Bankruptcy Asset Sales and Purchases | Bankruptcy Code Section 363
Buying Assets from Bankruptcy Estates — finding the inefficient market! There is a huge untapped resource of undervalued assets available for sale from bankruptcy estates. A common financial concept is the idea of efficient markets. Purchasing assets from large companies in Chapter 11 through 363 sales is a more efficient market–meaning that more buyers are looking and the prices of the assets more accurately reflects current market value. However, assets in small chapter 11 (or even Chapter 7 cases) get much less attention and are ripe for picking at discount prices.
Moreover, these purchases are among the safest. You can obtain a federal court order ensuring that you are purchasing the assets under Bankruptcy Code Section 363 “free and clear of all liens, claims and encumbrances” on the asset — effectively removing those “warts” from the asset that kept it from being sold in the first place.
How do you buy assets from a Bankruptcy Estate? What is a Section 363 Sale?
After a company files for bankruptcy, it must obtain court approval to sell its assets outside of the ordinary course of business. Section 363(b) of the Bankruptcy Code (11 U.S.C. § 363) provides a procedure for a debtor to obtain this approval on a motion and a hearing. Section 363 sales are generally used to sell smaller assets, but they can also include all or substantially all of a debtor’s assets if certain additional legal requirements are satisfied (see Sales of All or Substantially All Assets). They are usually conducted by public auction under the supervision of the bankruptcy court (see The Section 363 Sale Process), but section 363 sales can also be private. A main advantage of a section 363 sale is the ability to obtain assets free and clear of liens and most liabilities attached to the assets (see Free and Clear of Interests).
Typically, during economic downturns there are increasing numbers of financially troubled companies with assets that may be attractive targets for private equity firms and strategic buyers to purchase using section 363 sales. These prospective buyers should consider the advantages and disadvantages of buying assets through a section 363 sale, how the process works and strategically at what point in the process to engage with the debtor-seller.
The Sale Process
A process of conducting a section 363 sale (under 11 U.S.C. § 363) is usually conducted using a double auction process to generate the highest and best offer and generally involves the following key steps:
Step 1: First auction (unofficial deal negotiation with stalking horse):
After marketing the assets, the debtor enters into an asset purchase agreement with a prospective buyer, who is usually selected in an unofficial mini-auction. The buyer typically acts as a stalking horse, which functions to set the floor purchase price in the auction and to attract other prospective buyers to bid on the assets. In many cases, the deal is negotiated before the bankruptcy filing and the seller files for bankruptcy a day or two after signing the asset purchase agreement.
Step 2: Notice and a hearing:
The debtor must give at least 21 days’ notice of the hearing to approve the sale process to all creditors (§ 363(b)(1), Bankruptcy Code and Fed. R. Bankr. P. 2002(a)(2)). If there are no objections to the section 363 sale, the court can approve the plan to sell the assets without conducting a hearing. If there are objections (usually from creditors), the court must decide if the sale is in the debtor’s best interest.
Step 3: Second auction (the “Courtroom” auction):
After the bankruptcy court approves the sale process, the buyer is usually (but not always) chosen by a court-supervised second auction, to satisfy the requirement that the debtor obtain the highest and best price for its assets.
Step 4: Entry of Order Approving Sale.
All of the transaction documents are submitted to the court for approval and the court enters an order authorizing the sale. The sale order is automatically stayed for 14 days, giving any objecting parties time to seek a further stay while they appeal the sale order (Fed. R. Bankr. P. 6004(h)). Courts can (and typically do) waive or reduce the 14-day appeal period, on request of the parties, if there is a reason to close the sale before its expiration.
Step 5: Closing.
The transaction is generally closed either immediately after entry of the sale order (if the court waives the 14-day appeal period) or after the sale order has become final and non-appealable (after expiration of the 14-day appeal period).
Though the timing depends on the jurisdiction in which the bankruptcy case is filed and how busy the court is at the time, the process generally takes about two months. However, a three-month sale timeline was standard prior to Lehman’s sale of its North American business to Barclays in 2008, which was completed in a record seven days. Some commentators have expressed concerns about the increasing speed of section 363 sales, noting that quick sales may deprive creditors of certain protections that they would otherwise have if the assets were sold under a plan of reorganization, which would require their approval.
Section 363 sales offer many important benefits not available to buyers in asset sales conducted outside of bankruptcy. The bankruptcy court has the power to approve the sale of assets free and clear of liens and most liabilities if one of the following conditions is satisfied:
- Non-bankruptcy law permits the sale free and clear of interests (§ 363(f)(1), Bankruptcy Code). This condition is rarely met because non-bankruptcy law typically requires the debtor satisfy the lien before it can sell the property free and clear.
- The party holding the interest in the property being sold consents (§ 363(f)(2), Bankruptcy Code). Consent can be implied by a failure to object after receiving notice.
- If the interest is a lien, the purchase price for the property is greater than the aggregate value of all liens on the property (meaning the debtor has equity in the property) (§ 363(f)(3), Bankruptcy Code). Since the aggregate value of the liens can exceed the value of the property, courts are divided over whether the purchase price must exceed the face amount of the lien or the value of the collateral securing the lien (see Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25, 39-41 (B.A.P. 9th Cir. 2008) (Clear Channel) (purchase price must exceed face amount of the lien); In re Boston Generating, LLC, 440 B.R. 302, 332 (Bankr. S.D.N.Y. 2010) (purchase price must exceed the value of the collateral)).
- The validity of the interest is in bona fide dispute (§ 363(f)(4), Bankruptcy Code). There must be an objective basis for either a factual or legal dispute, not merely an allegation that a dispute exists. It must be a good faith dispute not made solely for the purpose of satisfying this condition.
