United States: What Buyer's Counsel Needs To Know About Bankruptcy Sales

Overview of the Sale Provisions of the Bankruptcy Code

Among other things, Section 363¹ of the Bankruptcy Code authorizes a bankruptcy trustee, or a Chapter 11 debtor-in-possession, to sell bankruptcy estate assets outside of the ordinary course of business free and clear of all liens, claims and encumbrances.

Section 363(f)² sets out the requirements for a sale free and clear of liens, claims and encumbrances. A discussion regarding the satisfaction of these requirements is beyond the scope of this seminar.

Notably, there is nothing in Section 363 that requires a bankruptcy sale to be by public sale with competitive bidding. Rather, Bankruptcy Rule 6004(f)(1) specifically provides that "all sales not in the ordinary course of business may be by private sale or by public auction."

Similarly, there is nothing in the Bankruptcy Code or the Bankruptcy Rules that discuss sale procedures, bidder protections, higher and better bids, back-up bids or other matters that routinely arise in bankruptcy sales. Rather, all of these matters have developed over the years through practical experience by practitioners and courts.

Advantages of Buying Assets from a Bankruptcy Estate

From a buyer's perspective, there are several significant advantages of buying assets from a bankruptcy estate through a Section 363 sale.

For example:

• A purchaser will take title to the assets free and clear of any "interests" of a third party in the assets (e.g., liens, claims, and encumbrances) pursuant to a federal court order.
• Generally, a buyer of assets under § 363 can avoid the potential risks of assuming a seller's liabilities that a purchaser of assets may be subject to, outside of bankruptcy, under theories such as the "mere continuity doctrine," "substantial continuity doctrine," "successor liability doctrine," "de facto merger doctrine," and the Bulk Sale Act that purchasers of substantially all of an insolvent business's assets will inherit some or all of the business's liabilities.
• A bankruptcy order approving a sale can bind non-consenting constituents and other parties that may have an interest in the property. For example:
• • Some corporate bylaws require the approval of a majority of shareholders in order to sell substantially all of the assets of a company. In bankruptcy, such provisions generally will not prevent the sale of assets free and clear of those requirements.
  • Section 363(h)³ allows for the sale of a non-debtor co-owner's interest in estate property under certain circumstances.
• Pursuant to Section 365 of the Bankruptcy Code, a purchaser will be able to assume beneficial unexpired leases and executory contracts while cumbersome agreements can be rejected with no liability to the buyer.

Disadvantages of Buying Assets from Bankruptcy Estates

There are some disadvantages for a buyer in a Section 363 bankruptcy sale, as well. For example,

• The Court will usually require a public auction with competing bids.
• Because the sale must be noticed to interested parties, and almost always must be subject to pre-sale marketing efforts by the seller, the sale of assets will be publicly and widely known. Sometimes, this may engender negative publicity that could have a negative effect on the business operations.
• Because of the noticing requirements, competitive bidding process, potential objections to the sale by secured creditors and other constituents, and the sale procedures usually adopted by a bankruptcy court, Section 363 sales can often take a long time and cost more than a sale outside of bankruptcy.

Sale Procedures and Process

The primary goal for a bankruptcy seller in a bankruptcy sale is to maximize the recovery and benefits to the bankruptcy estate and the seller's creditors. This goal, of course, is not always aligned with the buyer's goal of getting the best deal possible for the assets. Therefore, the buyer and the seller frequently negotiate the processes and procedures for conducting the bankruptcy sale.

In this regard, because there are no general rules of procedure governing the process and procedures for conducting bankruptcy sales under Section 363—other than certain timing requirements--bankruptcy courts generally have considerable discretion in conducting sales.

Note that some local rules address bankruptcy sales that can vary widely from jurisdiction to jurisdiction. In Arizona, the local rules mainly address the filing and noticing processes and are silent on the procedures governing the auction process.

