Pathology of Section 363 Sales (Not as Simple as They Look)
Section 363 sales have shouldered past competing methods for the disposition of financially distressed businesses. Traditional stock or asset acquisitions, secured party sales, sales by assignees for the benefit of creditors and bankruptcy trustees and sales under chapter 11 plans of reorganization have taken a back seat to sales by chapter 11 debtors under Section 363 of the United States Bankruptcy Code ("Section 363"). Recent transactions such as One Equity Partners' purchase of Polaroid, Savvis Communication's purchase of the U.S. portion of Cable and Wireless, Pegasus Partners' purchase of Cannondale and Cerberus' purchase of Alamo and National Car Rental exemplify Section 363 deals by private equity funds acting directly or as sponsors of strategic portfolio companies. The term "363 sale" has thus entered the M&A vernacular robed in its virtues but concealing its difficulties.
Advantages of a Section 363 sale include speed, transfer of assets free and clear of encumbrances and interests, transfer of restricted contracts and avoidance of exposure to claims under fraudulent transfer laws. For a seller, the Section 363 process eliminates director and officer exposure for the sale and limits exposure for breach of representations and warranties. Cosmic balance, however, requires a few clouds to accompany the silver linings.
Traditionally, the sale of a business in chapter 11 was accomplished through a plan of reorganization that identified and dealt with each class of creditors and equity holders. The sale plan was described to the affected creditors and equity holders in a prospectus-like disclosure statement and put to a vote. Bankruptcy law required acceptance of the plan by specified majorities of affected parties, a cumbersome process that lasted for several months and sometimes several years. Initially, courts were skeptical of Section 363 sales that circumvented the protective reorganization plan process. Early cases required the debtor to prove that a sale outside of a reorganization plan was necessary, for example by showing that the debtor's business had insufficient cash flow to survive the full plan process. Lately, however, the Section 363 sale, which can be completed in as little as two to three months, has become the preferred method for sales of distressed businesses.
A Section 363 sale looks much like a traditional controlled auction. Basic Section 363 sale mechanics include an initial bidder, colloquially known as a "stalking horse," who reaches an agreement to purchase assets from the chapter 11 debtor. The buyer and the debtor in possession ("DIP") negotiate an asset purchase agreement ("APA") which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to "higher and better" bids. The protections afforded to a stalking horse generally include a combination of a break-up fee between 1% and 5% of the sale price, expense reimbursement up to a negotiated cap, minimum increments for overbids, qualification requirements for competing bidders, strict deadlines for competing bids and dates for the run-off auction, final court approval and closing.
In the storybook version, the Bankruptcy Court will approve the bidding procedures, including the incentives for the stalking horse, and will pronounce clear rules for the remainder of the sale process. Notice of the sale will be given, qualified bids will arrive and there will be an auction. The sale to the highest bidder will close within four to six weeks after the notice and the stalking horse will either acquire the assets or take home its break-up fee and expense reimbursement as consolation. Predictably, the real life version is grittier than the script. Although a Section 363 sale is an excellent vehicle for acquiring a troubled business, there are risks, tricks and detours to be considered by a sophisticated bidder in developing its strategy and price.
For instance, not every early suitor becomes a stalking horse due to competition for this role. The significant time and expense invested to be first at the starting gate may go to waste if the debtor backs a different horse. To avoid this risk, the potential stalking horse should talk to the seller and its advisors and tap its intelligence network to try to learn whether there are other stalking horse candidates before investing heavily in being first in line. Often, the so-called DIP lender which is providing post-chapter 11 financing may act as stalking horse to ignite the process but will usually drop out upon receipt of a third-party bid. When the DIP lender is an investment fund, it may compete in the sale. Indeed, investment funds frequently agree to serve as the lender to a distressed company prior to a bankruptcy in order to position themselves to bid at a Section 363 sale.
In addition, not all buyer protections negotiated between the stalking horse and the DIP survive third-party scrutiny. The break-up fee, expense reimbursement, minimum topping bid and bidding increments may be further negotiated by the creditors committee and the DIP lender. These negotiations will not improve the bidder's position. The discussions with the DIP lender are critical since the break-up fee and expense reimbursement may be illusory if they will not be senior to the rights of the DIP lender and the sale proceeds fail to fully pay the DIP loan. The conditions upon which the break-up fee and expense reimbursement will be paid can also be tricky. At a minimum, the closing of an alternative transaction or wrongful breach by the seller should trigger the break-up fee and expense reimbursement while the inability to close (for example due to a material adverse change) should trigger expense reimbursement. Non-willful failure of the DIP to meet deadlines or to obtain court approval may not trigger any payment to the stalking horse or may trigger only expense reimbursement.