- The interest can be reduced to a claim for money (§ 363(f)(5), Bankruptcy Code). While money can satisfy most interests, it cannot satisfy some types of equitable relief, such as a federal injunction to clean up an environmental hazard.
Although there is a good amount of litigation over the interpretation of section 363(f), the lienholder often consents because its liens attach to the proceeds of the sale. This means that, although not required, the lienholder often receives a distribution of the sale proceeds to pay off the debt secured by the lien. If the debtor uses the proceeds of the sale rather than distributing them, the lienholder is entitled to adequate protection of its interest in the sale proceeds (§§ 363(c)(2) & 363(e), Bankruptcy Code). This typically requires a lien on substitute collateral.
Buyers have the ability to chose to assume certain favorable executory contracts and leases despite anti-assignment clauses, which are generally unenforceable in bankruptcy (§ 365(f)(1), Bankruptcy Code). The buyer decides which of the debtor’s agreements it wishes to assume and reject in connection with the transferred assets, and directs the debtor to assume or reject accordingly. In the case of assumption, the debtor must first assume the contract and cure any defaults (or provide adequate assurance that the default will be cured promptly (§ 365(b)(1)(A), Bankruptcy Code)). The debtor can then assign the contract to the buyer, who must give adequate assurance of future performance, even if the contract is not in default (§ 365(f)(2)(B), Bankruptcy Code).
The court examines the conduct of the buyer in determining whether it is a good faith purchaser. Good faith is marked by an absence of fraud, collusion, attempts to take grossly unfair advantage of other bidders or bribes to insiders of the debtor. The sale order must explicitly state that the buyer is a good faith purchaser to obtain this protection. Good faith purchasers are given assurances of finality of the sale in two ways:
- The court can waive the automatic 14-day stay period after the section 363 sale order is entered and make the sale effective immediately on issuance of the sale order (Fed. R. Bankr. P. 6004(h)).
- A sale to a good faith purchaser cannot be modified or overturned unless the sale is stayed while the appeal is pending (§ 363(m), Bankruptcy Code). This is known as statutory mootness because any appeal of the sale order is moot unless the party appealing the sale order has obtained a stay of the closing of the transaction. While this protection has been called into question by the Ninth Circuit’s BAP decision in Clear Channel, the general trend has been towards rejecting this decision as an aberration (see Box, Clear Channel Decision Threatens Finality of Free and Clear Relief on Appeal). In addition, a 2011 decision by the US Court of Appeals for the Eighth Circuit held that a state court judgment interpreting the free and clear provisions of a sale order was entitled to “full faith and credit” by the bankruptcy court because it was not the result of an attack on the sale order, but rather an interpretation concerning its merits (see Mid-City Bank v. Skyline Woods Homeowners Ass’n. (In re Skyline Woods Country Club), 636 F.3d 467 (8th Cir. 2011)).
The finality of section 363 sale orders was recently affirmed in the Lehman bankruptcy proceedings, concerning the sale of its assets to Barclays Capital Inc. (see Legal Update, Lehman Court Denies Motion to Modify Section 363 Sale Order Approving Sale to Barclays. Also, the US District Court for the District of Delaware recently expanded the scope of good faith purchaser protection by holding that “transactions integral to a sale” (in this case, the establishment of a litigation trust) deserve this protection, even if they are a use, rather than a sale, of estate property (see Boeing Co. v. Kaiser Aircraft Indus., Inc. (In re Alabama Aircraft Indus., Inc.), 464 B.R. 120, 124 (D. Del. 2012).
The auction process ensures that the debtor receives the best possible offer for the assets sold, so there can be no claim that reasonably equivalent value was not received (one of the elements of a constructive fraudulent transfer) and § 548(a)(1)(B)(i), Bankruptcy Code). In addition, the sale order normally bars any future claims of fraudulent transfer. However, if the buyer is aware that the assets it is purchasing were originally acquired by the debtor in a fraudulent transfer, it does not have the protection of the future good faith transferee defense and § 550(b)(1), Bankruptcy Code). In that case, the buyer must return the assets and may be left with an unsecured claim, which may not be worth much.
Some other important advantages of section 363 sales for buyers include:
- Price. Bankruptcy sales present an opportunity to buy valuable assets at below-market prices because there are generally fewer prospective buyers competing for the assets. Some parties shy away from section 363 sales merely because the company is in bankruptcy and others because of the limited time frame to conduct due diligence (see Disadvantages of Section 363 Sales).
- No bulk transfer liability. Article 6 of the Uniform Commercial Code (UCC), which contains the bulk transfer laws, specifically excludes bankruptcy sales.
- Procedural advantages. For example, the waiting period to investigate antitrust concerns under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR) can be reduced to 15 days for a section 363 sale.
- Ability to bind non-consenting stockholders. Provisions in corporate charters requiring the approval of a majority of stockholders to sell substantially all of the assets of a company are not enforced in bankruptcy.
- Less due diligence of liabilities required. Due diligence with respect to the liabilities attached to the assets (see Liabilities) is generally less of a concern because the assets are sold free and clear of liens and most liabilities (see Free and Clear of Interests).
- Ability to credit bid. Secured creditors holding claims against the assets being sold are permitted to bid for the assets and offset the full face amount of their claim (including any unsecured portion) against the purchase price even if the debt is trading below par or was bought at a discount. § 363(k), Bankruptcy Code).
