to undertake due diligence, but the diligence may need to be accelerated and limited. And because of the coronavirus ‘stay at home orders,’ in-person diligence may be limited or difficult.”
In addition, techniques that used to be essential for predicting the future of a distressed company may be less effective now. For example, one advisory company stated prior to the onset of the COVID-19 pandemic, “the recent loss of a major client…can have profound impact on the value of a business. ‘We do many due diligence projects where we’ll go back and look at revenues and costs associated with that customer for the last 12-month period. To be accurate, we strip all that out to show how the business will perform in the future.’” Impacts like client losses sustained during COVID-19, however, may be more long-term than in eras past, so strategies like this one for predicting the future value and success of a company might not be as useful in the context of the pandemic.
There may still be valuable opportunities in distressed M&A during the pandemic. Like in many other areas of life today, however, updated practices are in order. Specifically, there are a few major ways buyers should change how they approach due diligence. For instance, buyers should contemplate bringing third-party experts into the process. “Buyers should consider going beyond their own usual [due] diligence and [obtain] a third-party valuation of the assets being acquired, seeking releases and waivers from third parties who might have claims against the seller and using deal mechanisms more directly involving the seller’s creditors…”.
These evaluations, in addition, will need to account for the lasting effects of COVID-19 on a company’s future. For example, if the distressed company owns a chain of restaurants, how long will there be legal and medically advisable limitations on how many customers a restaurant may serve at once? Will restaurants be expected to have much more robust pickup and delivery operations in the future, even beyond the eventual end of the pandemic? Moving forward, due diligence should include strategies for evaluating a distressed company’s ability to change and adjust to the state of the world as it adapts to and recovers from the constantly changing circumstances. “[A] bidder will want to dig deeper as to the nature, extent, and likely duration of the COVID-19 causation based on the target company’s individual situation, as well as whether or not there are contributing causes unrelated to COVID-19.” Relatedly, it is important for buyers in the current climate to consider the changing practices of representations and warranties (R&W) insurers in response to COVID-19, particularly with respect to exclusions.
Finally, buyers must be aware of the relevant jurisdictions’ responses to the pandemic. As discussed above, the safety and legality of travelling and having in-person meetings will almost certainly affect due diligence. Additionally, bankruptcy courts across the country are conducting activities differently. “To manage the effects of the pandemic, Bankruptcy Courts in each Federal District are formulating individualized approaches based on each court’s unique circumstances – which include disparate levels of local exposure to the pandemic, varying disaster declarations and Shelter-in-Place Orders, and uneven investment in courtroom technology.”
In circumstances that yield a lot of unknowns, one thing is certain: the procedures of due diligence in today’s distressed M&A world present untrodden terrain. There are certainly many aspects of due diligence that are more difficult and higher-stakes than before. Nevertheless, buyers should also be cognizant of the potential that distressed companies may have to adapt to the changing economy and the unique consumer demands that have arisen with COVID-19. “The identification of opportunities during buy-side diligence is a key component in the purchaser’s ability to maximize value post-closing via the integration of the business or assets being purchased.” In the hands of a thoughtful buyer, due diligence can be a tool to seek out ways a struggling business can grow to serve the new needs arising in the age of COVID-19.