Mergers & Acquisitions

With the recession and credit crunch affecting virtually all sectors of the economy, a greater proportion of company acquisitions today involve distressed companies. Whether the seller or target company is already in bankruptcy proceedings or simply experiencing financial difficulties, these deals present unique challenges, says Ann Gelfand, managing director of Aon Risk Services Central Inc.

When a company finds itself in financial distress, it often sells off noncore assets, subsidiaries or the entire company. The goal of the seller is to maximize the amount of cash it receives, which often means compromising on deal points such as indemnity terms. Even if a seller makes it a priority to keep the indemnity cap low, its financial condition may cost it the bargaining power to achieve this. The likely result is that the seller is forced to accept indemnity terms (high cap and/or escrow) with which it isn’t comfortable.

Smart Business spoke with Gelfand about how to do deals with financially distressed companies.

How can both parties get comfortable enough to close a deal?

In many instances, transaction liability insurance products can provide a solution. In the seller-friendly deal environment of past years, representations and warranties insurance (RWI) was used to supplement a relatively low seller indemnity cap for breaches of reps and warranties, resulting from the buyer’s lack of negotiating leverage or as an accommodation to the seller by replacing or reducing an escrow.

Distressed deals come with their own unique issues, for which RWI can offer a valuable solution. In these deals, it is critical to minimize cash escrows yet still offer a buyer protection against contingent liabilities. A seller-based RWI policy can be written to insure a large percentage of the seller’s indemnity obligation to the buyer. For example, the seller may agree to a high cap but would be able to insure most of that indemnity obligation.

Alternatively, if a buyer is purchasing assets from a seller in financial trouble, the buyer will likely have the leverage to negotiate favorable indemnification terms. The issue is whether that indemnity offers true protection for the buyer if the seller is unable to satisfy its indemnity obligation.

The survival period for the reps and warranties (and the related seller indemnity) usually extends from one to three years (often longer for tax, environmental and title reps). Moreover, even if the buyer negotiates an escrow of purchase price as security, the escrow will likely only cover a portion of the indemnity cap.

How does this apply to bankruptcy situations?

Potential buyers of bankrupt companies (or of their assets or subsidiaries) can usually perform due diligence and negotiate the purchase agreement to include customary reps and warranties. Because of the need to maximize the return to creditors immediately upon the sale, however, those reps and warranties usually will not be backed by any seller indemnity for breaches discovered after closing, as reps and warranties do not survive the closing. In a bankruptcy sale in which the buyer cannot negotiate indemnification, a buyer-based RWI policy could be written in excess of a retention of approximately 5 percent of the purchase price, providing recourse for the buyer where otherwise it would have none.