Profiting from the Downturn: Bankruptcy Asset Sales

Whether a bankrupt company is seeking to reorganize and emerge from bankruptcy as a healthy entity or simply to liquidate, a sale of some or all of the bankrupt company's assets is almost always a part of the debtor's bankruptcy strategy. Section 363 of the Bankruptcy Code provides a statutory framework for bankrupt debtors to sell their assets. This provision allows debtors and trustees of bankrupt companies to sell their assets either in or out of the ordinary course of business. This provision also allows debtors and trustees, subject to certain restrictions, to sell assets free and clear of interests in such assets. Because of this provision, bankruptcy asset sales are typically referred to as '363 sales.'

The Bankruptcy Code allows debtors or trustees who are authorized to operate the business to sell assets in the ordinary course of business without notice or a hearing before a bankruptcy court. What is in and what is out of the ordinary course of business is determined subjectively with reference to businesses similarly situated to the debtor's (e.g., would the transaction be one that normally would be entered into by the bankrupt debtor's comparables?) and with reference to the debtor's creditors (e.g., would the transaction be one that creditors normally would expect the bankrupt debtor to enter into in the ordinary course?). For example, a $1 billion (revenue) diversified debtor that regularly buys and sells whole business units may be able to argue credibly that the sale of an entire division with $5 million in annual sales is in the ordinary course, while a smaller debtor may not be able to justify any asset sales as being in the ordinary course.

There is obviously room for a lot of discussion between interested parties and creative lawyers on the issue of whether a particular transaction falls within the ordinary course of a particular bankrupt company's business. Importantly, if an ordinary course of business asset sale is later challenged and found to have been outside the ordinary course, the transaction may be avoided or invalidated by the bankruptcy court. For this reason, except in cases where an asset purchase is very clearly in the ordinary course of a bankrupt debtor's business, it is often advisable to comply with the notice and hearing requirements for out of the ordinary course asset sales.

Debtors and trustees are also authorized to sell assets outside the ordinary course of business after notice and a hearing before the bankruptcy court. The notice and hearing requirements placed on such sales generally mean that all creditors and parties-in-interest to a particular bankruptcy case must be given 20 days written notice of the proposed sale and given an opportunity to object. This time period can be shortened given the exigencies of a particular situation. Additionally, the bankruptcy court need not hold a hearing on the matter if an objecting party does not request one. Generally speaking, a proposed 363 sale probably will be approved by the bankruptcy court (absent any compelling objection) if the transaction meets the standard of the classic business judgment test. Some bankruptcy courts have interpreted the business judgment standard in this context to mean that the underlying transaction must be 'in good faith' or 'fair and equitable.' Other bankruptcy courts look to whether the transaction is in the best interest of the debtor's bankruptcy estate and, ultimately, the debtor's creditors.

A debtor or trustee may sell an asset free and clear of 'any interest in such property' if: 1) applicable non-bankruptcy law allows the free and clear sale; 2) the interest holder consents to the sale; 3) the interest is a lien and the asset is to be sold for more than the value of the lien; 4) the interest is in bona fide dispute; or 5) the interest holder could be compelled to accept a money satisfaction for its interest. The use of the disjunctive 'or' in the Bankruptcy Code means that only one of the five criteria must be met for a bankruptcy court to rule a sale free and clear.

Free and Clear Sales

The free and clear sale is not a third type of bankruptcy sale but a subset of the out of the ordinary course sale, and thus, every 363 free and clear sale will be subject to the notice and hearing requirements discussed above. Given the dire circumstances that drive most debtors into bankruptcy, the 363 free and clear sale is perhaps the most important feature of bankruptcy asset sales. The 363 free and clear sale provides a kind of judicial warranty or insurance policy to a purchaser that it will not end up liable for any of the claims against the debtor on account of its purchase of the debtor's assets.

After reviewing the statutory law on free and clear bankruptcy sales, the natural next step, and the one bankruptcy courts have spent the most time with, is what kind of interest the asset can be sold free and clear of. Clearly, liens attaching specifically to an asset sold in a 363 free and clear sale will not follow the asset to its new owner. Generally, a 363 free and clear sale approved by a bankruptcy court will preclude recovery against the purchaser for any claim that could have been brought against the bankrupt debtor's estate during the bankruptcy case by any party who was given proper notice of the 363 free and clear sale. For example, in the case of environmental claims based on the contamination of a particular piece of real property, the sold real property is probably free and clear of any liability for claims based on pre-sale conduct or contamination. Importantly, the free and clear sale does not immunize the real property or its owner from any claims based on post-sale conduct or contamination.

