Private Equity Acquisitions of Bankrupt Firms in the United States and Germany

Table of Contents

List of tables

List of figures

1 Introduction
1.1 Problem
1.2 Proceeding

2 The framework for private equity acquisitions of bankrupt firms
2.1 Acquisition options in the U.S. bankruptcy system
2.1.1 Introduction to U.S. bankruptcy legislation
2.1.2 Acquisition pursuant to a plan of reorganization
2.1.3 Acquisition pursuant to section 363 BC
2.1.4 Acquisition through purchase of claims
2.2 Discussion of the acquisition options in the U.S. bankruptcy system
2.2.1 General tendencies in U.S. bankruptcy procedures
2.2.2 Speed
2.2.3 Acquisition free and clear of liabilities
2.2.4 Competitiveness of transaction process / Price of acquired assets... 12 2.2.5 Management approval
2.3 Acquisition options in the German bankruptcy system
2.3.1 Introduction to German bankruptcy legislation
2.3.2 Acquisition pursuant to a transferring reorganization (Übertragende Sanierung)
2.3.3 Acquisition pursuant to an insolvency plan
2.4 Discussion of the acquisition options in the German bankruptcy system
2.4.1 Speed
2.4.2 Acquisition free and clear of liabilities
2.4.3 Asset appreciation
2.5 Other relevant factors
2.5.1 Influence of creditors
2.5.1.1 Debtor-/creditor-oriented bankruptcy systems
2.5.1.2 Situation in the U.S
2.5.1.3 Situation in Germany
2.5.2 Influence of labor laws
2.5.3 Influence of a firm’s stakeholders’ attitude towards its bankruptcy

3 The process and management of private equity acquisitions of bankrupt firms .
3.1 Particularities of the acquisition process in a bankruptcy environment
3.1.1 Creation of a competitive bidding environment
3.1.2 Time constraints
3.1.3 Due Diligence
3.1.4 Valuation
3.2 Companies and situations of interest for distressed private equity investors28
3.3 Distressed private equity investors as providers of “smart money”
3.3.1 Personal involvement
3.3.2 Operational expertise
3.4 Turnaround strategies of distressed private equity investors
3.4.1 Overview of generic turnaround strategies
3.4.2 Restructuring of leadership and organization / culture
3.4.3 Cost reduction
3.4.4 Repositioning strategies
3.4.5 Capital structure management
3.5 Competition between distressed private equity investors and strategic investors
3.5.1 Theoretical background
3.5.2 Influence of distressed private equity investors’ activity on bankruptcy costs
3.5.3 Anecdotal and empirical evidence on the efficiency of markets for bankrupt assets

4 The market for private equity acquisitions of bankrupt firms
4.1 Demand for distressed private equity
4.1.1 Bankruptcies in the U.S
4.1.2 Bankruptcies in Germany
4.2 Supply of distressed private equity
4.2.1 Development of distressed private equity funds in recent years
4.2.2 Characteristics of distressed private equity investments
4.2.2.1 Number and size of investments
4.2.2.2 Returns for investors

5 Summary and conclusion

Appendix

References

Laws

List of tables

Table1: Minimum revenues required by German distressed private equity funds

Table2: Founding years of German distressed private equity funds

Table3: Acquisitions of bankrupt firms by private equity investors in Germany, 2003-2004

Table 4: Fundraising by U.S. distressed private equity funds in 2003/2004. VIII

List of figures

Figure 1: Business bankruptcies and GDP growth in the U.S. 1995-2003

Figure 2: Business Chapter 11 filings 1995-2003

Figure 3: Business bankruptcies and GDP growth in Germany 1995-2003

Figure 4: Major business bankruptcies in Germany 2000-2003

Figure 5: Exercise of self-management, insolvency plan procedure and

bankruptcy trigger ”imminent illiquidity” in Germany, 2000-2003

Figure 6: Private Equity turnaround investments in Germany, 1992-2003.

List of abbreviations

illustration not visible in this excerpt

1 Introduction

1.1 Problem

In early December, 2004, German newspapers reported the acquisition of bankrupt automotive supplier Peguform GmbH, based in Bötzingen, by U.S. private equity investor Cerberus Capital Management¹. The transaction was announced 30 months after Peguform, a company with more than 5,000 employees that recorded EUR 1.4 billion in revenues in 2003², had filed for bankruptcy. As it involved a large firm with substantial importance for Germany’s core automotive industry, this transaction shone a spotlight on a sector of the private equity business that has not yet been widely recognized in Germany: investments in bankrupt firms. While traditional private equity buyouts of financially stable firms have become more and more commonplace in Germany in recent years³, little attention has been devoted to the niche of transactions at the corporate cycle’s very end. In the United States, in contrast, private equity funds investing in bankrupt firms constitute a well-established part of the financial markets.

In this thesis, I aim at providing an overview of the most important aspects concerning private equity acquisitions of bankrupt firms, both in the United States and Germany. This comprises an analysis of the institutional framework for such acquisitions, an investigation of the transaction process and the management of acquired businesses, a closer look at the actual market for these transactions and its development in recent years, and two case studies for practical insight and validation of the findings.

Several points make up the framework for this thesis. Firstly, I do not take exclusively the perspective of investors, but also focus, wherever appropriate, on a management perspective. Thereby, it is possible to show the effects of a sale to a private equity investor on the bankrupt firm’s operations. Additionally, I juxtapose the U.S. and German situations throughout the thesis, in order to highlight similarities and differences between the two markets. Furthermore, I aim at providing substantial anecdotal and empirical evidence, which is mainly derived from the eight interviews that I conducted for this purpose.

The title of this thesis makes it necessary to give some definitions. Following mainly Kraft (2001), the term “private equity” is defined by the following factors⁴:

Private equity investors are specialized financial intermediaries, making medium- term to long-term investments in the form of risky capital for a limited amount of time, and taking an active role in the control and support of their portfolio companies.

