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Alison D. Bauer and William F. Gray Jr.
Special to Law.com, February 28, 2007
Analysts predict that the number of bankruptcies will increase in 2007, enabling secured lenders, distressed fund managers and strategic acquirers to find significant opportunities to purchase financially challenged assets in Chapter 11 reorganization cases.
Buying assets through a Chapter 11 process affords advantages — principally, the ability to purchase assets “free and clear” under a court order — but is also fraught with many pitfalls for the unwary. We highlight here some of these advantages and pitfalls and look at recent trends.
There are three ways to buy assets from a Chapter 11 estate: through a sale under §363 of the Bankruptcy Code (§363 sale)[FOOTNOTE 1], under a Chapter 11 plan of reorganization or from a post-confirmation liquidating trust.
This article focuses on sales under §363, which allows a buyer to obtain court approval of a purchase cheaper and faster (and with the advantages and protections of a court order largely intact) than through a reorganization plan or from a post-confirmation trustee.
A §363 sale transfers the acquired assets free and clear of any liens, claims and encumbrances. The power of the §363 order to cleanse troubled assets propels many acquirers to condition their purchases on the Chapter 11 filing of troubled sellers to obtain its benefits. The flip side of these advantages is that the bankruptcy sale process is public, and the sale is almost always subject to higher and better offers at an auction.
RECENTLY PROMULGATED COURT GUIDELINES
On Sept. 5, 2006, the U.S. Bankruptcy Court for the Southern District of New York adopted Guidelines for the Conduct of Asset Sales (the Guidelines)[FOOTNOTE 2] to expedite the review and determination of applications to conduct asset sales. Although applicable only in the Southern District of New York, the Guidelines are helpful in understanding the sale process, generally, and represent the beginning of an effort to streamline and harmonize the bankruptcy sale process nationally.
ANYTHING AND EVERYTHING CAN BE FOR SALE
Any asset of a Chapter 11 estate may be sold through a §363 sale. The flexibility of the process is reflected in the growing number of sales of intangible property, mirroring the increasing commercial importance of these assets. Trustees and debtors-in-possession[FOOTNOTE 3] have realized that the sale of intellectual property can maximize value in a bankruptcy case. As intangible assets such as trademarks, brand names, patents, customer lists and copyrights become more prevalent in §363 sales, financial or strategic investors may look to bankruptcy sales to secure potentially valuable intellectual property at a discount.
In January 2007, for example, Sony outbid three competitors to purchase 28 patents from the Chapter 7 debtor Ipix for $3.6 million.[FOOTNOTE 4] Sony had initially offered $2.2 million, but the auction process generated spirited bidding that drove the final purchase price $1.4 million higher than the original offer. Sony purchased the assets free and clear of any liens, claims, encumbrances or disputes, but at a higher auction-driven price than it had hoped for — a transaction that showed the advantages and disadvantages of the §363 sale process.
Once they have determined which assets to sell, debtors usually attempt to find a “stalking horse” bidder. Experience shows that the presence of a stalking horse bidder generally yields greater value than an open auction. The stalking horse sets a bidding floor and, as we shall see later, is rewarded with special bidding protections. The stalking horse is used to attract competing bidders who are willing to acquire the same assets on the same terms and conditions but at a “higher and better” price. The stalking horse has the advantage of defining the transaction — it sets the price and the other terms and conditions of the asset-purchase agreement and has a better opportunity to conduct due diligence than later bidders. In exchange for the risk of spending time and money only to be outbid at auction, the stalking horse can negotiate for the bankruptcy court to approve certain bid protections in advance of the sale.
THE SALE MOTION
Once a sale has been agreed to, the debtor files motions with the Bankruptcy Court, seeking entry of two orders. The first order is the Sale Procedures Order, which seeks the approval of procedures for the sale and auction process, including proposed protections for the stalking horse. The Sale Approval Order is the second order, and it seeks approval of the sale itself to the successful bidder at the auction. (The Guidelines require that the motion provide an explanation if no auction is contemplated or the debtor has not or will not actively solicit higher and better offers.)
When time is critical, parties often file the Sale Approval motion after a term sheet is agreed upon so that the sale notice period starts running. The parties then negotiate the asset-purchase agreement before the hearing. This practice will likely be curtailed because the Guidelines require that the form of proposed purchase agreement that is acceptable to the debtor, whether or not executed, be attached to the motion.
BREAKUP AND TOPPING FEES
It is now common practice for a stalking horse bidder to be paid a “breakup” fee in case the transaction is not consummated because another bidder wins at auction or through some other default of the debtor.
A “topping” fee, which is a payment to the unsuccessful stalking horse of the difference between its bid and the winning bid, is rarely accepted by a seller or approved by a court.
The allowance of any breakup/topping fee is determined on a case-by-case basis. Generally, as set forth in the Guidelines, the breakup fee is paid from the proceeds of a higher or better transaction entered into with the successful bidder. Thus, to be the higher and better offer, the competing bid must exceed the stalking horse bid plus the breakup or topping fee. Provisions regarding these fees must be disclosed in detail in the sale motion. Breakup fees have been approved typically in the range of 1 percent to 5 percent of the purchase price.
The amount of the breakup fee is determined by the court and usually involves a balancing test that weighs the need for the fee to entice the stalking horse bidder against the chilling effect of the additional cost on competing bidders.
