Sales of assets pursuant to Section 363 of the Bankruptcy Code or pursuant to a plan of reorganization provide a number of benefits to a purchaser, but they also present a number of potential impediments, particularly to purchasers who are not familiar with the bankruptcy sale process. The benefits include obtaining the assets free and clear of liens, protection from fraudulent transfer claims, protection against certain liabilities and certainty with respect to the enforceability of the transaction documents as provided in the bankruptcy court's order, relief from the need to obtain consent to the assignment of certain contracts, an expedited waiting period under the Hart-Scott-Rodino Antitrust Improvements Act, exemption from certain state laws including bulk sales and stockholder approval, and in the case of sales pursuant to a confirmed plan of reorganization, exemption from transfer taxes. The factors that purchasers often find unfavorable are primarily those associated with a debtor's duty to obtain the highest and best value for the assets. These factors include, among other things, a longer period of time typically necessary to complete such deals, the need for court approval (including overcoming objections to the sale), and the uncertainty associated with the auction process required to maximize the value to the debtor's estate. Sales pursuant to a plan of reorganization involve even more potential obstacles and longer periods of time, as they are subject to the confirmation of a plan of reorganization, which can be a lengthy and uncertain process.

The initial bidder with whom the debtor negotiates a purchase agreement is called the "stalking horse" bidder. The term is an old hunting term referring to either a real horse or an image of a horse (typically some type of screen) behind which a hunter would hide to conceal himself from, and get closer to, his prey. Potential bidders in bankruptcies should not be misled by the origin of this term, because very little will be concealed in a bankruptcy proceeding and the purchaser will be forced to disclose much more information about the deal, as well as about the purchaser itself, than in a typical nonpublic deal.

Incentives for the Stalking Horse

Potential purchasers may be reluctant to take on the role of the stalking horse for a variety of reasons, preferring instead to wait for another bidder to negotiate the deal and then participate in the auction. The initial bidder typically has to expend greater resources than other bidders in negotiating the deal, performing due diligence, and otherwise setting the "floor" for the terms of the transaction. To compensate the stalking horse for its time and effort, certain incentives are typically negotiated. Without receiving these incentives, the potential purchaser would not otherwise agree to be the stalking horse. These incentives may include expense reimbursements, break-up fees, favorable bidding procedures, and exclusivity arrangements. The incentives requested by the stalking horse are often at odds with the debtor's duty to obtain the highest and best value and the requirements of the bankruptcy code. The negotiations between the debtor and stalking horse must strike an acceptable balance, or the bankruptcy court will likely not approve the stalking horse's proposed terms.

Expense Reimbursement. One of the most common incentives offered to stalking horse bidders is a reimbursement of its expenses related to negotiating the deal. Fees and expenses incurred with respect to legal and financial advisers, due diligence, and other reasonable expenses related to the deal are subject to reimbursement. The amount subject to reimbursement is usually capped at some maximum amount or percentage of the purchase price and may have other restrictions so as not to be perceived as an unreasonable drain on the debtor's estate. The bankruptcy court must approve the expense reimbursement, usually pursuant to an order approving bidding procedures and protections. To protect itself from having the reimbursement potentially treated as an unsecured claim, the stalking horse will often insist on having the reimbursement treated as an administrative expense.

One of the issues likely to be debated between the stalking horse and debtor will be the circumstances under which the stalking horse is entitled to receive the reimbursement and when the payment is actually due. A typical formulation is that the stalking horse becomes entitled to the payment when the debtor accepts a "higher and better offer" for the assets. What constitutes a "higher and better offer" will likely be the subject of negotiation, especially if the purchase price includes components other than cash. The stalking horse will want to be paid as soon after the higher and better offer is accepted, while the debtor will typically insist that the payment not be due until the deal with the new buyer actually closes, ensuring that proceeds of the sale rather than operating or other funds are available to make the payment. If the bidding procedures require the prevailing bidder to provide a deposit in an amount to cover the maximum potential expense reimbursement, as well as other amounts, then it is not uncommon to have the expense reimbursement be payable out of the deposit as soon as the stalking horse submits proper documentation supporting the request for reimbursement.

Break-Up Fees. Break-up fees or topping fees are also common protections offered to stalking horse bidders. Such fees, however, can be controversial in many jurisdictions, and it is important to be familiar with a jurisdiction's position on these fees before requesting them. For example, in Delaware, if the requested break-up fee does not meet the criteria set forth in In re O'Brien Environmental Energy, the judge will not approve the fee, and the process will be delayed if a new break-up fee structure has to be renegotiated or other steps have to be taken to comply with the O'Brien standards. Under O'Brien, the proposed break-up fee must meet the standards for an administrative expense claim under Section 503(b) of the Bankruptcy Code, meaning that the fee must be "actually necessary to preserve the value of the estate."

