Asset Sales in Bankruptcy

Notwithstanding the dramatic events of the historic mega-bankruptcies over the last two years and the considerable attention paid to them, little may actually have changed for debtors and potential acquirors of distressed assets on a going-forward basis for at least two reasons: First, the unprecedented nature of, and fear and pains caused by, the near total collapse of western capitalism as we know it may have produced bankruptcy court decisions that, in almost any other market condition, will be of little precedential value. And second, sophisticated secured lenders have already adapted to limit the impact of the two circuit court decisions. As a result, the practice of distressed asset sales may change very little following the Great Recession.

DIP Financing and Section 363 Sales

During the protracted credit crisis, DIP lending has been predominately a defensive exercise undertaken by existing lenders to protect prepetition credit exposure and maintain collateral and enterprise value of debtors. The lenders making defensive DIP loans have sought quick exits and repayment of their DIP and prepetition loans through asset sales. Defensive DIP lenders have increasingly asserted control over the bankruptcy process ' including by conditioning availability of funds on expeditious section 363 asset sales. These conditions have served to increase the number of section 363 sale transactions during the economic downturn.

At the Margins: Sub Rosa Plans and Business Judgment

There are limits on the debtor's ability to sell assets under section 363. A sale that is coupled with the distribution of proceeds to stakeholders could be challenged as a disguised, or “sub rosa,” plan of reorganization, which short-circuits the requirements of Chapter 11 for priority, distribution and plan confirmation ' and thus steps beyond the margins of section 363.

In addition, while the plain language of section 363 imposes no restrictions on a sale transaction other than “notice and a hearing,” courts have historically required more where the assets being sold constitute all or a substantial part of the debtor's assets. In Comm. Of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063 (2d Cir. 1983), the Second Circuit held that expediency alone is not sufficient justification for a section 363 sale: Debtors must show an independent business justification as well. While the exigency needn't be that the asset would waste away entirely before it could be sold through a plan of reorganization, something more than appeasing a particular creditor or other constituency is required. In practice, however, the implications of Lionel have been rather limited, as bankruptcy courts have readily allowed whole company sales with little of the scrutiny contemplated by the Second Circuit.

Lehman, Chrysler and GM

Recently, there have been several noteworthy uses of section 363 to sell assets in the Lehman Brothers, Inc., Chrysler LLC and General Motors Corp. bankruptcies. Yet while each of these transactions was historic, there is a good argument that, for all of the drama associated with them, the bankruptcies will be of little precedential value.

By way of background, less than one week after Lehman Brothers Inc. filed for Chapter 11, the section 363 sale of Lehman's investment bank to Barclays Capital Inc. was approved. In re Lehman Brothers Holdings Inc., No. 08-13555 (JMP) (Bankr. S.D.N.Y. Sept. 19, 2008). At a contentious sale hearing, certain creditors argued vociferously that the transaction should be delayed, or risk setting a terrible precedent for section 363 fire sales. While noting many of his own concerns with the speed of the sale, Judge James M. Peck approved the transaction. The assets were rapidly declining in value, and the sale “was so exceptional relative to [Judge Peck's] experience ' both as a bankruptcy lawyer and judge” that “it could never be deemed a precedent for future cases” absent “a similar emergency.” And it was “difficult” for Judge Peck “to imagine a similar emergency.”

But similar emergencies soon followed in In re Chrysler LLC, 405 B.R. 84, 2009 Bankr. LEXIS 1323 (Bankr. S.D.N.Y., 2009) and In re General Motors Corp., 407 B.R. 463 (Bankr. S.D.N.Y. 2009). Each bankruptcy saw the “good” assets of the struggling automakers divested in rapid-fire section 363 sales arranged prepetition. The transactions included significant and unprecedented pre-petition and DIP loans by the United States and Canadian governments. In addition, in exchange for strike, wage and other concessions, the United Auto Workers' retiree health care trust received significant equity stakes in the reorganized entities. Creditors raised numerous objections, including that the sales were impermissibly fast without adequate justification under section 363, and that, by distributing proceeds to creditors outside of a plan of reorganization, the sales constituted sub rosa plans. However, relying in part on Judge Peck's decision in Lehman, Judge Arthur J. Gonzales, presiding over Chrysler, and Judge Robert E. Gerber, presiding over General Motors, approved the sales.

