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.
Are there other insurance solutions for transactions?
Whether a company is looking to emerge from Chapter 11 bankruptcy or contemplating a transaction outside of bankruptcy, tax uncertainties often arise and may get in the way of the business goals of the parties. Tax insurance is invaluable in these situations.
For example, in one situation, a plan of reorganization required the funding of an escrow account to backstop a tax indemnity covering ‘golden parachute’ excise taxes under Code Section 280G. This effectively required the creditors of the company to wait up to six years for the IRS statute of limitations to lapse before funds could be paid. A tax insurance policy insured the former executive who was the beneficiary of the escrow in the event of a successful IRS challenge. Funds equal to the policy limit were released from the escrow account and paid to the creditors of the estate.
Bankrupt companies will often hold net operating loss carry forwards (NOLs) that can be used to offset taxable gains. Code Section 382, however, limits the ability of the successor company to use the historic NOLs going forward, except in limited circumstances. Whether or not these tests have been satisfied will require a determination by counsel and would leave the estate and/or the successor company with a tax bill should such determination be challenged by the IRS.
A tax policy ensuring that the Code Section 382 limitations have been properly applied would provide comfort to the parties to proceed with the transaction. The policy would cover tax, interest, penalties, contest costs and a gross up. Such a policy could insure the estate if it is required to provide a tax indemnity. Alternatively, it could ensure that the successor corporation will obtain the economic benefit expected.
Note that tax issues involving utilization of NOLs are not unique to bankruptcy and can arise in other deals, as well. Recent TARP legislation also enhanced the availability of NOL carry backs for various transactions.
RWI and tax insurance are the insurance products most commonly used in distressed deals, along with coverages such as environmental insurance. But outside of these areas, it is often possible to craft unique insurance solutions to address unusual issues that may arise in a distressed deal.
Transaction liability products can make the difference between completing a transaction or not, and the value is even apparent in distressed deals, in which the ability to close a deal can alter the future of the company.
Ann Gelfand is managing director at Aon Risk Services Central Inc. Reach her at (314) 719-5187.