A stubbornly directionless U.S. economy provides an array of investor opportunities in distressed assets and bankrupt companies. But against this backdrop, the nuts and bolts of such acquisitions are evolving in a number of ways. Two trends are of particular significance:
(1) the expanding role of Bankruptcy Code Section 363; and
(2) a growing willingness by court officers and judges to apply an expanded interpretation of the auction process rules.
In each instance, change is being driven less by statute and more by evolving practice, largely in response to a shortage of risk financing. But no matter the cause, would-be acquirers, sellers, creditors and other stakeholders need to stay abreast of these critical developments.
By design, the traditional role of US Bankruptcy Code Section 363, governing the auction of assets, is somewhat narrow. Fundamentally, Section 363 sales were intended to be a means for liquidating unique or extraneous assets that didn’t fit in with a broader reorganization. Such sales were generally limited to minor subsets of a larger enterprise. In practice, this might mean a discrete facility, a small division, a fleet, a subset of a fleet or other one-off assets. This section of the bankruptcy code was not designed or intended to serve as a mechanism to transfer substantially all the assets of an estate.
In practice, however, the role of Section 363 has been evolving since its inception. Today, it is being used in most cases to speed reorganizations, even at the risk of circumventing creditor input that would be sought as part of the traditional process. Perhaps the most prominent example is that of General Motors, where the US federal government worked with local jurisdictions to enable a transfer of the ownership of the entire company using Section 363 in just a few weeks
Selling entire companies through Section 363 was not the intent of the code, but a growing number of courts are being lenient in large part as a result of simply seeing few alternatives for the debtor. The principal challenge is that bankruptcy arenas are proving chronically short of debtor-in-possession (DIP) financing. Markets are so deprived of this risk capital that few deals can attract enough financing to facilitate a complete reorganization. This tends to force more assets to be transferred—sold—in the earliest possible stages of the bankruptcy cycle.
Other drivers of this trend come from the Bankruptcy Reform Act of 2005—legislation that significantly altered the implementation and speed of the bankruptcy process. One of the key changes was to modify the court’s ability to extend the time period in which a debtor could choose to accept or reject a contract. In the past, a debtor could often extend this period well beyond a year. Under the 2005 Act, however, restrictions make it difficult for a court to go beyond 120 days. This change affects the debtor’s ability to operate for long periods of time inside bankruptcy protection, modify operations to improve profitability and emerge from the process as a going concern. Instead, the debtor faces increased pressure to sell the business before the 120-day period concludes.
Another change from the 2005 Act was the significant curtailment of key-employee retention payments. In the past, debtors could rely on such programs, which typically allowed certain incentive payments to help retain key management during the reorganization process. However, as courts increasingly do not permit such payments, more debtors are compelled to move for a quick sale before losing still more value through the attrition of key talent. The use of section 363 provides a viable alternative for the rapid monetization of assets prior to the loss of key employees.
Good Or Bad?
Overall, this trend toward an expanding role for Section 363 sales can be good for some and bad for others. From a seller’s perspective, there are myriad benefits. For one, any process that moves a company’s assets out of court control faster is good. Getting out of distress quickly means a clearer focus on the business at hand. The company also saves on professional fees, avoiding the need to deal with the demands of a bankruptcy filing. The company can simply monetize its assets through a sale and then address allocation of proceeds to creditors following the sale. A side benefit: the company avoids any potential commercial taint associated with operating inside of Chapter 11.
At the same time, for would-be buyers, a Section 363 sale can be good or bad. In terms of potential benefits, acquisition is clearer, simpler and less costly. Formal reorganizations can be complex. For example, a potential buyer may have to both acquire a controlling interest in a so-called fulcrum security and then negotiate a plan of reorganization that grants control of the company to another party at a later point. In addition to benefiting from a faster transaction (60 days versus one year for a typical bankruptcy plan), buyers avoid entanglement with creditor disputes. Because they sidestep these and related complications, Section 363 sales are often the preferred route for private-equity investors.