Setting aside the complex arguments against the use of section 363 raised in each case, the precedential value of these decisions may be limited. It seems unlikely that, as Judge Peck posited in Lehman, similar exigencies ' imploding global economies and financial markets, unprecedented government investment, and immense political pressure ' will converge again. Therefore, barring another perfect storm of risk of systemic failure of potential catastrophic national and global financial consequence, the changes to existing law stemming from these cases, if any, may be limited.

Credit Bidding After Philadelphia Newspapers

The ability of a secured creditor to credit bid their debt is an important protection against the sale of a secured creditor's collateral for insufficient value. It may also be important to “loan to own” investors as a tool to acquire control over a debtors through the asset sale process. And unsurprisingly, the decisions of the U.S. Courts of Appeals for the Third and Fifth Circuits in Philadelphia Newspapers, LLC and In re Pacific Lumber Co. restricting credit bidding received a considerable amount of attention. Together, the decisions stand for the proposition that a plan of reorganization may permit the sale of a creditor's collateral under section 1129(b)(2)(A)(iii), without allowing that creditor to credit bid, if the affected creditor receives the “indubitable equivalent” of its claim under the plan.

However, the decisions may have limited impact. First, they have already impacted market practice, with DIP lenders and secured creditors negotiating for DIP and cash collateral orders which require that plan-based asset sales be conducted under section 1129(b)(2)(A)(ii) (which, by its terms, permits credit bidding). And second, the decisions are applicable to plan of reorganization sales only. Section 363 sales are unaffected.

Strategies After the Perfect Storm

As the financial climate continues to improve, recent events, though seismic, may have little effect on most asset sales. Indeed, in recent memory, the bid procedures for a typical section 363 sale have changed very little. Typically, working with investment banking and other financial advisers, debtors will conduct a marketing process to locate potential suitors for assets to be divested. If successful, the marketing process will result in a potential acquiror executing an asset purchase agreement with the debtor. This potential acquiror will act as a “stalking horse,” and its “bid” will be shopped by the debtor to other potential acquirers. If no additional suitors emerge, the debtor will close on the sale transaction with the stalking horse. If there is additional interest, the debtor will hold an auction. Should a new bidder top the stalking horse's bid, it will often be required to pay the stalking horse's legal and adviser fees and expenses, as well as a break-up fee.

Yet notwithstanding the limited impact of recent events, debtors can improve the likelihood of a successful asset sale in several ways.

Focus negotiations with the stalking horse on deal terms, not price. As bankruptcy auctions tend to focus most often on price, with competing bidders forced largely to accept the stalking horse asset purchase agreement, negotiations with the stalking horse are perhaps the best opportunity to craft favorable deal terms. Carve indemnities back to bare minimum. Remove diligence, financing and other closing conditions. As a corollary, avoid tight milepost deadlines ' such as court approval and closing dates ' that lead to termination events. Limit deferrals of purchase price and closing escrows.

Low bid increments may yield the best deal terms. Minimal incremental bid amounts may engage more potential acquirors in the auction for a longer period of time. Each round of bidding is an opportunity for unsuccessful bidders to offer more favorable deal terms to the debtor, which the winning bidder will often be forced to accept.

Build as much time into the process as possible. Mindful of the exigencies driving the asset sale process, debtors should build as much time into the pre-auction process as is feasible to afford the maximum number of potential acquirors the opportunity to participate. In addition to broadening the competitive pool, allowing bidders an opportunity to conduct a robust diligence inquiry increases the debtor's leverage to negotiate for no diligence closing condition. If a stalking horse bidder is committed with limited termination rights, the risks to the debtor are relatively small in expanding this pre-auction timeline.

