Competitive advantages through early preparation for acquisition opportunities in a crisis

Originally, this Article was published in German language on 8 February as part of issue 2023/1-2 of the renown German M&A Magazine M&A Review (Link).

1. Introduction

The market for distressed transactions is expected to grow in 2023 but will also become more difficult. This makes it all the more important to deal with the specific legal aspects of acquiring a company in times of crisis or insolvency at an early stage.

2. A look back at 2022 and ahead to 2023

The year 2022 will probably go down in history as the year of accumulated disasters. Rarely have crises developed in such a concentrated form and from all sides. While the global economy was still battling with the aftermath of the COVID 19 pandemic and another wave is currently emerging from China, Russia's attack on Ukraine not only shook the existing peace, but also caused economic turmoil through massive energy price hikes and aggravating supply chain problems.

The full dimensions are hardly foreseeable yet. The high inflation rates, which were not believed to be possible, and the constantly rising interest rates are adding to the problems. The crises had little impact on insolvencies until around mid-2022. While the number of opened insolvency proceedings actually fell slightly by 0.4% between January and September 2022 as compared with the same period of the previous year, the number rose by 18.4% between September 2022 and October 2022 and slightly by 1.2% in November 2022 ¹. However, insolvency petitions are regularly filed some three months before proceedings are opened. Hence, the increase in the October figures is due to applications filed in July/August 2022.

The number of insolvencies is expected to continue to rise in 2023. As a result of the considerable rise in interest rates, business models involving strong debt financing are being put to the test, especially when it comes to follow-up financing. If insolvency follows, the circle of potential investors narrows if they finance the acquisition − as is often the case − with a substantial share of borrowed capital. For insolvency administrators, this means that they will have to make it clearer in future investment processes where the business opportunities are in the debtor's business operations. This will probably lead to insolvency administrators thinking more often about the sale of parts of the business. The business skills of the insolvency administrator are therefore coming into sharper focus. This also increases the importance of specialised advisory firms dealing intensively with the further development of the debtor's business model in order to proactively address investors.

In addition, the number of companies that will not find an investor while insolvent is expected to increase. This is because it has already become apparent in 2021 and 2022 that, due to the partial suspension of the obligation to file for insolvency as part of the COVID legislation, the statistics only showed a small number of cases. Nonetheless, many enterprises were materially insolvent and proceedings that were opened suffered from a significant lack of assets. This trend will become even more evident in 2023. Still, in 2023 there will again be numerous opportunities to acquire companies in crisis or insolvency. For this reason, the following is an overview of the legal particularities of the purchase from special situations.

3. Special legal features of distressed acquisitions

If a potential target is in crisis, selling the company is often a strategic option to ensure its economic survival. Prospective buyers are then facing the question of the right time to buy and of the best acquisition structure. The strategic considerations start with the potential acquirer but can only be completed together with the target and, where necessary, the insolvency administrator.

3.1 Tactical considerations regarding the timing of the acquisition

1. Acquisition in a crisis

Basically, the acquisition of a company that is in crisis or has already filed for insolvency is a normal M&A transaction that can be carried out as a share deal or an asset deal.

2. Acquisition of a company in a crisis by a share deal

In a share deal, the buyer acquires the shares in the target company. The legal entity and, as a rule, the legal form of the target company remains the same. The acquirer takes over the target with all assets and, above all, all liabilities, including all tax obligations. If the target company is already insolvent (section 17 (2) InsO (German Insolvency Code) or over-indebted (section 19 (2) InsO) at the time of the acquisition, the management remains obliged to file for insolvency unless it has already done so ². The acquirer must therefore provide the target company with the necessary financial resources immediately after the takeover to survive any factual insolvency that may have occurred.

If the target company is only threatened with insolvency, the company is not obliged to file for insolvency, but has a right to do so. Nevertheless, the acquirer must ensure that the target is adequately financed.