Bankruptcy court approval is necessary for the buyer protections to be enforceable and the APA will be conditioned on this approval. The DIP will submit a motion seeking approval of the bidding and sale procedures and of the sale to the stalking horse or the winning bidder. The motion will implicitly invoke a long-running academic debate about whether buyer protections enhance recoveries by stimulating the sales process or whether they are simply an unnecessary charge assessed against otherwise realizable proceeds.
While bankruptcy judges have generally become receptive to Section 363 sales, not every judge will approve buyer protections as presented by the parties. Some courts, like those in the Second Circuit and the Southern District of New York, apply a relatively lenient "business judgment standard" and allow break-up fees and expense reimbursement if they represent a reasonable exercise of the DIP's business judgment. Others, including the Third Circuit, and the District of Delaware, require proof that the fees are actually necessary to preserve the value of the chapter 11 estate. Because of the large volume of chapter 11 cases filed in Delaware, its constraints on buyer protections have drawn the attention of the community of professionals and investors that specialize in distressed assets and companies. In two recent casesÂ—Top-Flite (SHC, Inc.) and Epic Capital Corp., one of the permanent Delaware bankruptcy judges (Delaware also hosts visiting judges to assist with its caseload) denied any break-up fee, while a visiting judge reduced the break-up fee in the Burlington Industries case from 2.4% of the bid price to a maximum of 1% of the final price. Expense reimbursements are not as controversial and are likely to be allowed if the maximum amount is reasonable.
Concealed within the apparently straightforward bidding process are additional subtleties. Notice of the sale process will issue almost immediately after the court approval of the bidding procedures and will be published and sent to the parties in the case and to potential bidders. The notice will contain either detailed bidding rules or a contact from which they can be obtained. The rules will set the date and time for submission of competing bids, the "topping" amount by which it must exceed the stalking horse price, the minimum bidding increments at the auction, the time and place of the auction, the amount and terms of the deposit to accompany the bid, the condition that the bidder demonstrate its financial ability to close and a requirement that the bidder submit an APA marked to show changes from the stalking horse APA. The procedures should provide that all bids will be kept confidential until the deadline.
The orderly appearance of the bidding and sale process belies its anarchic reality. Bidders who dutifully comply with the rules find themselves in competition with others who do not. The debtor may accept late or non-conforming bids, may overlook the absence of an APA or evidence of financing or may entertain bids that are for a modified package of assets. The seller and its creditors will support any action that may enhance recoveries and thus they conceal modification rights within the bidding procedures. The following is an example of an escape hatch built into bid procedure orders in the Alterra Healthcare case in Delaware:
"However, if a party approaches the Debtor prior to the commencement of the auction without having submitted a bid, but is able to establish its financial wherewithal to consummate a transaction and is willing to make an offer on substantially the same terms as set forth in a previously proposed Transaction which the Debtor has deemed a qualified Bid, the Debtor may deem such party to have provided a Bid such that it may take part in the Auction."
Ambulatory rules are not the only disadvantage faced by competing bidders. First, to be competitive, the new bid must exceed the total of the stalking horse bid plus the cost of any buyer protections. The stalking horse essentially benefits in its subsequent bids since the dollar amount of the buyer protections reduces the value of the competing bids (although some courts will require the stalking horse to waive the protections if it submits a subsequent bid).
Second, the subsequent bidder may have inadequate time for due diligence and will almost certainly have less time than the stalking horse. The stalking horse and rejected stalking horse bidders will likely have had a head start on diligence. Once the bid procedures are approved, the time frame for diligence and competing bids will be limited. While some sales start with a process managed by an investment banker, replete with an offering book, confidentiality agreements and organized diligence, many do not. In addition, diligence may be further complicated if the seller's management prefers the stalking horse or another of the contenders (for example, because it is a financial buyer which would retain existing management) and is surreptitiously uncooperative in providing diligence to subsequent bidders.
Third, the competing bidder may have very limited ability to negotiate the APA signed by the stalking horse. Changes sought by the competing bidder may be rejected or cause the bid to be discounted. The APA will be similar in many respects to a non-bankruptcy agreement, but will contain embellishments to reflect the need for bankruptcy court approval, to permit termination if court approvals are not obtained and to accommodate solicitation of counter-bids and the auction among bidders. Until the winning bid is chosen, no potential purchaser will obtain an exclusive right to conclude the deal.