The subset of private equity investors with relevance in the context of this thesis are those investors who invest in companies in bankruptcy proceedings. These are mainly, but not exclusively, private equity firms specializing in investing during times of financial distress in the target firm; such specialized investors are called “distressed private equity investors” in the context of this thesis.

Beyond being a subset of private equity investors, distressed private equity investors are also a subset of all “distressed investors” or “vulture investors”. These terms are frequently applied to all investors who specialize specializing in acquiring securities of firms in financial distress, without regard to the investor’s specific investment objective. The approach of the group which is of interest in the context of this thesis is to take an active role in the management and governance of the target firm – specifically, these investors are not comparable to corporate raiders as sometimes

suggested in the popular press⁵, as their business model is to profit by improving the intrinsic value of the target as an ongoing business⁶. In order to achieve this goal, they “assume a management or control position in the company and directly influence its investment and operating policies”⁷. Groups of “vulture investors” that I do not consider are passive distressed debt traders (e.g. certain hedge funds) and investors who seek to profit from a hold-up behavior in the bankruptcy process (“bondmailers”)⁸.

The meaning of the term “acquisitions of bankrupt firms” is distinctive in two senses: Firstly, the thesis focuses on those transactions in which the distressed private equity investor acquires a controlling stake in the business. Secondly, only acquisitions of stand-alone businesses fall into the scope of the thesis, i.e. not acquisitions of individual assets like machines or real estate. However, the investor may acquire only one or several of the bankrupt company’s units; she may also acquire the business in form of an asset deal, i.e. the takeover of the bankrupt legal entity is not a condition for a transaction to fall into the scope of this thesis.

The thesis does not exclusively fit into any major field of prior research, but relies on and makes contributions to three such fields. Firstly, the ongoing discussion about the benefits and inefficiencies associated with Chapter 11 style reorganizations as opposed to asset sales is of high relevance, because private equity acquisitions of bankrupt businesses mostly involve a transfer of the debtor’s assets to a newly created entity. Therefore, the thesis contributes to this discussion by providing an insight into the possibilities of maintaining a bankrupt business as a going concern through a sale rather than an independent reorganization. Secondly, the thesis contributes to the legal field of acquisition laws analysis, by outlining and comparing the legal options for acquiring a bankrupt firm in the U.S. and Germany. Thirdly, research in the field of turnaround management is relevant with regard to the manner in which distressed firms are managed after being acquired by a private equity investor. The thesis contributes to understanding which techniques investors employ in order to lead a formerly bankrupt business back to profitability, and which particular challenges arise in this situation.

1.2 Proceeding

The work proceeds as follows. Chapter 2 sets out the framework for private equity acquisitions of bankrupt firms. This comprises, in first place, the implications of U.S. and German bankruptcy laws for this kind of acquisitions, and a discussion of the advantages and problems associated with the different acquisition methods. I also discuss further elements in the framework, including influence of creditors, labor laws, and a firm’s stakeholders’ attitude towards its bankruptcy⁹. Considering all these elements, it is possible to understand why a large and active market for distressed private equity could flourish in the U.S., and to which extent this can be replicated in Germany.

The understanding of the framework described in Chapter 2 constitutes the basis for Chapter 3, which is concerned with the process and management of private equity acquisitions of bankrupt firms. In this chapter, I set about discussing the particularities in the acquisition process induced by the bankruptcy environment, and summarize which factors distressed private equity investors generally expect to find in an attractive investment target. Additionally, the chapter describes in which ways distressed private equity investors differ in their approach from traditional buyout investors, and can therefore be regarded as providers of “smart money”, from a management perspective. It follows a discussion of those turnaround strategies which are regarded most central in the management of a business acquired out of bankruptcy. Finally, I analyze the competition between private equity investors and strategic bidders for bankrupt firms’ assets, by comparing the theoretical arguments in this field with some anecdotal and empirical evidence.

Chapter 4 provides information about the potential and actual size of the market for acquisitions of bankrupt firms by private equity investors, for both Germany and the U.S. This information is presented by separating between the demand side, i.e. the number and nature of bankruptcies in recent years, and the supply of this form of corporate financing, i.e. the number and size of private equity funds interested in the acquisition of bankrupt businesses.

In Chapter 5, I present two case studies, which show the practical impact and application of the factors discussed in the previous chapters.

Chapter 6 summarizes the central findings and concludes.

2 The framework for private equity acquisitions of bankrupt firms

2.1 Acquisition options in the U.S. bankruptcy system

2.1.1 Introduction to U.S. bankruptcy legislation

The U.S. has codified its bankruptcy legislation in the Bankruptcy Reform Act of 1978, generally referred to as the Bankruptcy Code (BC). Corporate bankruptcies are mostly executed either pursuant to Chapter 7 BC (titled “Liquidation”) or pursuant to Chapter 11 BC (titled “Reorganization”). In the Chapter 7 process, the firm is closed down and goes out of business; a trustee is appointed by the U.S. Trustee and given specific tasks, which include the liquidation of the assets belonging to the estate. The Chapter 11 process, in contrast, generally allows the debtor to stay in control, aiming at a continuation of the business pursuant to a plan of reorganization after the termination of the bankruptcy proceedings. The rationale of Chapter 11 is to save viable businesses from being shut down and inefficiently liquidated, and allow them to elaborate a suitable plan of reorganization under the protection of the bankruptcy process. While the debtor remains effectively in control throughout the Chapter 11 procedure, one should not overlook that the maximization of asset value for the creditors’ benefit is the main objective of the bankruptcy court and “deeply ingrained in the entire bankruptcy process”¹⁰.

As those acquisitions which are of interest in the context of this thesis concern only companies or parts of them that qualify for continuing as operating businesses, the following discussion excludes asset sales in Chapter 7 procedures, and focuses on Chapter 11 sales.

