Why write an article focused on transactions involving bankruptcy? Because buying assets out of bankruptcy is different. In more than twenty years as an environmental lawyer, I have worked on a significant number of transactions. In recent years, for obvious reasons, I have found myself working on more bankruptcy deals. While being the environmental attorney on a deal team is always a challenge—dealing with last minute requests to review Phase I site assessments or environmental indemnities or to obtain environmental liability insurance—bankruptcy deals are by nature more complex. In this article, I discuss the reasons these transactions are more challenging and offer strategies I have found to make the whole thing just a little bit easier.
In a Chapter 7 bankruptcy, the company is liquidated, and all the assets are sold. Under Chapter 11, the company is reorganized, but as part of reorganization some assets still may be sold. I have focused on the sale of real estate in this article, because of the potential for liability associated with ownership of real estate. I also include thoughts on other hard assets, such as equipment, inventory, or scrap that may have environmental implications and warrant specific due diligence and risk assessment.
In bankruptcy, the company—the debtor—is represented by the bankruptcy trustee, appointed by the US Trustee, who has the obligation to represent the debtor’s estate and make recommendations to the bankruptcy judge on managing the estate and, under Chapter 7, liquidating the assets. The creditors’ committee represents the company’s creditors and advocates for how it thinks the assets should be sold in order to maximize the returns to the creditors. Ultimately, however, it is the trustee’s recommendation that is presented to the bankruptcy judge for approval, and the buyer is negotiating with the trustee.
Transactions involving the purchase of assets through bankruptcy are different from other transactions in a number of ways. First, there is usually a compressed time schedule, and it is dictated by the court, which also is responding to the creditors. The deadline for bids is often very short, and the client has very little time to put together a proposal, unless the client is the stalking horse, as discussed below. Second, because the seller is the bankruptcy trustee rather than the company that owns the property, it may have only limited information available to provide to bidders in the deal room. The bidder will need to review this limited information and respond to it and the stalking horse agreement, all within that short time period. Sales of “distressed” assets (and here, I am using the term “distressed” broadly to mean any assets that are financially or physically challenged, not just those that are subject to foreclosure) that are not in bankruptcy but are being sold pursuant to a bidding process often are similarly time challenged.
Lastly, the opportunity to negotiate “traditional” or “market” deal terms, such as representations, warranties, or the allocation of responsibility for environmental liabilities is limited, both for practical reasons and as a result of bankruptcy law itself. The company that owned the assets simply may be gone, if the bankruptcy is a liquidation, or potential claims against a seller may be discharged by the bankruptcy, if it is a reorganization. In short, bankruptcy deals can be more difficult to manage. But because they are often very lucrative, clients will keep doing them. So, how can we best serve our clients in this space and minimize the risks associated with buying assets out of bankruptcy?
Preparation is the key to any transaction involving assets of a company in bankruptcy. So, how to prepare? First, before there is a deal in sight, I make sure I understand the client’s risk tolerance. Every client is different, with different risks it is willing to assume. In addition, its approach may change over time; a past deal gone bad can make the client more leery of a given issue but still willing to take other risks.
Questions that I might ask include: How comfortable is the client with potential environmental exposure? Is this a company in the business of buying environmentally challenged assets, such as a brownfield developer? Is this a client who has been in the real estate business long enough to be comfortable with, but does not typically seek out, brownfields? Or is this a client that avoids environmental risk altogether, which from our perspective is good to know, but makes for a very dull deal? Other questions I want answered: How comfortable is the client with uncertainty? How does it manage risk? Is insurance an option? When does the client get the environmental attorney or advisor involved in the discussions? Knowing the answers to these questions helps present the client with an appropriate risk analysis of a deal, once one is on the horizon.
I also like to have a consultant already retained by the client and ready to go. By “retained,” I mean that the client and the consulting firm have already entered into a master-services or similar agreement, or I have already negotiated up front the terms and conditions of the contract between the consultant and the client. Once the master services agreement or prenegotiated terms are in place, the client can contact the consultant directly for a given project, without negotiating the agreement (between client and consultant) each time, and the consultant can simply provide project-specific costs and timing.
While I am generally a fan of smaller consulting firms with good local knowledge, for a client that may be acquiring assets anywhere in the county or large portfolios I typically will recommend a national firm or at least a firm with a broad range of contacts and capabilities. I want to make sure the firm is capable of going pretty much anywhere and getting a Phase I done, perhaps on a significant number of properties and in a very short time. If this client is buying real estate, does it also need or want a property condition assessment (PCA) for the property? Can the same firm do both, perhaps saving time and money? It also is important that the firm is on the client’s preferred lender’s “list” or at least that the lender is comfortable with the consulting firm. This often is easier if the consulting firm is a national firm.
