The concept of the stalking horse originates in hunting, where a hunter releases a horse in a field and trails behind it so as not to alarm the targeted game. In distressed M&A, a stalking horse bid (the Bid) is an initial proposal from an offeror selected from a group of prospective bidders (the Bidder) to buy assets from a distressed company, typically one that is involved in bankruptcy and insolvency proceedings (the Target). The purpose of the Bid is to induce an auction process and a baseline offer price for assets.

The transactional framework for distressed M&A involves a court-approved auction process with prospective bidders, leading to confidentiality agreements, expressions of interest or letters of intent, a due diligence period, binding vendor purchase agreements (typically with minimal representations and warranties), negotiations with top bidders, and final executed purchase agreements.

While the Target benefits from avoiding the opportunity costs associated with dealing with low and undesirable offers throughout the competitive bidding process, in turn, the Bidder receives certain advantages:

  1. Deal protections

    The Bidder may receive deal protections in light of its Bid, including break fees, matching rights, or costs and expenses in relation to court proceedings, consulting fees, and appraisal fees. For example, earlier this decade, in Stelco Inc.'s restructuring under the Companies' Creditors Arrangement Act (CCAA), the Bidder submitted the Bid for a $900 million refinancing, with 9 percent of the resulting company going to existing Stelco shareholders. In this case, the break fee amounted to $6 million guaranteed to the Bidder in the event that Stelco accepted a superior bid. Similarly, in the same auction process, Stelco provided deal protection to a subsequent bidder in the form of all costs and expenses assumed by this party in relation to ongoing CCAA proceedings.

  2. Structuring the transaction and the auction process

    The Bidder may determine the scope of assets and the initial terms of the transaction. Upon announcement of the Bid, subsequent bidders may have difficulty in respect of structuring the transaction. As a result of entering the transaction in its preliminary stages, the Bidder has the opportunity to provide input in creating the framework for the court-approved auction process. This often entails consulting with the Target and establishing relationships with committees of both the Target's secured and unsecured creditors prior to submitting a proposal to the relevant court. In this role, the Bidder has the opportunity to propose restraints on competitive bids, such as timing of bids or minimum deposits required to submit compliant bids. Such bargaining power may dissuade future bidders, while establishing a lead for the Bidder. From a judicial perspective, it is important to balance fairness of process with fairness of price, as certainty outweighs speed and price in the auction process. The Bidder should be mindful that the transaction may close only after expiration of the appeals process to the relevant court.

With the above advantages comes the downside of initial outlays and risks associated with over-canvassing the market for the transaction. In its role, the Bidder assumes costs in the form of time and money, associated with due diligence as well as negotiating the aforementioned structure of the deal and the auction process. The Bid establishes the benchmark for all subsequent bids; therefore, it is important that it is at such a level that it catalyzes the auction process. If the Bidder bids too high, there is no going back. Thus, for the Bidder, it is important to perform thorough due diligence and be wary of the Target's reservation price as compared to the Bidder's own valuation. When the purchase agreement is executed, the Bidder is bound – make sure the horse is the right size.

The author would like to thank Sam Zadeh, articling student, for his assistance in preparing this legal update.

Norton Rose Fulbright Canada LLP

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