Buyer Beware: Counterparties and Covenant Strength

In times of growing economic uncertainty business owners will face numerous commercial and strategic challenges. Ultimately, this may result in corporate restructuring or asset and business sales in order to manage liquidity or in more serious cases, protect parties from insolvency.

This may provide investment opportunities for buyers with excess cash reserves, recession-proof revenues or healthy balance sheets to alleviate financial pressure on distressed sellers.

Below, we reflect on how we advised a client to best mitigate the risks associated with transacting with a seller in financial distress with limited covenant strength, a scenario which parties may be dealing with increasingly in the current climate.

Our client sought to acquire the entire issued share capital of a special purpose vehicle (SPV) holding a commercial property as its only asset. During the due diligence exercise, we identified from the accounts of the Seller, that it had been loss-making over the last two financial years. Furthermore, aside from the property being sold, it appeared to have a very limited asset base.

As the transaction documents included a large suite of general corporate and property warranties given by the Seller, which in reality, had very little substance due the Seller’s precarious financial position, it was necessary to consider which potential avenues could mitigate this risk and give our client comfort in proceeding with the transaction.

In doing so, we looked at the some of the following options to determine which best suited our client in the circumstances:

• obtaining warranty and indemnity insurance (W&I Insurance);
• seeking a guarantee;
• holding back some of the purchase price; or
• "taking a view".

We briefly look at each of these options below:

W&I Insurance

W&I Insurance can be an effective tool in any transaction where the buyer is seeking some protection in respect of seller warranties and the seller is looking for a clean exit to utilise funds from the sale following completion. In this regard, a buy-side policy allows the buyer to claim directly against the insurer for a breach of warranty or claim in a share purchase agreement. The policy period can mirror or extend the time limits set out in the share purchase agreement but usually ranges from 18 - 36 months for general warranties and up to seven years for title, capacity and tax warranties. The insurance premium is linked to the policy limit and dependant on several factors including the amount and nature of the excess (deductible), limitations on the warranties, the jurisdiction and the nature and complexity of the transaction.

The cost of the premium for most corporate transactions generally ranges from 1% - 1.5% of the amount of coverage required. We note however, that during periods of economic uncertainty, some of the cover provided by insurers may be restricted or heavily caveated and pricing may vary based on the nature of the business or assets being sold.

Given the deadlines we were working towards to complete the transaction, obtaining a policy in the time available was not commercially feasible, as the process usually takes around two weeks to organise to give the underwriters sufficient time to diligence the transaction and familiarise themselves with the various transaction documents. This timing may also be impacted when the prevailing economic or social conditions mean that insurers are more cautious in their approach and require greater due diligence before insuring transactions.

Guarantees

Guarantees can protect the buyer in situations where the seller may not have the financial resources to cover warranty claims but a parent company or ultimate beneficial owner might. This enables a buyer to rely on the parent’s guarantee to cover the liabilities of the seller in the event of a warranty claim. For guarantees to be effective, the financial position of the guarantor needs to be thoroughly analysed in order to give comfort to those seeking to rely on the guarantee.

In our case, seeking a parental guarantee was not possible given the structure of the Seller.

Deferred consideration

Negotiating a deferral of part of the purchase price or holding back consideration can be a useful method to ensure that there is cash available to satisfy a successful warranty claim following completion of the transaction. Part of the purchase price can be paid into an escrow account or retained by the buyer and released on the satisfaction of conditions or certain time periods. In the circumstances of our transaction, the Seller was unwilling to accept deferred consideration given its need to be in funds following completion to satisfy obligations under various financing facilities. Furthermore, we were already holding back some of the purchase price to deal with certain remediation obligations in relation to the property.

"Taking a view"

Given the fact we had undertaken a thorough and detailed due diligence process in respect of the SPV and the property, in conjunction with a detailed disclosure process, our client formed the view that there was limited risk of any long tail liabilities associated with the transaction, notwithstanding the fact that some risks were identified during the course of our investigations coupled with the precarious financial position of the Seller.

Further mitigating this risk, our client had a history of dealing with the Seller and there was also the possibility of entering into some management arrangements in respect of the property going forward, incentivising the Seller to be professional and transparent in respect of its conduct, the warranties being provided and the associated disclosure regime.

Accordingly, our client was able to take comfort in the fact that despite the limited covenant strength of the Seller, the risks associated with the purchase of the SPV was low enough for them to enter into the transaction. This was ultimately down to the quality of diligence undertaken both from a legal and financial perspective and our client’s intimate understanding of the sector and underlying asset being purchased.

There is no one size fits all solution to structuring and negotiating a transaction where you may be dealing with a party with limited covenant strength or in a distressed sale scenario, however, it is important to consider what works best for you and how you will manage the risks associated with the transaction.

Please contact the Fosters Corporate team if you have any questions or would like any legal or transaction structuring advice.