Whether an acquisition of the target in times of a financial crisis by means of a share deal makes sense can generally only be assessed through a careful legal, financial and tax due diligence examination. If the crisis of the target company has already progressed to the point that a petition for insolvency must be filed or will have to be filed in the near future, there is often not enough time for an in-depth examination. If the company is insolvent, the petition must be filed within three weeks and within six weeks if the company is over-indebted (section 15a (1) InsO). Another question is whether the personnel required for the due diligence process is (still) available at the target. Unless the target company is being assisted by professional restructuring advisors, there is often a lack of clarity about the actual extent of the crisis and the real need for financing.
Therefore, an acquisition by way of a share deal in a crisis is generally considered only if the acquirer ensures the full financing of the target company immediately after the takeover on a scale that removes any doubt as to the non-existence of any grounds for insolvency.

3. Acquisition of a company in a crisis by an asset deal

If the acquirer does not want to take over the company in crisis with all its liabilities, the alternative is the asset deal structure. In an asset deal, the acquirer buys the assets of the target company – usually through a separate acquisition company – and takes over the existing contractual relationships, provided each contractual partner agrees to the transfer. This normally results in a transfer of the business pursuant to section 613a BGB (German Civil Code). All existing employment relationships are transferred to the acquirer by operation of law if the employee concerned does not object. The seller in crisis is therefore left with the purchase price, any assets not sold, and any contracts not taken over. The seller also keeps those employment relationships whose transfer is objected to by the individual employee. Finally, all of the seller's liabilities will remain with the seller. If these cannot be settled in full from the purchase price, the seller may have to file for insolvency due to insolvency and/or over-indebtedness.
If insolvency proceedings are opened against the assets of the seller before the purchase agreement has been consummated, the insolvency administrator may choose not to perform the purchase agreement in accordance with section 103 (2) InsO. In this case, any repayment claims or claims for damages of the acquirer are mere insolvency claims on which the quota is paid.

If the purchase agreement has already been executed when insolvency proceedings are opened over the assets of the seller, the acquirer runs the risk of the company purchase agreement being contested due to insolvency or of the assets being transferred by the insolvency administrator of the seller. The closer the seller was to being declared insolvent at the time of the sale to the acquirer, the greater the risk of contestation for the acquirer. The particular grounds for contesta-tion reach back to a period of up to three months prior to the filing for insolvency (sections 130, 131 InsO). However, this period may be extended – especially with regard to the acquirer's knowledge of the crisis and the motives of the seller – up to four, and even up to ten years in the most extreme cases (section 133 InsO).

The consequence of the contestation is that the acquirer must return the acquired assets and the transferred contracts to the insolvency estate. In return, the acquirer has a claim against the insolvency estate for repayment of the purchase price. This claim, however, is only a simple insolvency claim (section 38 InsO). This claim will be satisfied with the insolvency quota in the final distribution in the insolvency proceedings. Even if, in a specific case, an insolvency administrator may not be interested in actually bringing the company back to the insolvency estate by way of an insolvency contestation, the actual risk of contestation is enough to jeopardise the continuation of the target company.

Regardless of the risk of contestation, there are undesirable liability implications for the acquirer. According to section 25 (1) HGB (German Commercial Code), the acquirer is responsible for all liabilities of the former owner arising from the operation of the business if he takes over the company name, i.e., the business name of the seller. Such liability may be excluded, though. This requires a registration of the fact in the commercial register.
The acquirer's responsibility for tax liabilities of the seller under section 75 (1) AO (German Tax Code), however, cannot be excluded. The acquirer is responsible for taxes for which the obligation to pay is based on the operation of the business and for tax deductions, provided that the taxes have accrued since the beginning of the last calendar year preceding the transfer and are assessed or declared within one year of the date of registration of the business by the acquirer.

It is possible for the contracting parties to agree on an indemnity against such responsibility. If the seller becomes insolvent after the closing, however, the indemnity claim is usually worthless.