With regard to the possibilities of acquiring a business in the Chapter 11 context, it is possible to distinguish among three basic methods¹¹,¹²:

(1) Acquisition pursuant to a plan of reorganization (a “plan acquisition” or, from the seller’s perspective, a “plan sale”)
(2) Acquisition pursuant to section 363 BC (a “section 363 acquisition” / “section 363 sale”)
(3) Acquisition through a purchase of creditor claims

2.1.2 Acquisition pursuant to a plan of reorganization

In order to understand the process of a sale through a plan of reorganization, it is necessary to review briefly the typical Chapter 11 process.

Subsequent to the Chapter 11 bankruptcy filing, the debtor essentially stays in charge of the business (“debtor-in-possession”) unless the court appoints a trustee¹³. Every significant decision is, however, subject to court review and legal motions by the creditors. All debt becomes due subsequent to the bankruptcy filing, but an automatic stay is invoked, and any payments to creditors are stopped¹⁴. For the sake of coordination, various creditor committees can be formed; the formation of a committee of unsecured creditors is mandatory under the BC¹⁵. The first 120 days of the Chapter 11 process constitute the debtor’s exclusivity period, i.e. during this time only the debtor can file a plan of reorganization¹⁶, which is “essentially a proposal to exchange the firm’s existing financial claims for a new basket of claims”¹⁷. After the expiration of the exclusivity period, which is often extended, either the debtor or any of the creditors is entitled to file a plan. In order to approve a plan, creditors are grouped into classes; all impaired classes participate in the voting procedure. A plan of reorganization is accepted if all classes of impaired creditors and the court approve it. Sometimes, stockholders also have a right to vote on the plan. For the plan to be approved by an individual class of creditors, two thirds of the allowed monetary interests and a majority in number within the class are required to accept the plan¹⁸. It is possible for a dissenting member within a class to object to a plan if she can prove that that her claim is worth less under the plan than in a liquidation of the estate. If the plan is not accepted by a creditor class, it is possible for the court to “cram down” the dissenting class, i.e. compel it to accept the terms of the plan¹⁹. If a plan finds the creditors’ approval, the court will terminate the bankruptcy proceedings, the company will emerge from bankruptcy, and the securities called for in the plan will be distributed.

The possibility of selling the company in form of an asset deal in the context of a plan of reorganization arises from 11 U.S.C. § 1123(a)(5)(d) BC, which authorizes the “sale of all or any part of the property of the estate, either subject to or free of any lien”. There are two possibilities for a bidder to acquire a business through a plan of reorganization²⁰. She can file a plan proposing the transaction either by teaming up with the debtor’s management or, after the expiration of the initial exclusivity period, with a creditor. The voting process on both kinds of reorganization plans is essentially the same and equal to the typical Chapter 11 process as described above²¹. The intent of a plan sale is essentially to transfer the debtor’s assets (“asset deal”) while leaving the liabilities behind in the bankrupt entity.

With respect to the distribution of the sale proceeds to unsecured creditors, it is possible, under certain circumstances, to file a so-called “pot plan“²². In this case, the acquirer provides a “pot” of money or securities, leaving the distribution of it either to the negotiation among creditors themselves or to court decision. Within each class, proceeds are divided pro-rata. This method allows the acquirer to mitigate the time- consuming negotiations with each creditor class.

2.1.3 Acquisition pursuant to section 363 BC

A section 363 asset sale – that is a sale of assets “other than in the ordinary course of business”²³pursuant to 11 U.S.C. § 363 BC - is the “most basic technique for acquiring assets out of bankruptcy”²⁴and can involve either (substantially) all of the debtor company or only parts thereof. As in a plan sale, the rationale behind a section 363 sale is to sell off the company’s assets to an outside acquirer while leaving substantially all liabilities in the bankrupt entity. According to 11 U.S.C. § 363 (f), section 363 sales are intended to transfer the assets “free and clear of any interest” in the property, i.e. excluding any future claims by impaired creditors.

Section 363 sales normally have the advantage of a very structured sale process. Typically, the debtor will sign an asset purchase agreement with a first bidder (the “stalking horse”). The asset purchase agreement and the bidding procedures agreed upon by seller and stalking horse must be sent to the court for approval. The debtor must then “provide all parties in interest with at least 20 days’ notice of the proposed sale”²⁵, in order to give creditors an opportunity to object to the terms of the sale.

Higher and better offers have to be elicited in order to create a competitive bidding environment. Competing bids must be submitted until a specified bid deadline, usually within four to six weeks after the notice²⁶. If there are no competing bids, the seller may cancel the auction²⁷; if she does not, the court can readily approve the sale to the stalking horse at an approval hearing. In case there are competing bids - which is the normal scenario -, the debtor conducts an auction²⁸. The auction result is the selection of the bidder with the highest and best offer by the debtor. “Best” offer implies that not only purchase price, but also factors like the form of consideration²⁹ or the amount of contingencies required by the bidder³⁰can be taken into account. Court approval is unambiguously required to effect a section 363 sale, because pursuant to 11 U.S.C. § 363 (b)(1) BC, a sale may only take place with court approval “after notice and hearing”. Notably, the sale process in a section 363 procedure is relatively centralized, as the debtor needs solely the court’s approval and not the approval of each individual creditor³¹. The court usually requires the following

factors for an approval of the sale³²:

- Sound business reasons for the sale
- Parties in interest received proper notice
- Sale price is fair and reasonable under the circumstances
- Purchaser is acting in “good faith”
- Any secured lenders have either consented to the sale of their collateral or are otherwise protected under the code

Once a bidder receives court approval for the acquisition, virtually all uncertainty is eliminated, because even an overturn of the sale by an appellate court (which is per se highly unlikely³³) cannot reverse the transaction as long as the purchaser acted in “good faith”³⁴. The distribution of the proceeds among creditors is left to creditor negotiations³⁵.

