Open auction v. sealed tender distressed sales processes: which is better and when?
March 2014 | SPECIAL REPORT: GLOBAL RESTRUCTURING & INSOLVENCY
Financier Worldwide Magazine
In an insolvency, the main goal of any sales process ought to be the maximisation of the net realisable value of the assets over some relatively reasonable period of time. In North America, such sales processes have historically been predominantly sealed tender in Canada while the United States has favoured an open auction process. This has certainly been the case in so-called ‘Section 363 Sales’ under Chapter 11 of the United States Bankruptcy Code since the early 1990s. In coordinated cross-border insolvency proceedings between Canada and the United States, such Section 363 Sales processes have been adopted into the Canadian element of such proceedings without much, if any, resistance. Accordingly, the assumption that open auction processes are the best at maximising realisable value is now almost conventional wisdom in North America.
This is an interesting development because there is little objective evidence to support the correctness of this assumption. Indeed, in a recent article by law professors Yaad Rotem and Omer Dekel which appeared in the Spring 2013 volume of The Review of Litigation, the authors mention their surprise that auction design in the US bankruptcy context has “barely been studied”. Those legal scholars also note that much of the finance and economic literature on auction efficacy and efficiency has yet to find its way into any serious academic legal analysis of the issue. One will certainly be very hard pressed to find any Canadian academic work on such matters in the context of insolvencies.
Historically, Canadian insolvency sales processes for the entire business as a going concern presumably warranted the use of sealed tenders because of the very limited breadth and depth of Canada’s distressed acquisition market. That is, there was a good chance only one bidder would surface in most cases and a very limited number in the best cases. Obviously, if you only have one bidder in an open auction process then it is very unlikely that such a bidder will tender the most that bidder is prepared to pay. However, in a sealed tender process, the risk of not knowing whether or not one or more competing bids will be tendered encourages any bidder to put in a bid that is at or very close to the maximum that such a party would be prepared to pay for the business. In addition, such sealed tender processes in Canada have never strictly accorded with the theoretical model. Often, if not always, the court officer (historically a trustee in bankruptcy, private or court appointed receiver) would meet with the bidders (even if there was only one) to work on ‘clarifying’ the bids received after they had been opened and considered. These meetings often have the effect of giving the impression that there are multiple bids being considered with the bidder almost always being encouraged to see if they can do better on price as doing so would obviously make their bid more competitive. Again, the risk of not knowing for sure whether or not there are in fact other competing bids (and from whom) that are, in fact, superior, works towards maximising the bid price at the end of the process.
Presumably, the United States favours open auction processes as a result of having a broader and more competitive market for distressed businesses. If auctions attract a multiple of competitive bidders, then it would appear to be more transparent and certainly more efficient to simply hold an open auction with the best bid winning the day. The academic finance and economics literature tends to support this difference. Sealed tender auctions are generally held to theoretically produce higher bids when: (i) buyers are risk averse (i.e., losing matters); (ii) buyer valuations of the asset may differ by material amounts; or (iii) there is a limited pool of potential buyers.
Surprisingly, however, in an article appearing in the October 2007 volume of the Michigan Law Review, professors Lynn LoPucki and Joseph Doherty found that in their survey of 30 large public company Section 363 Sales between 2000 and 2004 the average number of bidders was 1.6 and that in 58 percent of the cases for which they had data there was only one bidder. Given the propensity to begin Section 363 Sales with a so-called ‘stalking horse’ bid, such data should be very concerning in its empirical challenge to an assumed deep and competitive market warranting the benefits of an open auction process for sales price maximisation. The practical fact of the matter is that a stalking horse bid entry into an open auction process will theoretically always be materially less than what such a bidder’s maximum price would be (because they will get to bid in the auction if anyone does show up). Therefore, if a preponderance of stalking horse bids are in fact the winning bid in such Section 363 Sales processes then it is inevitable that such processes are certainly not maximising realisable value. In the same data set just referred to, 26 cases had a stalking horse bid and, of those, the stalking horse ended up being the buyer in 22 of them (i.e., 85 percent of the time).
The assumption that an open auction process is the best way to maximise the realisable value of a distressed business warrants significant and careful scrutiny. If it is expected that there will be many competitive bidders, then an open auction process appears to make the most sense which is a conclusion supported by the academic literature on point. However, if there is likely only to be one bidder and not many more, then a sealed tender process appears to be empirically supported as being superior. This is especially the case given that valuations of going concern distressed businesses will likely be materially different across bidders due in no small part to the very nature of such valuations, and that most buyers will be risk averse to some degree (especially considering the due diligence costs involved in being able to formulate a bid). Of course, there are many other variables and dynamics that can and should be considered in a thoughtful and methodical approach to designing a sales process that will have the best likelihood of maximising the ultimate sale price.
The point is, however, that it would appear worthwhile to approach such sales process design in such a manner rather than simply accepting, without much question, what appears to be the current conventional wisdom.
Robin B. Schwill is a partner at Davies Ward Phillips & Vineberg LLP. He can be contacted on +1 (416) 863 5502 or by email: email@example.com. The author would like to thank Dina Milivojevic, an associate at Davies Ward Phillips & Vineberg LLP, for her research assistance in the preparation of this article.
© Financier Worldwide
Robin B. Schwill
Davies Ward Phillips & Vineberg LLP