- Certain M&A transactions in distressed situations—in particular, Section 363 asset sales—may provide opportunities for risk allocation to a transactional liability insurer through a tailored representations and warranties insurance (“RWI”) policy.
- The Section 363 process will likely eliminate numerous post-closing risks that would ordinarily be covered by RWI; however, RWI may provide useful protection for a buyer's post-closing risk that is not extinguished through a Section 363 process.
- Certain Section 363 processes—and certain debtors/sellers—may be more or less suited for placing RWI than others; for example, severely distressed sellers conducting hastily arranged sale processes may not be a good fit for RWI.
- Despite these challenges, RWI tailored to these specific situations may present opportunities for buyers and sellers in Section 363 processes to increase value and reduce risk.
To date, the explosion of representations and warranties insurance in the US—to the point that it is now standard operating procedure in most US private M&A deals—has largely occurred during a robust M&A cycle. With the dramatic slowdown in the US M&A market in light of the COVID-19 pandemic and related global financial crisis, the industry that places RWI and other forms of transactional liability insurance is exploring new avenues for the product. One such avenue is the possibility of insuring the types of distressed transactions that are likely to become more prevalent in the coming months as a consequence of the pandemic, including transactions done under Section 363 of the US Bankruptcy Code.
Section 363 transactions (named for the relevant part of Chapter 11 of the Bankruptcy Code) are sales of assets outside the debtor’s (i.e., the seller’s) ordinary course of business that are conducted as part of an in-court bankruptcy proceeding. Because Section 363 transactions are done within the confines of federal bankruptcy laws, these transactions have many unique features from both a substantive standpoint and a procedural standpoint. Understanding how Section 363 transactions differ from normal M&A transactions with respect to these substantive and procedural issues is the key to understanding the opportunities—and challenges—in procuring RWI in connection with Section 363 transactions.
Substantive Risks May Be Minimized in a Section 363 Transaction, but Certain Risks May Survive and Be Candidates for RWI
Generally speaking, there are several reasons that a Section 363 transaction will typically present much more limited post-closing risk for a buyer. First, from a structuring standpoint, most Section 363 transactions are done as asset deals. While asset deals outside of bankruptcy are frequently insured using RWI, distressed asset sales done in the context of bankruptcy may reflect the sale of a collection of assets rather than a going concern. If this is the case, certain risks typically covered by RWI may simply not be present in the transaction. For example, if the buyer is not acquiring a going concern, then the historical financial statements related to the assets being sold may be less relevant. These financial statements are often a key area of focus for buyers of RWI protection; financial statements representations are also some of the most common sources of claims under RWI policies. Similarly, if the transaction does not involve the transfer of employees, standard labor and benefits risks will not be present.
Second, as noted above, Section 363 transactions offer special legal protections that may mitigate or eliminate certain risks that are typically covered by RWI. As a starting point, Section 363 deals generally allow the buyer to take the assets “free and clear” of most liabilities. This means that the deal structure itself may provide significant “cleansing” that may reduce the buyer’s perceived need for insurance. In addition, the Bankruptcy Code also provides for special rules in a Section 363 transaction with respect to executory contracts and leases, which are typically key areas of focus for both RWI insurers and insureds alike. These rules reduce or eliminate many of the risks typically associated with assuming these contracts in transactions. For example, in Section 363 transactions, executory contracts and leases can be assumed or rejected; however, if the contracts and leases are assumed, then the debtor/seller is required to cure all monetary defaults. This eliminates a key risk for the buyer in a transfer of contracts and leases. Furthermore, in most instances, the Section 363 process allows the transfer of executory contracts and leases without the need to obtain the consent of the counterparty regardless of the terms of the underlying agreement, thereby eliminating another risk related to contracts that is present in a typical M&A transaction.