2.1.4 Acquisition through purchase of claims

A third option for acquiring a bankrupt firm, which is very commonly executed in the United States³⁶, is the acquisition of claims from the firm’s creditors: “Distressed debt investing can be a form of private equity investing”³⁷.

By acquiring the necessary amount of claims to obtain a blocking position, the acquirer is able to control the reorganization process by exercising her voting power³⁸. In this situation, the acquirer can either negotiate a plan with the debtor and vote for it in the creditor voting procedure, or – if a consensual plan with the debtor cannot be agreed upon - file its own plan after the expiration of the initial exclusivity period. An alternative is the acquisition of large amounts of debt of the distressed firm prior to the actual insolvency filing, followed by an elaboration of a plan of reorganization in cooperation with the debtor management and a subsequent “pre- packaged” Chapter 11 bankruptcy filing³⁹.

The acquirer will usually try to direct the reorganization towards a “stock-for-debt” plan, i.e. she will aim at exchanging her claims for new voting stock that is to be issued under the plan of reorganization⁴⁰. If an investor manages to purchase a sufficient amount of claims that stand to be exchanged for equity according to the plan of reorganization, she can become the majority stockholder of the post- bankruptcy company. The bidder has to consider that more senior claimholders of the bankrupt firm usually receive more senior claims (debt or cash) in the reorganization, whereas more junior claimholders receive more common stock. Therefore, the investor has to “concentrate on buying relatively junior debt, but not so junior that one ends up receiving nothing”⁴¹; pre-bankruptcy stockholders, for instance, typically receive less than ten percent of the reorganized firm’s stock⁴².

It is important to note that an acquisition through purchase of claims is different from plan purchases and section 363 purchases insofar as it does not involve a transfer of the debtor’s assets to a separate legal entity. In contrast, the acquirer takes over the existing entity and reorganizes it through a plan of reorganization, with the aim of becoming the majority stockholder after the termination of the bankruptcy process.

2.2 Discussion of the acquisition options in the U.S. bankruptcy system

2.2.1 General tendencies in U.S. bankruptcy procedures

Generally speaking, acquisitions of bankrupt firms require a thorough understanding of bankruptcy laws and their implications on the side of the acquirer. In this environment, legal issues tend to play a much more salient role than in acquisitions outside bankruptcy⁴³. While this may make bankruptcy situations appear less favorable for acquisitions, the Bankruptcy Code also offers various attractive features for both seller and buyer. These advantages frequently make buyers either wait until the target has filed for bankruptcy to start negotiations, or negotiate a “pre-packaged” bankruptcy filing with the target, instead of acquiring the distressed firm pre- bankruptcy. As a result of the favorable provisions offered by the Bankruptcy Code, most distressed acquisitions in the U.S. are executed in Chapter 11 rather than before the actual bankruptcy filing⁴⁴.

The frequency of acquisitions in the Chapter 11 context may seem to conflict with the traditional understanding of U.S. bankruptcy legislation as strongly favoring an independent reorganization of the bankrupt firm. Quite to the contrary, it can be observed that Chapter 11 is leading increasingly to sale rather than reorganization of the bankrupt business in recent years⁴⁵, with the technique of section 363 sales and its increasing application being an accelerator for this trend⁴⁶. There are also two other major influences underlying this development⁴⁷. Firstly, the significance of distressed debt investors as compared to bank lenders has been increasing in recent years. These investors appear to be strongly inclined towards a sale of the debtor rather than an independent reorganization because their investment focus is more short term. Secondly, private equity players are not only increasingly interested in buying bank- rupt businesses, but also have enough free capital to step in quickly, which was not the case in the past⁴⁸.

Among the methods to sell a bankrupt business, a shift from plan sales to section 363 sales is observable during the last years; the trend is so significant that section 363 sales have now become the dominant transaction method in bankruptcy⁴⁹, and have even come to be called “the future of bankruptcy”⁵⁰. Abramowitz et al. (2003) state that bankruptcy judges have formerly been reluctant to section 363 sales of all or substantially all of the firms’ assets “without the procedural and substantive protections of a confirmed plan of reorganization”⁵¹; however, this attitude has changed, and U.S. case law has shaped a strong majority view that a sale of the debtor’s entire asset base can be executed under section 363 BC: “It is therefore now very well established that a sale of all of the debtor’s assets may be lawfully accomplished outside a plan of reorganization under section 363 (b) of the Code”⁵².

2.2.2 Speed

Speed of resolution is possibly the main advantage of section 363 sales over plan sales⁵³. Speed is of paramount important because of the time constraints associated with a bankruptcy situation and the frequent decline in value of the debtor’s assets⁵⁴. Moreover, Chapter 11 procedures often bring about not only large indirect bankruptcy costs like fading trust from customers and suppliers as well as employee attrition, but also ongoing direct costs like professional fees to attorneys, advisers and investment bankers⁵⁵. Therefore - in contrast to a 363 sale -, “a sale made under a plan of reorganization can be significantly more time-consuming and, as a result, more expensive”⁵⁶. Plan sales can take “several months and sometimes several years”⁵⁷, whereas section 363 sales can be consummated in “as little as two to three months”⁵⁸. The higher speed of a 363 sale is mainly a result of the centralization of the selling process, because the seller is solely required to get the court’s approval, and not to negotiate individually with creditors⁵⁹. In a sale through a plan of reorganization, in contrast, the bidder will likely have to face a time-consuming process of negotiation with creditors. Hotchkiss / Mooradian (1998), referring to plan sales, argue that “for bankrupt firms with more complex debt structures, gaining creditor approval for an acquisition is likely to be difficult because of possible disagreements among creditor groups over the distribution of the proceeds from the sale”⁶⁰. The bidder may be obliged to negotiate with each single class of creditors and define the benefits each class stands to receive from the plan, unless she is able to file a “pot plan” to mitigate the problem⁶¹. Lies (2002) reports that “in most cases the debtor-in-possession or a potential purchaser do not want to wait until the time- consuming plan confirmation is completed”⁶², i.e. they prefer a section 363 acquisition. In an acquisition through purchase of claims, the investor also faces the hurdle of a plan confirmation process; she may, however, possess a strong voting position within her creditor class, which can help to at least partially mitigate the lengthy negotiation process.