In addition to the master services agreement, I also like to discuss with the consultant up front any client-specific preferences for the format of the Phase I reports. For example, I want the consultant to know before the reports are written if I want recommendations or specific reliance language for the lender or equity investors; this saves the client time and money otherwise spent on me redrafting reports. And I always get drafts of reports.
Ideally, I have entered into these arrangements with at least two consulting firms. If there is time, this allows the client to obtain multiple quotes for projects, to get the best price. It also means that it is much more likely that one of the firms will have someone available at short notice or have the right person in the right place.
The reason for having a consultant “ready to go” is that there is rarely the time or opportunity to perform a Phase II site assessment before bidding or being selected as the winning bidder, but there is always time for a Phase I site assessment. If the Phase I site assessment can be completed before the bids are due, all the better. If not, I still want the time to perform the Phase I before closing. Lenders and insurers likely will require it, and if the client wants to take advantage of the bona fide prospective purchaser defense, a Phase I site assessment is an important first step, as discussed more below.
There are certain clients, certain lenders, and certain deals that require environmental insurance. If environmental insurance is a tool the client may want or need to rely on, I recommend having a relationship with an insurance broker you are comfortable with and can call to get coverage in a short time frame. The ideal broker specializes in environmental insurance, knows which insurers are currently offering what kinds of policies and which are tolerant of different situations, and can quickly negotiate favorable terms. This usually means it is not the client’s “regular” insurance broker. If the deal involves insurance and will also have a lender, I also recommend finding out as soon as possible if the lender will accept being named on the legal liability policy or whether it requires a lender-specific policy (or whether it will be obtaining its own).
Due Diligence and Negotiations in the Distressed Arena
As I briefly described above, buying assets in a bankruptcy auction is different from a “normal” deal. In a “normal” deal, the timeline may look like this:
- sign the letter of intent;
- review the deal room, which is fully loaded with the company’s documentation;
- negotiate the purchase and sale agreement, which provides for a due diligence period and has an environmental contingency that lets the client terminate if it does not like the environmental conditions, has substantive representations and warranties, disclosures, and indemnities and allocates environmental liability, perhaps on a preclosing as compared to postclosing basis;
- sign the purchase and sale agreement;
- perform due diligence;
- after the due diligence period has passed without the buyer exercising its termination rights, the deposit goes hard, meaning the buyer cannot get it back unless the seller breaches the agreement; and then close.
In a bankruptcy auction, the timeline looks more like this:
- find out about the assets up for sale;
- learn as much a possible about the assets as quickly as possible, reviewing the deal room and any other sources you can find;
- review the stalking horse agreement, if one exists;
- assemble a bid, which will include a description of the assets being bid on, the bid price, any proposed changes to the stalking horse agreement, and any contingencies (which might allow the bidder to “get out” of the deal, but which typically make the bid less attractive);
- if the bidder wins, it gets the deal, and the deal is hard (meaning the deposit no longer is refundable); and
- close in the near future.
Clearly, these are different ways to do a deal. Again, the most significant difference is time, but the ability to negotiate for an allocation of responsibility for environmental liabilities also is greatly diminished. In fact, the ability to negotiate anything is greatly diminished, unless the client is the stalking horse. I discuss below the role of, and the benefits of being, the stalking horse and then discuss the issues that come up in negotiating a purchase and sale agreement.
The “Stalking Horse” Bidder
One factor that can greatly impact the course of a bankruptcy deal is whether the client is designated as the “stalking horse” by the debtor company. A company uses a stalking horse to ensure it is getting a minimum, acceptable bid on terms that it has already negotiated. In other words, the company negotiates its best deal and then puts that out to bid and has the other bidders bid against it.
It can be good to be the stalking horse. If the client is the stalking horse, it is more like a “normal” deal, because the prospective buyer and the seller actually are negotiating the purchase agreement. While the seller will strive for the most seller-friendly deal it can get, it has to reach a deal with someone, or it will not have a stalking horse agreement for the auction. As a result, the stalking horse will have more time for due diligence. Negotiating takes time, and while the negotiations are ongoing, the potential buyer can learn more about the assets, work on its numbers, and put together its financing—in short, perform due diligence.
