Transaction structure – shares, assets or debt?

The transaction structure can make or break a deal. The key question often asked at the outset of structuring a non-distressed M&A transaction is whether the acquisition will be of shares or assets. A distressed M&A transaction adds another potential dimension – debt. 

In the ordinary course, debt features less prominently as debt holders such as trade or bank creditors do not typically have control over a target business. However, the reverse is often true in a distressed situation – should the target become subject to winding-up proceedings, its business and assets will be managed by a liquidator, who ultimately answers to the creditors (and not the shareholders or management). The liquidator’s ultimate objective is to realise assets to settle debts owed to the creditors. It is in such circumstances that creditors have a much more significant say over how a target is to be managed.

A debt acquisition strategy can thus be deployed as a stand-alone feature or coupled with the acquisition of shares and/or assets. Deployed properly, it can be used to allow a potential buyer or investor to surface as a major creditor with a strong say in how a distressed business ought to be restructured (or to block or hamper any unfavourable restructuring proposals). An acquisition of secured debt is also useful in circumstances where the objective is to acquire certain ‘crown-jewel’ assets or businesses that happen to be the security given for such debt. Beyond this, an astute buyer or investor could also consider acquiring a significant portion of a target’s debt so as to prepare for a debt-to-equity conversion at an opportune moment. 

The starting point when structuring a distressed transaction is to consider the exact party in distress – be it the target, the seller or, perhaps, the seller’s parent company. 

If it is the target rather than the seller in distress, there is the potential for the buyer or investor to negotiate a typical M&A deal, but always being mindful of the possibility of an insolvency situation. The circumstances may thus require the negotiation of certain standstill assurances or comfort from key creditors of the target, and potentially a legally binding debt restructuring plan as a condition to completion, so as to allow the target to continue as a going concern after the deal is concluded. 

If, however, it is the seller that is in distress, an immediate concern would be whether buying the target at an attractive valuation would give rise to undervalue implications (discussed further below). There would also be concerns as to whether the seller is able to offer and/or fulfill the usual buyer protections such as indemnities, representations and warranties, and the alternatives that can be considered.

Consideration then needs to go into the interests of the various stakeholders, such as management, shareholders and employees, and in a distressed scenario, a broader spectrum of stakeholders, including creditors, financiers, customers and suppliers (all of whom would be understandably concerned about whether they can recover their debts or whether it can be business-as-usual after the transaction). An acquisition in distressed circumstances may be scuttled by an appropriately timed winding-up application from a creditor, if this creditor does not have the confidence that the acquiror would ensure that its debts are going to be paid. It is also conceivable that a perfectly viable restructuring plan may not be proposed to all relevant parties in the first instance, unless the management team charged with proposing the plan is given greater involvement in the transaction and the ability to share in the benefits of a successful deal implementation. 

Insolvency implications

In the course of structuring a distressed transaction, there are three immediate areas of relevance under Singapore laws. These are likely to be relevant concepts for most common law jurisdictions. 

Undervalue transactions – A transaction may be invalidated if it is at an undervalue. For a transaction to qualify as an undervalue transaction, it must be established that the seller was insolvent at the time of the transaction or became insolvent as a consequence of the transaction. This is an immediate concern where the seller is distressed, given that the attendant risk is an unwinding of the transaction. The discerning and well-advised buyer should thus be cautious when approached by a distressed seller, and depending on the circumstances, should insist that certain mitigating measures be put in place or that an alternative deal structure be considered.

Unfair preference – Closely linked to the concept of an undervalue transaction is the concept of unfair preference. The underlying principle is a simple one – creditors in general should be treated equally in times of crisis, and no single creditor should be entitled to any favouritism or preference, such as in having its debts repaid ahead of other creditors of the same class. In the context of distressed M&A transactions, this can materialise in a situation where the acquiror is also a creditor, and perhaps seeks to acquire an asset in consideration of the set-off or forgiveness of a debt. Proper due diligence is important in understanding the creditor profile and composition and also assessing the materiality of the risk. 

Wrongful and fraudulent trading – Wrongful trading refers to a situation where a distressed company takes on additional debt despite the directors knowing that there is no reasonable or probable likelihood that the company will be able to repay such debt. In practice, this is of relevance to any transaction structure involving a lifeline extended to the target – the directors should be understandably cautious about accepting such a lifeline, even if the alternative of doing without is to put the target into liquidation. Certain transaction structures may help to address such concerns, for example ‘loan-to-own’ structures which involve the repayment of debt by the issue of equity. Fraudulent trading is a closely linked concept, where directors of a target can be held personally accountable if the business of the target is carried on with an intent to defraud creditors of the target or for any other fraudulent purpose. The relevance here is similar to that of wrongful trading in that the directors of a distressed target are likely to exhibit a certain degree of caution and resistance, and it may sometimes be in the interests of a prospective acquiror or investor to help in addressing some of these concerns with a view to reaching a consensus on a viable deal. 

