(TMA International Headquarters)
Despite the potential for reorganization under Chapter 11 of the
U.S. Bankruptcy Code, a company that has filed for bankruptcy protection often
will not experience a true restoration from the point of view of its owners.
Instead, by one means or another, the company’s assets often are sold to or
become controlled by a new party or group. One of the most common procedures
leading to this result is a sale of a company’s assets under Section 363(b) of
the Bankruptcy Code.
A company that files
for bankruptcy obviously is faced with financial and/or operational distress.
Whatever problems troubled companies had prior to bankruptcy may continue and
even compound while they are in Chapter 11. While a bankruptcy filing may
alleviate some immediate financial stress, a company is not protected from the
competitive markets of which its customers, employees, suppliers, and lenders
are a part. Sometimes, despite the best efforts of its leaders and turnaround
consultants, a company’s going concern value remains at risk or declines while
it is in Chapter 11.
In connection with many
Section 363 sales, a central question confronting a company is: Within what
period of time must or should it accomplish a sale? How much staying power a
company has—that is, the amount of time before it may lose a critical component
of its working capital, customers, suppliers, and financing sources—greatly
influences the length and breadth of the marketing and sale process. In some
situations, the potential sale price of the company can be like an ice cube on a
hot griddle—time is of essence to accomplish a sale before all value
evaporates.
In many Chapter 11
cases, a company faces the prospect of running out of operating cash sometime in
the not-too-distant future, or it confronts a deadline to accomplish a sale that
is built into its post-bankruptcy financing arrangements. In addition, recent
amendments to the U.S. Bankruptcy Code require commercial real estate leases to
be assumed or rejected within 210 days after a bankruptcy filing. For retail
chains and other companies that lease many of their facilities, this can be a
crucial factor in the marketing and sale of assets.
On the other hand, the
breathing space afforded to some companies in Chapter 11 can provide them with a
last clear chance to make required changes and return to profitability. Perhaps
it is the drastic nature of a bankruptcy filing that gets the attention of
certain suppliers, customers, or other stakeholders and finally convinces them
to alter their positions and therefore provide the foundation for improvement in
a company’s operations. A bankruptcy filing also may allow a company to ride out
a storm that is temporary in nature, such as a spike in commodity or input
prices. In such situations, time might be an ally and could foster improved
viability and a potentially higher sale
price.
Competing Interests
Compared to the traditional mergers and acquisitions (M&A)
process, especially for a privately held company, perhaps the single most
distinguishing characteristic of a Section 363 sale is that it occurs in the
fishbowl of a bankruptcy case. Everything that leads up to a hearing on the sale
of a company’s assets, including the terms and conditions of the sale, are
subject to review and approval by a Bankruptcy Court.
Notice on significant
steps in the sale process must be issued to the company’s creditors, who have
the right to object and be heard on questions that arise. In a conventional sale
outside of bankruptcy, negotiations and dealings primarily involve only the
seller and the purchaser. In a Section 363 proceeding, secured creditors,
non-debtor parties to contracts and leases, unsecured creditors, the U.S.
trustee, and others all can become actively involved before the Bankruptcy Court
and in various aspects of a proposed sale.
Although the bankruptcy
rules contemplate the possibility of a “private sale,” another core feature of
most Section 363 sales is some form of an auction or organized competitive
bidding process for a company’s assets. This, of course, is in pursuit of
maximizing the value of the bankruptcy estate and providing the best return to
creditors.
Accordingly, at a final
hearing before the Bankruptcy Court on approval of the sale of a company’s
assets, much of the inquiry by creditors and the court focuses on confirming
that various parties were informed about the sale and had an opportunity to bid
on the assets in direct or indirect competition with each other. In general,
Bankruptcy Courts require a showing that a marketing process undertaken was
appropriate under the circumstances before it will approve a sale to the party
that has apparently made the “highest” and/or “best” bid for the assets.
In the review and
scrutiny of a marketing and sale process in a Chapter 11 case, various questions
may arise. Was the due diligence process level and fair for all prospective
purchasers? For example, in the interests of saving their jobs after a sale, did
management favor financial buyers over strategic buyers? Was management
justifiably suspicious about the motives of a competitor in seeking sensitive
information as a purported prospective purchaser?
Creditor conflicts may
arise regarding the allocation of the purchase price among various assets.