A third type of traditional M&A risk that might be mitigated or reduced in the context of a Section 363 transaction is tax risk. As a starting point and as noted above, Section 363 transactions are typically structured as asset transactions, thereby eliminating many tax issues that would be present in a stock deal. That said, the Section 363 process goes even further in limiting tax risk to the buyer. In particular, most bankrupt sellers aim to give notice to taxing authorities of the sale of assets, and most buyers typically negotiate to have any pre-closing tax obligations remain the responsibility of the seller’s bankruptcy estate. Bankruptcy courts regularly hold that because section 363(f) of the Bankruptcy Code permits a debtor or trustee to sell property “free and clear” of “any interest,” the court has the ability to enter a “free and clear” sale order that extinguishes the rights of any taxing authority to recover these tax obligations from the purchaser or the underlying assets that are sold.
That being said, the Section 363 transaction process certainly does not eliminate all risks to the buyer with respect to the purchase. Certain types of liabilities may specifically be excluded by law or negotiation from the “free and clear” cleansing, and representations in a transaction agreement on these subjects could serve as the basis for a buyer to mitigate these remaining risks through RWI coverage. These key areas include:
- Products Liability: Following a Section 363 transaction, a buyer may still be liable for post-closing products liability damages related to persons that, at the time of closing, had not yet been injured and had no identifiable connection as potential creditors to the debtor or its products. In other words, a Section 363 transaction may not extinguish the unknown potential products liability risk related to persons who do not receive notice and have no opportunity to object.
- Compliance: Target businesses that operate in regulated industries (e.g., financial services, healthcare) may have deficient compliance or regulatory regimes that a buyer inherits as part of the transaction, even if the buyer does not technically take the target as a "going concern." More generally, all businesses are required to operate in compliance with applicable laws. On Day 1 after the closing, the buyer will be operating the newly acquired business on its watch and RWI coverage could address this risk if compliance deficiencies existed as of the closing and there are representations that address compliance in the transaction agreement.
- Environmental: Similar to risks related to regulatory or compliance issues, in a Section 363 transaction, a buyer may inherit future potential environmental liabilities that are unknown at the time of the transaction or that are beyond the power of the bankruptcy court to extinguish. In particular, some courts have held that environmental claims (particularly under a successor liability theory) that could not have been asserted before the sale might survive a “free and clear” order. If there are adequate representations in the transaction agreement, RWI may be available to shift some of this risk to an RWI insurer and away from the buyer.
- Intellectual Property: Especially if the purchased assets include patents or other key intellectual property, infringement risks may arise after closing that are significant to the business. These risks (and the related damages that may arise) are not extinguished in a Section 363 transaction; a buyer may seek coverage of this risk through non-infringement representations in the transaction agreement that are covered by RWI.
Procedural Requirements of a Section 363 Process Will Impact Parties' Ability to Use RWI
In addition to the substantive issues to be considered in determining whether to use RWI in a Section 363 transactions, there are also unique procedural issues that need to be considered. First and foremost, the Section 363 transaction process mandates an auction for the assets in an effort to maximize the value received by the debtor for the assets. However, unlike a typical sell-side M&A auction process, in the case of Section 363 transactions, a “stalking horse” bidder signs a purchase agreement with the debtor/seller first, and then the auction plays out (in a typical sell-side M&A auction process, the auction culminates with the winning bidder executing the purchase agreement). In certain instances, the Section 363 auction concludes with a live auction among multiple bidders in open court in order to determine if a bidder will “top” the stalking horse bidder and win the assets (in which case the stalking horse bidders gets a break-up fee and its expenses reimbursed for its efforts).
As a result, any Section 363 auction process would need to be navigated from the perspective of providing RWI on the transaction. For example, an RWI underwriter could certainly agree to underwrite insurance for the stalking horse bidder, or even one of the competing bidders, knowing there was a chance that the party would not ultimately win the deal. (In this scenario, we could foresee the insurer and insured agreeing to some sort of fee that is payable to the insurer, similar to what is done in connection with “pre-exclusivity underwriting.”) Moreover, as a general rule in Section 363 auctions, the competing bidders largely inherit the purchase agreement that was negotiated and signed by the stalking horse bidder, including the representations negotiated by the stalking horse bidder. While presumably these representations will cover the key areas that any bidder would be interested in, the competing bidders may have limited ability to modify the representations to address their own specific areas of concern.
