Hhgregg Appliances Inc. recently signed a lease to take over a massive building to house its new central distribution centre in Brandywine, Md. The news might not be all that surprising for the specialty electronics outfit that has opened nine new stores in the past two months, despite all the economic soothsayers warning of slower consumer spending from now until forever. What is interesting is the 393,440-square-foot building once housed a Circuit City distribution centre.
Other stories have been scattered through business news about hhgregg taking over the former homes of Circuit City stores left vacant when the electronic giant filed for Chapter 11 bankruptcy. But if it comes over the border into Canada looking for the same vacancies it may be surprised to find The Source by Circuit City is still selling electronics gear. The Source, the Canadian arm of Circuit City, was a thriving enterprise in almost every mall and shopping centre across Canada. Dragged down into Chapter 11 by its parent company, the Canadian arm consisting of 750 stores owned by InterTAN, was snapped up by Bell Canada last March.
Another joint purchase by Hilco Consumer Capital Corp. and Gordon Brothers Group LLC snagged retailer Linens ‘n Things intellectual property assets last February. Companies such as Ericsson and Avaya Inc. also got on the buying bandwagon to beat out other contenders and pluck business units from bankrupt telecom manufacturer Nortel Networks.
As is the case whenever there are tough economic times, there are bargains to be had. Those bargains may be picking up successful business units like Nortel’s wireless division, or buying up undervalued real estate as is the case with Canada’s Brookfield Asset Management Inc. The Toronto-based company that focuses on property, power, and infrastructure assets, is one group that has made crystal clear its intentions to cash in on the current economic situation.
Brookfield’s gambit came in August when it announced the creation of a US$4-billion investor consortium aimed at underperforming real estate opportunities. The group, including various institutional real estate investors, each assigning at least US$300 million to the initiative, will invest in equity and debt in real estate companies or portfolios where greater value could be created. The consortium is focusing its efforts on North America, Europe, Australia, and Asia.
Joseph Freedman, Brookfield’s general counsel, is confident opportunities abound in this volatile environment, but he suggests just how much can be gained remains up in the air. “It will depend on the nature of what comes out on how much the capital availability and lending availability becomes pervasive, and whether we continue to have the type of recovery in the credit markets, or increase in activity in the credit markets, that we’ve seen.”
David Kohlenberg, deputy general counsel of corporate development and finance law at TransCanada PipeLines Ltd., says his company is eager to capitalize on struggling U.S. businesses as well. Valuations in the industry have taken a steep drop from highs reached two years ago, which he attributes to a decline in energy demand due to the recession. Prices may be tantalizing, but Kohlenberg says it is vital to take a step back and determine just how much of an opportunity you are looking at. That consideration has forced TransCanada to take a conservative approach to possible deals. “Because of the fact that these opportunities exist in a time of economic downturn, you’ve got to really still figure out whether there is a need, [and] what is the longer-term value of this particular opportunity.”
The company has noted, for example, project developers have run into difficulty financing ongoing development activity. As capital markets collapse, the developers have often come up empty in searching for the funds needed to move projects along. Many are teetering on the brink of insolvency. A quick appraisal may make such a deal seem encouraging, but Kohlenberg says it is easy to get scared off. “It’s difficult to deal with those kinds of entities, because you’re not 100-per-cent certain whether any transaction that you do is going to get challenged or not in a proceeding that some other creditor, or interested party, might take.”
Counsel involved in the purchase of an insolvent company must work out the same types of considerations
present in any deal involving a company in financial distress: who are the creditors; what is the nature of the claims parties have; who has legal rights to various assets that might become part of the deal; are there secured assets in which secured creditors have interests and how can those be dealt with; how long will it take to get the transaction through the insolvency process; and what is the status of any priority claims, such as pension or other employee-related claims?
What it really comes down to is extremely thorough due diligence, says Kohlenberg. Unlike a typical deal, transactions for struggling companies rarely come with a full set of representations and warranties backed by an indemnity. And even if you land them, “you don’t really have any remedy if they prove to be wrong.”
There are some options for those looking for deals, but are worried about potential encumbrances. Philadelphia, Pa., lawyer Raymond Agran, a business law partner at Saul Ewing LLP, advises in-house counsel looking for deals in the U.S. to read up on the “363 sale” process, where assets of insolvent companies can be sold off free and clear of liens and encumbrances. Agran has plenty of garden-variety mergers and acquisitions experience, but says that in the last few years he has done a “boatload” of 363 deals.
Many of the companies involved in this process are leveraged up, says Agran. A buyer will often look at them and decide that, rather than taking the traditional successor risk, they will get court-ordered certainty that approves the purchase and — aside from a small number of things such as union contracts — washes away factors that could prove troubling. “There’s so much leverage all over the place, and people say they’re going to fight a little bit harder than they might in other environments, and then what happens is you have the court as a civilized way of dealing with this degree of frustration,” says Agran. That has led to a steep rise in the number of deals utilizing this process.