Finally, the target company may have contractual relationships that are necessary for its operations, and which can only be transferred with the consent of the relevant contractual partner. This may, for example, be a rental agreement for a production facility or an important patent. In such case, completion of the deal will be made conditional on the contractual partner consenting to the transfer of the contract. If the consent process takes too long, the company's economic situation may deteriorate to such a point that a petition for insolvency will have to be filed and the deal will ultimately fail. For the acquirer, this may result in the need to provide financial support to the target company in order to avoid a petition for insolvency before the closing. In this case, the acquirer bears the risk that the deal will nevertheless fail for lack of the third party's consent.

The acquirer can therefore achieve the required certainty of the transaction only to a limited extent, and in some cases even not at all.

4. Acquisition after the opening of insolvency proceedings

The risks associated with an acquisition of the company in crisis before the opening of insolvency proceedings can largely be avoided if the acquisition takes place only after the opening of insolvency proceedings. In normal proceedings, the seller is the insolvency administrator or – if the insolvency proceedings are in self-administration – the debtor company itself or its shareholders (see 3.2. below). When regular insolvency proceedings are opened, the debtor's management and transfer rights are transferred to the insolvency administrator (section 80 InsO).
There is no risk of contestation for the acquirer, in particular after the opening of insolvency proceedings. This is because the provisions on contestation are only applicable to legal acts that were performed before the opening of the insolvency proceedings. The insolvency administrator cannot later contest his sales transaction with the acquirer. The same applies if the sale is carried out using an insolvency plan, especially in self-administration proceedings. An acquirer seeking the greatest possible legal certainty will not purchase the company before the opening of the insolvency proceedings but instead purchase it after the opening of the proceedings.

3.2 Tactical considerations regarding the acquisition structure

After the opening of insolvency proceedings, the transfer can take place in various ways. Which acquisition structure is chosen in a specific case depends, on the one hand, on the type of proceedings chosen by the debtor and, on the other hand, on the acquisition structure preferred by the acquirer. Basically, asset deal or share deal are again possible. Often – particularly with larger insolvency proceedings – a structured bidding process is carried out, which is already prepared and, where appropriate, started during the opening proceedings. The deal structure is usually not yet defined in the initial stage of the bidding process. This is because the first priority at this point is the economic viability of an acquisition concept. Once a narrower circle of acquirers has been identified, the focus shifts to the actual structuring of the transaction.

1. Reorganisation by transfer

The typical way of buying a company from insolvency is what is known as reorganisation by transfer (übertragende Sanierung), which is done through an asset deal. The assets are bought from the insolvency administrator. There are, however, some particularities that distinguish such reorganisation by transfer from an ordinary asset deal where there are no insolvency proceedings.