Another benefit to being the stalking horse is that the stalking horse often is reimbursed its due diligence costs. As you likely realized, the most significant difference between a stalking horse arrangement and a “normal” deal is that the stalking horse is investing time and money up front in its evaluation of the deal with no commitment from the seller that it will sell to the buyer, such as the exclusivity or “no-shop” provisions in normal deals. Rather, the stalking horse understands that the seller is looking for other, better deals potentially during, and certainly after, their contract negotiations. To provide a stalking horse an incentive to work with the company, the agreement often provides for “stalking horse protections.” This means that if someone else wins at the auction, the stalking horse is paid a negotiated amount to offset its due diligence costs and other up-front dollars it spent.
Despite the stalking horse’s opportunity to negotiate the deal, the agreement still is likely to be very seller-friendly. While I discuss below in more detail the issues I focus on in negotiating a purchase and sale agreement, whether on behalf of the stalking horse or a bidder at auction, one obvious difference between an agreement in the bankruptcy scenario as compared to a “normal” transaction is likely to be a lack of any contingencies. Remember, this is the agreement the company will be willing to enter into with the winning bidder, which may or not be the stalking horse, and once the auction has concluded the seller wants a buyer who is required to close. For the stalking horse, this is likely to be less of an issue, since it has had more time to assess the deal.
Bidding Against the Stalking Horse
If the client is not the stalking horse, what are the implications? First, someone else (the stalking horse) has the inside track; that entity actually negotiated the agreement with the seller, an agreement with which the seller is comfortable and that the bankruptcy judge has approved. In contrast, the bidder is reacting and bidding in response to the purchase price and agreement approved by the bankruptcy court. The bidder needs to decide whether it can pay more, if it can close more quickly, which provisions to keep and which to remove from the agreement, if any, and whether the court will even entertain such a bid. If the bidder rejects parts of the agreement, its bid has to be better somehow—perhaps better financially for the seller, or the buyer can close sooner. Will the bidder be able to put together a deal that is “better” than the stalking horse bid?
In addition, the stalking horse also had the time to get comfortable with any due diligence materials provided. It likely has spent the time and effort to perform its own due diligence; assuming the agreement has stalking horse protections, the stalking horse knows that it will recover its costs even if it loses the bid and had no disincentive to perform due diligence. The bidder, in contrast, will be engaged in due diligence in the absence of a signed agreement. How much does the bidder want to invest in due diligence, knowing those are sunk costs if it loses? Perhaps more importantly, the bidder may not have much time or access to perform due diligence, even if it were willing to invest the money. In that case, the bidder needs to determine how much risk it is willing to live with and, based on its experience, what is a reasonable worst-case scenario with respect to the environmental condition of the assets.
Issues to Address in the Purchase and Sale Agreement
Whether my client is the stalking horse or a bidder, there are certain provisions I try to make sure are covered, even in a very seller-friendly purchase and sale agreement. While my approach is influenced by the fact that this is a distressed deal, I would likely be looking for similar protections in a traditional deal. Representations and warranties are likely to be limited, if given at all, though it never hurts to ask. Typical topics of representations are compliance with laws; whether there have been any releases of hazardous substances; the existence of storage tanks; the presence of hazardous materials, such as asbestos or PCBs; notice of law suits or other actual or potential claims; and whether the facility has required permits and the status of those permits. If representations are given, they are likely to be qualified as to knowledge, and it is important to identify whose knowledge these representations are based on. Is it the trustee, who in reality knows next to nothing about the company’s environmental operations? Or has the agreement identified someone at the debtor company? Who is that person, and does he or she have any real knowledge of the operations? The representations may also be limited by time (e.g., during the seller’s period of ownership), or subject to a “materiality” qualifier.
Because these are by their nature asset and not stock deals, what the buyer cares most about is the condition of the assets, rather than compliance and liability (except as related to or arising from those conditions). For example, the buyer cares whether there has been a release of hazardous substances on the real estate being acquired but does not care whether the company ever received a CERCLA 104(e) request for waste sent to a landfill. If the buyer’s goal is to find a similar entity to operate the real estate, the buyer may care about the status of permits—whether the facility has them and if renewal applications have been submitted—but not about past noncompliance with those permits.
