Can stalking horse bids be used in Australian insolvency proceedings?
April 2015 | EXPERT BRIEFING | BANKRUPTCY & RESTRUCTURING
It is disappointing that, while the use of stalking horse proceedings, or bids, appears to have widespread acceptance in the United States, there would appear to be little academic commentary on the topic beyond its borders.
What is a stalking horse process?
In a formal insolvency process, a sale of a distressed business or asset may be undertaken by formal court order. This occurs in the US, where outside Chapter 11 proceedings there can be a standalone order made for sale under section 363 of the Bankruptcy Code. This would appear to be a powerful tool, because: (i) section 363(f) permits debtors to sell their assets ‘free and clear’ of existing liens and interests, even if the interest is in bona fide dispute or if the holder of that interest can be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest; and (ii) section 363(l) protects good faith purchasers of property sold under the section from a reversal on appeal. Section 363 has its limits, with the court being prepared to reject the process, if is being used as a ‘sub rosa plan’ which is being used to circumvent the hurdles associated with a Chapter 11 process.
It is in this context that a stalking horse process is typically adopted. An initial bidder, with whom the debtor negotiates, is identified as a ‘stalking horse’ bidder. The term has its origins in hunting, with the hunters said to hide behind a horse – real or replicated – in order to get closer to their target. This bid then sets a floor both as to price and also some of the key terms and conditions of the proposed sale. The bidder may also seek to negotiate the terms and conditions of the bidding process in which it is to participate.
This bidder is typically well up the curve in terms of due diligence and the like and so is, in reality, in a box seat as against other potential bidders. There is also negotiated a breakup fee which the stalking horse bidder will be paid if the sale is made to another bidder. This will be offset against the price if the stalking horse bid is successful. Provision is also made for the recovery of the stalking horse bidder’s costs.
In its commentary on the topic, Jones Day reports that as a general rule in most jurisdictions, combined breakup fees and expense reimbursements in excess of 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. Arrangements with insiders are also said to be subject to heightened scrutiny. They also point to Delaware authority in which there is a requirement that the fee meet the standard for an administrative expense under section 503(b) of the Code, which states that the fee is “actually necessary to preserve the value of the estate”. They say “...some bankruptcy judges take extraordinarily narrow views in this areas and regularly disapprove break-up fees well below the thresholds typical in non-bankruptcy sales”.
The point should be made, though, that once the breakup fee and cost recovery provisions are agreed and confirmed by the court, for other bidders to make a worthwhile bid, their bid will have to exceed not only the staking horse bid, but this bid plus the amounts that will be paid to the stalking horse bidder if they become the under bidder, because it is only when this offer is made will the net return to the estate be the same, as if the stalking horse bid is accepted. For example, if the stalking horse bid is $1m, plus a breakup fee of $30,000 and cost recovery of $20,000, other bidders will need to bid $1,050,000 for their bid to be of equal value to the stalking horse bid (other terms and conditions being equal). This explains why the breakup fee cannot be too high, lest the market is ‘chilled’.
So when is it useful?
So when can a stalking horse process be said to support or most likely result in a sale at market value? And when can the opposite be true?
In its commentary, Focus Management Group points to a logical distinction between: (i) those cases where the process is initiated to confirm a sale to the stalking horse which is a natural or obvious buyer for the company’s business, such as a strategic competitor, management or a financial sponsor, as “an end result of a disciplined auction process”, with the position pre filing being that the assets being sold are no longer viable on a standalone basis; and (ii) a case where the assets have value to several potential buyers, in which event the stalking horse “will likely chill the bidding”.
Can the process be deployed outside the United States?
In common law jurisdictions, such as the United Kingdom and Australia, there are general law duties imposed on insolvency practitioners, in connection with the sale of assets under their control.