• Schedule
  The acquisition of an insolvent company often takes place under considerable time pressure. The opening of insolvency proceedings means that there are natural dissolution tendencies. Employees, customers, suppliers, and other contractual partners are worried and expect quick and reliable signals with regard to the future of the company. Therefore, there are usually only a few weeks left for the review and negotiation process before the signing. The time pressure is intensified by the often tight liquidity situation of the target company.
• Due diligence
  Despite the tight schedule, a due diligence exercise should be conducted. Such review may leave out company-law aspects because the transaction is an asset deal. What is necessary, however, is an examination of contractual relationships and employment-law issues. With regard to contractual relationships, it is important to examine whether the conditions are reasonable enough for the contract in question to be taken over. The assumption or the new conclusion of contracts required for the operations should be made the subject of closing conditions. It should also be examined whether the transaction requires a merger control and/or foreign trade law approval. The tax audit, however, is not the primary focus (more on this below). Based on our experience, a due diligence process is shorter and more superficial than for common transactions due to the considerable time pressure under which the parties are. The information on the insolvent target company often has a lower quality or the personnel resources do not allow to provide this information in the desired quality. Overall, a less clear picture of the target company thus often emerges.
• Guarantees
  Acquisition risks are warded off by guarantees and indemnities in common transactions. This is usually excluded in case of a reorganisation by transfer. Insolvency administrators are only very rarely willing to provide guarantees or indemnities. The personal liability of the insolvency administrator (sections 60 or 61 InsO) is also usually excluded - except for intent. Risks may only be considered to reduce the purchase price.
• Takeover of contracts
  Contracts, which the acquirer takes over, are limited to the economic closing date of the transfer. Receivables and payables from the time before the economic closing date of transfer remain with the insolvency estate. As of the economic closing date, the acquirer shall be responsible and shall fulfil the contract with third parties from that date. The transfer of contracts to the acquirer requires the consent of the respective contractual partner. Therefore, it should be clarified - in coordination with the insolvency administrator - with the most important contractual partners already prior to the signing whether the contract with the acquirer can be continued.
• Responsibility for old liabilities
  The responsibility of the acquirer for liabilities shall be excluded until the economic closing date of transfer. The insolvency administrator shall pay the insolvency quota on old liabilities from the time up to the opening of insolvency proceedings if the contractual partner is not specially secured and, therefore, may assert rights to separation from the estate or rights to separate satisfaction. Liabilities which the insolvency administrator assumes as of the opening of proceedings, are liabilities of the insolvency estate and have to be fulfilled by the insolvency administrator in the full amount. The acquirer, however, has nothing to do with this, since the delimitation takes place - as already stated - at the time when the target company is transferred to the acquirer with economic effect.

Even if the acquirer takes over the debtor's company name, a responsibility pursuant to section 25 HGB for the liabilities arising from the operation of the debtor's business is not an option ³.

• Taxes
  In case of a usual asset deal, the acquirer shall be liable for operating taxes of the target company pursuant to section 75 (1) AO (cf. above, 3.1(3)). Section 75 (2) AO explicitly excludes this liability for acquisitions from insolvency.
• Transfer of business
  The transfer of the holding to the acquirer by way of the reorganisation by transfer out of insolvency leads to a transfer of business as in case of the usual asset deal if the preconditions of section 613a BGB are met. However, the legal consequences are limited. In fact, the employment relationships will be transferred to the acquirer. Claims and entitlements to benefits arising from the company pension scheme, however, shall remain, irrespective of whether non-vesting or not, with the insolvency estate ⁴, to the extent that they relate to the period up to the opening of insolvency proceedings. Wages in arrears up to the opening of insolvency proceedings neither have to be paid by the acquirer. Insofar as wages are unpaid as of the opening of proceedings, the acquirer, however, shall be liable for this.

If the cause of the insolvency (also) lies in excessively high personnel costs, the acquirer will be interested in a reduction of personnel. Terminations for operational reasons, however, are inadmissible pursuant to section 613a (4) sentence 1 BGB if they are announced due to the transfer of business. A termination invalid pursuant to section 613a (4) sentence 1 BGB by the previous employer due to transfer of business, however, is not given if the workplace no longer exists due to a restructuring plan of the acquirer of the business and the implementation of the binding concept or restructuring plan of the acquirer has already taken on a concrete form at the time of the receipt of the notice of termination ⁵ (so-called acquirer's concept).
The right of termination is also modified by section 125 (1) sentence 1 No. 1 InsO: If an operational change (section 111 BetrVG (German Works Constitution Act)) is planned and if the insolvency administrator and the works council reach an agreement on a reconciliation of interests, in which the employees who should receive notice of termination are listed by name, it is assumed that the termination of the employment relationships of the listed employees is due to urgent operational requirements which impede a continued employment in this company or a continued employment under unchanged working conditions. Furthermore, pursuant to section 125 (1) sentence 1 No. 2 InsO, the social selection of the employees can be verified only with regard to the length of service with the company, the age, and the maintenance obligations and insofar only for gross incorrect-ness; it shall not be regarded as grossly incorrect if a balanced personnel structure is maintained or created.

