Distressed M&A in Germany
January 2014 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING
Financier Worldwide Magazine
Distressed situations offer great M&A opportunities. Acquisitions of distressed companies before the commencement of insolvency proceedings or afterwards from the insolvency estate have unique characteristics. Before the commencement of insolvency proceedings, the acquisition provides the opportunity to carry out a restructuring at an early stage and to avoid reputational damage due to insolvency. But, even after insolvency has occurred, the acquisition of a distressed business can be very attractive, particularly regarding the commercial terms. In any case, the acquirer of a distressed business faces various risks. This article provides an overview of the advantages and challenges of distressed M&A transactions, in particular comparing the benefits and risks of acquiring a distressed business before or after insolvency proceedings have been commenced.
Share deal or asset deal?
Generally, the two different ways to purchase a company are the acquisition of the shares in the target company from its shareholders as sellers (share deal) and the acquisition of a part or all of the assets from the target company itself as seller (asset deal). A share deal only affects the shareholder level and leaves the target company itself unchanged; a share deal does not allow restructuring the debt during the course of the acquisition. In an asset deal, in principle it is possible to cherry pick assets and liabilities, i.e., to leave certain liabilities back with seller and to restructure the debt of the distressed business. Against this background, asset deal structures are most commonly used for distressed transactions in practice.
Liability risks regarding asset deals
Even if a purchaser does not contractually assume any liabilities in the course of an asset deal, certain imminent risks of this structure and the different impact for acquisitions before and after insolvency should be considered.
According to Section 613a of the German Civil Code, all labour contracts – and consequently all employees – are, by operation of law, transferred to the acquirer of a business provided that he maintains such business as an ‘economic unity’ (wirtschaftliche Einheit). This will often be the case with asset deals and entails the risk for the investor to become liable for all obligations resulting from the transferred labour contracts, including, in particular, unpaid salaries and wages. This liability is mandatory and cannot be excluded by contractual provisions. It is also not possible to dismiss any employees during the transaction, but only on general grounds for termination according to German labour law, such as a termination ‘for operational reasons’ (betriebsbedingt).
If the investor intends to reduce the workforce as part of its restructuring of the business, this can be far better structured in the course of insolvency proceedings. Whereas in a pre-insolvency transaction all employees are transferred to the investor and leave the legal difficulties and financial impact of the workforce reduction with the investor, the insolvency proceedings provide legal options to reduce the workforce which is actually transferred to the purchaser: part of the workforce can be separated from the transferred business to a newly founded separate entity which, for example, offers training opportunities for new employments. In this scenario only the remaining workforce will be transferred to purchaser by the operation of law. Furthermore, Section 113 of the German Insolvency Code allows, under certain circumstances, extraordinary terminations of employment contracts with a shortened notice period.
The acquisition of a business after the commencement of insolvency proceedings has a further advantage in this context: the purchaser cannot be held liable for any liabilities vis-à-vis employees which result from periods before the commencement of insolvency proceedings.
Maintaining the company name
Section 25 para 1 of the German Commercial Code provides that an acquirer of a company which continues to use the company’s name is liable for all liabilities incurred by such company’s business. This provision is interpreted quite broadly by the German courts as it remains applicable even if the purchaser acquires only a significant part of the assets.
In an insolvency scenario, this concept of law does not apply to any liabilities resulting from pre-insolvency periods; this is clearly another argument to acquire the distressed business only after the commencement of the insolvency proceedings.
However, liability risks can be handled prior to insolvency. Liability can be excluded by means of an agreement between seller and purchaser which needs to be registered in the commercial register or otherwise made available to third party creditors.
According to Section 75 of the German Fiscal Code, the acquirer of a company is liable for any business-related taxes that originate from the year preceding the acquisition and are assessed within one year after the acquirer has registered the business with the tax authorities. This mandatory liability is limited to the amount of assets of the acquired entity.
Section 75 of the German Fiscal Code does not apply to any liabilities resulting from pre-insolvency periods, which, again, is a clear advantage of the acquisition from the insolvency estate.
A dangerous situation arises if the seller (i.e., the former shareholder in case of a share deal or the remaining entity in case of an asset deal) becomes insolvent subsequently, as the insolvency administrator may be entitled to challenge the acquisition agreement or to refuse its performance.
Section 103 of the German Insolvency Code allows the insolvency administrator to uphold or to rescind bilateral contracts that have not yet been completely fulfilled. Even if an insolvency occurs after the completion of the transaction but before all mutual claims are fulfilled (e.g., the earn out purchase price is not yet paid), the buyer may be required to unwind the transaction and re-transfer the acquired business to the insolvency administrator; the corresponding claim for repayment of the purchase price or damage claims based on non-performance is worthless, as it is treated only as an unsecured insolvency claim.
If the acquisition has been fully completed by both parties, the insolvency administrator may still challenge the purchase agreement if creditors of the company have been adversely affected by a reduction of the company’s assets – for example, in cases where the purchase price was below the objective value of the target. Unwinding the transaction in this scenario may also leave the purchaser with a worthless insolvency claim.
Consequently, from this perspective it is also advantageous to only acquire the distressed business after the commencement of the insolvency proceedings, as the transaction cannot be challenged or rescinded on the grounds outlined above.
Purchase price, reps and warranties
The purchase price for a distressed business will usually be fairly low, compared to the acquisition of a profitable and successful business. It should be carefully considered in the specific transaction structure whether certain risks can be protected by representations, warranties and indemnities or whether all respective risks have to be taken into account in the calculation of the purchase price.
Prior to the insolvency, the seller should be able to provide customary representations and warranties.
However, claims resulting from representations are usually of limited value if the seller does not have sufficient substance or also faces the risk of going bankrupt. In general it is recommended to establish an insolvency-proof escrow structure backing claims under the representations and warranties.
After insolvency proceedings have been commenced, the situation is different. Representations and warranties will be reduced to a minimum of title protection as an insolvency administrator is usually unwilling to grant any guarantees with regard to the insolvent company he barely knows and which will burden the insolvency estate. There is often no solution other than considering any possible risks in the purchase price.
In distressed M&A transactions, opportunities and challenges should be carefully considered. Specialised lawyers can assist in assessing and reducing the legal risks to a large extent. In particular, prior to insolvency it should be determined whether the risks of the subsequent insolvency of the seller and the unwinding of the transaction can be sufficiently protected. Often, from a risk perspective, it will be more sensible to wait until insolvency proceedings have been commenced before acquiring the business.
Dr Heiko Tschauner and Dr Nikolas Zirngibl are partners at Hogan Lovells International LLP. Dr Tschauner can be contacted on +49 89 29012 153 or by email: email@example.com. Dr Zirngibl can be contacted on +49 89 29012 131 or by email: firstname.lastname@example.org.
© Financier Worldwide
Dr Heiko Tschauner and Dr Nikolas Zirngibl
Hogan Lovells International LLP