The global economy is in intensive care. What started as a sub-prime credit crisis has now morphed into a global recession with no end in sight. With the daily deluge of bad news, it is not surprising that few have the stomach to pursue fresh deals. But while traditional M&A activity may have declined, there are still opportunities for nimble buyers who are able to navigate the distressed M&A market.
Even under normal circumstances, the dynamics of M&A transactions vary widely between deals. The prospect of potential distress over a transaction does however add another layer of complexity to the process. A potential purchaser of distressed assets needs to be aware of a number of pitfalls when navigating such acquisitions in Malaysia.
Know who you are dealing with
The stakeholders can be varied in a distressed M&A situation. A purchaser may be dealing with the shareholders of a company or management of the company in the case of an asset sale, just to find the deal scuttled at the eleventh hour by the companyâ€™s creditors. A buyer therefore should seek to inter alia, understand the fiduciary duties of the board of directors of the seller from the outset to prevent any nasty surprises. Under normal circumstances, a directorâ€™s fiduciary duties are owed solely to the company. Depending on the particular circumstances of the case, these duties may also extend to the companyâ€™s shareholders as they are the ultimate beneficiaries of the company. That said, the scope of directorsâ€™ fiduciary duties expands once a company enters the â€˜zone of insolvencyâ€™ to include the interests of the companyâ€™s creditors (which may not be a homogenous body). This could alter the dynamics of the deal significantly.
Rigorous and thorough due diligence is paramount when contemplating a distressed transaction. Issues that may not be of great concern in a healthy company may be deal- breakers in a distressed transaction. More importantly however, there may be limited avenues for recourse, post-acquisition if the seller subsequently goes bust and is wound-up. For instance, the post-closing insolvency of the seller would eliminate any indemnification recourse in the absence of escrows. The seller will also typically have been wound-up by the time a material breach of a representation or warranty has been discovered.
The typical practical solution under these circumstances would be to establish an escrow to hold back a certain percentage of the purchase price to secure the sellerâ€™s indemnification. A later insolvency by the seller also could, however, result in attacks on the effectiveness of the escrow itself, but escrow agreements can be drafted appropriately to minimize or eliminate those risks by making it clear that they secure indemnification, and that the escrowed funds themselves are not the property of the seller (or its later bankruptcy estate).
In the case of an acquisition of a distressed business, solid due diligence is required to understand among others, the sources of distress, the financial position of the target and in particular the cash flow and capital requirements of the target. Failure to do so could expose the buyer to significantly larger liabilities and the potential loss of the entire investment in the case of the subsequent insolvency of the target.
While deal structures will vary depending on the opportunity, in a distressed situation, buyers tend to prefer asset purchases as it has the benefit of protecting them from contingent liabilities. An asset purchase however can be attacked by the liquidator of the seller, if the seller is subsequently wound-up. Amongst others, the liquidator could try to disclaim the transaction on grounds that it is an unprofitable contract or the entire transaction could be avoided for undue preference. Though very remote, the liquidator may also try to undo the transaction by alleging that the sale was tainted by fraud. This risk, however, can be minimized, if not completely eliminated, in armâ€™s length transactions properly documented with contemporaneous appraisals and a reasonable, market-driven sales process.
Reaching the silver lining
Hidden opportunities do exist even in the current economic climate. Buyers should however proceed with caution and with the appropriate guidance to avoid the additional pitfalls involved in a distressed M&A transaction.
This article is for information purposes only. The contents do not constitute legal advice and should be regarded as a substitute for detailed advice in individual cases. No decision to act or not to act in a particular way should be taken merely on the basis of this article, and detailed legal advice should always be sought at the earliest possible moment.
+603 2298 7999
+603 2298 7895
Wong & Partners (Member Firm of Baker & McKenzie International)