Insolvency laws 

Needless to say, insolvency and pre-insolvency laws that are applicable to the target and/or the seller or its parent have a significant role in structuring and implementing a favourable deal. In Singapore for instance, the Singapore Companies Act has undergone significant changes to enhance Singapore’s corporate insolvency regime and debt restructuring processes. The changes include features adapted from Chapter 11 of the U.S. Bankruptcy Code, such as: 

• an automatic 30-day moratorium to allow a distressed business time to work out a restructuring plan;
• fast-tracked pre-negotiated schemes of arrangements, i.e., a ‘pre-packaged’ scheme; 
• debtor-in-possession (DIP) financing (sometimes referred to as rescue financing); 
• the cross-class cram-down of dissenting classes of creditors; and
• the extension of the judicial management regime (akin to administration) to foreign companies. 

Take for instance the scenario of a distressed business which is temporarily crippled by cash flow issues due to macro-economic factors (such as the ongoing COVID-19 situation). It may be besieged with letters of demand or threats of legal action, but a prospective investor or buyer may nonetheless see value in the strong fundamentals of this business. In such circumstances, the investor or buyer may possibly appear as a white knight with a conditional offer to buy or invest in the business. A condition may be imposed that a ‘pre-packaged’ scheme of arrangement be proposed and implemented, whereby major creditors take a ‘haircut’ to trim down the target’s debt levels. Alternatively a traditional scheme of arrangement may be proposed and implemented, whereby all creditors agree to trim down the target’s debt levels, or allow for a longer period of repayment or, potentially, for the target’s debt to be converted into equity. A scheme ordinarily requires the approval of a majority in number of creditors (or class of creditors) holding 75 per cent in value of the overall debt, and if such approval is given, the scheme can bind all other creditors. The target itself may also make optimum use of this white knight approach, possibly seeking an automatic 30-day moratorium to work out a viable deal with the white knight and major creditors. If the scheme is implemented successfully, the outcome may well be satisfactory to all stakeholders – the white knight acquires or successfully invests in a target with an acceptable level of debt, the target is restructured to continue as a going concern, and the creditors are bound by an acceptable debt repayment schedule. Even if there is some resistance from certain minority creditors, a satisfactory outcome can still be arrived at by judiciously seeking and deploying the power to cram down such dissenting creditors. 

DIP financing is also a very useful feature, particularly for ‘loan-to-own’ structures or any structure involving debt financing. Any investor or lender would understandably be cautious when offering any lifeline or other loan facility to a distressed target, given that the proceeds may fall within the general pool of unsecured debt, of which recovery is uncertain and likely limited. DIP financing was thus introduced to encourage the provision of fresh funds by investors or lenders to distressed targets, and such funds can, with the blessing of the Singapore court, be conferred ‘super-priority’ status over all other creditors. 

Singapore continues to take a progressive stance in reforming its insolvency and restructuring laws, with the latest key development being the passing of the Insolvency, Restructuring and Dissolution Act (Omnibus Act) in October 2018. This new act seeks to consolidate and enhance personal and corporate insolvency laws currently spread among various legislative instruments. The Omnibus Act has yet to come into force pending finalisation of its subsidiary legislation, of which the Singapore Ministry of Law concluded its latest round of consultation in April 2020. 

As can be seen from the above, structuring a transaction in distressed circumstances involves a more complex analysis than is typically the case for a non-distressed M&A transaction. Having an in-depth understanding of the relevant insolvency laws is imperative to help steer a prospective purchaser or investor through troubled waters, and to increase the repertoire of options available to arrive at a favourable transaction outcome.

In Part 2 of this series on distressed M&A transactions, we will share insights on the transactional process for distressed M&A transactions, such as due diligence, sale process considerations and the key terms of deal documentation.

Reed Smith LLP is licensed to operate as a foreign law practice in Singapore under the name and style, Reed Smith Pte Ltd (hereafter collectively, "Reed Smith"). Where advice on Singapore law is required, we will refer the matter to and work with Reed Smith's Formal Law Alliance partner in Singapore, Resource Law LLC, where necessary.

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