Provide buyers a broad menu of options. Particularly when auctioning multiple business units or groups of assets, debtors are well advised to consider marketing assets separately, running separate auctions or, at minimum, fashioning bid procedures which allow bids on individual assets or combinations of individual assets. Mindful of the incremental closing risk posted by multiple acquirors, the “highest and best” offer may in fact come from several bidders.

Negotiate for minimal bid protections. The stalking horse serves a critical role in many distressed auctions, setting a floor at which assets will be monetized. However, high break-up fees can have a chilling effect on additional bidders expending the necessary resources to participate in a challenge to the stalking horse. In addition, each dollar of break-up fee is ultimately one less dollar received by the debtor.

Similarly, there is room for improvement around the margins for acquirors as well.

Cash is (often, but not always) king. The potential buyer willing to offer the greatest amount of cash consideration typically wins the auction. Deal terms are important, but potential acquirors are wise to carefully consider the maximum amount of cash they are willing to offer. Potential acquirors should also consider their available cash as compared with their competitors: Can additional cash be offered to buy more favorable deal terms then less cash-rich competitors would receive?

Certainty of closing can be king. Often the “best” bid is the one which is most certain to close. Presenting a lower risk profile then competitors ' particularly by reducing the number of walk-away rights ' will often be viewed favorably by the debtor, creditor constituencies and the bankruptcy judge, even though the purchase price may be lower. Potential acquirors should therefore engage legal and financial acquirors in the diligence process as soon as possible. If the stalking horse agreement includes diligence, material adverse change or other contingencies, can they be deleted or softened? Can letters of credit or other security be posted towards purchase price and closing costs?

Look carefully at liabilities. What liabilities are being assumed by the stalking horse? Are there additional liabilities which could be assumed to increase the non-cash component of a bid? This analysis, however, must always be performed in light of the likely recovery scenarios for the estate.

Non-cash consideration. Strategic acquirors in particular are often well-advised to consider non-cash consideration ' particularly if faced with potentially lower cash availability than their competitors. Can competing bids be topped by offering the debtor shares of the acquiror's common stock?

Plan for the worst-case scenario. As financial markets rebound, the pressure to propose asset purchase agreements with few contingencies will increase. Closing conditions ' including diligence, financing and absence of a material adverse change ' will become increasingly rare, and will decrease the competitiveness of bids which include such contingencies. However, to avoid buyers' remorse, acquirors should carefully consider the drivers behind their purchase and actively play out crisis scenarios with a view towards the finality of asset purchase agreements prior to bidding.

Conclusion

Much has recently transpired in the world of distressed asset sales. However, going forward, debtors and acquirors are well advised to consider the potentially limited impact of these developments, and thus to sharpen the tools already at their disposal to ensure successful asset sales.

Douglas P. Bartner, a partner in the Bankruptcy & Reorganization Group of Shearman & Sterling LLP, regularly represents debtors and creditors and acquirors of assets in Chapter 11 bankruptcies and out-of-court restructurings. Jordan A. Costa is an associate in the Bankruptcy & Reorganization Group of the firm.

For distressed asset sales, the Great Recession has been something of a perfect storm. The global economic near-catastrophe affected virtually every industry in both the national and global economies, and presented financial market players, corporate CEOs, regulators and government leaders with the horrifying prospect of systemic collapse of the global financial system.

Exacerbating the extreme challenges faced by distressed companies and debtors once in bankruptcy has been an unparalleled contraction in global credit markets. Indeed, at the very same time that bankruptcy filings dramatically increased, the availability of DIP financing dramatically decreased. This has resulted, in part, in an increasing number of asset sales to fund corporate wind downs and reorganizations ' including in the high profile bankruptcies of Lehman Brothers, Inc., Chrysler LLC and General Motors Corp. In addition, many debtors able to obtain DIP financing have been required to agree to asset sales on highly compressed timelines as a condition to borrowing.