While the ability to obtain assets free and clear of interests is an important advantage, it is subject to several caveats:
- Lienholders must receive notice of the sale, or else they can later assert rights against the assets on the basis of due process violations (see Liabilities).
- Some liabilities cannot be eliminated, such as environmental liabilities and successor liabilities relating to certain types of tort claims (see Disadvantages of Section 363 Sales). For example, one court recently held that buyers were not absolved from successor liability claims asserted by tort claimants who, at the time of the sale, had not yet been injured and had no relationship to the debtor or its products (see Morgan Olson, LLC v. Frederico (In re Grumman Olson Indus., Inc.), 445 B.R. 243, 250-56 (Bankr. S.D.N.Y. 2011), aff’d by 2012 WL 1038672 (S.D.N.Y. Mar. 29, 2012).
- Although the bankruptcy court has worldwide jurisdiction, the order approving the sale of assets free and clear of interests may not be enforceable with respect to assets sold outside of the US, meaning the buyer may remain liable for claims of non-US creditors against non-US assets.
- Buyers often agree to assume specified liabilities. For example, in the interest of preserving key business relationships, buyers typically agree to assume all of the trade obligations related to the acquired business. Doing so also eliminates a class of creditors that might otherwise object to the sale
- although the Bankruptcy Code provides finality of sales to good faith purchasers (see Good Faith Purchaser Protection and § 363(m), Bankruptcy Code), an important 2008 Ninth Circuit Bankruptcy Appellate Panel (BAP) decision provides disgruntled parties with precedent to challenge the free and clear provisions of section 363 sale orders (see Box, Clear Channel Decision Threatens Finality of Free and Clear Relief on Appeal). However, the general trend has been towards rejecting this decision as an aberration.
The advantages of buying assets in a section 363 sale must be carefully weighed against the following disadvantages:
- Informal and disruptive process. The bankruptcy process is informal and subject to disruption by interested parties. All of the debtor’s creditors have a voice in the process and can object to the sale. Also, the informal nature of the process means the court can override its approved bidding procedures and accept late or non-conforming bids (see Stalking Horse Disadvantages). Potential buyers must be prepared to deal with unpredictability and many competing interests.
- No confidentiality. The bankruptcy process is transparent. Mandatory notice provisions require the terms of an asset purchase agreement to be made public. The asset purchase agreement must be filed in the bankruptcy court along with the sale motion explaining the terms of the agreement and seeking approval of the sale.
- Negative publicity. Because bankruptcy is a public and transparent process, a section 363 sale exposes the buyer to the potentially stigmatizing effects of a bankruptcy filing. This publicity can negatively impact the debtor’s business operations, including the value of the assets to be sold.
- Transaction costs. court approval and timing. Bankruptcy court approval is required at several stages of the sale process after notice and a hearing. The process can take between 30 to 90 days, depending on the court’s schedule and the number and nature of objections to the sale. Time is of the essence in sales of distressed assets, where value can erode quickly. In contrast, a sale outside of bankruptcy can often be completed faster and more economically.
- Due diligence. While the overall process can take longer, the time frame to conduct due diligence is often dramatically shortened by either the court’s schedule or by the appearance of another competing buyer. This increases the risk that the buyer may fail to identify issues and overpay for the assets. This risk is heightened by the fact that the debtor’s representations and warranties regarding the assets are usually minimal (or none) and post-closing indemnification rights are typically limited or non-existent.
- Successor liability issues. The bankruptcy court has limited ability to cut off successor liability claims. These trailing liabilities often relate to mass torts such as products liability, environmental claims and labor liabilities. It is important to identify these liabilities in the due diligence process.
- No guarantee of success. Prospective buyers in section 363 sales typically are required to submit irrevocable bids with limited closing conditions and contingencies, with no corresponding commitment from the debtor until the sale is approved by the court.
There are a number of considerations and strategies behind buying assets at a 363 sale:
Section 363 sales raise a variety of tactical issues for a prospective buyer, including:
- Special considerations in the due diligence process (see Due Diligence).
- Structuring the bid (see Valuation).
- When to enter the process (see Bid Timing).
While the due diligence process in a section 363 sale has many of the same underlying characteristics of the due diligence process in non-bankruptcy sales, the particularities of the bankruptcy process raise some unique issues.
For example, legal due diligence in a section 363 sale must include an analysis of the:
- Executory contracts and unexpired leases relating to the assets. This analysis must consider which executory contracts and leases should be assumed or rejected, the debtor’s ability to assign executory contracts and any adverse economic consequences triggered by a change of control.
- The intellectual property rights included in the sale, which can be subject to many restrictions under the Bankruptcy Code.
Although not unique to bankruptcy sales, potential buyers should also consider whether their purchase of assets at a section 363 sale would have any anticompetitive effects on the market generally, as standard bankruptcy court approval (that is, without specific findings in the sale order stating that the sale has no anticompetitive effects) does not insulate buyers from antitrust claims (see Gulf States Reorganization Group, Inc. v. Nucor Corp., 466 F.3d 961 (11th Cir. 2006)). If such issues are a concern, they should be raised before the bankruptcy court before it approves the sale, and the buyer should be ready to offer relevant evidence.
Overall, the bankruptcy process affects the fundamental approach taken towards due diligence, with respect to the review of the assets bought and the liabilities related to such assets
Due diligence of the assets is crucial in section 363 sales for several reasons. Unlike non-bankruptcy sales, the buyer assumes all risks of any latent defects discovered (and discoverable) after the sale has closed. Most asset sales in bankruptcy are sold on an “as is, where is” basis. Because one of the primary goals of bankruptcy is to provide debtors with a fresh start, debtors generally wish to avoid future claims arising from the asset sale and prefer to sell property with either minimal or no representations and warranties.