Secured lenders holding liens against different assets may find that sale
proceeds are insufficient to pay all of the liens in full. Unsecured creditors
will look for ways to reduce the sums paid to secured creditors to maximize the
allocation of sale proceeds to any unencumbered assets that are
included.
Other issues arise if
the bid procedures established for a Section 363 sale allow competing offers to
take different forms. Given the irreducible risk in getting any transaction to
close, even after it is approved by the Bankruptcy Court, what is the proper
method for comparing several bids on individual assets with a single bid on all
of the assets? What if one offer is all cash with few conditions, while another
is nominally higher but includes a note payable to the company over time, an
“earn-out” feature, or some other contingent component?
In addition, some
offers may contemplate a debtor assuming and assigning to the buyer all or
virtually all contracts and leases, sometimes with the attendant costs for
curing payment defaults under those agreements borne by the debtor. Other offers
would result in the rejection of many contracts and leases, which often results
in additional unsecured claims being brought against the estate for rejection
damages. The potential impact on what might be recovered by various classes of
creditors in such situations can be quite
significant.
On the various issues
that arise in connection with a sale process, a debtor company’s determination
or recommendation often carries a good deal of weight with the Bankruptcy Court.
But creditors and other parties in interest whose recoveries may be affected by
the outcome of the bidding also have opportunities to argue which offer they
believe is best and therefore should be
approved.
These parties can range
from a lender providing post-bankruptcy financing and secured creditors with
pre-bankruptcy claims to general unsecured creditors (usually represented by an
official committee) and non-debtor parties involved with contracts and leases.
Those who have important stakes in the company’s future operations, such as
employees and labor unions, also may become actively involved. In addition,
various governmental agencies with environmental, tax, and other special claims
may join in the proceedings.
In some cases, the
entire sale process for a company, including initial marketing efforts, might
not begin until after a Chapter 11 case is commenced. In other situations, much
of the marketing and even initial bidding on a company’s assets might occur
before the Chapter 11 case is filed. Nevertheless, those activities are subject
to the same scrutiny once the company has entered bankruptcy. Whether the
efforts occur before or after formal filing of a Chapter 11 case, if a
Bankruptcy Court concludes that marketing and other processes were insufficient
to identify, approach, and bring in prospective purchasers, it may require that
the company do more before a final sale hearing will be held to choose a winning
bid.
Jumpstarting a Sale
At
some stage in a Section 363 sale process, particularly before the date that an
auction is to be conducted, it often is a good idea for the debtor to announce a
minimum price that it may be willing to accept for its assets. Doing so may
demonstrate to the company’s customers, suppliers, employees, and other
stakeholders that its exit strategy of a sale is truly viable. The announcement
also may pique new interest from parties that may have expected the company to
fall into liquidation or otherwise fail to accomplish a going-concern sale.
These potential buyers may include strategic players who had hoped to pick up
some of the company’s customers and business by
default.
When a company has
begun marketing its assets and perhaps has held discussions with multiple
prospects about price and terms, one party may emerge early on as a strong or
leading contender to purchase the assets. To establish a floor for the sale of
its assets, a company may ask this party to become the “stalking horse” and
enter into a definitive and viable agreement to purchase the company’s assets
with the understanding that the agreement will be shopped around to other
prospective purchasers, who will be solicited to top its
deal.
The stalking horse
understands that other potential bidders could reproduce the agreement,
schedules, and related documentation that it has prepared to accompany sale
pleadings in Bankruptcy Court. At least to some degree, subsequent bidders may
be able to piggyback on the due diligence that the stalking horse has conducted.
Thus, simply by following the initial bidder’s steps, these new bidders could
incur less time and expense and then beat the stalking horse’s price during
additional bidding or an auction that
follows.
In return for its
jumpstarting the sales process and providing a pricing floor, various types of
incentives often are put in place for a stalking horse bidder. One frequently
used provision is an expense reimbursement that repays the stalking horse for
the fees and expenses it incurs, usually up to a maximum amount, in conducting
due diligence and pursuing its offer. Another common provision is a “break-up”
or “topping” fee, which is paid to the stalking horse if it is outbid at auction
or otherwise is not the successful purchaser of the company’s assets.
These and other
provisions that compensate a stalking horse for being the first mover in a
Section 363 sale process must be approved by the Bankruptcy Court, typically in
a preliminary hearing in which bidding rules and other procedures related to the
sale are established. Again, creditors have an opportunity to be heard on
whether and to what extent these provisions are worthwhile under the
circumstances. While some Bankruptcy Courts are loath to accept any such
protections, most have approved break-up fees in the range of 1 to 3 percent of
the stalking horse’s initially set purchase
price.
