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Originally published in The Bankruptcy Strategist. © 2020 ALM LLC. Reprinted here with permission.
The COVID-19 pandemic is already leaving its mark on the bankruptcy asset sale landscape. Some going-concern and liquidation sales have been suspended or cancelled. Debtors have struggled to market their assets, both pre- and post-petition, in the face of unprecedented disruption and uncertainty. Despite this uncertainty — or even because of it — bankruptcy should still be viewed as a useful tool to effectuate the acquisition of assets. The current situation and anticipated distress across many industries presents opportunities for purchasers to acquire assets on favorable terms. The benefits to the purchaser of, among other things, receiving the assets free and clear of liens, claims and encumbrances and the ability to cherry pick executory contracts caught the attention of financial and strategic acquirers for quite some time. However, each industry presents unique issues that should be considered when weighing bankruptcy as an option and, if a case is already pending, a bid for or acquisition of assets of a debtor.
Section 363 of the Bankruptcy Code allows a debtor to sell all or substantially all of its assets free and clear of all interests in the assets without confirming a Chapter 11 plan (363 Sales). In recent years, 363 Sales of a debtor’s business as a going concern or other major business assets have increased in importance and regularity. Below is a brief overview of the benefits and drawbacks of a 363 Sale, the 363 Sale process, the role of stalking horse bidders, the auction process and other aspects of 363 Sales.
There are numerous benefits of 363 Sales versus non-bankruptcy asset sales, including:
However, there are some potential drawbacks of 363 Sales versus non-bankruptcy asset sales that should be considered, including: 1) the risk that any purchase agreement with a debtor will be subject to court approval and usually be subject to higher and better bids at an auction; 2) the potential for negative publicity for the target business as result of bankruptcy; and 3) the increased costs and time due to the court approval process.
Following the commencement of a bankruptcy case, a debtor may only sell its assets outside the ordinary course of business after notice and a hearing. Unlike the plan confirmation process, there are relatively few statutory requirements regarding the 363 Sale process. Because of this flexibility and the reduced time and costs associated with 363 Sales as opposed to plan confirmation, many debtors and purchasers prefer a 363 Sale rather than a sale as part of plan confirmation.
Companies seeking to dispose of some or most of their assets often begin the 363 Sale process prior to filing a bankruptcy case by hiring professionals such as financial advisors, investment bankers, and bankruptcy counsel to assist with finding and negotiating with potential purchasers. The goal often is to enter into a purchase and sale agreement with a "Stalking Horse" purchaser either prior to filing a bankruptcy case or soon after a case is filed. During this time, prospective debtors also generally seek to secure post-petition financing to fund the costs of the bankruptcy case and operations. It is not uncommon for a Stalking Horse bidder to be the source of the debtor’s post-petition financing. This is commonly referred to as a loan-to-own debtor-in-possession financing.
In the current financial crisis, many debtors have been forced to file more precipitously than they otherwise might have done, often without a Stalking Horse bidder in place. Others have filed with their pre-petition secured lenders credit bidding their debt to serve as the Stalking Horse.
The purchase and sale agreement with the Stalking Horse (the Stalking Horse Agreement) serves an important function of setting the "floor" for the sale of the debtor’s assets, as well as signaling to other potential purchasers (and creditors and constituents) that a debtor’s assets have value and that the debtor has a strategy to emerge from bankruptcy. The Stalking Horse also receives important advantages in a bankruptcy sale, including the ability to negotiate the terms of the proposed bid procedures order and bid protections, a customary no-shop period until entry of the bid procedures order, and (often) a head start in discussions with important customers and vendors.
Some key differences between a Stalking Horse Agreement and non-bankruptcy purchase agreements are as follows:
Once the bankruptcy case is actually commenced, the 363 Sale process will usually be in two stages: stage one — the approval of auction procedures, notice of sale, and pre-auction activity; and stage two — the auction (if necessary) and sale hearing.
The first thing that usually occurs is the debtor filing a motion seeking the bankruptcy court’s approval to proceed with a sale. Usually this motion seeks approval to sell assets at an auction and seeks approval of procedures related to bidding and the auction process (the Auction Procedures). (A secured creditor is generally entitled to credit bid the allowed amount of its secured claim, i.e., bid the amount of its secured claim instead of coming out of pocket. Secured creditors may insist that their credit bid rights be explicitly reserved in the Auction Procedures. If a Stalking Horse is not the secured lender and the proposed purchase price is less than the amount of secured debt, credit bid rights can lead to significant issues when negotiating the terms of a Stalking Horse Agreement, Auction Procedures, and Bid Protections. A prospective Stalking Horse will often be reluctant to undertake the expense and risk of an auction process if a secured lender can outbid the Stalking Horse with "monopoly money" and drive up the bid price at an auction.) At this point, a Stalking Horse Agreement has often been executed or is close to being finalized and is filed with the bankruptcy court, but not always — particularly now, when exigent circumstances may force debtors into bankruptcy with less pre-planning. A Stalking Horse may also be designated after the bankruptcy is filed, and even after bid procedures are approved by the court. Parties in interest may object to the Auction Procedures and/or Bid Protections on or before the deadline set by the bankruptcy court, but as a general rule, potential bidders do not have standing to raise any objections.