Along with this increased asset sale activity were the In re Philadelphia Newspapers, LLC, 559 F.3d 298 (3d Cir. Mar. 22, 2010) and Bank of New York Trust Co., NA v. Official Unsecured Creditors' Committee (In re Pacific Lumber Co.), 584 F.3d 229 (5th Cir. 2009) decisions in the Third and Fifth Circuits, holding that secured creditors do not have the right to credit bid at distressed auctions in certain circumstances.

Notwithstanding the dramatic events of the historic mega-bankruptcies over the last two years and the considerable attention paid to them, little may actually have changed for debtors and potential acquirors of distressed assets on a going-forward basis for at least two reasons: First, the unprecedented nature of, and fear and pains caused by, the near total collapse of western capitalism as we know it may have produced bankruptcy court decisions that, in almost any other market condition, will be of little precedential value. And second, sophisticated secured lenders have already adapted to limit the impact of the two circuit court decisions. As a result, the practice of distressed asset sales may change very little following the Great Recession.

DIP Financing and Section 363 Sales

During the protracted credit crisis, DIP lending has been predominately a defensive exercise undertaken by existing lenders to protect prepetition credit exposure and maintain collateral and enterprise value of debtors. The lenders making defensive DIP loans have sought quick exits and repayment of their DIP and prepetition loans through asset sales. Defensive DIP lenders have increasingly asserted control over the bankruptcy process ' including by conditioning availability of funds on expeditious section 363 asset sales. These conditions have served to increase the number of section 363 sale transactions during the economic downturn.

At the Margins: Sub Rosa Plans and Business Judgment

There are limits on the debtor's ability to sell assets under section 363. A sale that is coupled with the distribution of proceeds to stakeholders could be challenged as a disguised, or “sub rosa,” plan of reorganization, which short-circuits the requirements of Chapter 11 for priority, distribution and plan confirmation ' and thus steps beyond the margins of section 363.

In addition, while the plain language of section 363 imposes no restrictions on a sale transaction other than “notice and a hearing,” courts have historically required more where the assets being sold constitute all or a substantial part of the debtor's assets. In Comm. Of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063 (2d Cir. 1983), the Second Circuit held that expediency alone is not sufficient justification for a section 363 sale: Debtors must show an independent business justification as well. While the exigency needn't be that the asset would waste away entirely before it could be sold through a plan of reorganization, something more than appeasing a particular creditor or other constituency is required. In practice, however, the implications of Lionel have been rather limited, as bankruptcy courts have readily allowed whole company sales with little of the scrutiny contemplated by the Second Circuit.

Lehman, Chrysler and GM

Recently, there have been several noteworthy uses of section 363 to sell assets in the Lehman Brothers, Inc., Chrysler LLC and General Motors Corp. bankruptcies. Yet while each of these transactions was historic, there is a good argument that, for all of the drama associated with them, the bankruptcies will be of little precedential value.

By way of background, less than one week after Lehman Brothers Inc. filed for Chapter 11, the section 363 sale of Lehman's investment bank to Barclays Capital Inc. was approved. In re Lehman Brothers Holdings Inc., No. 08-13555 (JMP) (Bankr. S.D.N.Y. Sept. 19, 2008). At a contentious sale hearing, certain creditors argued vociferously that the transaction should be delayed, or risk setting a terrible precedent for section 363 fire sales. While noting many of his own concerns with the speed of the sale, Judge James M. Peck approved the transaction. The assets were rapidly declining in value, and the sale “was so exceptional relative to [Judge Peck's] experience ' both as a bankruptcy lawyer and judge” that “it could never be deemed a precedent for future cases” absent “a similar emergency.” And it was “difficult” for Judge Peck “to imagine a similar emergency.”