Stalking Horse Bidders, Bidder Protections and Stalking Horse Fees

While it is possible for a trustee or debtor in possession to seek authority to sell assets without an existing purchase offer, that is unusual.

Rather, a bankruptcy sale most often starts with an offer from an initial bidder—the "stalking horse" bidder. Below are some suggestions for what should be included in the LOI and, ultimately, the purchase and sale agreement.

The stalking horse bidder is important to the sale process because its opening offer is the catalyst for competing bids and the maximization of value to the estate and creditors.

Typically, the stalking horse bidder will incur costs and time engaging in due diligence, lining up financing, and negotiating a purchase agreement. In doing so, the stalking horse bidder is risking that it will be the successful bidder at the public auction sale.

Therefore, to encourage a prospective buyer to be a stalking horse bidder and take those financial risks, a bankruptcy seller will frequently offer certain bidder protections to the opening bidder. These incentives and protections may include certain stalking horse fees, in addition to exclusivity rights, overbid requirements, etc. outlined below in the discussion regarding the LOI.

Stalking horse fees are designed to encourage the stalking horse bidder by compensating it in the event it is not the successful bidder at the auction sale. There are several types of stalking horse fees, such as:

Expense reimbursements are payments to the initial bidder to reimburse it for its out of pocket fees and expenses. Sometimes these fees are subject to a negotiated cap. These fees are usually not controversial and are routinely approved by courts as an incentive for stalking horse bids.

A break up fee is similar to an expense reimbursement. It is paid to a stalking horse bidder in the event that the contemplated transaction fails to be consummated and/or that certain criteria in the purchase agreement are not met. The most common condition giving rise to the payment of a break-up fee is the seller's acceptance of a subsequent bid at the auction sale. Break up fees are also sometimes payable if, for a reason outside of the stalking horse bidder's control, the Court fails or refuses to approve the sale (e.g., the seller was unable to satisfy the conditions of a free and clear sale under Section 363(f)).

A topping fee is an amount payable to the initial bidder equal to a certain percentage of the amount by which a prevailing bid from a competing bidder exceeds the initial bidder's offer.

The tests for approving these fees vary from jurisdiction to jurisdiction, and even from court to court. Note also that the United States Trustee's Office will often weigh on the approval of stalking horse fees.

Some courts hold that the entitlement to stalking horse fees should be determined simply under the "business judgment rule," just as they would outside of bankruptcy.

Other courts have established certain tests for considering whether to approve stalking horse fees, such as: (1) whether the relationship between the parties was tainted with self dealing; (2) whether the break-up fee hampers, rather than encourages, bidding; and (3) whether the fee is unreasonable in relation to the proposed purchase price.

Other courts look to whether the fees serve the best interests of the bankruptcy estate. In this regard, several factors are examined, such as whether: (1) the requested fee correlates with a maximization of value to the debtor's estate; (2) the terms were negotiated at arm's length; (3) the requested fees were supported by the secured and unsecured creditors of the estate; (4) the requested fees were reasonable and fair in relation to the proposed purchase price; (5) the break-up fee was so substantial that it would "chill" bidding; (6) safeguards beneficial to the debtor's estate existed; and (7) unsecured creditors would be adversely impacted by objecting to requested fees.

In Arizona, the seminal case on break-up fees is In re America West Airlines, 166 B.R. 908, 912 (Bankr. D. Ariz. 1994), which found that:

It is prudent for the stalking horse bidder to require that any stalking horse fees approved by the Court and that are ultimately payable to the stalking horse bidder be (a) paid from the sale proceeds and/or (b) be allowed as administrative claims against the bankruptcy estate, so that they are paid with priority over other claimants.

The seller and the buyer should (a) include these bidder protections in the purchase and sale agreement that is to be approved by the bankruptcy court and (b) specifically request in the sale motion, discussed below, that the court approve the protections prior the sale.

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Footnotes

1. Section 363(b) provides that:

2. Section 363(f) provides that:

3. Section 363(h) provides that:

Originally published May 18, 2022.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.