Bankruptcy Courts Allowed to Reopen Section 363 Auctions

In Paloian, the debtors, Goss Holdings, Inc. and Goss Graphin Systems, Inc. (collectively, “Goss” or the “Debtor”) conducted an auction pursuant to section 363 of the Bankruptcy Code to sell its personal property. To be considered a “qualified bidder” under the bidding procedures approved by the bankruptcy court (the “Procedures”), potential bidders had to submit a written bid to the Debtor in advance of the auction, execute an asset purchase agreement (APA) and demonstrate their financial capability to close the sale. At the beginning of the auction, the Debtor would announce the written bid of each qualified bidder, and then the bidders would be invited to increase their bids.

The Procedures provided that Goss could reject any bid prior to entry of an order by the bankruptcy court approving the bid. Significantly, the Procedures also provided that: “At or before the Sale Hearing, Goss may impose such other terms and conditions as it may determine to be in the best interests of Goss' estate, its creditors and other parties in interest.” As we shall see below, this existence of these reservations was an important consideration for the bankruptcy court and the Seventh Circuit.

Also, the draft APA contained a provision that required the purchaser to remove the bulk of the personal property to be purchased from its current location before June 1, 2002, but reserved to Goss the right to require the removal of the assets at an earlier date if the facility in which the personal property was located was sold. Prior to the auction several interested bidders objected to this provision and the Debtor removed it from the APA but did not alert all bidders to this change.

At the auction, but prior to bidding, a qualified bidder asked Debtor's counsel, “Will this be final today, or will someone be able to go to the court … 3 days from now and up our bid?” Debtor's counsel responded, “[T]oday is the day for the auction, and when we close the auction it will be final. I cannot obviously state that someone can't walk into court on Wednesday and offer $10 million for the stuff and have the Court say that its not going to accept their bid … So I guess I can't give you 100% assurances that someone can't … try to outbid whoever wins today, but I that this is a very slim possibility.”

At the auction, the highest bidder was Corporate Assets, Inc. (CAI), with a winning bid of $2.25 million. Myron Bolling Auctioneers (MBA) was the second highest at $2.075 million. The Debtor's counsel declared the auction closed. The next day, an MBA representative contacted the Debtor and indicated that MBA was unaware of the change to the APA. As such, they were willing to bid $2.45 million, approximately 9% higher than CAI's bid. The Debtor, its lenders and the committee of unsecured creditors decided that it would seek authority from the bankruptcy judge to reopen the auction. The court granted the request.

At the second auction, CAI again presented the highest offer at $2.6025 million, approximately 16% higher than its previous “winning” bid. At the sale hearing, the Debtor asked the court to confirm the results of the second auction. CAI objected and argued that the results of the first auction should be reinstated and it asked the court to approve its expenses for the second auction as an administrative expense under section 503(b) of the Bankruptcy Code. Both requests were denied by the bankruptcy court.

The Ruling

The bankruptcy court held that CAI's second winning bid was in the best interests of the Debtor's estate. Furthermore, the modification clause in the Procedures gave the Debtor authority to reject any bid prior to the Sale Hearing and to impose any conditions. The Debtor's decision to reopen the auction and to reject CAI's first winning bid “would fit within that very, very broad language.” Thus, CAI's expectation that its winning bid would be approved by the bankruptcy court was unreasonable. CAI appealed the decision to the district court which affirmed.

On subsequent appeal, the Seventh Circuit affirmed. As the Seventh Circuit observed, when a bankruptcy court is asked to confirm the results of a sale, there are two principles that must be balanced. First is the principle that the highest and best bid should be obtained for the estate. Second is the principle of preserving the finality and integrity of the process. These principles are in tension when, after an auction is concluded, a higher offer is made.

As the parties' expectations solidify, the discretion of the bankruptcy court to reopen the bidding diminishes. Once the bankruptcy court has approved the sale, its discretion is sharply reduced and bidding can be reopened only in a narrow range of circumstances, such as fraud in the auction or a grossly inadequate price. However, the Seventh Circuit stated that prior to bankruptcy court approval of the bid, the bankruptcy court enjoys greater discretion.

The Seventh Circuit concluded that the bankruptcy court did not abuse its discretion. As the bankruptcy court noted, the Procedures provided Goss with broad discretion to reject bids and impose additional conditions at any time prior to the hearing. The retention of such discretion would have tempered any expectation that the assets would necessarily be sold to CAI. Further, the court noted that Goss did not accept the higher bid and did not declare CAI the winner. Under the Procedures, a bid was deemed accepted only after bankruptcy court approval.

The Seventh Circuit thought it significant that the first auction was not “on an entirely level playing field” because some bidders did not know about the revisions to the APA relating to the removal of assets. The court also thought that the upset price was material, although it could be argued that a bid 9% above the highest bid at the first auction was not enough to reopen the auction.