But similar emergencies soon followed in In re Chrysler LLC, 405 B.R. 84, 2009 Bankr. LEXIS 1323 (Bankr. S.D.N.Y., 2009) and In re General Motors Corp., 407 B.R. 463 (Bankr. S.D.N.Y. 2009). Each bankruptcy saw the “good” assets of the struggling automakers divested in rapid-fire section 363 sales arranged prepetition. The transactions included significant and unprecedented pre-petition and DIP loans by the United States and Canadian governments. In addition, in exchange for strike, wage and other concessions, the United Auto Workers' retiree health care trust received significant equity stakes in the reorganized entities. Creditors raised numerous objections, including that the sales were impermissibly fast without adequate justification under section 363, and that, by distributing proceeds to creditors outside of a plan of reorganization, the sales constituted sub rosa plans. However, relying in part on Judge Peck's decision in Lehman, Judge Arthur J. Gonzales, presiding over Chrysler, and Judge Robert E. Gerber, presiding over General Motors, approved the sales.

Setting aside the complex arguments against the use of section 363 raised in each case, the precedential value of these decisions may be limited. It seems unlikely that, as Judge Peck posited in Lehman, similar exigencies ' imploding global economies and financial markets, unprecedented government investment, and immense political pressure ' will converge again. Therefore, barring another perfect storm of risk of systemic failure of potential catastrophic national and global financial consequence, the changes to existing law stemming from these cases, if any, may be limited.

Credit Bidding After Philadelphia Newspapers

The ability of a secured creditor to credit bid their debt is an important protection against the sale of a secured creditor's collateral for insufficient value. It may also be important to “loan to own” investors as a tool to acquire control over a debtors through the asset sale process. And unsurprisingly, the decisions of the U.S. Courts of Appeals for the Third and Fifth Circuits in Philadelphia Newspapers, LLC and In re Pacific Lumber Co. restricting credit bidding received a considerable amount of attention. Together, the decisions stand for the proposition that a plan of reorganization may permit the sale of a creditor's collateral under section 1129(b)(2)(A)(iii), without allowing that creditor to credit bid, if the affected creditor receives the “indubitable equivalent” of its claim under the plan.

However, the decisions may have limited impact. First, they have already impacted market practice, with DIP lenders and secured creditors negotiating for DIP and cash collateral orders which require that plan-based asset sales be conducted under section 1129(b)(2)(A)(ii) (which, by its terms, permits credit bidding). And second, the decisions are applicable to plan of reorganization sales only. Section 363 sales are unaffected.

Strategies After the Perfect Storm

As the financial climate continues to improve, recent events, though seismic, may have little effect on most asset sales. Indeed, in recent memory, the bid procedures for a typical section 363 sale have changed very little. Typically, working with investment banking and other financial advisers, debtors will conduct a marketing process to locate potential suitors for assets to be divested. If successful, the marketing process will result in a potential acquiror executing an asset purchase agreement with the debtor. This potential acquiror will act as a “stalking horse,” and its “bid” will be shopped by the debtor to other potential acquirers. If no additional suitors emerge, the debtor will close on the sale transaction with the stalking horse. If there is additional interest, the debtor will hold an auction. Should a new bidder top the stalking horse's bid, it will often be required to pay the stalking horse's legal and adviser fees and expenses, as well as a break-up fee.

Yet notwithstanding the limited impact of recent events, debtors can improve the likelihood of a successful asset sale in several ways.

Focus negotiations with the stalking horse on deal terms, not price. As bankruptcy auctions tend to focus most often on price, with competing bidders forced largely to accept the stalking horse asset purchase agreement, negotiations with the stalking horse are perhaps the best opportunity to craft favorable deal terms. Carve indemnities back to bare minimum. Remove diligence, financing and other closing conditions. As a corollary, avoid tight milepost deadlines ' such as court approval and closing dates ' that lead to termination events. Limit deferrals of purchase price and closing escrows.

