Distressed M and A in the UK

Since the initial outbreak of coronavirus in 2020 and the resultant economic impact, the investor world has been poised for an abundance of distressed M&A opportunities. Thus far no such abundance has materialised. However, as we look ahead to the predicted 'winter of despair' it is difficult to see how governmental policy or alternative capital can continue to stem the tide. UK businesses across all industries continue to suffer the effects of supply chain and labour shortages, rising interest rates and rampant currency inflation. Consumer-facing businesses, including retail and hospitality, are still likely to be the most vulnerable, joined and are now by energy companies and other players in the energy sector impacted by the sector's volatility.

Such conditions of course present the need for solutions and mechanisms for realising the value in such businesses and assets, but investing in businesses operating in (or around) the zone of financial distress requires careful consideration, expert advice and guidance to avoid potential pitfalls.

This article:

• provides a reminder of why distressed M&A transactions should be treated differently to traditional M&A, and discusses the key considerations for both prospective sellers and purchasers; and
• explores recent law reform, and its impact, worth bearing in mind when contemplating distressed M&A opportunities in the current economic climate.

When a target business in stress or distress is the subject of an acquisition, there is a financial and regulatory backdrop which cannot be ignored and which will influence the valuation assessment and parties' priorities. The solvency status of the relevant entities involved, and the cashflow runway for the business, must be understood and closely monitored by all interested parties because this could dictate: who the economic owner is and therefore who a purchaser needs to negotiate with, the format the transaction can take (whether a formal insolvency process is required to effect a sale), the specific structuring of the transaction (share vs asset sale), the urgency of a completion and the potential (or lack thereof) for purchaser contractual value protections. Of course the situation is likely to evolve as the parties negotiate and, as such, remaining flexible is key.

We unpack these considerations further below.

Seller Considerations

1. Are the directors OK?

The directors of a company operating in the zone of insolvency will need to remain cognisant of the potential for the subjects of their Companies Act 2006 directors' duties to flip from being the members of the company to its creditors. This will happen gradually from the moment that the company is on the verge of insolvency or where insolvency (administration or liquidation) is 'probable', until those creditors' interests become paramount when an insolvent administration or liquidation is inevitable. Once the interests of the creditors are paramount, a director – regardless of whether they have been appointed by an existing shareholder – has a statutory and fiduciary duty to ensure those interests are protected and therefore to guide the board's decision-making in the context of any M&A process.

The directors must ensure their actions do not fall foul of the wrongful trading rules (for example, by trading when they knew, or ought to have concluded, that there was no reasonable prospect the company would avoid an insolvency process), nor constitute fraudulent trading (for example, where directors knowingly allow the business to be carried on with the intent to defraud creditors, or for any other fraudulent purpose). Wrongful or fraudulent trading carries personal and potentially criminal liability for the directors and, accordingly, must be avoided.

It may be prudent to consider at the outset of a proposed M&A process involving a company in the zone of insolvency whether the directors should receive their own separate advice, or whether the board should be supplemented (or advised) by someone with insolvency and/or restructuring experience. An easy, but important, defence tool for directors in such processes is the accurate and fulsome record keeping of board decisions, reflecting due consideration by directors of the discharge of their duties and the solvency status of the company.

It is worth keeping in mind (and remaining open to) whether the risk of insolvency dictates using an insolvency process to effect the disposal, for example an administration sale or a Company Voluntary Liquidation, where the buyer transacts with an appointed officeholder and not the directors. However, as mentioned below, this could have value implications.

2. Director conflicts?

Where the business involves multiple operating entities, focus should be on the discharge of directors' duties, and compliance by directors with the legal framework needs to be carried out at each entity within the structure – not solely focused solely on the 'topco' or 'holdco'. Accordingly, another key consideration for directors of multiple target companies within a group is the possibility for conflicts arising from wearing multiple governance hats. Each corporate entity and each board of directors must separately make determinations as to the solvency status and discharge of duties to the appropriate stakeholders (who may not be the same across the group, especially where layered or restricted security structures are in place). It may be appropriate for board sub-committees to be formed to the exclusion of directors with such active conflicts, in order to remove any concerns about tainting the M&A process.