The asset purchase agreement typically contains the following disclaimers:
- A warranty disclaimer, disclaiming any representation or warranty of any kind, whether express or implied, concerning merchantability, fitness for a particular purpose or compliance with applicable laws or regulations.
- A representations disclaimer, disclaiming liability for any inaccuracy in the description of assets.
The buyer may also be required to represent that it has not relied on any express or implied representation or warranties of the debtor, and further, that the buyer has inspected the property (or has had the opportunity to inspect) and is relying on its own investigation. Finally, the willingness to accept more limited representations and warranties can increase the value of the buyer’s offer (see Valuation).
Generally, the doctrine of caveat emptor (let the buyer beware) applies to sales of assets in bankruptcy, leaving the buyer with limited ability to assert claims after the sale has closed.
Due diligence with respect to the liabilities attached to the assets is generally less of a concern in section 363 sales than in non-bankruptcy sales because assets are sold free and clear of liens and most liabilities (see Free and Clear of Interests). It is also less of a concern where the transaction is structured as a sale of assets rather than a sale of stock, where the liabilities may be less apparent. Section 363 sales are typically asset sales, although if the debtor is a holding company, it can sell its stock in its subsidiaries in a section 363 sale.
Despite the form of the transaction, the buyer should still identify all claims and liabilities that exist against the assets, including any unrecorded, disputed or contingent liabilities. The buyer should obtain an independent report on filings of:
- UCC-1 financing statements.
- Tax liens.
- Real estate tax liens.
- Personal property tax liens.
- Fixture filings.
- Judgment liens.
The buyer should also request a written representation from the debtor regarding the existence of liens on the assets. The debtor must notify all creditors and third parties asserting liens against the assets that their rights will attach to the proceeds of the sale at closing. Parties who do not receive adequate notice can later assert rights against the assets on the basis that their due process rights were violated, despite the bankruptcy court’s order approving the sale free and clear of liabilities (see Limitations). As a result, it is critical that the buyer ensure that the debtor’s notice list of claimants is accurate and complete so that all potential claimants receive notice of the sale.
In addition, many courts have allowed tort liability claims (primarily products liability), environmental liabilities and certain labor liabilities to survive the sale, imposing successor liability on the buyer (see Disadvantages of Section 363 Sales). If the buyer is aware of these potential liabilities it can negotiate a fair price for the assets. In addition, some courts have used their general equitable powers to reject successor liability claims (§ 105, Bankruptcy Code). In doing so, one factor they consider is whether interested parties received notice of the sale (another reason for the buyer to ensure that the debtor’s list of claimants is sufficiently comprehensive).
Finally, if purchasing assets located outside the US, the buyer should uncover any claims against the assets by non-US creditors, as the bankruptcy court’s order approving the sale free and clear of liabilities may not be enforceable in other jurisdictions, leaving the buyer liable for these obligations (see Limitations).
Because the debtor must select the bid that offers the highest and best price for the assets, it must value each bid and compare it to others. Therefore, prospective buyers should be aware that the following items reduce the value of the bid and make it more difficult to value and compare to other bids:
- Bids consisting of non-cash consideration, such as stock or notes.
- Offers for less than all of the assets.
- Offers that specifically exclude certain liabilities relating to the assets (such as labor agreements, pension plans or employee benefit programs).
- Material closing conditions, such as a material adverse change.
- Cure costs and damage claims in connection with executory contracts and leases. For example the debtor must cure monetary defaults if the buyer wishes to be assigned certain contracts or leases; and is liable for rejection damages if the buyer does not want certain contracts or leases, resulting in additional unsecured claims being brought against the estate.
In valuing which bid is the highest and best, the debtor must balance its two key goals of maximizing value to the estate and the certainty of closing. Therefore, the highest bid may not always be the best bid. For example, if the debtor is under pressure to close the sale for liquidity issues or other reasons, a higher bid with a financing contingency may be worth less than a lower bid with no MAC condition or financing outs. Conversely, if the debtor has no liquidity concerns, it may be willing to accept the risk associated with the higher bid.
The debtor can also attribute value to non-tangibles, such as whether regulatory approvals have been obtained and whether various creditor constituencies support the sale.
Stalking Horse Bidding
In an emerging trend, some winning bidders are providing value to unsecured creditors in the form of equity ownership in the sold assets (which occurred in the bankruptcies of General Motors, Chrysler and Polaroid, among others). This gives the estate the potential for additional recoveries if the sold assets increase in value under new ownership.
In section 363 sales, the winner of the first auction serves as the stalking horse. Selected by the debtor as the initial bidder, the stalking horse sets the threshold price, contract terms and transaction structure. In return, the stalking horse receives moderate deal protections to compensate it for its significant time and expense investments and the risk that its offer may be topped by a competing bidder in the later auction supervised by the bankruptcy court (see Deal Protections).
However, bidders may not want to invest significant resources in negotiating a sale that may not close. Instead they may prefer to rely on the due diligence performed by the stalking horse (at least to some extent) and to reproduce the asset purchase agreement, schedules and related documents prepared by the stalking horse.
Prospective buyers must assess whether it is more advantageous to compete for the stalking horse position or to enter the competition later. The advantages and disadvantages of acting as the stalking horse should be carefully considered, since the stalking horse is bound to its bid even though the debtor is not until the sale is approved by the court.
The advantages of being the stalking horse include:
- Due diligence. The stalking horse has more time to conduct due diligence, which is crucial in a section 363 sale (see Due Diligence). It also has access to information on a real-time basis and to the debtor’s internal resources, including its management (while other bidders do their due diligence through virtual data rooms).
