If a business is on the cusp of bankruptcy, because of the pandemic-driven economic downturn or otherwise, it might consider filing Chapter 11. That's what Comcar, the Florida-based parent of five operating companies, did recently. As a result, PS Logistics is set to acquire Comcar's flatbed company, CT Transportation.
But selling all or some assets under Section 363 of the U.S. bankruptcy code might be a better option for some firms, rather than going through Chapter 11. Under Section 363, a company can often sell more quickly and for higher valuations, and investors can buy free and clear of liens and other encumbrances, according to bankruptcy and insurance specialists.
"A 363 sale is often a prudent choice," Shmuel Vasser, a partner at law firm Dechert LLP, said in a recent webcast. "It allows for a streamlined sales process and focuses on maximizing the value of the assets being sold, rather than on reorganizing the debtor as a going concern."
Under 363 sales, a business works with an interested investor, known as a "stalking horse," who does the due diligence and enters into an asset purchase agreement before the bankruptcy case is even filed. In addition to getting an early look at assets, the investor can designate milestones for the company to meet and have expenses reimbursed after the sale.
On the flip side, the investor assumes considerable risk. Before the sale can close, the assets must be made available to other investors through an open bidding process, with its offer serving as the opening bid. That means the stalking horse could invest time, money and effort to enter into the purchase agreement without acquiring the assets.
"The entire sale is done on full public display, so the stalking-horse bidder runs the risk of being out-bid," Vasser said.
That’s not the only risk. The unsecured creditors might also attempt to take another bite at the assets by seeking additional marketing, or challenging the marketing and bid protections that were conducted. What's more, as one of the bidders, the stalking horse is subject to bankruptcy court jurisdiction. So, any attempt to back out of the deal can be subject to litigation.
But by and large, the stalking horse position is a good one, because it stands the best chance to win the bidding war. The other bidders are required to make bids based on certain price increments, which can quickly push them into lofty valuations they might not be prepared to pay. They also don't get as much time to do their due diligence, but that might be less of a concern because they know the stalking horse has to vet the assets thoroughly to set its price.
Who wins the bid? "Usually it's the stalking horse," said Vasser.
Although having the assets made available free and clear of liens and other encumbrances makes 363 sales attractive, there remains liability risk after the sale.
"Some state courts may be unfamiliar with the process and precedent under the bankruptcy code," Vasser said. "And there is typically no recourse under the purchase agreement for the representation and warranties beyond any escrow or reserve amounts that may be negotiated as part of the sale."
In other words, if the representations and warranties a company makes are inaccurate, the purchaser can be on the hook, if the assets don’t perform at the level to which they were expected.
The lack of recourse for representations and warranties can be a significant concern, but traditional representation and warranties coverage is available.
"The key is, [insurers] still need reps to be made and the diligence to happen," Jay Rittberg, managing principal of representation and warranties insurance provider Euclid Transactional, said in the webcast. "The nature of the 363 process is very similar to other no-seller indemnity transactions that we underwrite and where seller recourse is contractually eliminated other than for fraud. So, 363 transactions are similar to other [representation and warranties] deals we see, where we take on the risk because of the limitations in the structure."
Rittberg said the biggest hurdle in 363 sales is that, sometimes, the representations might be in the style of public companies, which means qualifications are added to assertions of materiality and material adverse effects.
To get around that, Rittberg said, insurers can synthetically remove the qualifications from assertions of materiality and material adverse effects, as long as the company, as the one selling the assets, provides enough information for insurers to feel comfortable about what’s being claimed.
"Where there’s enough diligence and disclosure from the seller and through the buyer’s diligence process, [synthetic policies provide] a flexible alternative that’s been used by 363 purchasers in the past, so it really helps deals on the front end," he said.
If the seller doesn’t provide any representations or warranties, though, insurers are unlikely to provide coverage.
"In our view, the seller should be comfortable enough to make the representations we’re being asked to cover, and generally, there hasn’t been a problem in getting sellers to make these representations," Rittberg said.
Insurers’ hesitancy to cover sales without reps and warranties could change because of the downturn, said Rittberg. Given the uncertainty the pandemic has caused, more asset sales could come with no reps and warranties, and insurers might find a way to underwrite them.
"With COVID-19, there’s a chance people will look to find solutions, and if there’s a good rationale, we can look at it," Rittberg said.
Bottom line: If a company is teetering towards bankruptcy, it's likely to get a quicker sale and a higher valuation for assets to pay off creditors using a 363 sale. But to attract buyers, a business should make strong representations and warranties.