In understanding the effect of a 363 free and clear sale on products liability or other broad tort claims, it is important to understand that the extent of the 363 free and clear claims protection typically will be tied to the extent of the notice of the sale provided to actual and potential claimants. If the claimants were properly notified, their claims are likely to be expunged. If the claimants were not properly notified, the claimants have a better argument that their claims survive the sale. A free and clear sale also will not get rid of claims that are nonmonetary. For example, a 363 free and clear sale of real property will not serve to sever an easement or equitable covenant running with the land. Given the fact that most bankrupt companies face a large volume of claims, and given that most bankrupt companies do not have records that enable a buyer to fully evaluate the scope of potential successor liability, the 363 free and clear sale provides a significant protection to purchasers.

Conclusion

Buying assets from bankrupt companies offers investors many advantages. It provides a large opportunity for companies and investor groups to profit from the downs of the economic cycle. Assets of virtually every kind and size can, at one point or another, be found for sale by a bankrupt debtor or trustee. The prices that 363 sale purchasers pay, even if there is a spirited auction for the asset in question, typically are heavily discounted relative to those realized in orderly sales conducted outside of bankruptcy. In addition, a 363 free and clear sale allows a purchaser to buy assets with potentially significant protection against successor liability.

The 363 sale process is a predictable hurdle that almost all purchasers of assets from bankrupt debtors will face. Companies and investors looking to find and exploit distressed investment opportunities would be well advised to familiarize themselves with these procedures and to ally themselves with professional advisers capable of negotiating the nuts and bolts of these oftentimes complex and difficult transactions.

David Lee Tayman is an attorney in the bankruptcy and creditors' rights department of Dickstein Shapiro LLP. Tayman has significant experience representing clients in financial distress or dealing with the ramifications of the financial distress of others. He regularly represents clients (leasing and finance companies, creditors, debtors, trustees, and equity holders) in a range of bankruptcy, commercial litigation, and transactional engagements. He can be reached at 202-420-4728 or [email protected].

The recent turmoil in the financial markets has caused many businesspeople to actively seek out opportunities in undervalued or distressed assets. Buying assets out of a bankruptcy case represents one of the best ways to profit from financial distress. However, just as there is no typical bankrupt company, there is no typical asset sale in a bankruptcy case. Bankruptcy and distressed company investing, while potentially lucrative, is also complex and oftentimes contentious.

Bankrupt debtors seek to sell assets that range from entire businesses to individual pieces of equipment. Old, worn-out, or obsolete assets are as likely to be on the block as new, freshly purchased or produced materials. The range and quantity of assets sold by debtors means that opportunities abound for purchasers able to quickly and efficiently analyze the value of assets and close transactions. Spectacular tales of outrageous returns realized by so-called vulture investors abound. Less often told are the stories of would-be vultures spending significant time and money chasing deals that end up going nowhere. While it is true that the assets of bankrupt companies can often be purchased for literally pennies on the dollar, the bankruptcy asset purchase process can be challenging and the legal aspects of bankruptcy asset sales place severe demands on any would-be vulture.

Section 363

Whether a bankrupt company is seeking to reorganize and emerge from bankruptcy as a healthy entity or simply to liquidate, a sale of some or all of the bankrupt company's assets is almost always a part of the debtor's bankruptcy strategy. Section 363 of the Bankruptcy Code provides a statutory framework for bankrupt debtors to sell their assets. This provision allows debtors and trustees of bankrupt companies to sell their assets either in or out of the ordinary course of business. This provision also allows debtors and trustees, subject to certain restrictions, to sell assets free and clear of interests in such assets. Because of this provision, bankruptcy asset sales are typically referred to as '363 sales.'

The Bankruptcy Code allows debtors or trustees who are authorized to operate the business to sell assets in the ordinary course of business without notice or a hearing before a bankruptcy court. What is in and what is out of the ordinary course of business is determined subjectively with reference to businesses similarly situated to the debtor's (e.g., would the transaction be one that normally would be entered into by the bankrupt debtor's comparables?) and with reference to the debtor's creditors (e.g., would the transaction be one that creditors normally would expect the bankrupt debtor to enter into in the ordinary course?). For example, a $1 billion (revenue) diversified debtor that regularly buys and sells whole business units may be able to argue credibly that the sale of an entire division with $5 million in annual sales is in the ordinary course, while a smaller debtor may not be able to justify any asset sales as being in the ordinary course.

There is obviously room for a lot of discussion between interested parties and creative lawyers on the issue of whether a particular transaction falls within the ordinary course of a particular bankrupt company's business. Importantly, if an ordinary course of business asset sale is later challenged and found to have been outside the ordinary course, the transaction may be avoided or invalidated by the bankruptcy court. For this reason, except in cases where an asset purchase is very clearly in the ordinary course of a bankrupt debtor's business, it is often advisable to comply with the notice and hearing requirements for out of the ordinary course asset sales.