- Setting the baseline. The stalking horse sets the floor price, basic contract terms and structure of the transaction. It negotiates the form of the asset purchase agreement that is likely to be the template for other bidders. This gives the stalking horse the unique opportunity to negotiate for contract terms that are particularly important to it, that it otherwise would likely not obtain. Also, the stalking horse may be more comfortable accepting more debtor-friendly contract terms than other bidders because it has conducted more due diligence. This makes it difficult for competing bidders to alter the stalking horse contract in ways that make their bids more attractive. Also competing bidders have limited ability to negotiate the asset purchase agreement negotiated by the stalking horse because any changes sought may cause the bid to be disqualified (see Bidding Procedures).
- Regulatory issues. In a regulated industry, the stalking horse has more opportunity to work with regulators to develop a plan to obtain approval of the sale, as well as a head-start on seeking approvals and the ability to start the running of waiting periods before the auction process.
- Strategic relationships. The stalking horse’s early entry into the process allows it a unique opportunity to develop strategic relationships with management and key players in the bankruptcy case, such as the debtor, the creditors’ committee, lenders and other interested parties. Obtaining their support and commitment can give the stalking horse a competitive edge over competing bidders.
- Deal protections. To induce potential bidders to act as the stalking horse, they are given various incentives to compensate them for the risk of losing the auction, such as break-up fees and topping fees.
- Bidding procedures. The stalking horse’s offer is subject to higher and better bids, as determined in a competitive auction. In connection with its negotiation of the asset purchase agreement, the stalking horse is involved in formulating and negotiating the procedures governing bidding in the auction. Bidding procedures determine the fundamental terms of the auction, such as the timing of the process, who can participate in the auction and the nature and form of qualifying bids (see Bidding Procedures). They not only set the stage for the sale process, but can also impact its outcome. Negotiating the bidding procedures is a key advantage because it provides the stalking horse with an opportunity to inhibit competition.
The disadvantages of being the stalking horse include:
- Time and expense. The stalking horse invests a significant amount of effort and expense conducting due diligence, negotiating the deal and preparing documents for a transaction that will be shopped later for a higher and better offer. There is no guarantee that the stalking horse will win the auction and much of its investment is used for the benefit of competing bidders. Although an unsuccessful stalking horse typically receives a break-up fee and expense reimbursement fee (see Deal Protections), they may not adequately reimburse the stalking horse for its transaction expenses, such as professional fees, bank fees and other related fees incurred in connection with negotiating the asset purchase agreement. Competing for the stalking horse position is expensive as well, and in that phase of the sale process, there is no compensation to a losing competitor.
- Reputational damage if unsuccessful. There is a reputational cost associated with losing a deal in bankruptcy court, which is a public forum.
- Late and non-conforming bids. The bankruptcy process is informal and unpredictable. In order to obtain maximum value for the assets, courts may be willing to entertain late and nonconforming bids, despite court-approved bidding procedures (see Bidding Procedures). The stalking horse can be outbid even while it is preparing for closing if a higher and better offer emerges before the sale is officially approved by the court.
- Risk of overbidding. If no other bidders participate in the auction, it is likely that the stalking horse’s offer was too high.
- Binding bid. The stalking horse is bound by its agreement, which typically contains few outs and contingencies, while the debtor is not bound until the sale is approved by the court. The court auction process reduces the chance that the deal with the stalking horse will be successfully closed.
- Court approval. Deal protections and bidding procedures must be approved by the bankruptcy court. Courts carefully scrutinize deal protections because they impose an expense on the estate. Accordingly, bankruptcy courts tend to use much stricter standards to evaluate deal protections in section 363 sales than those used by other courts in sales outside of bankruptcy. Other interested parties also scrutinize deal protections and bidding procedures to ensure they promote competitive bidding and do not unreasonably favor the stalking horse. As a result, deal protections for the stalking horse can be less than what could be obtained in a non-bankruptcy sale.
The stalking horse starts the sales process and sets the framework for the sale. Because of the uncertainty of closing the deal and the other disadvantages associated with acting as the stalking horse, potential buyers may be reluctant to commit the resources required for performing due diligence and negotiating the asset purchase agreement and related documents.
To overcome these concerns, debtors offer various incentives to attract potential buyers and encourage bidding. However, bankruptcy courts do not approve deal protection terms that chill bidding, are unreasonable in proportion to the size of the transaction or do not benefit the debtor’s estate (see Deal Protections). They also do not approve bidding procedures that too strongly favor the stalking horse and deter competing bidders (see Bidding Procedures).
The stalking horse often obtains some of following deal protection terms:
- Break-up fee. A fixed amount payable to the stalking horse if the sale is made to another bidder to compensate the stalking horse for lost opportunity costs. The fee is typically between 2-4% of the purchase price. Other aspects of the break-up fee can be negotiated, including:
- Expense reimbursement fee. Typically an amount up to a specified cap payable to the stalking horse to reimburse it for its actual, out-of-pocket due diligence expenses. The cap is generally based on the expected intensity of due diligence and the complexity of the transaction. It is usually triggered by the same conditions as the break-up fee.
- Topping fee. An amount payable to the stalking horse as a percentage of the amount by which the winning bid exceeds the stalking horse’s initial bid. Alternatively, the stalking horse can sometimes credit any topping fee it would otherwise be entitled to receive against the purchase price if it participates in the auction and submits the winning bid.