An important part of the APA will be the schedules of contracts to be assigned to the buyer and of those to be rejected by the debtor. For a contract to be assigned, the seller must first cure any monetary defaults. If a contract is rejected, the counterparty will have a damage claim which adds to the pool of unsecured claims against the seller. Since both cure costs and damage claims affect the value of the deal, they must be calculable to permit the evaluation of competing bids. Consequently, the deadline for the contract selection process should precede the auction date.
Finally, there may be heightened closing risks. Notwithstanding condensed or truncated diligence, the bidder will be expected to produce an offer and an APA with neither a diligence nor a financing condition and which provides that seller's representations and warranties do not survive closing. The seller constituencies will be fixated on certainty of a prompt closing and avoidance of possible pre-closing or post-closing price adjustments. While Section 363 sales occasionally include escrows, they are usually for limited price adjustment matters such as final working capital calculations and not to protect breaches of representations or warrantees.
There are two remaining cautions: the buyer can't always get what it wants and sometimes gets more than it bargained for. Certain contracts may not be transferable to a buyer. To assign a contract to a buyer, the seller must first "assume" the contract, making it a viable post-bankruptcy obligation of the seller. Assumption requires the DIP to cure all pre-bankruptcy defaults, compensate the counter-party for any damage caused by the defaults and provide adequate assurance of future performance of the contract (which, for an assigned contract, will generally be a function of the buyer's credit rating). Monetary defaults and damages are calculable and the cure costs can be paid. However, some courts have held that non-monetary defaults which are incapable of cure (in one case, the breach of a "going dark" provision in a lease) preclude assumption and without assumption there can be no assignment. Moreover, if the counter-party is excused by non-bankruptcy law from accepting performance by an assignee (the classic example is the personal service contract) or if the contract is subject to laws which prevent assignment (for example, a government contract to build a fighter plane), then the contract cannot be assigned without consent of the counterparty.
These principles cast a longer shadow over the DIP seller's intellectual property. The analysis of the intellectual property rights of a chapter 11 debtor is an obstacle course, with different hazards for distinct types of intellectual property and different treatment for debtors who are the licensor and those who are the licensee. This area of diligence and documentation requires sophisticated, careful lawyering. Of particular importance are the cases which hold that non-exclusive patent licenses held by the debtor either cannot be assumed or, if assumed, cannot be assigned without the consent of the licensor. If the debtor's business is dependent on non-exclusive patent licenses, its sale may be impeded by an uncooperative or avaricious licensor. Equally as important is the debtor's inability to deprive its licensee of rights under a license of intellectual property (by rejection of the license) so long as the non-debtor licensee wishes to retain its rights and continue to pay royalties (similar rules protect non-debtor lessees of real estate when the lessor becomes a debtor).
The second caution relates to the "free and clear" transfer of assets to the buyer. The Bankruptcy Code permits transfer of the debtor's property free and clear of any interest in the property if specified conditions are satisfied. Clearly, "interests" includes claims to title, liens, mortgages and security interests. It is not as clear that "interests" encompass "claims" such as employment discrimination or product liability. Most exposure for "successor liability"Â—the buyer being liable as successor of the sellerÂ—can be eliminated if the bankruptcy process and paperwork is done effectively. Cases have held that employment discrimination claims under ERISA and state liquor tax claims did not pass to the buyer of the business. Notice of the sale and its potential effect on the claimant and notice of the bankruptcy and of the right to file a claim against the debtor are essential if claims are to be eliminated.
Future claims for product liability against a buyer which continues the seller's business are more problematic. The future claimant may be uninjured at the time of the sale only to have the product that it purchased years before the chapter 11 case cause an injury after the closing. Courts are divided on whether this type of future claim can be eliminated in a Section 363 sale. The Bankruptcy Code was amended so that debtors whose liabilities are largely asbestos-related and who face substantial, unidentified future claims can be protected against those claims if a representative for future claimants is appointed. While the statute is limited to asbestos cases, an analogous approach may work for other product liability claims. Again, this is a complicated area calling for as much diligence and prophylactic legal work as possible.
The goal of the purchaser at a Section 363 sale is to take advantage of the financial distress of the seller and the power of the Bankruptcy Code to make a safe, profitable investment. While a Section 363 sale is a complex exercise with risks for the unwary, it can be an efficient avenue for a well-prepared buyer to acquire a financially troubled business.