The changing face of asset sales in Chapter 11
March 2013 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING
Financier Worldwide Magazine
Only a handful of sections contained in the United States Bankruptcy Code are so quintessential to the fabric of the reorganisation process that even a slight change in either their interpretation or implementation can directly affect the outcome of almost every Chapter 11 case. Two such sections are Section 363, which permits the debtor to, among other things, sell all or substantially all of its assets and business ‘free and clear’ of liens and claims, and Section 364, which permits a debtor to obtain debtor-in-possession (DIP) financing. As discussed below, the interaction of these two Bankruptcy Code sections has greatly impacted the manner in which Chapter 11 cases are administered, and while much has been written about these two sections and how they work in tandem, we are again seeing changes in the Chapter 11 process attributable to the evolving implementation of these sections.
In the wake of the sweeping changes made by the 2005 Amendments to the Bankruptcy Code (which limited the amount of time a debtor could enjoy the uninterrupted benefits of Chapter 11), the financial crisis of 2008 and the over-leveraged capital structures of borrowers resulting from the liberal financing environment preceding the financial crisis, secured lenders became ultra-conservative in their view of the Chapter 11 process and the approach taken toward recovering on their secured loans. As such, lenders increasingly conditioned their DIP financing commitments on their borrowers agreeing to achieve Section 363 sale ‘milestones’. These 363 sale conditions to the DIP financing would typically require Chapter 11 borrowers to sell their assets within a relatively short period of time following the commencement of the Chapter 11 case (e.g., typically not more than 90 days allocated for the entire marketing process, bid submission, auction, sale hearing and sale closing). This compressed sale process oftentimes failed to produce a ‘stalking horse’ or selected opening bidder who was willing to pay more than liquidation value for the debtor’s assets, unless such bidders were permitted to conduct and complete their due diligence prior to the Chapter 11 filing. Under this regime, the secured lender limited its exposure to the absolute minimum financing required to permit a Chapter 11 borrower to stay in business long enough to complete a 363 sale and pay necessary administrative costs required to fund the 363 sale process. In these situations, the DIP financing order entered by the Bankruptcy Court (the form of which is customarily prepared by the secured lender’s counsel) would implement the lender’s business decision by ordering the debtor’s compliance with these very tight sale milestones. While popular with lenders because it was cost efficient, the actual sale results were less than robust and would produce bids that hovered around the liquidation value of the debtor’s assets.
With the advent of a stronger economy and an increasingly sophisticated approach to the Section 363 sale process, secured lenders are increasingly abandoning their prior practices of requiring a quickly administered 363 sale process as a condition to extending DIP financing, and are instead supporting an extended 363 sale marketing period, and in some instances, even supporting a Chapter 11 plan process to effect a successful reorganisation of the Chapter 11 borrower’s business. This recent trend is having the short term effect of increasing the amount secured lenders are prepared to advance to their borrowers under the DIP facility, and having the correlated effect in many situations of increasing the value recovered for Chapter 11 debtor’s assets.
What has caused this change? We can identify at least four reasons.
The first reason is the economic recovery. There are simply more funds available to invest in the distressed market, and therefore lenders are seeing greater values for their collateral in the 363 environment.
The second is the sophistication of the lending community which, after many years of only achieving liquidation value returns for their collateral, are realising that giving the debtor more time to market its assets combined with the assistance of sophisticated advisers produces, in most instances, a greater return.
The third is the sophistication of the Official Committee of Unsecured Creditors and their advisers, who no longer object to what they perceive as onerous and overreaching DIP financing arrangements, so long as the secured DIP lender allows the Creditors Committee to participate in the sale process (usually evidenced by granting the Committee access to all bid information generated during the 363 sale process), and funds a 363 sale process that provides sufficient time to permit the Creditors Committee the opportunity to find a third-party willing to pay enterprise rather than liquidation value for the debtor’s assets.
The fourth and most unrecognised, but perhaps most influential, of these changes is the evolving role of the stalking horse bidder and the sophistication of prospective 363 bidders generally who have learned how to better play the 363 sale process to their advantage.
It used to be common wisdom that being selected by the debtor as the stalking horse bidder would most likely result in this stalking horse bidder being the winning bidder for the sale of the debtor’s assets. As such, it was not uncommon that the private ‘mini auction’ held for the stalking horse bidder status would also serve as thede facto auction for the sale of the assets. The stalking horse bidder would traditionally be granted bid protections in the form of ‘break-up’ fees (e.g., 1 percent to possibly 4 percent of the proposed purchase price) and expense reimbursement protection for the out-of-pocket diligence costs in the event a higher and better bid was accepted, in addition to the right to credit bid the break-up fee and expense reimbursement against competing bids (which effectively gives the stalking horse bidder an automatic cash credit at the auction equal to the dollar amount of the bidding protections).
Notwithstanding these benefits associated with being the stalking horse bidder, as the market for distressed assets sales have become more sophisticated, many bidders are now inclined to wait and see what the marketplace value is for such assets at the time of the Section 363 sale, rather than spending the time and effort of becoming the stalking horse bidder several months prior to when the assets are actually auctioned. As a result of the prospective bankruptcy bidders’ ‘wait and see’ approach, Chapter 11 debtors are running more ‘blind’ 363 sale processes (i.e., without a stalking horse bidder) than in previous years.
We are also seeing prospective 363 buyers placing more weight on the value of the assets without regard to the supposed added benefits that a Section 363 sale process provides, i.e., the ability to sell distressed assets free and clear of all claims, trailing liabilities, liens and encumbrances. This trend is attributable in part to ongoing and evolving case law that has limited this cornerstone benefit of conducting Section 363 sales. Notwithstanding that 363 sale orders have eclipsed DIP financing orders and plan confirmation orders as having the longest, most comprehensive terms and provisions of any orders entered in the Chapter 11 case, buyers have learned that even the best crafted sale order cannot eliminate all liabilities associated with the purchased assets. Aside from the more common examples, such as existing environmental problems associated with purchased real property, recent court decisions have affirmed that certain successor liability claims stemming from product liability that arises after the sale cannot, in certain circumstances, be discharged by a Section 363 sale order.
For those who are interested in the Chapter 11 sale process, whether as a secured lender seeking to maximise its collateral value, or as a prospective Section 363 purchaser, they would be well advised to take notice of these recent developments in order to use the bankruptcy sale process to their best advantage.
Daniel F. Fiorillo is a partner at Otterbourg, Steindler, Houston & Rosen, P.C. He can be contacted on +1 (212) 905 3616 or by email: firstname.lastname@example.org.
© Financier Worldwide
Daniel F. Fiorillo
Otterbourg, Steindler, Houston & Rosen, P.C.