What It Means

This decision demonstrates the dangers facing winning bidders and stalking horses: Bidders at an auction should always be aware that they can be outbid after the auction but prior to the sale hearing. There is always the possibility that during the time between the auction and the hearing, a bidder will emerge with a materially higher bid. The longer the time between the auction and the hearing, the greater the risk. If a bidder makes a significantly higher bid after the auction is closed, the bankruptcy court will entertain the offer. Paloian, however, involves a slightly higher bid, combined with what appears to be a typical reservation of rights provision and an important modification to the APA that was not noticed to all bidders prior to the auction.

This decision also highlights the need for clear and tight bidding procedures. Many debtors will include broad reservations of rights in their auction procedures so that there is flexibility to address unanticipated events or issues at the auction. What Paloian shows is the importance of those provisions for reopening an auction because a higher bid is submitted after the auction. The Seventh Circuit made clear that those provisions give the debtors and the bankruptcy court additional leeway to reopen an auction. Potential acquirers that are negotiating with the debtor prior to the auction may want to pay particular attention to the debtor's reservation of rights provision. Now that a generic reservation of rights provision has been construed as permitting a debtor to reopen an auction for a slightly higher bid, a party that seeks to become a stalking horse may wish to limit the debtor's flexibility to reject the bid because a higher bid is submitted late. While the bankruptcy court may still reject the lower timely bid, its discretion to do so may be limited by the expectation of the winning bidder.

Paloian, however, can be read more narrowly, a reading that should alleviate some of the concern (and risk) for winning bidders at the auction and should discourage bidders from strategically withholding their best bid. As the Seventh Circuit noted, this is not a case where the losing bidder at the auction intentionally withheld a higher bid and then regretted its decision. Instead, the late hour at which MBA learned of the “highly material” change in the APA was the reason for the higher bid. MBA submitted a revised bid the next day, and prior to the presentation of the results to the bankruptcy court. Thus, Paloian involved a bidder who learned at the auction of a material change, could not react in time at the auction to make its best bid, and the next day submitted its higher bid.

A bankruptcy judge's mandate, and the purpose of a section 363 sale process, is to obtain the “highest and best” offer for the assets. Finality and integrity of the process are also important policy considerations. Bankruptcy sales are designed to facilitate the estate's ready realization of value from its assets, while at the same time giving purchasers some degree of certainty that they will obtain clear title to an asset, without the fear of having the transaction later reversed. At times, however, these principles may be in conflict, as outlined by the Seventh Circuit.

For potential acquirers of a bankrupt's assets, the Seventh Circuit's recent holding in Corporate Assets, Inc. v. Paloian 386 F.3d 761 (7th Cir. 2004) is cause for concern. In that case, the court upheld the decision of the bankruptcy court to reopen an auction conducted pursuant to section 363 of the Bankruptcy Code when a losing bidder increased its offer by 9% to top the highest bid after the conclusion of the auction. The decision demonstrates that an auction may not be the last time to bid.

The Case

In Paloian, the debtors, Goss Holdings, Inc. and Goss Graphin Systems, Inc. (collectively, “Goss” or the “Debtor”) conducted an auction pursuant to section 363 of the Bankruptcy Code to sell its personal property. To be considered a “qualified bidder” under the bidding procedures approved by the bankruptcy court (the “Procedures”), potential bidders had to submit a written bid to the Debtor in advance of the auction, execute an asset purchase agreement (APA) and demonstrate their financial capability to close the sale. At the beginning of the auction, the Debtor would announce the written bid of each qualified bidder, and then the bidders would be invited to increase their bids.

The Procedures provided that Goss could reject any bid prior to entry of an order by the bankruptcy court approving the bid. Significantly, the Procedures also provided that: “At or before the Sale Hearing, Goss may impose such other terms and conditions as it may determine to be in the best interests of Goss' estate, its creditors and other parties in interest.” As we shall see below, this existence of these reservations was an important consideration for the bankruptcy court and the Seventh Circuit.

Also, the draft APA contained a provision that required the purchaser to remove the bulk of the personal property to be purchased from its current location before June 1, 2002, but reserved to Goss the right to require the removal of the assets at an earlier date if the facility in which the personal property was located was sold. Prior to the auction several interested bidders objected to this provision and the Debtor removed it from the APA but did not alert all bidders to this change.

At the auction, but prior to bidding, a qualified bidder asked Debtor's counsel, “Will this be final today, or will someone be able to go to the court … 3 days from now and up our bid?” Debtor's counsel responded, “[T]oday is the day for the auction, and when we close the auction it will be final. I cannot obviously state that someone can't walk into court on Wednesday and offer $10 million for the stuff and have the Court say that its not going to accept their bid … So I guess I can't give you 100% assurances that someone can't … try to outbid whoever wins today, but I that this is a very slim possibility.”

