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Law360 (December 21, 2020, 2:55 PM EST )
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| Felicia Perlman |
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| Heidi Steele |
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| Max Brady |
Given the continuing increase in bankruptcy filings due to the COVID-19 pandemic, SPACs may want to consider taking advantage of acquiring businesses that, but for the unique stressors of the pandemic, would be going concerns.
Section 363 Overview
Section 363 sales are a unique aspect of the U.S. Bankruptcy Code intended to generate the highest and best offer for a debtor's business. The sale is generally conducted as a public or private auction for the debtor's assets and typically takes anywhere from 30 to 90 days to complete, depending on the urgency of the sale and nature of any objections raised.
As incentives for prospective bidders, Section 363 sales provide two powerful advantages to buyers that are not available to purchasers outside of the bankruptcy process. First, the assets in a Section 363 sale are sold free and clear of liens and most liabilities.[1] Second, the buyer has the ability, regardless of anti-assignment clauses, to assume or reject most executory contracts and leases associated with the assets.[2]
Additionally, Section 363 sales typically attract only a few buyers, which may provide an opportunity to purchase assets at below-market prices. Some potential buyers avoid Section 363 sales simply because such sales occur within a bankruptcy setting, while others find the risks associated with the sale process to be overwhelming.
Such risks include the intertwined hurry-up-and-wait aspects of a compressed diligence timeframe in conjunction with a relatively lengthy 30- to 90-day sale process, as well as the potential for bankruptcy stigma to attach to the debtor's business and continue to depress its economic value post-acquisition.
A SPAC capable of leveraging the benefits of a Section 363 sale while mitigating the risks arising from the same would be well-placed as a competitive bidder and may find that such sales present unique opportunities not available outside of the bankruptcy process.
Leveraging the Advantages of the Section 363 Sale
Similar to a private equity fund, investors in a SPAC are betting on the ability of the SPAC's management team to identify and purchase an attractive company with strong growth potential.
However, unlike a private equity company, a SPAC must use at least 80% of its net assets for its business acquisition and the SPAC is on a deadline to get the business combination done, with the SPAC usually being required to either complete a business combination or liquidate within two years of its initial public offering.[3]
This pressure to commit such a significant amount of resources within a short time frame can have disastrous results for investors in the long run when SPACs focus on companies with little to no revenues.[4]
Furthermore, since SPAC investors have the right to redeem their shares in a SPAC if they do not like the business combination, a SPAC must be careful to identify target companies that will either appeal to existing investors or new investors willing to invest in the business combination via a private investment in public equity, or PIPE, transaction or other capital infusion.[5]
Although acquiring a company in a Section 363 sale cannot entirely mitigate the risks inherent with such a concentrated investment, it does provide an opportunity for SPAC managers to acquire a revenue generating business with investor appeal whose economic value may be depressed by an overleveraged balance sheet or existing general liabilities.
Through a Section 363 sale, a SPAC can free an acquired business and its associated revenues from such liability, thereby strengthening — in conjunction with the cash available from the SPAC trust or a related PIPE in the business combination — the merged company's balance sheet and allowing management to focus on mitigating the risks to the SPAC and its investors of taking on such a concentrated investment.
This opportunity to acquire a business that is an otherwise going concern may be even more pronounced in the current environment, given the number of filings by companies with relatively healthy balance sheets that have succumbed to the sudden and severe decline in business due to the economic impact of the COVID-19 pandemic.
In conjunction with the free-and-clear nature of a Section 363 sale, a buyer's ability to assume or reject executory contracts and leases is an especially powerful tool that SPACs can leverage. A management team with a judicious hand will find that such a tool provides greater flexibility in shaping the assets to the SPAC's strategic vision than can be found in an out-of-court sale by allowing for the rejection of burdensome agreements and assumption of those that are beneficial.
Section 363 sales may also provide SPACs with the opportunity to purchase assets at depressed prices otherwise unavailable outside of the bankruptcy process. Although this year has seen a record number of SPAC IPOs, the average SPAC size is only about $340 million.[6]
Even with additional PIPE or debt financing, smaller SPACs would likely have challenges swallowing an acquisition much larger than $1 billion. A SPAC with a discerning management team may find that the right Section 363 sale offers the opportunity to acquire a larger than expected business at a depressed valuation.
Moreover, recent bankruptcy proceedings have demonstrated that a ready pool of potential acquisitions of varying sizes and valuations exists, such that nearly any SPAC, regardless of its capital resources, could find a transaction to participate in.[7]
SPACs, however, should be aware that bankruptcy courts do not look favorably upon parties with uncommitted financing — especially if seeking to participate as a stalking horse bidder. This raises a potential issue for SPACs in that they may find their application as a stalking horse bidder or winning bid at auction challenged because of the risk that shareholders may exercise their right of redemption and strand the SPAC without the capital necessary to consummate a transaction.
While not entirely dissimilar to the concerns of a SPAC target in a typical out-of-court transaction, SPACs participating in Section 363 sales should be prepared to demonstrate committed financing prior to approval as a stalking horse bidder or, if not participating as a stalking horse, prior to an auction closing.