Low bid increments may yield the best deal terms. Minimal incremental bid amounts may engage more potential acquirors in the auction for a longer period of time. Each round of bidding is an opportunity for unsuccessful bidders to offer more favorable deal terms to the debtor, which the winning bidder will often be forced to accept.

Build as much time into the process as possible. Mindful of the exigencies driving the asset sale process, debtors should build as much time into the pre-auction process as is feasible to afford the maximum number of potential acquirors the opportunity to participate. In addition to broadening the competitive pool, allowing bidders an opportunity to conduct a robust diligence inquiry increases the debtor's leverage to negotiate for no diligence closing condition. If a stalking horse bidder is committed with limited termination rights, the risks to the debtor are relatively small in expanding this pre-auction timeline.

Provide buyers a broad menu of options. Particularly when auctioning multiple business units or groups of assets, debtors are well advised to consider marketing assets separately, running separate auctions or, at minimum, fashioning bid procedures which allow bids on individual assets or combinations of individual assets. Mindful of the incremental closing risk posted by multiple acquirors, the “highest and best” offer may in fact come from several bidders.

Negotiate for minimal bid protections. The stalking horse serves a critical role in many distressed auctions, setting a floor at which assets will be monetized. However, high break-up fees can have a chilling effect on additional bidders expending the necessary resources to participate in a challenge to the stalking horse. In addition, each dollar of break-up fee is ultimately one less dollar received by the debtor.

Similarly, there is room for improvement around the margins for acquirors as well.

Cash is (often, but not always) king. The potential buyer willing to offer the greatest amount of cash consideration typically wins the auction. Deal terms are important, but potential acquirors are wise to carefully consider the maximum amount of cash they are willing to offer. Potential acquirors should also consider their available cash as compared with their competitors: Can additional cash be offered to buy more favorable deal terms then less cash-rich competitors would receive?

Certainty of closing can be king. Often the “best” bid is the one which is most certain to close. Presenting a lower risk profile then competitors ' particularly by reducing the number of walk-away rights ' will often be viewed favorably by the debtor, creditor constituencies and the bankruptcy judge, even though the purchase price may be lower. Potential acquirors should therefore engage legal and financial acquirors in the diligence process as soon as possible. If the stalking horse agreement includes diligence, material adverse change or other contingencies, can they be deleted or softened? Can letters of credit or other security be posted towards purchase price and closing costs?

Look carefully at liabilities. What liabilities are being assumed by the stalking horse? Are there additional liabilities which could be assumed to increase the non-cash component of a bid? This analysis, however, must always be performed in light of the likely recovery scenarios for the estate.

Non-cash consideration. Strategic acquirors in particular are often well-advised to consider non-cash consideration ' particularly if faced with potentially lower cash availability than their competitors. Can competing bids be topped by offering the debtor shares of the acquiror's common stock?

Plan for the worst-case scenario. As financial markets rebound, the pressure to propose asset purchase agreements with few contingencies will increase. Closing conditions ' including diligence, financing and absence of a material adverse change ' will become increasingly rare, and will decrease the competitiveness of bids which include such contingencies. However, to avoid buyers' remorse, acquirors should carefully consider the drivers behind their purchase and actively play out crisis scenarios with a view towards the finality of asset purchase agreements prior to bidding.

Conclusion

Much has recently transpired in the world of distressed asset sales. However, going forward, debtors and acquirors are well advised to consider the potentially limited impact of these developments, and thus to sharpen the tools already at their disposal to ensure successful asset sales.

Douglas P. Bartner, a partner in the Bankruptcy & Reorganization Group of Shearman & Sterling LLP, regularly represents debtors and creditors and acquirors of assets in Chapter 11 bankruptcies and out-of-court restructurings. Jordan A. Costa is an associate in the Bankruptcy & Reorganization Group of the firm.