- Events that trigger the right to payment of the fee;
- ”tail” provisions triggering payment of the fee if an alternative transaction is closed within a specified period of time after termination of the agreement with the stalking horse
- timing of payment; and
- priority of any fee claims, although fees are typically granted administrative expense claim status (§ 503(b), Bankruptcy Code). This means they are determined to be actual and necessary costs of preserving the estate and are paid before most all other unsecured claims.
Bidding procedures are usually heavily negotiated between the debtor and the stalking horse. They are important for the stalking horse because they can directly impact the probability of competing bids. Some typically negotiated aspects of bidding procedures include:
- Minimum overbids. A minimum specified amount by which any competing bid must exceed the earlier bid. In other words, bidders are required to make overbids in minimum increments. The first opening bid must exceed the stalking horse’s bid by the sum of the minimum overbid amount plus the break-up and expense reimbursement fees. Subsequent bids must exceed the existing bid by just the minimum overbid amount.
- Bid deadline. Competing bids must be submitted a minimum number of days in advance of the auction. Stalking horses favor short deadlines because this makes it difficult and expensive for potential bidders to complete the necessary due diligence, obtain any required regulatory approvals or secure financing. This can impact the ability of potential bidders to compete in the auction.
- Late bids. The stalking horse should insist on a provision stating that the debtor will not consider or accept bids submitted after the bid deadline. However, courts do not always enforce this provision in the interest of maximizing the purchase price (see In re Women First Healthcare, Inc., 332 B.R. 115, 119 (Bankr. D. Del. 2005)).
- Deposits. Used to demonstrate the good faith of competing bidders and to signify that these bidders can meet their bid obligations. They can be as much as 10-15% of the purchase price.
- Bidder qualification. In addition to requiring the posting of a deposit, prospective bidders must demonstrate that they have the financial ability to complete the transaction. This typically requires the prospective bidder to submit their most recent audited and unaudited financial statements. If the bidder is an acquisition vehicle, typically its equity investors must submit their financials and a written commitment. While the stalking horse generally does not have the right to review prospective bidders’ financial information, the requirements of bidder qualification assure it that competing bidders driving up the purchase price actually have the ability to close the sale.
- Bid qualification. The terms and conditions of competing bids must be the same as, or substantially similar to, those agreed to by the stalking horse. Competing bids are typically required to include a marked copy of the stalking horse’s asset purchase agreement showing any changes sought by the competing bidder. They are often only considered if they are on terms “not materially more burdensome” than the terms of the agreement with the stalking horse. For ease of comparability, bids for asset groupings different than the group of assets to be bought under the agreement with the stalking horse are often not permitted. Bidding procedures also commonly require that competing bids be irrevocable with limited closing conditions, often specifically precluding financing, due diligence and regulatory approval conditions. It should at least contain no more contingencies than the stalking horse’s bid.
- Right of first refusal. Also known as a last look provision, a right of first refusal grants the stalking horse the right to match any higher bids. Sometimes the stalking horse can credit any topping fee, break-up fee or expense reimbursement fee it would otherwise be entitled to receive against the final purchase price. Alternatively, the debtor can require that competing bidders seeking to top the stalking horse’s bid must do so by an amount that exceeds the total amount of these fees. Both approaches should produce the same result. The treatment of these fees when the stalking horse competes in the auction is usually not addressed explicitly in the bidding procedures.
- Changes to bidding procedures. A stalking horse with substantial leverage should insist that the debtor cannot materially modify the bidding procedures without its consent and a court order. Otherwise, the bidding procedures usually permit the debtor to supplement or modify the bidding procedures if the terms of the bidding procedures order or the asset purchase agreement are not violated.
Courts and other interested parties carefully scrutinize bidding procedures because they can determine the balance of control in the sale process and influence the outcome of an auction. Courts are divided over which standard of review to apply in approving bidding incentives:
- Business judgment rule. Second Circuit courts (including the Southern District of New York) apply a relatively lenient business judgment standard, presuming bidding incentives are valid unless there is evidence of self-dealing. In applying this standard, courts consider whether fees deter or encourage bidding and whether the amount of the fee is reasonable in relation to the proposed purchase price (see Official Comm. of Subordinated Bondholders v. Integrated Res., Inc. (In re Integrated Res., Inc.), 147 B.R. 650, 657 (S.D.N.Y. 1992)). However, this approach may be losing favor, as in 2008 a bankruptcy court within the Southern District of New York approved a break-up fee under a combination of the best interest test and the administrative expense standard (see below) (see In re Fortunoff Fine Jewelry & Silverware, LLC, 2008 WL 618983, at *1-2 (Bankr. S.D.N.Y. Feb. 22, 2008)). Recently, the US Court of Appeals for the Fifth Circuit applied the business judgment standard to approve expense reimbursement to non-stalking horse bidders (see ASARCO, Inc. v. Elliot Mgmt. (In re ASARCO, L.L.C.), 650 F.3d 593, 600-03 (5th Cir. 2011)).
- Best interests of the estate test. Other courts apply the best interests of the estate test. This is a higher standard than the business judgment rule and focuses on whether the bidding incentive at issue and the transaction, as a whole, make economic sense and are in the best interests of the estate (see In re Wintz Cos., 230 B.R. 840, 846-47 (B.A.P. 8th Cir. 1999); In re Tiara Motorcoach Corp., 212 B.R. 133, 137 (Bankr. N.D. Ind. 1997); In re S.N.A. Nut Co., 186 B.R. 98, 104 (Bankr. N.D. Ill. 1995); In re America W. Airlines, Inc., 166 B.R. 908, 912 (Bankr. D. Ariz. 1994)).
