The unprecedented economic downturn has once again made the purchase of a bankrupt’s assets under section 363 of the Bankruptcy Code a viable option for financial investors.
In general, a distressed company may dispose of its assets in one of three ways: through a standard asset sale, pursuant to a plan of reorganization under Chapter 11 of the Bankruptcy Code, or through an asset sale pursuant to section 363 of the Bankruptcy Code. Although the first two options remain feasible in certain situations, the economic distress of many target companies and the unavailability of other financing alternatives, including debtor-in-possession financing for Chapter 11 debtors, has resulted in an increased reliance on the section 363 sale process.
For today’s financial acquirer of distressed assets, an understanding of section 363 sales is pivotal in determining who will be winners and losers in this highly competitive and fast-paced sale process.
The Section 363 Sale
The primary method in which assets of a bankrupt entity are acquired by a third party is through a court-supervised sale pursuant to section 363 of the Bankruptcy Code.
While the section 363 sale process technically begins when a Chapter 11 debtor files a motion with the bankruptcy court to sell assets pursuant to section 363, in today’s market this process actually begins months before when the company contemplates—or is forced by economic considerations to conduct an asset sale. It is at this point that the company searches for an acquirer and when a potential investor can inexorably integrate itself into this process as the “stalking horse” bidder. The factors guiding the selection of the stalking horse vary by case, but will include, at a minimum, the purchase price and other consideration offered, adequate financing and the ability to promptly close the transaction. Once selected, the parties negotiate a proposed asset purchase agreement (“APA”). It isat this point that a company, if it is not already in bankruptcy, will commence its bankruptcy case and seek authority from the court to approve procedures to sell its assets and eventually consummate the sale.
The section 363 sale is, by its very nature, a competitive and open process, and thus presents dueling considerations for the investor. On the one hand, the stalking horse bidder is highly desirous of avoiding competition so that it can acquire the assets without further investment. On the other hand, those investors who are “late to the game” want to explore ways to participate in the process at the lowest cost.
Asset Purchase Agreement
In many ways, an APA entered into in connection with a section 363 sale—while not wholly dissimilar to one outside of bankruptcy sale—is the key to both the stalking horse and other potential bidders. There are four key ways in which the section 363 sale process is critical to these participants. First, in a section 363 sale, the seller is typically not required to make extensive representations or warranties, and those which are required are generally of limited duration with very little, if any, related indemnification. This is a direct result of section 363(f) of the Bankruptcy Code, which expressly provides clear title to the assets sold under this section and therefore obviates the need for typical indemnification provisions. As a corollary to this, the APA contains few, if any, contingencies such as financing or due diligence “outs”.
Second, the consideration paid for the asset may take many forms not typically seen in traditional asset sales. As courts of equity, bankruptcy courts place great emphasis on the benefits a transaction confers on the debtor’s estate. Accordingly, the purchaser may assume certain of the debtor’s liabilities or consent to pay the costs incurred by the debtors in assuming and assigning certain of its executory agreements to the purchaser under section 365 of the Bankruptcy Code. Thus, a stalking horse bidder or other potential bidder can enhance the consideration of their respective proposal without necessarily contributing additional cash. Purchasers may also be able to enhance their footing in the process by acquiring secured indebtedness in the target and using such security to “credit bid” all or a portion of the purchase price. However, great care should be taken in the purchaser’s review of the rights and obligations with respect to such indebtedness.
Third, in acquiring assets of the debtor, the purchaser (stalking horse or other) can determine which of the debtor’s contracts it wishes to have the debtor assume and assign to it. The prudent buyer can, among other things, look to assume certain key management, benefit or vendor agreements, which can immediately attract the support of that constituency in the process. To the extent the stalking horse bidder has made these decisions at the inception of the process, it will have an enormous competitive advantage. To the extent it has not, a prudent alternative investor can advance its position with diligence and aggressiveness around these issues.
Fourth, the APA will dictate the timing of the section 363 process, which can confer a significant advantage on the stalking horse bidder. As bankruptcy courts will generally be willing to complete a section 363 sale in fewer than 45 days—and in a much shorter timeframe if liquidity or other operational exigencies can be established—a stalking horse bidder that places very tight timing milestones on their sale will drive a considerable competitive advantage.