The duty to sell for market value
At one end of the spectrum, it is clear that the mortgagee and its receiver (in Australia, a ‘controller’) has a duty in equity arising out of the relationship of mortgagor and mortgagee. In other places, such as Australia, there is a clearly expressed statutory duty under section 420A of the Corporations Act 2001 (Corporations Act) to take reasonable care to seek to sell for either market value or, if the asset does not have a market price, the best price reasonably obtainable.
Case law on section 420A – most of it focused on the sale of real estate – although the section applies equally to the sale of any asset or business, indicates that the section is focused on the steps that the controller actually took with a view to securing market value, as opposed to the price actually obtained. Perversely, it is possible to contravene the section (albeit without any consequences), if the controller’s processes are defective, even though a sale at market value is secured. An oft repeated theme is that to discharge the duty, the controller must in some way test the market and when doing so maintain a competitive tension between competing bids.
The role of the court
It is to be noted that the court does not need to be involved in the process, although the controller is entitled to obtain directions which takes the form of judicial advice to the controller. However, the fact that the court gives the controller a direction that he or she is justified in proceeding with the sale falls well short of the kind of features a section 363 sale order confers, as discussed earlier. It is personal advice by the court to the controller on a legal issue. It is not binding on a mezzanine lender, shareholders or a liquidator ultimately appointed to the seller and so, in a formal sense provides no protection for the purchaser; albeit there is no precedent for an arm’s length sale being set aside, even though the sale process is ultimately found to be defective.
The benefit for controllers is that if they make full disclosure to the court, and follow the court’s advice, this will provide a defence to any claim brought against the receiver for breach. Importantly, the court’s advice is limited to legal issues.
The court will not give a direction about a commercial matter such as price, which is the controller’s responsibility to resolve. In connection with section 420A, the Court will answer a legal question about the property’s sale (e.g., if there any impediment to the receiver selling to the property to the mortgagee), but the court will not give a direction that the receiver has actually complied with the section.
Stalking horse processes in Australia
Against this backdrop the question might be asked: How could a stalking horse process be managed in an Australian context?
Workouts. The first point to make is that section 420A would not provide any impediment to a board of directors of a distressed company entering into such an arrangement in the context of a work out. If this arrangement was consented to by key stakeholders, principally the secured creditors, there would be no reason in principle why it could not remain binding after the commencement of a formal insolvency process, provided it could not be impeached as being entered into in breach of the directors duties to the company, or as an uncommercial transaction.
After a company enters external administration, a prior sale by the board will only be set aside if the company was insolvent at the time, and it was one which no reasonable person in the company’s circumstances would have entered into. A sale which involves a breach by the directors of their duties to the company might also be set aside, if the purchaser was on notice of the facts giving rise to the breach.
External administration. Section 420A does appear to create some problems, in the sense that the appointment of a stalking horse bidder may be said to be anathema to the open, market testing processes preferred by the cases. But, while it has been suggested but not tried in Australia, it should not be ruled out as an option. There are perhaps two bright lines.
The first is that section 420A only applies to a sale by a controller (i.e., receivers and mortgagees). The section does not apply to a sale by a voluntary administrator, noting that he or she also has a statutory power of sale, which can be exercised without reference to the court or the creditors. A secured creditor can appoint an administrator as an alternative to its own controller. The problem is that as a matter of prudent practice, Australian administrators rarely make the distinction and proceed as if they are subject to section 420A on the basis that this presents a well known if high hurdle which, if met, should leave them safe from criticism.
The second is that noting the limits referred to earlier, the court may be prepared to provide a controller with judicial advice on the legal issue that, of itself, the process is not inimical to the objective of securing market value. An administrator can make a similar application; indeed he or she could make an express application to vary the operation of the administration process generally to make specific provision for the process. The precedent to this kind of approach is the advice often given to receivers appointed to the so called ‘melting’ businesses which will simply not stay alive for enough time to undertake a proper market process, in which event the court has sanctioned completing a sale which had been negotiated with a party which had emerged shortly before the administrators were appointed.
Michael Hughes is a lawyer at Minter Ellison. He can be contacted on +61 2 9921 4647 or by email: firstname.lastname@example.org.
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