Distressed M&A: Managing Liability Risks in Carve-Out Transactions | Germany

While the impact of COVID-19 on the global economy as well as M&A transactions and the various challenges related thereto have been, to a great extent, successfully tackled, the war in the Ukraine, unprecedented inflation rates and the end of Europe’s decade of low interest rates have caused investors to rethink their M&A activities. The last two to three months have shown that following an initial shock, investors (both strategic and financial) are starting to adapt to the new market conditions. Distressed assets, in particular, are seen as promising investment opportunities, allowing an investment to be made at a significantly lower valuation and thereby compensating the increased financing costs to a certain extent.

In the current market surroundings, carve-out transactions in particular are becoming more popular as investors’ “cherry picking” allows for acquiring selected profitable parts of a company’s business and leaving unprofitable parts and, if properly handled, liability risks behind. Some investors, in particular corporates, are looking to acquire only certain selected assets, technology, IP rights, etc, and to integrate these into their own businesses.

Even in a non-distressed environment, carve-out transactions represent a highly complex transaction type for all involved parties as they entail a number of legal, commercial and technical challenges resulting from countless interdependencies of the separated business part with the transferring company or related liability risks. In distressed situations, those challenges and even further increased legal risks typically have to be managed and solved in very limited time.

Interdependencies between the carved-out business and the remaining business are associated with various known and unknown risks that have to be considered and mitigated. The ongoing financing of the carved-out business needs to be secured at any time. This includes, during the preparatory phase, ensuring solutions are found for existing (shareholder) loans, cash pooling arrangements, profit and loss transfer or similar intra-group agreements. In particular, the termination of profit and loss transfer agreements requires careful planning in order to avoid additional funding obligations or detrimental tax treatment, such as the non-acceptance of the tax group for the current or even previous financial years.

Depending on the nature of the transaction, whether implemented by way of a share deal or asset deal, further liability risks may be attached to the carved-out business. In the case of share deals, the carved-out entity will be acquired “as is” with all existing liabilities whether known or unknown by the acquirer. Asset deals on the other hand have the advantage that the acquirer is, in principle, free to choose which risks they want to take. However, there are certain liability risks that acquirers cannot avoid, even in asset deals. Those successor liability risks arise, for example, from environmental law, product liability law or labour law. In the case that a spin-off pursuant to the German Transformation Act (UmwG) is implemented as a preparatory step for the carve-out, the legal entities involved in such spin-off are liable vis-à-vis creditors as joint and several debtors (both directions), typically for a period of five years (and up to ten years for certain pension obligations). In practice, this is a more relevant risk for the purchaser.

The most severe liability risks in distressed carve-out transactions, however, emerge around insolvency risks. In the context of insolvency proceedings, transactions from the past can be challenged (Insolvenzanfechtung) and declared null and void. This may affect a time period of up to ten years and puts the carve-out transaction (in the case of an insolvency of the seller) or transactions still carried out under the old ownership structure (in the case of an insolvency of the target) into focus and at risk. Typically, the structuring of the settlement of shareholder loans requires particular attention to prevent claims from being made against the seller in an insolvency scenario after closing. Of course, insolvency risks would be significantly less relevant when buying from the insolvency administrator out of insolvency; however, waiting for such a scenario is usually less commercially attractive.

Once identified, risk allocation is one of the parties’ key items for commercial discussions and during negotiation of the transaction documentation. For the general risks attached to the carved-out business, the transaction documentation provides for representations and warranties by which the seller guarantees to the buyer that the business will be in the condition agreed between the parties. Any deviations from the provided guarantees must be compensated by the seller in the scope of the agreed contractual arrangements.

In a distressed scenario where the seller’s potential capacity to fulfil a claim for breach of representations and warranties may be adversely affected, one of the keys to success is conducting a particularly careful and attentive legal (and financial) due diligence.

Particular risks that are known by the parties can be dealt with by way of indemnity, ideally supported by a suitable and financially equipped guarantor (which is often not available in distressed situations). The indemnity claim aims to ensure that the obligated party puts the beneficiary in the same position it would be in if the third-party creditor had not made a claim. In theory, short-term risks could also be excluded by way of respective closing conditions that prevent the deal’s consummation if a risk materialises. In practice, sellers are usually very reluctant to accept such conditions precedent as they reduce transaction certainty.

For a “clean cut”, the popularity of warranty and indemnity (W&I) insurance has rapidly increased. With synthetic W&I insurance policies, the coverage can be decoupled from the purchase agreement’s warranty and indemnity scope.

The mentioned risks and the position the parties have taken during the negotiation of the transaction documentation will always be reflected in the purchase price. It may be advisable to consciously take and not hedge certain risks in order to achieve a preferable purchase price for either party.

All these considerations need to be embedded in an overall transaction plan that includes the solution of the practical challenges. This may include all kinds of transition processes, often including the provision of certain transitional services of members of the seller group for a certain period after closing. While the negotiation of appropriate transitional services agreements can be a challenge in itself, it should always be considered that the same applies to a discontinuation of certain services being provided after closing, which may give rise to serious commercial difficulties – as a consequence of the insolvency administrator’s right to refuse performance of the underlying agreement, for example.

As outlined, carve-out transactions in distressed situations place the highest demands on all involved parties and advisors. Their complex and time-critical implementation is often a deterrent to strategic investors. However, with experienced advisors, an attractive chance/risk profile can be pursued and promising opportunities, both for strategic and financial investors, can be grasped.