2.2.3 Acquisition free and clear of liabilities

In constrast to an acquisition through purchase of claims, buyers have the opportunity to acquire assets free and clear of liabilities in plan acquisitions as well as in section 363 acquisitions⁶³. However, in a section 363 acquisition of assets which are subject to successor liability claims, environmental claims or product liability claims, U.S. jurisdiction is not clear with regard to the possibility to effect the sale free and clear of these liabilities; it appears that an acquisition through a plan of reorganization is preferable with regard to such assets, as it may cleanse the transferred business of liabilities in a more thorough way than a section 363 transaction⁶⁴. For instance, a plan acquisition offers the buyer the opportunity to eliminate future mass tort and product liability claims by issuing a so-called “channeling injunction” under a plan of reorganization, which serves to channel “any future claims to a specific fund or assets dedicated to payment of such claims”⁶⁵.

2.2.4 Competitiveness of transaction process / Price of acquired assets

Whereas a fast resolution of the transaction is in the interest of both seller and buyer, a highly competitive transaction process is something the seller is aiming at and the buyer is trying to avoid in asset deals, as it tends to lead to higher prices. Competitiveness is virtually guaranteed for in a section 363 sale as the solicitation of competitive bids is mandatory.

In a plan sale, on the contrary, an acquirer who decides to team up with the debtor’s management in the early stage of bankruptcy has the chance to elaborate a plan of reorganization before other bidders can enter the process⁶⁶. The opportunity for cooperation with the debtor arises from the fact that the initial 120 days exclusivity period effectively places the debtor in the driver’s seat in the bankruptcy process.

Although impaired creditors have a voting right on the plan and may object to it, the first initiative stays with the debtor. Acquirers can use this approach to mitigate the price risk of an auction process in a section 363 sale, especially if they manage to additionally negotiate the terms of the plan with creditors prior to the filing. To the senior managers of the debtor company, an acquisition through a consensual plan of reorganization may seem a viable way of maintaining their employment in the future⁶⁷.

2.2.5 Management approval

A complication affecting plan acquisitions, section 363 acquisitions and acquisitions through purchase of claims must be seen in the incumbent management retaining control over the firm in Chapter 11 procedures. As pointed out by Baird (1993), self- interested managers may be reluctant to a sale of the firm’s assets even if it is the preferred solution of creditors and shareholders, especially if a sale would mean the replacement of senior management⁶⁸. The bidder might be left with no other choice than elaborating a plan of reorganization together with the incumbent management, guaranteeing e.g. managers’ continuing employment subsequent to the acquisition⁶⁹.

2.3 Acquisition options in the German bankruptcy system

2.3.1 Introduction to German bankruptcy legislation

The German Insolvency Code (Insolvenzordnung) was passed in 1994 and came into force on January 1, 1999, replacing the Bankruptcy Act from 1877 (Konkursordnung), the Composition Act from 1935 (Vergleichsordnung), and the Joint Execution Act from 1975 (Gesamtvollstreckungsordnung, which regulated bankruptcies in the area of the former German Democratic Republic and was amended in 1990). The necessity for revamped bankruptcy legislation was primarily triggered by several inefficiencies associated with the pre-1999 bankruptcy system⁷⁰. Under the Insolvency Act, the bankruptcy process is divided into three distinct phases: a first phase between bankruptcy filing and opening, a second phase between bankruptcy opening and information hearing, and a third phase following the information hearing.

The opening of a bankruptcy procedure occurs pursuant to and within a period of normally three months after a bankruptcy filing, which can be a voluntary filing by the debtor herself or an involuntary filing by one of her creditors. German bankruptcy legislation requires prove of a bankruptcy trigger for a formal opening of the bankruptcy process; the debtor has the legal obligation to file for bankruptcy if the existence of a bankruptcy trigger is discovered⁷¹. Bankruptcy triggers are over- indebtedness, illiquidity, and imminent illiquidity⁷². In contrast to the U.S., a bankrupt German debtor normally loses control over the business from the time of the bankruptcy filing.

During the period between bankruptcy filing and opening, the court usually stops any payments to creditors and appoints a preliminary insolvency administrator⁷³. This can be either a “strong” or a “weak” preliminary insolvency administrator. Whereas a “weak” administrator is only entitled to approve or veto administrative actions of the debtor, a “strong” administrator takes over all administrative power⁷⁴. The more frequent case is the appointment of a “weak” preliminary insolvency administrator⁷⁵.

In any case, the debtor management loses control over the company’s cash to the insolvency administrator, depriving it of any significant operative control⁷⁶. Employee wages can be paid with Insolvenzgeld, i.e. money from an insurance fund maintained by a federal government agency (Bundesanstalt für Arbeit), in the phase before the bankruptcy opening⁷⁷. This is a very frequent measure in larger bankruptcy cases⁷⁸and allows the insolvency administrator to accumulate a certain amount of liquidity until the bankruptcy opening. However, this liquidity position often melts away rapidly after the opening⁷⁹.

If the court finds that (1) the debtor’s asset base suffices to cover the costs of the bankruptcy procedure and (2) a bankruptcy trigger is in place, it will formally open the bankruptcy procedure. Subsequent to the opening decision, the preliminary insolvency administrator is usually promoted to the insolvency administrator, and assumes control over the debtor’s assets⁸⁰. Additionally, a creditor assembly is generally installed, with the task of supervising the insolvency administrator in the administration of the debtor estate. The court also specifies a date for the information hearing (Berichtstermin)⁸¹and the examination hearing (Prüfungstermin)⁸².