Jay Swartz is a partner with Canadian law firm Davies Ward Phillips & Vineberg LLP who specializes in corporate and commercial, financial restructuring and insolvency, and mergers and acquisitions. He says in-house counsel are wise to keep an eye out for distressed opportunities. “These situations are often great buying opportunities for synergistic buyers to pick up assets cheaply, or to pick up market share.” Companies can make a low-cost deal on an insolvent business, while at the same time shedding many of the liabilities that would be hanging around in a normal transaction.
“Courts can eliminate a lot of liabilities, they can eliminate bad contracts, they can eliminate a lot of employees, things like that,” Swartz says. “So you can buy a downsized, streamlined business, and usually at a bargain-basement price as long as you understand the process for doing the acquisition.” Companies with in-depth knowledge of an industry likely have a leg up on financial buyers, he says.
Swartz points to the automotive sector where competitors have been eager to buy up pieces of financially strapped companies. Those low-cost deals will turn into significant acquisitions when the market fully recovers. Such deals may come with a few added forks in the road, but the pitfalls are worthwhile for companies with cash, he says.
Not everyone is convinced many companies can make a meaningful deal through insolvent companies across the border. James Gage, a partner with McCarthy Tétrault LLP’s bankruptcy and restructuring group in Toronto, says there is currently no “gold rush” of opportunities to snap up financially strapped companies in cross-border deals. He suggests such deals likely only pop up when a U.S. parent company is facing a cash crunch and looks north for an infusion, likely from a non-core, stand-alone operation in Canada. That type of deal likely would come about outside of a formal restructuring proceeding.
Gage points to Nortel as an example of a completely integrated business that largely does not present an opportunity to sell off Canadian parts as distinct from selling off a particular business unit with a more “cross-border or international flavour.” He contrasts that example with Linens ‘n Things and Circuit City, where units were easily divided.
Overall, Gage says companies face “some interesting challenges” when looking to restructure when their affiliates are solvent. It is common for reasonably well-performing Canadian wings to face pressure from their U.S. counterparts for cash — whether through dividends, inter-company trade credit, or loans. That puts the heat on directors, who are forced to balance those demands with performance expectations from Canadian stakeholders. Businesses also face a slew of issues once they begin debating the merits of either divesting Canada or selling the entire company. A joint process where the entire company is sold off may maximize overall recovery, but it could be best to sell the parts individually, or to sell the Canadian side separately for those stakeholders. Those decisions come down to number crunching, and determining whether the value of one side of the operation will be too drastically downgraded by marketing it separately. Either way, allocation issues must be addressed, as it would be unfair to give a less than fair value payout to one segment of the business.
Gage says there are a number of considerations businesses must factor in when eyeing divestment of non-core business lines or assets. For example, they must discover what kind of structure is available to convey the assets. “If you’re an insolvent company, asset sales are often difficult because of bulk-sales legislation and other things that make it just more difficult to do it outside of the context of either a filing of some kind or some kind of court process.”
Speed will also come onto the radar screen. There is a clock ticking on how long it will take for the struggling company to run out of cash, and at the same time the company may be weakened due to deteriorating relationships with customers and suppliers.
Andrew Kent, chief executive officer and chairman of debt products and restructuring at McMillan LLP in Toronto, says it can be difficult to separate the U.S. segment of a company from its Canadian side in the first place. “Even if the Canadian operation is fairly significant, it can be quite integrated with the U.S. operations.”
Also, even if the Canadian side is a legally separated entity, its affairs may remain strongly intertwined. The Canadian wings of General Motors and Chrysler Group LLC, while highly integrated with their U.S. counterparts, did not file for bankruptcy in Canada. Kent highlights that for in-house lawyers, advising them to take note of that and form a legal approach best accounting for it. “It’s not all plain and obvious what should happen.”
Companies also may tweak their approach based on the need for debtor-in-possession financing. A situation may arise that forces a company to file its Canadian subsidiary, says Kent. The business might decide it does not make sense to raise a DIP loan in the U.S. without the benefit of Canadian collateral. The next question, says Kent, is what is the exit plan? Answering that question can go a long way to determining whether the Canadian side needs to file as well. Focusing specifically on the retail sector, Kent suggests there is a range of legal considerations for potential suitors to consider before pulling the trigger on a deal. He notes most large retail companies have a sizeable pool of landlords for their store locations. So it’s important for them to weigh the advantage of creating a leaner stable of stores. The state of the Canadian dollar should also be considered. “With the rise in the Canadian dollar, to the extent that your inventory is sourced out of Canada, probably that helps the economics of Canadian retailers. Presumably the cost of inventory is probably going down, relative to sale price.”
There is clearly no end to the complexity of making a cross-border deal involving a struggling company, and each business will form its own strategy. But those content to simply tread water in hopes of avoiding the pitfalls may be missing out on a rare opportunity to position themselves for future growth.