Several standards to determine the allowance of breakup fees have emerged: the business judgment rule, a stricter “best interests of the estate” test and allowance of the fee as an administrative expense under §503(b), based on the court’s determination that the fee is necessary to preserve the value of the estate or that the claimant confers a demonstrable benefit to the estate. Reimbursement of expenses also falls under this canopy and can vary widely so long as the stalking horse demonstrates that its activities conferred some benefit to the estate, regardless of the stalking horse’s self-interested motive.[FOOTNOTE 5]
Although the Bankruptcy Court for the Southern District of New York stated that it did not address substantive legal issues in the Guidelines, the Guidelines dictate that the court will entertain a motion for bidding procedures if, according to a reasonable business judgment, these procedures are likely to maximize the sale price. “Such procedures must not chill the receipt of higher and better offers and must be consistent with the seller’s fiduciary duties.”[FOOTNOTE 6] The Guidelines recommend that bidding procedures include steps for the qualification of bidders, who would be required to deliver financial information by a stated deadline to the debtor and other key parties, and to submit a good faith deposit.
Courts have also allowed potential purchasers to submit a good-faith deposit to conduct due diligence but not necessarily be bound to an auction or an asset-purchase agreement. Under the arrangements, in essence, the potential purchasers are paying for an option to purchase the assets. Such arrangements are, of course, subject to court approval and appropriate confidentiality agreements.
The bidding procedures may deal with a wide variety of issues: the time and manner of notice of the sale, qualification of bidders, due diligence, bidding increments, deposits, etc. The Sale Procedures Order may also provide that the debtor-in-possession accept and close with a “backup buyer” — the second-highest qualified bid if the winning bidder fails to close the transaction before the drop-dead date.
The initial bidding increment should be more than any proposed breakup or topping fee or expense reimbursement. As suggested in the Guidelines, higher bidding increments should not be so large that they chill further bids or so low that they provide insubstantial consideration to the estate.
LOCKUP, NO-SHOP OR NO-SOLICITATION PROVISIONS
Generally, lockup provisions requiring the sale to the buyer and no-shop or no-solicitation clauses forbidding the debtor from seeking other bidders are not allowed in the bankruptcy context. However, the Guidelines allow such provisions “in unusual circumstances, if they are necessary to obtain a sale, they are consistent with the debtor’s fiduciary duties and they do not chill the receipt of higher or better offers.”[FOOTNOTE 7] In those cases, the provisions must be prominently disclosed in the sale motion.
Nevertheless, modified no-shop clauses entailing that the seller not actively shop assets, but may respond to good faith inquiries, on notice to the stalking horse, have been routinely approved.
ENFORCEMENT OF PROCEDURES
The private sale route is available in bankruptcy but strongly disfavored. The Guidelines suggest that the Sale Procedures motion explain the rationale for not conducting an auction. Courts will typically not consider bids made after the auction has closed absent irregularities in the conduct of the auction or reasonable and material confusion during the bidding.[FOOTNOTE 8] Unsuccessful bidders typically lack standing to appeal a bankruptcy court’s sale unless they are creditors or purchase another creditor’s claims before the auction; so it is important that the sale procedures are vetted before the auction.
The Guidelines require disclosure of “extraordinary provisions” pertaining to the conduct of §363 sales. These provisions are frowned upon and would ordinarily not be approved without good cause or compelling circumstances, as well as reasonable notice. Such provisions include sales to insiders, employment agreements with management, private sales (no auction) or no-shop or no-solicitation provisions, unusually short deadlines, limited notice, no good faith deposit required of bidders, interim arrangements with a proposed purchaser, such as interim management arrangements, tax exemptions under §1146 of the Bankruptcy Code and the sale of avoidance actions.
The §363 sale process can be sticky and full of pitfalls, but with knowledge, perseverance and skilled advisers, savvy buyers may be able to squeeze unrealized values from someone else’s lemons. Experienced bankruptcy counsel should be retained to guide the seller or potential purchaser through the myriad procedural requirements of the Bankruptcy Code, Bankruptcy Rules and local court rules, and through legal substantive issues in order to reap the benefits of a successful §363 sale.
William Gray Jr. (firstname.lastname@example.org) and Alison Bauer (email@example.com) are partners in the restructuring and insolvency group in the New York office of Torys LLP.
FN1 11 U.S.C. §363.
FN2 Available at U.S. Bankruptcy Court for the Southern District of New York, http://www.nysb.uscourts.gov/orders/m331.pdf.
FN3 Debtor-in-possession is the technical term for a debtor that continues to own and operate its business during the Chapter 11 case without the appointment of a trustee.
FN4 Ipix, No. 03-bk-31932 (Bankr. E.D. Tenn. filed April 8, 2003).
FN5 In re Women First Healthcare, Inc., 332 B.R. 115 (Bankr. D. Del. 2005); In re Tama Beef Packaging Inc., 321 B.R. 396 (B.A.P. 8th Cir. 2005).
FN6 Guidelines, supra note 2, at 3.
FN7 Guidelines, supra note 2, at 5.
FN8 But see Corporate Assets, Inc. v. Paloian, 386 f. 3d 761 (7th Cir. 2004) (affirming bankruptcy court’s decision to reopen auction when changes to the sale agreement were not disclosed to all bidders and sale procedures gave debtor broad discretion to reject bids before bankruptcy court approval of the sale).
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