As for potential negatives, a more open auction process can lead to more bidding competition and therefore higher asset prices. Furthermore, in the hopes of maximizing creditor recoveries, there is greater potential today for courts to overrule an auction’s results after the gavel drops.
From a creditor’s perspective, a Section 363 sale may be beneficial in that overall, it could lead to more recoveries because of improved process efficiency. But there could be drawbacks. For example, the monetization of the asset eliminates any option value for those whose stakes are out of the money. Also, while creditors have the right to vote on a reorganization there is no similar provision in a Section 363 sale. While they may object to the use of Section 363 based on issues such as the breadth of assets to be sold or the timing in the case, there is no way of discerning how the court will rule. In general, courts are leaning toward broader use of this provision of the code and creditors face an uphill battle in having the court block the sale from moving forward. In practice, creditors may find that some of the most critical components of the case that dictate their recoveries will occur in the first 90 days after filing.
Participants in Section 363 processes should also recognize the increasing frequency with which courts are invalidating initial auction results—of both Section 363 and more rigorously defined Chapter 11 auctions. In general, the court will approve a well-defined process to conduct a Section 363 auction. Meanwhile, a bankruptcy auction moves forward based on an opening price from a favored bidder. This so-called “stalking horse” is given an opportunity to obtain a detailed look at the target, and, based on its early involvement in the transaction, is entitled to break up fees should it fail to win at auction. Additional participants may join the auction process, but bid increments are established by the court. No matter who ultimately succeeds, the auction results are deemed final.
In practice, however, a growing number of courts are interpreting the rules of both forms of auctions, Section 363 and Chapter 11, in a much more lenient fashion. The trend today is to modify the auction process “after the fact” to protect creditor interests and maximize recoveries. For example, in a recent deal, a company was heading into court for what it thought would be final approval of a concluded auction. But another bid arrived a full hour after official bidding had closed. This new bid represented an increase of less than 2 percent over what was, by a literal interpretation of the court-approved bidding procedures, the initial winning bid. The court decided, however, that this new bid was in fact not too late and as a result, reopened the bidding process.
Long And Short Of It
The good news for the seller and its creditors was that the process moved on and the new winning bid represented a significant increase over the initially concluded selling price. But this is bad news for buyers who play by the rules only to see their bids negated by late entrants. In this instance, the winner of the initial auction ultimately went on to complete its desired acquisition in the second, extended auction—albeit at a higher cost. Still, the court’s decision to accept a late bid is even now being challenged.
Many view this trend as unhealthy. Robert Albergotti, a bankruptcy partner at Haynes and Boone LLP in Dallas notes, “A bankruptcy auction is conducted in a fishbowl. Everyone knows the rules and the deadlines. Everyone is incented to take their best shot before the final bid round concludes. Now, however, some bidders have the expectation that a post auction appeal to the court will get them back in the game.” So while bending auction rules may on occasion obtain greater value for creditors and owners in the short run, over the long haul, modified auction processes may tend to frustrate and deter the buyer pool, resulting in lower valuations overall.
Theory And Practice
As in so many other walks of commerce, there are differences between the letter of the law and its interpretation. Driven by a range of circumstances, courts are allowing more assets to be disposed of through Section 363 as opposed to a more formal bankruptcy plan process. This trend is likely to result in more distressed assets available in the market. Buyers that have the ability to move quickly and evaluate transactions in this high paced environment may find increasing opportunities. Meanwhile, no matter the forum of the asset sale, neither buyers nor sellers can be 100 percent certain of the finality of any transaction. Sellers should continue to look for opportunities to increase value, even after the auction has closed. Buyers, meanwhile, must remain aware that a sale may later be voided by the courts.
Michael Scott is a partner in Ernst & Young LLP’s Transaction Advisory Services US Restructuring Services Group. The views expressed are those of the author and do not necessarily reflect those of Ernst & Young LLP.