3. Valuation questions

Maximising value will be the key focus of the seller and its financial advisers. In this regard the usual rules apply: maintaining leverage through competitive tension is critical and a seller should ensure as much preparedness as possible, with a spotlight on risk and cost mitigation. It is likely that the speed of the transaction will result in little or no due diligence time for prospective buyers and, as such, the extent to which the seller team can provide ready information and solutions to liability exposure will make all the difference. To this end, questions of management (key personnel) transaction incentivisation should be considered and resolved early on to ensure the necessary effort and resources are applied to the process. This is of particular importance in approaching distressed M&A, as the role of management going forward and their ordinary course incentivisation may not be as certain as with traditional M&A processes.

The directors of a seller entity also need to approach questions of valuation with an eye on solvency. If the disposal realises less value than the liabilities of the seller, questions of the seller's solvency and any post-completion obligations of the seller need to be carefully considered. Further, if the realised proceeds net of the costs of running the M&A process are forecasted to be lower than the likely proceeds from an insolvency process, directors may be required to pursue such means instead. 

4. Increased importance of speed and certainty

In a distressed process, speed and certainty for the seller are usually high on its list of priorities, driven by the cashflow runway and upcoming liability/cost milestones. While frustrating, the urgency of reaching a deal that avoids a value-destructive insolvency can (and often should) take precedence over other factors such as a higher bid price. Accordingly, a prospective buyer that can deliver a transaction in short order is likely to be preferred to a conditional, but higher value, bid if the bid cannot be delivered in time to avoid the sale being subsumed by an insolvency process. It would be prudent to discuss with the M&A financial adviser the benefit (in the context of the relevant transaction) of apprising prospective buyers of important cashflow milestones.

Purchaser Considerations

1. Expect an accelerated process

The biggest consideration for a purchaser will likely be the seller's accelerated timeframe for a completion, and the consequences of this on the purchaser's ability to meet its internal decision-making requirements. As a result, the due diligence portion of the transaction is often truncated. Purchasers should therefore focus their due diligence on the key areas of the business: a purchaser will be well advised to have a clear understanding of its own 'bottom lines' in terms of the diligence it must carry out before a transaction is realistic, ie is it financial only; are any legal issues critical; does that answer depend on the industry/ sector; what about issues such as anti-bribery and corruption and ESG matters?

A purchaser should expect that a seller will be unlikely to have vendor diligence reports and that a seller may not be able to facilitate a full-scale buyer diligence process (or may not have compiled a virtual data room). On the plus side, a well advised seller will anticipate that a purchaser will need to 'price in' the level of risk it takes in accelerating these traditional phases of M&A processes.

Certainty of financing will be paramount for the seller. Further, a purchaser should expect the seller to resist conditionality and deferred consideration mechanisms. Should regulatory or third party processes require a conditional process and split signing and completion, the purchaser should prepare a solution for funding (or bridging the funding) of the business during that period.

2. What is the best transaction structure?

Where the target business has atypical liabilities that are immediately identifiable as undesirable, it is worth considering transaction structures other than a share sale to maximise the value for the seller (by removing the need for a price deduction to accommodate the acceptance of such risk). Sellers will likely be more amenable to business or asset sales in a distressed context, as their planning has likely involved consideration of solvent or insolvent winding-up of one or more group entities post completion in any event. However, this will need to be balanced against the risks to the seller's directors if the seller's remaining business cannot support itself and enters an insolvency process and, from the purchaser's perspective, potential loss of any tax relief that may otherwise be available should the target corporate have available tax losses and/or should the group structure provide tax benefits. It is critical to engage a tax and accounting adviser early on in the process.

Consideration should also be given from the purchaser's perspective as to whether an insolvency process, and therefore contracting with an officeholder, may provide a more beneficial route to a purchase. Should the contracting entity go into an insolvency process after it has sold assets to the purchaser, there is a risk that the transaction itself may later be examined by the appointed officeholder for the purposes of claw-back, for example if the officeholder has cause to consider the transaction was made at an undervalue. Should the purchaser contract directly with the officeholder, for example as part of a pre-pack transaction, this risk is significantly reduced.

3. What contractual valuation protection will be possible?

Depending on the state of the seller and its group (or related entities) after completion of a sale, there may be no ability (or appetite) for the seller to offer the purchaser warranty and/or indemnity protections in the sale agreement. The W&I insurance market is still worth exploring even in a distressed situation, and since the coronavirus outbreak synthetic policies have become more readily available. However, W&I insurance will add to the complexity (and potential length) of the process, as insurers will likely need to be able to review a legal diligence report and/or include key exclusions to coverage.