To this litany, one further issue should be discussed; namely, emergency or debtor-in-possession financing. Often, the seller is in a dire liquidity position and may lack the resources to make payroll, let alone finance a Chapter 11 process for even the short time necessary to complete a section 363 sale. A strategic stalking horse investor can take advantage of this dilemma by agreeing to provide highly secured debtor-in-possession financing as a condition to its APA. This path, however, requires several words of caution. First, to the extent the debtor has a secured lender, its consent will generally be required to ensure that the debtor-in-possession lender is afforded “super-priority” status. Second, the stalking horse bidder will want to make certain that it is only providing enough liquidity to get the debtor to the sale, and not a dollar more. An alternative purchaser can also use the debtor’s need for financing to enter the process on competitive footing. Because the approval of debtor-in-possession financing involves a separate proceeding under differing judicial standards, an alternative investor can seek to offer more favorable financing at the inception of the case (along with its own stalking horse bid), thus dislodging the stalking horse bidder from the process far more quickly. Again, however, the alternative investor must have adequate information to participate at this juncture, which can be in short supply.
Bid Procedure
The bid procedure process is a key feature distinguishing the section 363 sale process from a standard distressed asset sale. In seeking the court’s authority for the sale of its assets, the debtor will ask the bankruptcy court to establish a number of “bid” procedures that will govern the sale. Among the key procedures are: the timing of the process, the conduct of diligence for other potential bidders, the requirements for other bidders to become “qualified” to participate in the eventual auction, and bid protections in the form of a break-up fee, expense reimbursement and the approval of bidding increments. At each turn, a prudent stalking horse bidder can use its unique position to minimize the competitive landscape. As noted above, the stalking horse bidder will press the debtor to expedite the process and seek appropriate hurdles to limit the diligence of others, especially meetings with existing management. Similarly, bid procedures that require alternative bidders to present their financing, post a deposit and use the stalking horse form of APA are common, and can further the cause of the stalking horse bidder.
Finally, bid protections can not only create additional barriers to entry, but also protect the stalking horse for its substantial investment of time and resources. While not ubiquitous, the inclusion of a break-up fee in the court-approved bidding procedures is standard. Similarly, the court will often allow limited reimbursement of certain expenses incurred by the stalking horse bidder in the process and establish bid increments. Thus, to even participate in the auction, an alternative bidder must beat the stalking horse bid with respect not only to purchase price (plus other consideration), but also the break-up fee, expense reimbursement and bid increment.
The Auction
From the perspective of the stalking horse, the ideal situation is one in which the efforts discussed above will circumvent the auction process entirely. In the vast majority of situations, this wish is granted. If, however, an auction does take place, uncertainty is the rule, rather than the exception, for several key reasons. First, absent unusual circumstances, the auction is not conducted by the court, but by the debtor and its advisors. Second, the standard for determining the prevailing party is highly subjective, with the victor being the party with the “highest and otherwise best” offer. Finally, the relevant constituencies (debtor, management, unsecured creditors and secured creditors) may have varying priorities in the process. Thus, potential bidders should approach the process with flexibility (and a hearty checkbook) in order to maximize their likelihood of success.
Finally, financial buyers may seek to participate in the auction process as a joint venture partner with either another financial buyer or a strategic investor. In taking this path, the investor must be cautious of the Bankruptcy Code’s clear prohibition of “bid rigging.” So long as the joint venture agreement is fully disclosed and does not affect the purchase price, this option provides an investor that is otherwise unwilling or unable to acquire all of a debtor’s assets the opportunity to at least participate in a piece of the investment.
Richard A. Chesley is a partner in the Corporate practice of Paul Hastings’ Chicago office. He practices primarily in the areas of restructuring litigation, with an emphasis on bankruptcy transactions both in the United States and internationally. Reach him at richardchesley@paulhastings.com. Amit Mehta is a partner in the Private Equity practice at Paul Hastings in the Chicago office. His practice is focused on private equity and venture capital transactions, mergers and acquisitions, private securities offerings, and counseling boards and senior management on strategic business, corporate governance, financial, and transactional matters. Reach him at amitmehta@paulhastings.com. Aaron Paushter is an associate in the Corporate practice of the firm’s Chicago office. His practice focuses on bankruptcy litigation and corporate restructuring.
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