Another potential approach to addressing these process issues would be for the debtor/seller to arrange for a so-called “seller flip.” This is a situation in which the seller works with a broker to lay the ground work for RWI coverage on the transaction, coverage which is then procured by the winning bidder once identified. The incentive for the seller to do this is to facilitate the transaction process and, ideally, increase the proceeds that are ultimately paid to the seller for the assets. Given that Section 363 transactions typically have no (or, if any, extremely limited) indemnification obligations or other potential post-closing recourse for the seller (not unlike a “no seller recourse” transaction in a normal M&A context), the theory for RWI in this scenario is that by providing the buyer with an avenue of potential recourse through the RWI, the buyer would be willing to pay more for the assets because it does not need to “self insure” as much for the assumed liabilities. There is typically at least some time between the end of the auction process and the closing of the transaction (even if the stalking horse bidder remains the winner) which, in a seller-flip scenario, would allow the RWI to be underwritten after the winning bidder is finally identified with certainty.
A third process issue for RWI coverage in a Section 363 transaction is how “normal” the deal process is. This largely turns on how distressed the debtor/seller is. Some Section 363 sales are relatively orderly and in turn proceed generally along the lines of a normal M&A deal. This means that there will be a relatively standard buyer due diligence process (though, again, the buyer may not see the need to conduct certain typical due diligence, such as commissioning a quality of earnings report, given the circumstances of the transaction), a relatively standard negotiation process with respect to the representations and warranties (though, not surprisingly, in most Section 363 situations the seller resists making extensive representations unless it has limited leverage and has no choice), and a relatively standard seller disclosure process (though, again, this disclosure may be against limited reps). When a Section 363 transaction proceeds along a relatively “normal” process, the RWI underwriting process should be able to be conducted in a relatively “normal” manner as well.
However, some Section 363 transactions are decidedly less “normal.” If the seller is in considerable distress, it may not be in a position to support a typical due diligence process or provide typical disclosures. Similarly, the process for negotiating the representations and warranties (which would be the representations and warranties that would be subject to the RWI) may be less disciplined than normal given the chaotic nature of the transaction. Section 363 transactions that are done under these circumstances may pose challenges to an RWI insurer since they may not be able to support a typical RWI underwriting process. That said, a buyer may also be less inclined to purchase RWI under these circumstances since the purchase price being paid by the buyer will likely reflect the distressed nature of the transaction, thereby allowing the buyer to “self insure.”
Wrapping Up: Challenges and Opportunities
It is important for both insurers considering issuing RWI in connection with a Section 363 transaction and insureds considering purchasing RWI in connection with a Section 363 transaction to understand the unique substantive and procedural aspects of these transactions in order to be able to properly analyze both the challenges and opportunities. In terms of challenges, the protections afforded the buyer by law under the Section 363 process may mitigate or eliminate certain post-closing risks to the buyer, thereby perhaps influencing the buyer’s decision to procure RWI. Moreover, the mandated auction process in a Section 363 transaction disrupts the normal timing and rhythm of RWI underwriting since the winning bidder will not be identified with certainty until late in the process and may be different from the initial stalking horse bidder. Though certainly not insurmountable, a plan will need to be made by both the insurer and the insured (perhaps with the assistance of the seller) for dealing with this unique timing and rhythm. Lastly, depending on how distressed the seller is, the seller may not be able to support the traditional due diligence, representation negotiation and disclosure processes that are needed to support RWI underwriting.
That said, under the right circumstances, RWI may be a very attractive option for a Section 363 buyer and therefor provide a compelling opportunity for an RWI underwriter. In order for this to be the case, the transaction and related risks would need to involve at least two key characteristics:
- The risks to be insured would have to be the specific types of post-closing risks for the buyer that survive the Section 363 process; and
- The transaction would also need be relatively orderly—akin to a “normal” M&A transaction—so as to support a sufficient level of RWI underwriting and diligence.
Since any RWI in these circumstances would need to be a relatively bespoke solution, Section 363 transactions could provide opportunities for creative and nimble underwriters to craft coverage that fits the facts and circumstances of a particular deal and the needs of a particular insured.