I like to remind clients that representations and warranties serve two purposes: they force the seller to provide the buyer information, and they provide an opportunity for recourse if the seller does not provide that information (i.e., the buyer can sue the seller for breach). In a bankruptcy, however, the opportunity for recourse is limited. If it is a liquidation, the company no longer will exist at the end of the process. In contrast, in a reorganization, a claim for a breach of representation or warranty may be made against the company after the reorganization. However, for that very reason a debtor-in-possession is unlikely to give representations, or if it does it is unlikely to agree that those representations will survive closing, since the company will want to minimize postbankruptcy obligations for prebankruptcy issues. Furthermore, any noncontractual claims against the company, such as common law or statutory claims that are often the basis of environmental claims, are likely to have been discharged in the bankruptcy.
Another, more practical concern with the liquidation of the company, or even a reorganization, is that information that might prove useful to the new owner is not readily available. For example, in one deal I was involved in, a client was trying to track down tank closure reports for tanks pulled by the old owner after it acquired a property; however, after the closing, those records were not provided and have since proven very hard to obtain. A contractual obligation to preserve records or to cooperate is a good provision to ask for, but it is only as good as any other contractual obligation entered into by a company going through bankruptcy, as discussed above.
Another issue that has environmental implications, albeit indirectly, is whether the client has the right to assign its rights in the purchase agreement. The client typically will want to take the assets in a special purpose entity, to limit its liability, but it is unlikely that this particular entity already exists. In addition, the client may want to take different assets into different entities. For example, if the deal involves a real estate portfolio and the client is going to finance the acquisition, it may be preferable to put certain properties into different entities, so there are different borrowers, avoiding the potential for cross-collateralization. If the assets are of distinctly different natures (e.g., inventory and real estate), the client may not be interested in both and may want to assign its rights to one or the other to another entity altogether. I want to make sure the agreement provides enough flexibility to allow the client to make these types of assignments.
Often real estate and equipment owned by a bankrupt entity has been abandoned, as a practical matter. For instance, there may be equipment or tanks simply left behind, with hazardous materials still in place. Who will ultimately be responsible for managing the disposal of these materials? In the absence of contractual provisions to the contrary, such responsibility for abandoned equipment is typically left to the buyer. In a number of situations, we have arranged to have the trustee remove the hazardous materials before my client takes title, as part of its obligations to properly manage the assets, so as to avoid the cost and potential liability associated with the disposal of hazardous materials. Even if the removal cannot occur prior to closing, the agreement can provide that it is a postclosing obligation of the trustee.
Lastly, purchase agreements in “normal” deals often have provisions for environmental investigations. A purchase agreement with a company in bankruptcy is unlikely to have the standard due diligence provision that allows the buyer time to perform an environmental site assessment such as a Phase I and maybe a Phase II and then decide whether it likes the results and to terminate if it does not. That does not mean that a buyer of assets out of bankruptcy should give up on performing environmental due diligence. In fact, I would suggest that the buyer, whether a stalking horse or optimistic bidder, make every effort to get a Phase I site assessment before making the decision to sign or bid, which is the bankruptcy deal equivalent of the end of due diligence period.
The most important reason to perform a Phase I is to identify those issues the client needs to know before buying the real estate. In other words, how much and how long? To help the client answer those questions the environmental lawyer needs to understand the client’s goals for the property. While this sounds basic, too few lawyers ask these questions and instead assemble a list of all the bad things that might happen postclosing, or try to protect the client to such an extent that the deal never gets done. Here’s what I want to know from the client: What is the postclosing plan? Does the client plan to immediately divest itself of the property or hold the property and improve it? Is it usable as is? Will there be tenants, and what kind? Knowing what the client intends to do with the property helps me evaluate the issues identified in the due diligence materials provided or in the Phase I report I receive.
As noted above, ideally the Phase I site assessment is done before the client makes the bids or signs. Unfortunately the ideal is not always reality, and there may not be the opportunity or even the time to get a Phase I done before the deal is hard. In those cases, I still want to make sure the client has the right to perform at least a Phase I site assessment before the closing. While CERCLA liability protections are not, in my opinion, the most significant reason to perform a Phase I, they are valuable and should be obtained if possible. To get those protections, I will ask for the time and access to perform a Phase I before the client actually acquires the property.
Transactions involving bankruptcy are different and, from the environmental lawyer’s perspective, more challenging. There is less time for due diligence and less opportunity to negotiate favorable deal terms. But these are often financially lucrative deals, and clients will continue to do them. With planning and forethought, the difficulties presented when acquiring these properties can be minimized, making the deals more manageable.