Break-up fees are more controversial than expense reimbursements because they provide payments to the stalking horse that are either unrelated to amounts expended negotiating the deal or, in many instances, in addition to a negotiated expense reimbursement. The break-up fee is essentially additional compensation to the stalking horse to induce it to be the initial bidder and lay the groundwork for other potential bidders in an auction. Theoretically, the initial bidder is setting the "floor" for the purchase price and other terms of the transaction, and the break-up fee is one of the incentives offered to induce the stalking horse to set a higher "floor." While many studies indicate that offering break-up fees may not actually result in higher floors being set, in most bankruptcy sales a break-up will likely be requested by a potential stalking horse and, at a minimum, whether a break-up fee will be included as part of the transaction will be one of the issues negotiated between the parties.

If the break-up fee is excessive, it may be viewed as having a chilling effect on potential bidding. As a general rule in most jurisdictions, combined break-up fees and expense reimbursements in excess of approximately 3 percent of the purchase price will be viewed with heightened scrutiny, and break-up fees in excess of 5 percent of the purchase price are rare. In addition, if the buyer is an insider of the seller, a break-up fee will likely be viewed with higher scrutiny. The parties most likely to object to break-up fees are the creditors' committee or the U.S. Trustee, typically objecting that the proposed fee has a chilling effect. Ordinarily a disgruntled potential bidder has no standing to object to the proposed break-up fee. Finally, some bankruptcy judges take extraordinarily narrow views in this area and regularly disapprove break-up fees well below the thresholds typical in non-bankruptcy sales. Accordingly, it is important to consider precedents before the particular court prior to proceeding in any bankruptcy sale.

Bidding Procedures. Perhaps the most important piece of leverage a stalking horse may have is its ability to negotiate favorable bidding procedures. In many instances, the debtor will attempt to take this leverage away by agreeing to bidding procedures with the creditors' committee, the secured lenders, and other relevant parties before a stalking horse is chosen. In some jurisdictions, preapproved break-up fees and expense reimbursements may be included in these procedures, but it is unlikely that preapproved break-up fees will be permitted in jurisdictions that follow O'Brien. Having preapproved bidding procedures in place helps deter a stalking horse from attempting to change the procedures, as any attempted changes will likely be viewed as attempts to chill the bidding process and discourage other bidders from entering into the auction process, even if the requested changes would normally be considered reasonable if presented as part of negotiated bidding procedures.

Some judges, however, are reluctant to approve bidding procedures before a stalking horse has been found. This was the case with the Aladdin Casino bankruptcy, in which the debtor attempted to obtain preapproved procedures but the judge ruled that it was premature to do so before a stalking horse was found. Jones Day represented the stalking horse, which was able to negotiate favorable bidding procedures. The stalking horse was the successful bidder approved by the court in part because, pursuant to the criteria it negotiated with the debtor for determining whether another bidder met the requirements for participating in an auction, the judge determined that no other potential bidders met the criteria for being "qualified bidders."

In addition to being able to negotiate the criteria for determining whether a bidder is qualified to participate in an auction, the stalking horse also typically attempts to include other bidding procedures that may give it an advantage in an auction. Both the debtor and stalking horse, however, must take care to avoid procedures that are so favorable to the stalking horse that they are perceived to chill the bidding process rather than encourage it.

Exclusivity Arrangements. In sales outside the bankruptcy context, the purchaser will often want to enter into an exclusivity arrangement with the seller. Such an arrangement in a bankruptcy context typically conflicts with a debtor's duty to obtain the highest and best value for the assets, which normally requires that an auction be held. However, it is not unusual for a potential purchaser to negotiate limited periods of exclusive dealing in a bankruptcy, thus maximizing the opportunity for it to become the stalking horse bidder. Like other incentives for the stalking horse, exclusivity arrangements must be approved by the bankruptcy court.

Conclusion

A potential purchaser unfamiliar with bankruptcy processes initially may find the process to be cumbersome and foreign. However, once the purchaser learns the process, or obtains legal and financial advisers experienced with it, the purchaser can typically use the process to its advantage as a stalking horse. In addition to attempting to negotiate some or all of the provisions described above, the stalking horse can often gain a tremendous advantage over other bidders simply by virtue of being the bidder with whom the debtor deals while negotiating the purchase agreement. The stalking horse becomes a known quantity and can use the opportunity to get both the debtor and creditor groups comfortable that the purchaser will be able to close the deal quickly and efficiently once the sale is approved.

Business and asset sales, and even transactions involving the divestiture of substantially all of a debtor's business, are an increasingly common element of the bankruptcy sale process. This is, however, a unique area, combining traditional M&A, bankruptcy, and related practices such as tax, benefits, HSR, and the like. As a firm, Jones Day is uniquely positioned to operate in this environment.

Further Information

This Jones Day Commentaries is a publication of Jones Day and should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship.