Distressed carve-outs: great risks, great opportunities

Buying parts of a distressed company may offer great opportunities for buyers. When a company is struggling but not yet insolvent, external financing might dry up and the sale of non-core activities may be a last resort to generate fresh cash.

Distressed M&A as such has become somewhat demystified over the years. Restructuring opinions, fairness opinions, non-distressed statements, and a specific structuring of deal and closing periods have become standard in the M&A lawyer’s toolkit. However, insolvency administrators might still find a loophole to refuse the fulfilment of or to contest deals retrospectively, posing significant uncertainty to potential buyers.

While the requirements for acquiring parts of a business in a carve-out are similar to those for acquiring an entire business from a distressed company, the distressed carve-out presents additional unique and largely unknown pitfalls and risks that must be carefully navigated to reap the full benefits.

Here are some of the key concerns:

Right scope and timing

A key right of insolvency administrators is to reject the fulfilment of an already signed (and pending) M&A transaction if the seller becomes insolvent prior to closing. Shortening the timeframe between signing and closing therefore seems crucial, but carve-outs, with their additional complexities such as defining the right scope and perimeters and establishing a resilient post-closing/day 1 operating model, have significantly longer lead times than a regular M&A transaction. In this context, "suspect periods" during which the administrator can retrospectively contest unfavourable transactions must be considered. Furthermore, these contestation rights could not only apply to the main M&A transaction but also to each preparatory individual carve-out transaction involving the insolvent seller or an insolvent affiliate. In addition, depending on the structure thereof, specific several and joint post-closing liabilities may arise (e.g., as a result of a statutory demerger).

Intellectual Property (IP)

IP rights and the allocation of ownership thereto are typically heavily negotiated in carve-outs. In contrast to a sale of the seller’s entire business, where the entire IP portfolio is transferred along with the business, the seller will tend to retain ownership of as much IP as possible in a carve-out scenario and only grant licenses to the buyer for IP particularly relevant to the divested business. Administrators may refuse to fulfil license agreements, potentially cutting off buyers and acquired businesses from essential IP. Buyers should therefore seek to secure ownership of as much IP as possible and, where this is not possible, negotiate licensing agreements that are robust enough to withstand a seller’s insolvency, or find other bespoke legal solutions.

Contract transfers and splits

The transfer and splitting of customer and supplier contracts add significant complexity to carve-outs, typically involving and requiring the consent of the relevant third parties. To ensure at least a beneficial transfer of the contract at closing, seller and buyer may enter into a contractual “treat-each-other-as-if” agency arrangement, whereby the seller holds the contract for the account of the buyer and passes on any contractual benefits, while the buyer indemnifies the seller and ensures that it has duly available products or services to be delivered under the contract pending consent. 

In the event of a seller's pre-closing insolvency, contract transfers are subject to the normal pending contract risks (see above). However, post-closing insolvency complicates matters:

While the buyer should generally have a strong legal position regarding the contracts to be transferred (which, however, must be assessed and confirmed on a country-by-country basis), a key question is how an insolvency may affect the seller's "pass-through obligations". 

This depends largely on the extent to which the relevant insolvency laws recognise such pass-through arrangements. Compelling arguments are required to prevent an administrator from refusing to perform such pending arrangement or claiming payments under or in respect of such arrangement against the estate. 

Ideally, diligent and careful planning of the contract transfer strategy and process will avoid post-closing agency arrangements altogether. Where this is not feasible, agency provisions need to be tailored to the circumstances, carefully drafted and reviewed on a country-by-country basis to support a ring-fencing of sold contracts from the insolvency estate.

Transitional Services 

Transitional services are designed to bridge resource gaps in the divested business that arise after closing, as the seller typically retains central (shared) functions, and to ensure continuity of the divested business until the buyer has independently built up the necessary resources. If still pending, the underlying transitional service agreement could also be terminated by the administrator in the event of an insolvency of the seller/service provider, with potentially serious consequences. This is particularly true in the area of IT, as the seller typically provides the entire IT platform as a service to the buyer from the time of closing until the full physical separation of the systems. Since few businesses can operate without IT support, the buyer may be forced to temporarily shut down the acquired business. A key focus in distressed carve-out scenarios must therefore be on the planning, structuring and implementation of the operational separation process and its timing.