2. Acquisition by an insolvency plan

In some cases, the acquisition from insolvency by means of a reorganisation by transfer is not possible or subject to excessive risks. This is, in particular, the case if certain legal relationships are dependent on the insolvent legal entity and a transfer to the acquirer is excluded or problematic. This might for instance be the case for certain permissions under public law of the insolvency debtor. One also thinks of the acquisition of a retail company with numerous lease agreements. Where there are no insolvency proceedings, the acquisition would take place by means of share deals so that it would not result in a change of legal entity. If the preservation of the legal entity and the legal relationships dependent on it is required, the execution of an insolvency plan procedure comes into consideration under insolvency law. The insolvency plan can either be submitted - in normal proceedings - by the insolvency administrator or by the debtor company within the framework of self-administration proceedings. In self-administration proceedings, the debtor itself conducts the proceedings. A trustee as a supervisor is deployed alongside the debtor who will supervise the correctness of the insolvency administration by the debtor.

The core of an insolvency plan is the debtor's restructuring concept. The concept usually comprises the operational restructuring of the company as well as its debt reduction by comprehensive debt waivers of the insolvency creditors. If the insolvency plan is approved by the responsible creditors' meeting and confirmed by the insolvency court, the regulations, in particular the debt waivers of the creditors, enter into force. The insolvency proceedings are terminated and the (former) insolvency debtor continues its business operations. Insofar as the creditors have not waived their claims, they will receive corresponding dividends from the insolvency estate.

In addition to the debt reduction, a change of shareholders can also easily take place by virtue of the regulations in the insolvency plan. This is because any regulation can be made in the plan which is permissible under corporate law, in particular, the transfer of shareholder or membership rights, section 225a (3) InsO. The plan may also provide for a capital decrease or increase, the performance of contributions in kind, the exclusion of subscription rights or the payment of severance payments to leaving shareholders, section 225a (2) sentence 3 InsO. The Insolvency Statute, thus, permits that, by means of the plan, the shares in the debtor are transferred to a third party or a new shareholder is admitted. It is significant that not the shareholders, but the creditors are responsible for the transfer of shares or the admission of new shareholders. If a change of shareholders should be executed, not the transfer of shares (real share deal) is usually preferred, but the capital decrease concept in case of corporations. In case of the capital decrease, the debtor's share capital will first be reduced to zero. The existing shareholders hereby withdraw from the company. In the following step, the capital will be increased to the amount requested by the acquirer. The acquirer as the sole beneficiary will be permitted to subscribe to the new shares. The subscription rights of the existing shareholders will be excluded. The new shares are unencumbered and any risks arising from the former shares do not exist for the acquirer. Usually, the capital increase and the payment of the corresponding contribution are accompanied by a further payment of the acquirer to the insolvency estate. The payment serves to be able to present an appropriate "purchase price" and an appropriate insolvency quota for the creditors, since they may not be placed in a worse position by the insolvency plan than in normal proceedings (cf. section 245 (1) No. 1 InsO).

4. Summary

It can be assumed that the number of insolvency proceedings will continue to increase in the current year. This could result in interesting opportunities for investors. A purchase in the crisis prior to the opening of insolvency proceedings is only rarely advisable. A purchase after the opening, however, provides legal certainty. The arrangement of the deal remains a tailored suit. In addition to the reorganisation by transfer, every investor should also review the acquisition by means of an insolvency plan.

Wilken Beckering

¹ Source: www.destatis.de
² Prerequisite for an obligation to file for insolvency is always that no natural person is a general partner.
³ BGH, judgment of 11 April 1988 - II ZR 313/87, NJW 1988, 1912
⁴ BAG, judgment of 29 October 1985 - 3 AZR 485/83, ZIP 1986, 100
⁵ BAG, judgment of 20 March 2003 - 8 AZR 97/02, NZA 2003, 1027