Further, if the sale is made directly with an officeholder, for example as part of a prepackaged transaction, it is very common not to offer a purchaser any warranties or indemnities at all.

What's new – reform worth bearing in mind

1. Impact of sanctions

It is worth both sellers and purchasers being cognisant of the potential impact of economic sanctions against Russia on transaction processes. It is important to preempt questions of transaction structuring particularly where the opportunity presents itself as a result of a sanctioned entity, individual or counterparty featuring in the corporate or commercial structure of the business.

Such considerations are always fact-specific, but, in our experience, it is more likely (for example) that a purchaser will be protected from the risk of transacting with a sanctioned person if the transaction is effected through an insolvency process (such as a pre-pack administration) and therefore executed by an officeholder. Early assessment of such considerations can assist in ensuring the transaction is as efficient as possible and should also feed into the purchaser's valuation and risk analysis.

2. Pension Schemes Act 2021 (and guidance)

In October 2021, the controversial Pension Schemes Act 2021 introduced new criminal offences for certain actions which affect defined benefit schemes. Where a target business operates a defined benefit scheme, these offences should trigger a red flag and both sellers and purchasers should seek specific advice. The offences are:

(a) doing an act or engaging in a course of conduct without reasonable excuse that detrimentally affects in a material way the likelihood of accrued pension benefits being received, where the person knew or ought to have known that the act or course of conduct would have that effect; and

(b) avoiding or compromising a debt under section 75 of the Pensions Act 1995 (which an employer owes to the trustees of an underfunded defined benefit scheme in specified circumstances), without reasonable excuse.

Broadly, if a transaction leaves the pension scheme in an unfavourable position compared with other stakeholders, or if the scheme would have fared better if certain corporate actions had not been taken, an offence may have been committed. Importantly, any person involved with the activity in question (other than an insolvency practitioner acting in that capacity) can potentially commit such an offence. This includes sellers, purchasers and lenders, and any individuals involved with the transaction. The Pensions Regulator has produced guidance that suggests that both sellers and purchasers should consider the position of the pension scheme at an early stage, that they should carefully document all decisions in relation to the scheme, and that they should engage with the scheme trustees as soon as possible to ensure that any detriment to the scheme is appropriately mitigated. The Pensions Regulator is likely to monitor any transaction which involves a sizeable defined benefit scheme whose sponsor is in distress. Accordingly, the presence of a defined benefit scheme in the transaction scope of the transaction should be placed high on the agenda in early transaction structuring discussions.

The Government plans to strengthen the regulatory regime even further later this year by requiring sellers and purchasers to engage with trustees and the Pensions Regulator at an early stage in transactions which involve a defined benefit pension scheme.

3. Building Safety Act 2022

More recently (and perhaps even more controversially) law reform impacting the house-building sector has come into force, and it is also worth paying careful attention to whether the reform is relevant to the proposed distressed opportunity. The key provisions in the Building Safety Act came into force in June and July of this year. These provisions make retrospective changes to the law that both expand existing liability and create new liabilities for developers and other parties involved in the construction of residential buildings (including product manufacturers and suppliers) in relation to historical building safety defects. The Act creates scope for developers to be ordered to contribute to the costs of remedying building safety defects, even where the developer is no longer the owner of the development, and also extends the limitation period for a developer (or other relevant party) to be pursued under the Defective Premises Act 1972 from six to thirty years.

Arguably most remarkable is the extension of liability to "associated persons" of a liable party. That is, a party that controls a liable party (Party L) through either:

(a) ownership of at least half of the shares in the capital of Party L;

(b) possessing the right to acquire at least half of the voting rights exercisable in general meetings of Party L;

(c) being economically entitled to at least half of the assets of Party L on a winding up or distribution of 100% of the income of Party L; or

(d) possessing the power (either directly or indirectly) to ensure that the affairs of Party L are conducted in accordance with its wishes.

This extension of the liability framework is a material lever for prospective claimants and enables a claimant to pursue the party with the deepest pockets. It is clear that the intent behind this feature of the legislation is anti-avoidance; it is designed to pierce the corporate veil if necessary to find a home for the liabilities.

This creates a novel problem for structuring distressed M&A transactions involving businesses impacted by these liabilities, one which is only made more difficult by the fact that the legislation is brand new and remains untested. We recommend that you seek specialist advice in respect of opportunities developing in this sector.

Authors: Molly Woods, Partner; Richard Bulmore, Partner; Liam Stoneley, Associate