For a prospective
purchaser, a Section 363 sale presents an opportunity to obtain valuable assets
at a bargain price. The process may include many potential bidders and/or an
auction before approval of a purchase is obtained. But, compared to traditional
sale processes outside of bankruptcy, there may be less overall competition
among prospective purchasers in the bankruptcy arena. Many parties that are
otherwise active in the M&A field may not have any interest in the assets
because of the mere fact that a company is in bankruptcy. Others may pass
because of the limited timeframe to conduct due diligence, which takes on even
more importance with the assets and business of a troubled seller, and to submit
a binding offer.
Further limiting the
number of participants is that some of the usual buyer protections provided in
traditional M&A deals are not practically possible or easy to obtain in the
bankruptcy context. For example, various representations or warranties and the
ability to hold back a portion of the purchase price against possible problems
arising after closing may not be available in a Chapter 11 sale process. Such
guarantees can be opposed by anxious creditors, and other bidders may omit or
waive them as a competitive tactic, giving them an advantage over other bidders.
Moreover, while the purchase price may eventually make the deal a bargain, the
process of getting to the endpoint, particularly for an early entrant, can be
more time-intensive and expensive than mainstream
deals.
Especially for
potential purchasers who are new to the process, navigating through the
potential minefield involved in addressing the questions and concerns of a
variety of parties interested in and potentially objecting to its bid can be
challenging. A buyer may wish to retain legal and financial advisors who are
experts with Section 363 sales in particular, as well as M&A transactions in
general.
Although a successful
purchaser typically obtains only limited representations and warranties from the
selling company in a Chapter 11 case—and the practical worth of any it does
obtain often are suspect anyway—it can take comfort in a fairly unique aspect of
the Section 363 process. A standard request routinely granted by Bankruptcy
Courts is for the assets to be transferred to the purchaser free and clear of
all liens, claims, and encumbrances, other than those expressly assumed by the
purchaser. However, creditors are entitled to notice and other due process
considerations before their specific interests in the assets may be eliminated.
Therefore, a purchaser’s advisors and those of the company should be especially
careful to ensure that notice of the sale proceeding has been issued to all
possible creditors holdings claims or liens.
In addition, despite
the apparent all-encompassing language of a free-and-clear order by a Bankruptcy
Court, a few types of the selling company’s liabilities may not actually be cut
off by the order. For example, certain environmental and product liability
claims can follow and remain viable against the assets even after they have
passed to a new owner. Various duties imposed under labor laws also may pass to
a new owner as a successor to the seller.
Caveat Emptor
When compared to the alternatives
of either acquiring a company outside of a bankruptcy or obtaining control of a
company through funding a Chapter 11 plan of reorganization, purchasing a
company in a Section 363 sale has advantages and disadvantages. Figure
1
generally ranks a variety of factors that might
be important to a purchaser within each of those three settings.
With the prospect of
obtaining a bargain in a Section 363 sale continuing to be seen as outweighing
the possible pitfalls for a purchaser, the array of entities that are dedicating
resources to the acquisition of assets in distressed situations has continued to
expand. Many hedge funds, simultaneously chasing yield and trying to deploy
capital in a more diversified manner, have reallocated personnel to look more
closely at distressed situations. Among other strategies is the increased use of
the so-called loan-to-own approach. In such a scenario, an investor acquires the
secured debt of a troubled company from a traditional lender, typically at a
discount, with an eye toward perhaps becoming the owner of the company in the
future through bidding the lien claim in a Section 363
sale.
New players in addition
to hedge funds have joined the ranks of vulture investors as well. Further,
funds that traditionally have been identified only with more mainstream
investments are showing more interest in allocating resources to the turnaround
and bankruptcy arena, bringing billions of dollars into
play.
Section 363 sales have
been and will continue to be one of the primary paths taken by companies in
Chapter 11. Today and into the future, bargain prices are available to shrewd
buyers in bankruptcy cases. However, especially in the world of bankruptcy,
caveat emptor
is the
guiding rule. In pursuing an acquisition out of a bankruptcy case, a buyer and
its advisors should carefully develop a detailed understanding of how it can
truly achieve a good
deal.