Purchasing assets from an insolvent entity on a truncated timeline with limited due diligence and no indemnities is not a process for the financial faint of heart.
The use of reps and warranties insurance in bankruptcy sales may help both debtors and asset purchasers, according to a new paper from Seyfarth Shaw.
Transactions that are executed under Bankruptcy Code section 363 can provide a higher value for debtors while simultaneously providing the purchaser with a backstop when transaction insurance is properly utilized.
How a 363 sale works
Before a 363 sale commences, the debtor usually markets its assets in search of a "stalking horse bidder". The stalking horse bidder has some advantages in the 363 process, including an earlier and extended period to conduct due diligence. The stalking horse also typically sets the "template" for the eventual agreement and leads the negotiation with the debtor.
After the stalking horse and other bidders compete, and the bankruptcy estate selects the successful bidder, the sale is approved by the bankruptcy court.
The authors explain that most 363 sales are "as is, where is", a bankruptcy term meaning that the asset purchase agreement has no indemnities and that the debtor is not standing behind the reps and warranties contained in the agreement.
A 363 sale wipes out third-party claims, but it does nothing for so-called "first-party claims" – that is the reps and warranties made between the debtor and buyer around the overall state of the assets. With the customary "as is, where is" structure, these risks are the sole responsibility of the buyer.
For buyers, having an insurance company back up the promises in the purchase agreement is a clear benefit.
This could be particularly important for the stalking horse bidder, as the negotiated purchase agreement with the inclusion of a reps and warranties insurance policy can become the baseline document for everyone else.
While buyers are usually the insured under the policy, the value of the policy is arguably even greater for debtors, although they may be reluctant to move from the customary "as is, where is" model. The authors note that some bankruptcy attorneys have concerns about the cost, necessity, and lack of clarity as to how insurance would "transfer" from a stalking horse bidder to a winning top bidder.
How much does M&A insurance cost?
In standard M&A transactions, insurers usually charge insureds a one-time upfront due diligence fee, ranging from $25,000-$50,000 plus another 10% of the premium at binding, with the remainder due at closing.
In the 363 process, and especially for the stalking horse bidder, carriers could potentially consolidate all of the pre-closing fees into a single pre-exclusivity fee. Stalking horse bidders usually negotiate a break-up fee equal to approximately 2-2.5% of the bid amount in the event that the stalking horse bidder is not the successful bidder.
For unsuccessful stalking horse bidders, the pre-exclusivity fee could then be recouped through the break-up fee. This break-up fee feature is not available in standard M&A transactions. As the paper explains, the breakup fee makes the use of reps and warranties insurance less expensive and risky in 363 sales than traditional M&A deals.
Current data generally shows that the use of reps and warranties insurance resulted in fewer escrows, holdbacks, and chargebacks and thus a higher sale price for assets, which should hold true in bankruptcy transactions - according to the authors - as it protects asset purchasers from overpaying based upon the existence of undetected liabilities, deficiencies, or defects related to the assets during the due diligence process.
While transactional insurance has been around for several decades for traditional M&A applications, it was not commonly used during the last economic downturn so many bankruptcy professionals are not aware of this new method for structuring an acquisition.
Originally published by Transaction Advisors on June 2020
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