At the information hearing, the insolvency administrator has to express a recommendation to the creditors on the objective of the further bankruptcy process, which is generally either a shutdown and liquidation of the business in whole or in part, a transferring reorganization (übertragende Sanierung) of the business in whole or in part, or a reorganization of the business pursuant to an insolvency plan. The creditors decide by means of a voting process⁸³, frequently following the insolvency administrator’s recommendation.

There are two important innovations introduced by the Insolvency Code, namely the insolvency plan procedure (Insolvenzplanverfahren) and the possibility of self- management (Eigenverwaltung). These innovations also play a certain role in the context of acquisitions of bankrupt companies.

While the insolvency plan procedure generally allows for a continuation of the business, it does not necessarily imply a debtor-in-possession situation, i.e. self- management, which has to be proposed and decided upon separately. An insolvency plan can be submitted either by the debtor or by the insolvency administrator. In any case, the creditors have to decide at the information hearing whether or not a continuation of the bankrupt firm and subsequent restructuring pursuant to an insolvency plan is desired and executed.

If the debtor applies for self-management, i.e. proposes to stay in charge of the business similar to a Chapter 11 debtor-in-possession, the court has to decide on the proposal at the bankruptcy opening. In case of an approval, the court appoints a trustee, whose task is to supervise the debtor in her administration of the estate. The trustee has a significantly weaker position than an insolvency administrator, because all operative control remains in the hands of the debtor. Generally, it is only possible for the debtor to be awarded self-management if she can prove that the reason for the bankruptcy does not lie within her responsibility⁸⁴. As courts are relatively reluctant to grant self-management to debtors, the number of cases is small in practice⁸⁵.

In the course of the bankruptcy process, bidders generally possess two options for acquiring a bankrupt business⁸⁶:

(1) Acquisition pursuant to a transferring reorganization (Übertragende Sanierung)
(2) Acquisition pursuant to an insolvency plan (“insolvency plan sale”)

2.3.2 Acquisition pursuant to a transferring reorganization (Übertragende Sanierung)

As in plan sales and section 363 sales in the U.S., a transferring reorganization is a classical asset deal: The acquirer takes over the assets and continues to operate the business of the bankrupt company, while the liabilities remain on the balance sheet of the bankrupt entity. Subsequently, the insolvency administrator distributes the proceeds from the sale to the creditors, and liquidates the empty “shell”, i.e. the bankrupt entity.

In Germany, the transferring reorganization is by far the most important technique for acquiring businesses out of bankruptcy - “approximately 90% of all successful transactions in bankruptcy situations are executed as transferring reorganizations“⁸⁷. For the execution of a transferring reorganization, the acquirer can either acquire the bankrupt company’s assets by herself or set up a new legal entity (“New Co”), with the latter technique being the more common⁸⁸. In this case, the investor establishes the New Co (frequently a GmbH) and provides it with (1) the legally required amount of equity⁸⁹, (2) the capital to execute the acquisition of the assets, and (3) the working capital necessary to start the operation of the new company⁹⁰.

The viability of a transferring reorganization depends strongly on the phase of the bankruptcy process.

A transferring reorganization can even be possible prior to the actual bankruptcy opening, but only if the court appoints a “strong” preliminary insolvency administrator. In this case, the acquirer’s claim on the assets constitutes a privileged claim (Masseverbindlichkeit) after the opening; nevertheless, it is not clear whether a strong preliminary insolvency administrator is at all entitled to sell the bankrupt firm prior to the bankruptcy opening⁹¹. According to the Insolvency Code, the duty of the preliminary insolvency administrator is to “secure” the estate and “continue” the operating business until the opening decision⁹². The dominant opinion in the scientific literature holds that a sale by a strong preliminary insolvency administrator prior to the opening is only justified in case of a rapidly decreasing value of the estate and with the consent of debtor and court⁹³.

Also in the phase between bankruptcy opening and information hearing, the insolvency administrator’s main duty is to secure and continue the operating business. If, however, a situation of rapid decline in the estate value urges the insolvency administrator to sell the firm prior to the information hearing, she may do so with creditor approval; debtor and court, in contrast, cannot object to the sale⁹⁴.

After the information hearing, the legal situation is clear. If the insolvency administrator has already found a bidder and the negotiations are not far from signing, the creditors can approve a sale to this bidder at the information hearing. Otherwise, the creditors can entitle the insolvency administrator to initiate a sale process, and set the minimum requirements for a purchase agreement. In both cases, the insolvency administrator receives all decision-making power and is not required to obtain another creditor approval at the time of signing⁹⁵.

Currently, the German government is planning to change the legislation regarding transferring reorganizations. The changes would affect § 22 I 2 InsO and § 158 InsO, which concern the possibility of a transferring reorganization prior to the information hearing. According to the preliminary draft, the “strong” preliminary insolvency administrator would be entitled to sell the company even prior to the bankruptcy opening if the legal criteria for a shutdown are fulfilled⁹⁶. In the context of this thesis, however, the proposed regulatory change would certainly not be of relevance, because a company qualifying for shutdown is not a potential target for distressed private equity investors⁹⁷.

2.3.3 Acquisition pursuant to an insolvency plan

An alternative option for the bidder is an acquisition in the context of an insolvency plan procedure. This implies that the reorganization takes place maintaining the existing legal entity, of which the acquirer becomes the majority stockholder. The existing equity position of the bankrupt entity – which is usually close to zero - is eliminated through so-called “capital cuts” (Kapitalschnitte); subsequently, the investor infuses new equity; simultaneously, the debt level of the company is reduced following negotiations with creditors⁹⁸. In order to execute these measures, a majority of the creditors have to agree to the debt reduction, and a stockholder meeting has to be convoked, in which a qualified majority of the current shareholders must approve the capital cuts⁹⁹.