Mitigating the Risks of Section 363 Sales
Unlike an out-of-court acquisition, the amount of time for conducting diligence versus the total time to close a Section 363 sale can be disjointed. Bidders often have only two to three weeks in which to conduct their diligence, while the entire sale process can take anywhere from 30 to 90 days. This tension in timing can dissuade potential bidders who do not have the resources to quickly complete the former and the patience for the latter from participating in a Section 363 sale.
However, given the acquisitive nature of SPACs entering the market and their lack of an operating business preacquisition, SPACs are generally well-placed to mitigate these timing risks.
As sophisticated entities actively searching for an acquisition, SPACs have the resources necessary to recruit the appropriate professionals to complete an expedited diligence process and the management experience needed to quickly evaluate the outcome of such diligence. Moreover, because of the free-and-clear nature of Section 363 sales, SPACs — and admittedly other bidders — can shift the focus of their efforts from liability diligence to prioritizing matters such as analyzing executory contracts and leases for assumption or rejection.
SPACs — unless quickly approaching the point of liquidation — also enjoy an advantage over other potential bidders when considering the risks of an uncertain and extended period of time before closing on a Section 363 sale. Such variability in timing can be burdensome for potential bidders with operating assets that have to closely coordinate the integration of their current operations with one purchased through a Section 363 sale, and the timeline for such integration.
A SPAC's lack of operations preacquisition, on the other hand, likely negates any similar risks and provides a degree of flexibility in shifting an integration timeline that other bidders generally do not enjoy.
One important caveat to the timing benefits enjoyed by SPACs is the need to carefully consider the timing of the necessary proxy solicitation to SPAC shareholders for an acquisition's approval in relation to the speed of a Section 363 sale.
Given that no SPAC has previously participated in a Section 363 sale, the timing of such solicitation and the extent of the disclosures contained therein need to be thoroughly evaluated.
The requisite shareholder approval also raises the risk that the stigma of the bankruptcy process will attach to the assets and disrupt the acquisition process. As previously discussed, SPAC investors have the right to redeem their shares if they do not approve of a proposed acquisition. Therefore, if a SPAC fails to manage the expectations of its shareholders prior to entering into a transaction to acquire a target through a Section 363 sale, shareholder dissent could result in the outflow of funds and possibly the failure of the transaction.[8]
To mitigate such risk, any SPAC intending to participate in a Section 363 sale should make clear to the market that it plans to considers distressed companies as potential targets, so that investors are not caught off guard when an acquisition is announced.[9]
In relation to the bankrupt company, however, a business combination with a SPAC likely provides a unique opportunity to mitigate the risk of stigma from the bankruptcy process attaching to the acquired business.
As discussed above, investors are betting on a SPAC management team's ability to identify and acquire a business that will become a successful public company. A SPAC's acquisition of a company in a Section 363 sale can carry a similar message to market, shifting attention away from the distressed origins of the acquired business to an endorsement by the SPAC in the merged company.
Although unprecedented, a SPAC working closely with its advisers to overcome the risks associated with a Section 363 sale may find that such a transaction provides unique advantages and a lucrative avenue for bringing a business to market.
Felicia Gerber Perlman and Heidi J. Steele are partners, and Max J. Brady is an associate, at McDermott Will & Emery LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] 11 U.S.C. § 363.
[2] Id.
[3] Guidance on Special Purpose Acquisition Companies. (n.d.). Retrieved December 10, 2020, from https://www.finra.org/rules-guidance/notices/08-54.
[4] See Stevens, P. (2020, September 21). Nikola saga hits three speculative areas at once: SPACs, Robinhood traders and electric vehicles. Retrieved December 10, 2020, from https://www.cnbc.com/2020/09/21/nikola-saga-hits-three-speculative-areas-at-once-spacs-robinhood-traders-and-electric-vehicles.html; NKLA. Retrieved December 14, 2020, from https://www.nasdaq.com/market-activity/stocks/nkla (Nikola shares traded at over $93 shortly after going public but saw a drastic decline after Hindenburg Research accused the company of making false statements and subsequent investigations were announced by the Securities and Exchange Commission and the Department of Justice; Nikola's shares closed at $16.41 on December 9).
[5] Guidance on Special Purpose Acquisition Companies.
[6] SPAC IPO Transactions Statistics – by SPACInsider. (2020, December 10). Retrieved December 10, 2020, from https://spacinsider.com/stats/.
[7] See In re Garrett Motion Inc., Case No. 20-12212 (MEW) (Bank. S.D.N.Y 2020) (auction starting at $2.6 billion for sale of the debtor); In re IntegraMed Holding Corp., Case No. 20-11169 (LSS) (Bank. D. Del. 2020) (debtor's clinics sold piecemeal to various bidders).
[8] Guidance on Special Purpose Acquisition Companies.
[9] See Winck, B. (2020, October 9). Billionaire investor Bill Ackman offers new hints on possible targets for his record-breaking SPAC. Retrieved December 10, 2020, from https://markets.businessinsider.com/news/stocks/bill-ackman-spac-psth-pershing-tontine-targets-buy-blank-check-2020-10-1029665772 (Pershing Square Tontine Holdings made statements to similar effect, stating that it is looking at employee owned and family controlled businesses as potential targets).
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