What to be aware of when investing in insolvent businesses

With the market for regular M&A transactions still very active, one would expect the niche market for insolvent business transfers to be at an all-time low. However, in 2018 we saw some major Danish companies in various sectors undergo insolvency proceedings, including retailer Top Toy/ToysR'Us, insurance agent Husejernes Forsikring, airline Primera Air, wind turbine group Total Wind and furniture manufacturer Tvilum. These bankruptcies all involved complex business and/or asset transfers. Although these insolvency proceedings may have come as a surprise to many, economic commentators see them as a natural consequence of the growing competitiveness of Danish businesses fueled by the current market conditions (with the retail sector, in particular, in disruption).

Stakeholders should act diligently when facing financial difficulties

Danish legislation supports the principle of limited liability, and an investor entering the Danish market should therefore not be overly worried about the risk of incurring personal liability. However, investors (and the management they put in charge) should always be aware of the interests they are required to protect and should the business plan not materialize into a profitable business, management could face personal liability if it does not shift focus.

Should the new business become insolvent, management must shift its attention away from safeguarding the interests of the business and instead focus on safeguarding the principle of equal treatment of creditors.

Should the management fail to do so, the directors could be held personally liable for the creditors' losses and could also face disqualification proceedings (in Danish: konkurskarantæne), preventing the individual members of management from serving as members of the management in Danish companies for up to three years.

Drafting is the key to success

The idiom "the devil is the detail" is key in the drafting process in connection with insolvent business transfers. Although each case is different, a common characteristic of such transfers is the limited time available for the parties to close a deal. In a distressed situation, focus will often be on the practical and factual circumstances of the target rather than on the general terms, which are usually standard bankruptcy ("as is") terms. 

Although time-consuming, it is always advisable (and usually practically possible) for an investor to visit the site and to interview key personnel, as future conflicts may easily be avoided by gaining first-hand knowledge of the practical surroundings where the business has been conducted. Such visit and interviews may give the investors a better idea of the assets, employees and know-how necessary to achieve the objectives of the future business plan, thus allowing them to address key issues in the transfer documentation and increase the chances of making the business viable again.

Restructuring proceedings under the Bankruptcy Act present tools and obstacles

Investors should also be aware that commencement of restructuring proceedings under the Danish Bankruptcy Act (in Danish: rekonstruktion) for the purpose of acquiring an insolvent business is a formalistic procedure and can be a difficult process. 

The possibility of commencing proceedings was introduced in 2011, one of the objectives being to make it easier to acquire insolvent businesses. This objective has been partially achieved by providing investors with certain tools, enabling investors to maintain the profitable parts of the business (e.g. by compulsory acceptance of both new debtors on certain agreements and valuations of pledged assets as well as revival of terminated agreements). 

However, certain formalities also have to be observed in connection with restructuring proceedings, and these can be counterproductive when trying to save a business (going concern). In contrast to bankruptcy proceedings, a business transfer cannot be completed without formal approval by both the creditors and the bankruptcy court. Also, a court-appointed accountant - with limited or no prior knowledge of the business - must be involved. These formal requirements often prove (too) time-consuming and can impede the objective of saving a viable business.

Careful attention to employees  

An investor entering the Danish market through acquisition of an insolvent business should be aware of certain employee-related issues which may both be helpful and harmful in the process of establishing a successful business. 

In general, the Danish Transfer of Undertakings Act (in Danish: virksomhedsoverdragelsesloven) makes a new owner liable for employees claims against the selling entity if the employees have not been dismissed and released at the time of the transfer. The act is based on the EU TUPE regulation.

Obviously, the employees will often have irreplaceable knowledge of a business, and therefore retention of key employees will often be a prerequisite of a successful business transfer. This prerequisite can often be fulfilled with the help of the legal entity selling the business as employees will often have preferential claims reaching beyond the date of termination of their employment (e.g. claims for compensation in the notice period etc.). Thus, the selling entity will happily let an investor take over such employees. Under certain circumstances, such transferred liabilities can also be set off against the purchase price for the business, effectively reducing the financing needed to acquire the business.

If the selling entity is being administered in bankruptcy, the Danish Employees' Guarantee Fund (in Danish: Lønmodtagernes Garantifond) must compensate the employees for any claims they may have against the selling entity relating to the period before the date of the bankruptcy order, and therefore the new owner will only be liable for any claims arising after that date, which will often be limited. Hence, bankruptcy proceedings may be helpful in limiting an investor's liability to employees.

However, based on recent case law investors should pay attention in pre-pack scenarios. Firstly, an investor must be very careful not to de facto conclude the business transfer before a bankruptcy and before the business has been officially taken over. In such cases, the investor may be held liable for all claims irrespective of the bankruptcy and irrespective of later dismissals. This calls for careful timing (i.e. patience) with respect to negotiation and start of operations. Also, an investor should be very careful in securing a remedy against the selling entity, should the investor be seen to have taken over more employees than originally planned.

The article is part of Investor Update: August 2019.