Clearly, the execution of such an insolvency plan sale is extremely complicated and involves a high amount of uncertainty¹⁰⁰. Therefore, insolvency plan sales play only a very small role in the German practice of bankruptcy resolutions¹⁰¹.

It is important to point out that, besides the prima facie verbal similarity, an acquisition pursuant to a plan of reorganization in the U.S. is a completely different concept than an acquisition pursuant to an insolvency plan in Germany. Whereas the U.S. plan sale is essentially an asset deal whose details are specified in a plan of reorganization, the German insolvency plan sale implies an acquisition of the bankrupt legal entity by the buyer (“share deal”).

2.4 Discussion of the acquisition options in the German bankruptcy system

2.4.1 Speed

The transfer of the debtor’s assets free and clear of liabilities in a transferring reorganization substantially facilitates the due diligence process¹⁰². In an insolvency plan sale, in contrast, the acquirer takes over the existing legal entity, and therefore has to conduct a much more extensive due diligence¹⁰³.

Additional complications in insolvency plan sales arise from the twofold voting procedure involving creditors and stockholders. This complex process has to be executed under the condition of high time pressure facing the bankrupt company¹⁰⁴, and therefore constitutes a disadvantage associated with insolvency plan sales.

Another issue contributing to the higher speed of transferring reorganizations is distribution of payments among creditors. Whereas in a transferring reorganization, the acquirer does not have to consider the question of how to distribute sale proceeds, an insolvency plan sale requires the bidder to develop a distribution scheme for future profits and specify it in the insolvency plan.

2.4.2 Acquisition free and clear of liabilities

The concept of a transferring reorganization implies that the acquired assets are transferred free and clear of liabilities. Specifically, neither debt nor tax liabilities are transferred, i.e. § 25 HGB and § 75 II AO are not applicable¹⁰⁵. However, there are two exceptions from the rule: Firstly, environmental liabilities associated with the acquired assets can constitute a problem for the acquirer¹⁰⁶. Secondly, German labor laws (§ 613a BGB) require the acquirer of assets to assume the responsibility for all employment contracts associated with these assets¹⁰⁷.

In an insolvency plan sale, the question of whether the bankrupt firm is freed from existing liabilities is not a matter of legislation, but of negotiation. If the acquirer desires freedom from existing liabilities, this must be negotiated with the company’s creditors.

An acquisition free and clear of liabilities, however, also creates a certain problem for the acquirer, who is forced to rebuild the entire capital structure, e.g. accounts payable. This imposes a substantial financing requirement on the acquirer¹⁰⁸.

[...]

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¹ See e.g. Godenrath, 2004 and Siebold, 2004.

² See Siebold, 2004.

³ See e.g. Fink, 2004 and Achleitner, 2004.

⁴ See Kraft, 2001, p. 34.

⁵ See e.g. Papendick, 2003, p. 72.

⁶ Wilbur L. Ross, chief executive officer of W.L. Ross & Company, one of the largest U.S. distressed private equity funds, states: “Our symbol is not the vulture but the phoenix.” Ross, 2003, p. 2.

⁷ Gilson, 1995, pp. 10f.

⁸ See Gilson, 1995, pp. 10f.

⁹ Additional factors of influence, which cannot be discussed here due to the limited size of this thesis, include distressed debt markets and tax legislation.

¹⁰Goldberger / Tepner, 2001, p. 14.

¹¹See Abramowitz / Krueger / Layne, 2003, and Goldberger / Tepner, 2001, p. 14.

¹²Additional but less significant methods are Interim Operating Agreements and “New Value” Auctions; see Goldberger / Tepner, 2001, pp. 18f.

¹³¹¹ U.S.C. §§ 1101 and 1107(a). Reasons for the appointment of a trustee include fraud, dishonesty, incompetence, or gross mismanagement of the debtor either before or after the commencement of the case; see Altman, 1993, p. 47. In Chapter 11 cases, the appointment of a trustee is a rare event and mostly an interim measure if a new management team needs to be found; see Gilson, 1989, p. 241.

¹⁴¹¹ U.S.C. § 362(a).

¹⁵¹¹ U.S.C. § 1102.

¹⁶¹¹ U.S.C. § 1121(b). The court can extend this exclusivity period, if judged necessary, upon request by the debtor, 11 U.S.C. § 1121(d).

¹⁷Gilson, 1995, p. 10.

¹⁸¹¹ U.S.C. § 1126(c).

¹⁹¹¹ U.S.C. § 1129(b).

²⁰A plan of reorganization which proposes a sale of the debtor’s assets is sometimes referred to as a “plan of liquidation”; see e.g. Mecham, 2004, p. 34.

²¹See Goldberger / Tepner, 2001, p. 16.

²²See Goldberger / Tepner, 2001, p. 17.

²³¹¹ U.S.C. § 363 (b)(1).

²⁴Goldberger / Tepner, 2001, p. 12.

²⁵Abramowitz / Krueger / Layne, 2003.

²⁶See Glosband, 2004, p. 61.

²⁷See Ball / Kane, 2003b, p. 17.

²⁸See Feldman / Gray / Leung, 2002, p. S5.

²⁹See Abramowitz / Krueger / Layne, 2003.

³⁰See Feldman / Gray / Leung, 2002, p. S7.

³¹See Feldman / Gray / Leung, 2002, p. S6.

³²See Abramowitz / Krueger / Layne, 2003.

³³See Abramowitz / Krueger / Layne, 2003.

³⁴ 11 U.S.C. § 363 (m).

³⁵See Freshfields Bruckhaus Deringer, 2004.

³⁶See Köhler, 2002.

³⁷Anson, 2002, p. 17.

³⁸See Goldberger / Tepner, 2001, pp. 17f.

³⁹This technique was employed, for instance, in the acquisition of bankrupt Regal Cinemas Inc. led by Oaktree Capital Management; see Anson, 2002, pp. 11f.