- Administrative expense test. Third Circuit courts (including the District of Delaware) apply the most restrictive test, which requires satisfying the standards for allowance of an administrative expense claim. Under this approach, the bidding incentive in question must be actually necessary to preserve the value of the estate (implying that approval of the break-up fee must be a condition to the bid) (see Calpine Corp. v. O’Brien Envtl. Energy, Inc. (In re OBrien Envtl. Energy, Inc.), 181 F.3d 527, 535 (3d Cir. 1999)). However, a 2010 US Court of Appeals for the Third Circuit decision may have relaxed this standard by also allowing courts to award break-up fees where doing so is necessary to compel the stalking horse to adhere to its bid (even if did not condition its bid on approval of the break-up fee) and outweighs the potential harm that a break-up fee would cause by deterring other bidders (see In re Kelson Channelview LLC v. Reliant Energy Channelview LP (In re Reliant Energy Channelview LP), 594 F.3d 200, 205-09 (3d Cir. 2010)).
- Multi-factor test used with the administrative expense standard. Some courts apply the administrative expense standard by analyzing several factors to determine whether a break-up fee is actually necessary to preserve the value of the estate (see AgriProcessors, Inc. v. Iowa Quality Beef Supply Network, L.L.C. (In re Tama Beef Packing, Inc.), 290 B.R. 90, 97-98 (B.A.P. 8th Cir. 2003); In re Hupp Indus., Inc., 140 B.R. 191, 194-96 (Bankr. N.D. Ohio 1992)). Focusing the inquiry on specific factors may facilitate these courts’ implementation of the administrative expense standard. At least one court has also used the multi-factor test to apply the best interests of the estate standard (see Sea Island Co. v. Official Comm. of Unsecured Creditors (In re Sea Island Co.), 2010 WL 4393269, at *3 (Bankr. S.D. Ga. 2010)).
The negotiating perspectives of the debtor and the stalking horse on bidding incentives are in direct conflict. The stalking horse wants the largest fees and the most restrictive bidding procedures acceptable to the debtor (to increase its chances of winning). In contrast, the debtor wants the smallest fees and the least restrictive bidding procedures acceptable to the stalking horse (to promote bidding and drive up the purchase price).
Although the Bankruptcy Code offers debtors much discretion about the method of conducting the sale (Fed. R. Bankr. P. 6004(f)(1)), the following conditions must be satisfied, regardless of the form of the sale:
- Notice and a hearing. Because of due process concerns, section 363 sales must be approved by the bankruptcy court, after at least 21 days’ notice to all interested parties and a hearing (§ 363(b)(1), Bankruptcy Code and Fed. R. Bankr. P. 2002(a)(2)). The notice must include the time and place of any public sale, the terms and conditions of any private sale, and the deadline for filing objections (Fed. R. Bankr. P. 2002(c)(1)). More stringent notice requirements can apply for a sale of substantially all of the debtor’s assets (see Sales of All or Substantially All Assets). All interested parties have a voice in the section 363 sales process and can object to a proposed sale. While binding on the bidder, the debtor is not bound by the asset purchase agreement until the court approves the sale.
- Highest and best price. The debtor has a fiduciary duty to obtain the highest and best price for the assets. To satisfy this requirement, the sale is usually subject to an auction. The highest price is not always the best price, and it is not necessary to show that the purchase price was the highest possible price obtainable under the circumstances (see Valuation).
- Good faith. The sale must be proposed in good faith in an arm’s-length transaction, but the court has the discretion to approve a proposed sale after a finding of unfairness or bad faith if the debtor is desperate for a buyer (see In re Blue Coal Corp., 168 B.R. 553, 569 (Bankr. M.D. Pa. 1994)). Good faith purchasers in section 363 sales receive special protection (see Good Faith Purchaser Protection).
In addition to the above legal requirements, the following conditions apply in sales of all or substantially all of the debtor’s assets:
- Not a sub rosa plan. A sub rosa plan is a transaction that has the practical effect of predetermining the essential terms of a plan of reorganization. Courts may prevent sales that function as sub rosa plans because they do not favor asset sales that circumvent the plan confirmation process and deprive creditors of the protections it affords (see § 1129, Bankruptcy Code). The Fifth Circuit rejected this type of sale in Pension Benefit Guaranty Corp. v. Braniff Airways, Inc. (In re Braniff Airways, Inc.) (see 700 F.2d 935, 939-40 (5th Cir. 1983)); see also In re Gulf Coast Oil Corp., 404 B.R. 407 (Bankr. S.D. Tex. 2009)).
- Sound business purpose. The debtor must demonstrate that the sale is supported by a sound business purpose. Although courts consider various factors in determining if there is a sound business purpose, the most important factor is whether the assets are decreasing or increasing in value (see Committee of Equity Security Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1064, 1071 (2d Cir. 1983)).
Section 363 sales seeking to sell most or all of a debtor’s assets have become more common in recent years, and this trend is expected to continue. While it was previously difficult to overcome objections to these sales, they are now generally accepted if the debtor complies with the legal requirements applicable to all sales and demonstrates sound business reasons.
Sales to Insiders
If the proposed section 363 sale is to an insider, or insiders will benefit from the sale, courts apply a higher degree of scrutiny to approve the sale (see In re Station Casinos, Inc., (Case No. 09-52477) (Docket No. 1777) (Bankr. D. Nev. 2009); In re Bidermann Indus. U.S.A., Inc., 203 B.R. 547 (Bankr. S.D.N.Y. 1997)). Outside of the bankruptcy context, courts review insider transactions under an “entire fairness” standard, which requires a demonstration of fair dealing and fair price. However, within bankruptcy, the standard is not clearly defined and has been developed on a case-by-case basis. Courts typically focus on:
- The nature of the sale process.