Auctions may be public or private — though auctions are usually public or open to all qualified bidders. In recent cases, bankruptcy courts have approved sale procedures that permit the marketing of assets by the debtor, with the winning bidder presented to the court as the purchaser. In addition, debtors have also been granted the ability to sell assets under certain values (usually relative to the overall size of the asset pool and sometimes referred to as de miminis assets) only upon consultation and approval of the major constituencies in the case, such as the debtor-in-possession (DIP) lenders and the Official Committee of Unsecured Creditors. Prospective purchasers should carefully review all sale-related orders and procedures that may have been approved by a bankruptcy court as part of any diligence exercise.
During the first stage of the auction, interested bidders are given access to information for their due diligence, typically collected in a data room, subject to a non-disclosure agreement. Because many debtors during this period are likely to enter bankruptcy with significantly reduced personnel, obtaining adequate diligence information may be somewhat more challenging. The diligence period is usually relatively brief — often just a few weeks. Yet it is critically important, since bankruptcy asset sales generally are on an as-is, where-is basis.
Also, during the first stage, adequate notice of the proposed sale generally must be mailed at least 21 days before the sale to all creditors and other parties in interest in the bankruptcy case. The 21-day period may be shortened or other methods of notice may be allowed for cause. The bankruptcy court must weigh: a) the legitimate reasons for requiring a compressed sale timeline, such as a liquidity crisis that may shut down the debtor’s business in the near future if no sale occurs; and b) the need for a fulsome marketing and auction process to generate maximum value for all creditors. Notice of a sale generally must include: a) the time and place of any public sale or the terms and conditions of any private sale; b) a description of the property to be sold; c) the deadline for objecting to the proposed sale; and d) the date of the hearing to approve the sale.
The second stage is the auction itself and a hearing to approve the auction results. The auction will be conducted according to the approved Auction Procedures. Auctions generally are conducted in a day or less, but some auctions can extend for multiple days. The hearing to approve the sale after the auction usually occurs within a couple of days of the auction. Some parties (generally junior secured lenders, unsecured creditors’ committees, or equity holders) may object to such sales as a "short-circuit" of the more stringent requirements of plan confirmation. However, the recent trend is to permit 363 Sales as long as the debtor proves a good, sound business reason for conducting a sale prior to confirmation. Courts consider a variety of factors in determining whether this "business judgment test" has been satisfied, including: a) whether a sound business reason exists for the proposed transaction; b) whether fair and reasonable consideration is provided; c) whether the transaction has been proposed and negotiated in good faith; and d) whether adequate and reasonable notice has been provided.
The assets subject to the sale may be, and generally are, sold free and clear of any entity’s "interest in such property," with those interests instead attaching to the sale proceeds, if certain requirements are met under the Bankruptcy Code. Courts differ on the scope of what "interests" may be included in a free and clear sale. Some courts interpret the phrase broadly to include any type of claim, while other courts have read the term much more narrowly. Generally, the more specific language a sale order contains concerning types of claims being affected, and the more notice that is provided to potential claimants, the more likely a purchaser will be able to shield itself from successor liability claims. Some notable claims that some courts have allowed against 363 Sale purchasers are products liability claims on products sold prior to a sale and environmental liability owed to the government.
As part of the 363 Sale process, the debtor may generally assume and assign to a purchaser any contract or lease the purchaser desires. To assume and assign a contract or lease, the debtor must cure all past defaults (including all monetary defaults), and the purchaser must provide adequate assurance that the purchaser will be able to perform under the contract or lease going forward. As a practical matter, the purchaser must include in its purchase price sufficient proceeds to cure all monetary defaults for assumed contracts and leases.
In addition, anti-assignment provisions in a contract or lease generally are not enforceable in a bankruptcy case. However, there is a limited exception for certain types of contracts where state or other non-bankruptcy law requires consent of the non-debtor party to the contract. Examples can include personal service contracts, nonexclusive IP licenses, and certain rights under partnership and LLC agreements. If the purchaser wants to take assignment of those contracts, it must try to obtain the consent of the counter-party. Contracts and leases the purchaser does not desire may be rejected by the debtor and become an unsecured claim of the bankruptcy estate, with no liability passing to the purchaser.
As with any asset acquisition, the purchaser will need to deal with the potential for latent defects and other liabilities. Due diligence is necessary to identify issues prior to closing. Often, bankruptcy sales are viewed as final. Thus, absent a reserve or indemnity, recourse back to the estate may not be possible for any defects or liabilities that are discovered post-closing. In addition, while the assets may be sold free and clear of any liens, claims and encumbrances, there can still be successor liability for certain liabilities, such as environmental contamination, product liability and ERISA-related claims. The potential purchaser should make sure that: 1) the order approving the sale clearly addresses the liabilities that the assets are being sold free and clear of, and 2) all parties with potential claims related to the assets have been given notice of the proposed sale.
While the COVID-19 financial crisis has wreaked havoc across multiple industries, it also presents opportunities for acquisitions for both financial and strategic investors. Any investor seeking to acquire assets should conduct the due diligence suggested herein and retain the appropriate advisors. The suggested diligence is but a starting point and each asset will present unique facts and circumstances that will have to be considered before bidding on any assets.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.