Debtors and trustees are also authorized to sell assets outside the ordinary course of business after notice and a hearing before the bankruptcy court. The notice and hearing requirements placed on such sales generally mean that all creditors and parties-in-interest to a particular bankruptcy case must be given 20 days written notice of the proposed sale and given an opportunity to object. This time period can be shortened given the exigencies of a particular situation. Additionally, the bankruptcy court need not hold a hearing on the matter if an objecting party does not request one. Generally speaking, a proposed 363 sale probably will be approved by the bankruptcy court (absent any compelling objection) if the transaction meets the standard of the classic business judgment test. Some bankruptcy courts have interpreted the business judgment standard in this context to mean that the underlying transaction must be 'in good faith' or 'fair and equitable.' Other bankruptcy courts look to whether the transaction is in the best interest of the debtor's bankruptcy estate and, ultimately, the debtor's creditors.

A debtor or trustee may sell an asset free and clear of 'any interest in such property' if: 1) applicable non-bankruptcy law allows the free and clear sale; 2) the interest holder consents to the sale; 3) the interest is a lien and the asset is to be sold for more than the value of the lien; 4) the interest is in bona fide dispute; or 5) the interest holder could be compelled to accept a money satisfaction for its interest. The use of the disjunctive 'or' in the Bankruptcy Code means that only one of the five criteria must be met for a bankruptcy court to rule a sale free and clear.

Free and Clear Sales

The free and clear sale is not a third type of bankruptcy sale but a subset of the out of the ordinary course sale, and thus, every 363 free and clear sale will be subject to the notice and hearing requirements discussed above. Given the dire circumstances that drive most debtors into bankruptcy, the 363 free and clear sale is perhaps the most important feature of bankruptcy asset sales. The 363 free and clear sale provides a kind of judicial warranty or insurance policy to a purchaser that it will not end up liable for any of the claims against the debtor on account of its purchase of the debtor's assets.

After reviewing the statutory law on free and clear bankruptcy sales, the natural next step, and the one bankruptcy courts have spent the most time with, is what kind of interest the asset can be sold free and clear of. Clearly, liens attaching specifically to an asset sold in a 363 free and clear sale will not follow the asset to its new owner. Generally, a 363 free and clear sale approved by a bankruptcy court will preclude recovery against the purchaser for any claim that could have been brought against the bankrupt debtor's estate during the bankruptcy case by any party who was given proper notice of the 363 free and clear sale. For example, in the case of environmental claims based on the contamination of a particular piece of real property, the sold real property is probably free and clear of any liability for claims based on pre-sale conduct or contamination. Importantly, the free and clear sale does not immunize the real property or its owner from any claims based on post-sale conduct or contamination.

In understanding the effect of a 363 free and clear sale on products liability or other broad tort claims, it is important to understand that the extent of the 363 free and clear claims protection typically will be tied to the extent of the notice of the sale provided to actual and potential claimants. If the claimants were properly notified, their claims are likely to be expunged. If the claimants were not properly notified, the claimants have a better argument that their claims survive the sale. A free and clear sale also will not get rid of claims that are nonmonetary. For example, a 363 free and clear sale of real property will not serve to sever an easement or equitable covenant running with the land. Given the fact that most bankrupt companies face a large volume of claims, and given that most bankrupt companies do not have records that enable a buyer to fully evaluate the scope of potential successor liability, the 363 free and clear sale provides a significant protection to purchasers.

Conclusion

Buying assets from bankrupt companies offers investors many advantages. It provides a large opportunity for companies and investor groups to profit from the downs of the economic cycle. Assets of virtually every kind and size can, at one point or another, be found for sale by a bankrupt debtor or trustee. The prices that 363 sale purchasers pay, even if there is a spirited auction for the asset in question, typically are heavily discounted relative to those realized in orderly sales conducted outside of bankruptcy. In addition, a 363 free and clear sale allows a purchaser to buy assets with potentially significant protection against successor liability.

The 363 sale process is a predictable hurdle that almost all purchasers of assets from bankrupt debtors will face. Companies and investors looking to find and exploit distressed investment opportunities would be well advised to familiarize themselves with these procedures and to ally themselves with professional advisers capable of negotiating the nuts and bolts of these oftentimes complex and difficult transactions.

David Lee Tayman is an attorney in the bankruptcy and creditors' rights department of Dickstein Shapiro LLP. Tayman has significant experience representing clients in financial distress or dealing with the ramifications of the financial distress of others. He regularly represents clients (leasing and finance companies, creditors, debtors, trustees, and equity holders) in a range of bankruptcy, commercial litigation, and transactional engagements. He can be reached at 202-420-4728 or [email protected].