At the auction, the highest bidder was Corporate Assets, Inc. (CAI), with a winning bid of $2.25 million. Myron Bolling Auctioneers (MBA) was the second highest at $2.075 million. The Debtor's counsel declared the auction closed. The next day, an MBA representative contacted the Debtor and indicated that MBA was unaware of the change to the APA. As such, they were willing to bid $2.45 million, approximately 9% higher than CAI's bid. The Debtor, its lenders and the committee of unsecured creditors decided that it would seek authority from the bankruptcy judge to reopen the auction. The court granted the request.

At the second auction, CAI again presented the highest offer at $2.6025 million, approximately 16% higher than its previous “winning” bid. At the sale hearing, the Debtor asked the court to confirm the results of the second auction. CAI objected and argued that the results of the first auction should be reinstated and it asked the court to approve its expenses for the second auction as an administrative expense under section 503(b) of the Bankruptcy Code. Both requests were denied by the bankruptcy court.

The Ruling

The bankruptcy court held that CAI's second winning bid was in the best interests of the Debtor's estate. Furthermore, the modification clause in the Procedures gave the Debtor authority to reject any bid prior to the Sale Hearing and to impose any conditions. The Debtor's decision to reopen the auction and to reject CAI's first winning bid “would fit within that very, very broad language.” Thus, CAI's expectation that its winning bid would be approved by the bankruptcy court was unreasonable. CAI appealed the decision to the district court which affirmed.

On subsequent appeal, the Seventh Circuit affirmed. As the Seventh Circuit observed, when a bankruptcy court is asked to confirm the results of a sale, there are two principles that must be balanced. First is the principle that the highest and best bid should be obtained for the estate. Second is the principle of preserving the finality and integrity of the process. These principles are in tension when, after an auction is concluded, a higher offer is made.

As the parties' expectations solidify, the discretion of the bankruptcy court to reopen the bidding diminishes. Once the bankruptcy court has approved the sale, its discretion is sharply reduced and bidding can be reopened only in a narrow range of circumstances, such as fraud in the auction or a grossly inadequate price. However, the Seventh Circuit stated that prior to bankruptcy court approval of the bid, the bankruptcy court enjoys greater discretion.

The Seventh Circuit concluded that the bankruptcy court did not abuse its discretion. As the bankruptcy court noted, the Procedures provided Goss with broad discretion to reject bids and impose additional conditions at any time prior to the hearing. The retention of such discretion would have tempered any expectation that the assets would necessarily be sold to CAI. Further, the court noted that Goss did not accept the higher bid and did not declare CAI the winner. Under the Procedures, a bid was deemed accepted only after bankruptcy court approval.

The Seventh Circuit thought it significant that the first auction was not “on an entirely level playing field” because some bidders did not know about the revisions to the APA relating to the removal of assets. The court also thought that the upset price was material, although it could be argued that a bid 9% above the highest bid at the first auction was not enough to reopen the auction.

What It Means

This decision demonstrates the dangers facing winning bidders and stalking horses: Bidders at an auction should always be aware that they can be outbid after the auction but prior to the sale hearing. There is always the possibility that during the time between the auction and the hearing, a bidder will emerge with a materially higher bid. The longer the time between the auction and the hearing, the greater the risk. If a bidder makes a significantly higher bid after the auction is closed, the bankruptcy court will entertain the offer. Paloian, however, involves a slightly higher bid, combined with what appears to be a typical reservation of rights provision and an important modification to the APA that was not noticed to all bidders prior to the auction.

This decision also highlights the need for clear and tight bidding procedures. Many debtors will include broad reservations of rights in their auction procedures so that there is flexibility to address unanticipated events or issues at the auction. What Paloian shows is the importance of those provisions for reopening an auction because a higher bid is submitted after the auction. The Seventh Circuit made clear that those provisions give the debtors and the bankruptcy court additional leeway to reopen an auction. Potential acquirers that are negotiating with the debtor prior to the auction may want to pay particular attention to the debtor's reservation of rights provision. Now that a generic reservation of rights provision has been construed as permitting a debtor to reopen an auction for a slightly higher bid, a party that seeks to become a stalking horse may wish to limit the debtor's flexibility to reject the bid because a higher bid is submitted late. While the bankruptcy court may still reject the lower timely bid, its discretion to do so may be limited by the expectation of the winning bidder.

Paloian, however, can be read more narrowly, a reading that should alleviate some of the concern (and risk) for winning bidders at the auction and should discourage bidders from strategically withholding their best bid. As the Seventh Circuit noted, this is not a case where the losing bidder at the auction intentionally withheld a higher bid and then regretted its decision. Instead, the late hour at which MBA learned of the “highly material” change in the APA was the reason for the higher bid. MBA submitted a revised bid the next day, and prior to the presentation of the results to the bankruptcy court. Thus, Paloian involved a bidder who learned at the auction of a material change, could not react in time at the auction to make its best bid, and the next day submitted its higher bid.