Transactions with distressed companies: key questions for directors.

• Author: McDonald, Matthew M.

As banks and other traditional sources of capital find their balance sheets reflecting more and more under-performing assets, lending standards continue to tighten, leading to the well-publicized lack of commercial credit. Alternative sources of capital, such as private equity financings or the public securities markets, are also out of reach for many companies. The unprecedented government spending packages sponsored by the Bush and Obama administrations have made funds available in certain key industries and to companies deemed "too big to fail," but many businesses are either unable to take advantage of the government programs or unwilling to accept the strings attached to the funds being offered. As a result, an increasing number of companies find themselves facing a significant liquidity crisis, with many seeking protection in bankruptcy proceedings. The Administrative Office of the U.S. Courts reports that over 43,000 businesses filed for bankruptcy during 2008, while the American Bankruptcy Institute reports over 14,000 bankruptcy filings by businesses during the first quarter of 2009, an increase of approximately 30% on an annualized basis.

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Although the current economic climate poses challenges to distressed businesses, it may also provide opportunities for more economically sound companies to acquire key assets or lines of business at bargain prices. But are these deals too good to be true?

Suppose that you are approached by your management team with an opportunity to acquire the assets of a competitor at an attractive price. Management advises that the deal will need to close quickly, as the competitor does not anticipate having sufficient liquidity to satisfy its outstanding obligations. If the asset sale does not close soon, the competitor will have no choice but to file for bankruptcy and seek to sell its assets off under the supervision of the bankruptcy court.

As a director evaluating this situation, one of the most important decisions to be made is whether your company is better off purchasing the assets offered outside of bankruptcy or allowing the target company to file before seeking to acquire the assets. Unfortunately, there is no "one-size-fits-all" answer, but here are some key questions to ask when contemplating a transaction with a distressed company:

Have you considered the costs beyond the purchase price?

Bankruptcy can be time-consuming and expensive, both in terms of...