⁴⁰See Gilson, 1995, p. 11.

⁴¹Gilson, 1995, p. 12.

⁴²See Gilson, 1995, p. 12.

⁴³See Shearer, 2001, p. 8.

⁴⁴See Shearer, 2001, p. 7.

⁴⁵See Hotchkiss / Mooradian, 2003, p. 556.

⁴⁶See Miller / Waisman, 2001, pp. 3f. and Miller / Waisman, 2003, p. 4.

⁴⁷See Brennan, 2003, and Miller / Waisman, 2003, p. 4.

⁴⁸See Brennan, 2003, and Miller / Waisman, 2003, p. 4.

⁴⁹See Ball / Kane, 2003a, p. 3.

⁵⁰Landau, 2003, p. 102.

⁵¹Abramowitz / Krueger / Layne, 2003.

⁵²Lies, 2002, p. 367.

⁵³See Abramowitz / Krueger / Layne, 2003.

⁵⁴See Lies, 2002, p. 365.

⁵⁵See Thornton / Palmeri, 2001, and o.V., 2003, Big Business.

⁵⁶Ferdinands / Graham / Schubert, 2001.

⁵⁷Glosband, 2004, p. 60.

⁵⁸Glosband, 2004, p. 60.

⁵⁹See Burr, 2003.

⁶⁰Hotchkiss / Mooradian, 1998, p. 241.

⁶¹See Goldberger / Tepner, 2001, p. 16.

⁶²Lies, 2002, p. 365.

⁶³See Ferdinands / Graham / Schubert, 2001.

⁶⁴See Goldberger / Tepner, 2001, p. 13f.

⁶⁵Goldberger / Tepner, 2001, p. 11.

⁶⁶See Goldberger / Tepner, 2001, p. 16.

⁶⁷See Goldberger / Tepner, 2001, p. 16.

⁶⁸See Baird, 1993, p. 635.

⁶⁹See Goldberger / Tepner, 2001, p. 16.

⁷⁰For instance, 75% to 80% of all proceedings were not even initiated because of lacking assets to cover the administrative costs associated with the bankruptcy proceedings, and another 10% were prematurely discontinued. Additionally, the recovery rate for unsecured creditors was, on average, very low (3 to 5%); see Breuer, 2003, p. 1.

⁷¹See especially § 92 II AktG for the AG and § 64 I GmbHG for the GmbH.

⁷²Imminent illiquidity is only applicable in case of a voluntary filing, § 18 I InsO, and does not trigger a legal obligation to file for bankruptcy.

⁷³See Jones Day, 2004 and Menke, 2003, p. 1134.

⁷⁴See §§ 21f. InsO for details.

⁷⁵See Menke, 2003, p. 1134.

⁷⁶See interview with Dr. E on 11/06/2004.

⁷⁷See interview with Dr. E on 11/06/2004.

⁷⁸See Dr. Wieselhuber & Partner, 2003, p. 35.

⁷⁹See interview with Dr. E on 11/06/2004.

⁸⁰ § 80 I InsO.

⁸¹The information hearing must take place within three months after the opening, § 29 I 1 InsO.

⁸²The creditors have to file their claims until the date of the examination hearing, §§ 21f. InsO.

⁸³For details on the voting procedure, see §§ 76f. InsO.

⁸⁴See Breuer, 2003, p. 154f.

⁸⁵See Chapter 4.1.2, figure 5.

⁸⁶Theoretically, an acquisition through a purchase of creditor claims would also be possible, but has not yet been exercised in practice in Germany.

⁸⁷Interview with Dr. E on 11/06/2004. In a study comprising 52 bankruptcies of German firms with revenues of at least EUR 15m, Dr. Wieselhuber & Partner (2003) find that transferring reorganizations accounted for 88% of all continuations of the businesses; see Dr. Wieselhuber & Partner, 2003, p. 36.

⁸⁸See interview with Dr. E on 11/06/2004.

⁸⁹EUR 25,000 in the case of a GmbH, see § 5 I GmbHG.

⁹⁰See interview with Dr. E on 11/06/2004.

⁹¹See Menke, 2003, p. 1134.

⁹² §22 I 2 InsO.

⁹³See Menke, 2003, pp. 1135f.

⁹⁴See Menke, 2003, pp. 1138f.

⁹⁵See Menke, 2003, pp. 1139f.

⁹⁶See Bundesministerium der Justiz, 2003, p. 2f.

⁹⁷See also the statement of the German Lawyer Association (Bundesrechtsanwaltskammer), which criticizes the draft for tying the possibility of a transferring reorganization to the criteria for a shutdown: “The scope of this regulation has to be considered very small, because it should be a rare exception to find a buyer for a company which is not any more economically viable.” Bundesrechtsanwaltskammer, 2003, p. 4 (translated from German original).

⁹⁸See interview with Dr. E on 11/06/2004.

⁹⁹See interview with Dr. E on 11/06/2004.

¹⁰⁰See Chapter 2.4.1.

¹⁰¹See interview with Dr. E on 11/06/2004.

¹⁰²See interview with Mr. C on 11/08/2004.

¹⁰³For instance, tax liabilities and contracts with lenders may be important issues in a share deal, but play no role in an asset deal.

¹⁰⁴See interview with Dr. E on 11/06/2004.

¹⁰⁵See Menke, 2003, p. 1140 and Rock, 2004, p. 269.

¹⁰⁶An example for this is the case of a transferred production site standing on contaminated soil. In this case, the resolution of the situation falls into the responsibility of the acquirer, she being the new owner of the contaminated soil; see interview with Dr. E on 11/06/2004.

¹⁰⁷See chapter 2.5.2 for a detailed discussion of § 613a BGB.

¹⁰⁸For a discussion of the associated problems that arise especially in Europe, see chapter 3.4.5.