- Whether the assets have been exposed to the market.
- The transparency of the proceedings.
- The fairness of the price.
At least one court has applied heightened scrutiny even to insider sales proposed by a bankruptcy trustee instead of a debtor in possession, declining to rely on the trustee’s business judgment (see In re Blixseth, 2010 WL 716198, at *9-10 (Bankr. D. Mont. Feb. 23, 2010)).
Good Faith Buyer Protection
Good faith buyers in section 363 sales routinely rely on the finality of sale orders issued by bankruptcy courts providing the sale is made free and clear of all liens and interests (§ 363(f), Bankruptcy Code). The Bankruptcy Code creates a rule of statutory mootness by providing that sales made to good faith buyers cannot be reversed or modified on appeal, unless the appealing party obtains a stay of the sale while the appeal is pending (§ 363(m), Bankruptcy Code). However, if the Ninth Circuit BAP’s 2008 decision in Clear Channel is followed by other courts it could have a dramatic impact on buyers’ willingness to rely on such protection in bankruptcy sale orders. Fortunately, three circuit courts have recently rejected the Clear Channel decision, showing a general trend towards establishing it as an aberration (see Official Comm. of Unsecured Creditors v. Anderson Senior Living Prop., LLC (In re Nashville Senior Living, LLC), 620 F.3d 584, 591-95 (6th Cir. 2010); United States v. Asset Based Res. Group, LLC, 612 F.3d 1017, 1019 (8th Cir. 2010); Asset Based Res. Group, LLC v. United States Trustee (In re Polaroid Corp.), 611 F.3d 438, 440-41 (8th Cir. 2010); Contrarian Funds LLC v. Aretex LLC (In re WestPoint Stevens, Inc.), 600 F.3d 231, 248-54 (2d Cir. 2010)). In addition, a district court within the US Court of Appeals for the Ninth Circuit has recently denounced the Clear Channel decision (see In re NAMCO Capital Group, Inc., 2011 WL 2312090, at *2-3 (C.D. Cal. June 7, 2011); In re Thorpe Insulation Co., 2011 WL 1378537, at *1 (C.D. Cal. Apr. 11, 2011)).
In Clear Channel, the bankruptcy court approved a sale of property to a senior lienholder who, as the stalking horse bidder, credit bid its $41 million secured claim. This means that the purchase price included no consideration other than the release of its secured lien. The sale was approved free and clear of all liens and interests, including a junior lien of $2.5 million held by Clear Channel. Because the credit bid did not result in any actual cash proceeds, Clear Channel received no payment on its claim. Clear Channel appealed the sale order and requested a stay of the sale pending its appeal, but the court denied its request. The sale closed while the appeal was pending.
The BAP held that the protection granted to good faith buyers under section 363(m) did not extend to the free and clear relief provisions of the sale order under section 363(f) (see Free and Clear of Interests). As a result, it allowed Clear Channel’s appeal to proceed despite the fact that it was not granted a stay pending appeal. The BAP narrowly construed section 363(m), holding that this provision only prohibits appeals that challenge the “essential attributes of the sale” (such as changes of title). The free and clear nature of the sale was merely a “term” of the sale and therefore not an essential aspect of the sale protected by section 363(m).
This decision is contrary to controlling precedent in the Ninth Circuit (see Unsecured Creditors’ Comm. of Robert L. Helms Const. & Dev. Co. v. Southmark Corp. (In re Robert L. Helms Const. & Dev. Co., Inc.), 139 F.3d 702, 704 n.2 (9th Cir. 1998)) as well as in other jurisdictions (see Canzano v. Ragosa (In re Colarusso), 382 F.3d 51, 61-62 (1st Cir. 2004); In re Wintz Cos., 230 B.R. at 844-45). Although BAP decisions are not given the same precedential weight as US Court of Appeals decisions, some bankruptcy judges follow, or are at least influenced by, BAP decisions.
If the Clear Channel decision is adopted by other courts it could have the following implications:
- Non-consenting junior lienholders whose claims are not satisfied by the proceeds of the sale may have greater leverage in blocking sales or obtaining payoffs or other concessions from the debtor or the senior lienholder.
- If buyers cannot rely on the free and clear relief in sale orders, this may chill their interest in buying assets in section 363 sales. As a result, lenders who would otherwise provide DIP financing on the assumption they will be repaid with proceeds from section 363 asset sales may be disinclined to lend money, leading to more Chapter 7 liquidations.
- More asset sales may occur through a plan of reorganization, which is more time consuming, cumbersome and expensive.
- Buyers may reduce the amount they are willing to pay for assets in section 363 sales or demand escrows to protect them if the free and clear provisions of the sale order are reversed.
Until the issue is settled, buyers in section 363 sales outside the Second, Sixth and Eighth Circuits should take the following precautions:
- If there is a serious objection to the free and clear aspect of the sale order and the objecting party is likely to file an appeal, it is advisable to include provisions in the asset purchase agreement allowing the sale to close on the later of the expiration of the 14-day appeal period after entry of the sale order (Fed. R. Bankr. P. 6004(h)); and the entry of a final appellate decision affirming the bankruptcy court’s denial of the objection.
- Seek protections in the asset purchase agreement, such as the right to return encumbered assets to the debtor for a refund of the purchase price; and an escrow of some or all of the sale proceeds, to be released to the debtor if no appeal is filed, but returned to the buyer if an appeal is filed and not resolved in a favorable manner within a reasonable period of time.