The credit crunch has not only meant more bankruptcies, but it has also pushed more bankrupt companies into asset sales and liquidations because they are unable to raise the “debtor-in-possession” or “DIP” financing that bankrupt companies use to try to reemerge from bankruptcy as going concerns. Three huge recent bankruptcies — General Motors, Chrysler and Lehman — used a procedure called a section 363 sale to make rapid sales of assets. This is a term that may be unfamiliar to most people in the project finance market.
Two Chadbourne bankruptcy lawyers — Andrew Rosenblatt and Douglas Deutsch — talked with Marc Alpert in mid-March about how the sales work, bidding strategies for potential asset purchasers and what secured lenders can do to protect their interests before an audience in New York. The following is an edited transcript. Rosenblatt and Deutsch have extensive experience representing creditors’ committees, lenders and debtors in some of the most complex and high-profile recent bankruptcy cases, including Enron, the Chicago Tribune and Spiegel. Marc Alpert is a corporate partner with Chadbourne in New York.
MR. ALPERT: What are the different ways debtors use to sell their assets in bankruptcy?
MR. ROSENBLATT: There are two ways a debtor can sell assets in a chapter 11 bankruptcy. A chapter 11 case is one where a company files for bankruptcy hoping to work out a deal with its creditors and shareholders that will allow it to continue as a going concern.
It can sell its assets pursuant to a plan of reorganization. A plan of reorganization is essentially an agreement between the debtor and its creditors and interest holders settling the claims of the creditors and the interest holders. The filing of a reorganization plan is the culmination of the chapter 11 process. It comes at the end of the case and in order to implement the plan, the plan needs to be voted on and approved by the creditors and interest holders as well as being approved by the bankruptcy court.
Most of you are probably familiar with the term pre-packaged chapter 11 case and, in such a case, the chapter 11 process can move quickly, but such a pre-packaged plan is the exception rather than the rule.
More often, chapter 11 cases can be very complex, and it is not unusual for a case to last more than a year and, in some cases, several years.
The alternative is for a debtor to sell its assets in a section 363 sale. Section 363 is a section of the bankruptcy code. Traditionally, debtors used section 363 to sell discrete assets, specific business units or subsidiaries, but we are seeing it used more and more to sell substantially the entire business.
Unlike a plan of reorganization or a sale that occurs under a plan approved at the end of a case, a section 363 sale can occur at any time during the chapter 11 process. The recent GM, Chrysler and Lehman bankruptcies demonstrate that section 363 sales can occur very early in the chapter 11 process.
MR. ALPERT: What approvals are necessary for doing a section 363 sale?
MR. ROSENBLATT: Unlike a plan of reorganization that must be approved by creditors and the interest holders, a section 363 sale must only be approved by the bankruptcy court. It is not necessary for creditors or interest holders to approve such a sale, although they certainly have the right to object.
When a court considers whether to approve a section 363 sale, it looks at a number of factors. They are sometimes called the Lionel factors after a case in the early 1980’s. The factors are the proportionate value of the assets to the estate as a whole, the elapsed time since the bankruptcy filing, the likelihood that a plan of reorganization will be proposed and confirmed in the near future, the effect of the proposed sale on the ability to put together a future plan of reorganization, how much can be raised from the sale compared to the appraised asset value and, perhaps most importantly, whether the asset is increasing or decreasing in value.
In the General Motors case, the bankruptcy court added four more factors. They are whether the estate has liquidity to survive until a plan can be approved, whether the sale opportunity will still exist at the time of a plan, how likely it is that there would be a satisfactory alternative sale opportunity or a standalone plan alternative as equally desirable or better for creditors if the opportunity to sell is likely to disappear and, finally, whether there is a material risk that failure to approve the sale will cause the “patient” to die on the operating table.
Thee Lionel factors really focus more on maintaining the integrity of the chapter 11 process while the GM factors are more geared toward maximizing value for creditors.
MR. ALPERT: The lack of liquidity in the credit markets has contributed to the spike in section 363 sales over the past couple of years. Do you see this changing in the near term as the economy recovers?
MR. DEUTSCH: Liquidity dried up in the second half of 2008. It became very hard to debtors to borrow what the market calls debtor-in-possession, or DIP, financing. This meant debtors had to sell assets on a more expedited basis. They couldn’t wait for the full-fledged normal plan that could take a year or 18 months to conclude. They needed cash sooner so they sold assets. This year, we are seeing a slowdown in section 363 sales, but we have heard that another wave is coming.
What’s the Attraction?
MR. ALPERT: Can one of you discuss some of the benefits of selling during the bankruptcy proceeding rather than waiting until the end?
MR. ROSENBLATT: One advantage is the ability to realize value on assets that may be losing value. The debtor can file a section 363 motion and try to maximize the recovery for creditors. The primary benefit for buyers is that section 363 sales must be approved by the bankruptcy court and this affords protection from a later challenge. Sales under section 363 generally are free and clear of liens and encumbrances and, although the free and clear language in section 363 omitted the word “claims,” bankruptcy courts have been willing lately to provide the maximum protections possible to buyers. Sale orders provide that a section 363 sale will be free and clear of all liens, claims, encumbrances, lawsuits and actions.
The final benefit is that the buyer can benefit from contracts despite the fact that the contracts contain anti-assignment provisions or change-of-control provisions that, outside of bankruptcy, would have prohibited the assignment of those contracts. The only caveat is that personal service contracts are typically not assignable. Courts also have held that certain non-exclusive intellectual property licenses also are not assignable. Therefore, if a buyer is buying intellectual property, it should be careful to have its lawyers advise whether the contracts or licenses are assignable in bankruptcy.
MR. ALPERT: Those are important advantages from the point of view of a buyer. How about disadvantages of sales during bankruptcy?
MR. ROSENBLATT: There are not many. Buyers should be aware that most section 363 sales are done by public auction. It is a competitive bidding process designed to generate the highest price possible. Buyers should be careful not to structure bids that have the effect of dictating the terms of a restructuring as that would allow any sale to be attacked as a sub rosa or disguised plan of reorganization that is intended to circumvent the formal plan approval process.
How Section 363 Sales Work
MR. ALPERT: So we have covered the advantages and disadvantages of both plan and section 363 sales. Let’s focus now on section 363, the process. There are two distinct court hearings in a typical section 363 sale.
MR. DEUTSCH: The process usually takes two to three months. The debtor usually starts the process by identifying a “stalking horse” or party who is willing and able to buy the assets. The debtor negotiates an asset purchase agreement with that stalking horse and, at the conclusion of the negotiation, the debtor drafts a bid procedures motion suggesting how it proposes to sell the assets. There are then two court hearings. The first is a bid procedures hearing. At that hearing, the court approves the bid procedures motion and the debtor goes about marketing the assets.
The debtor wants to find the highest possible bid. If the debtor finds one or more other bidders during the marketing phase, then an auction will be held. The marketing phase usually lasts 30 to 45 days. The debtor holds the auction. The stalking horse bids against the others. A winner is chosen. The debtor then goes to court for the second hearing to ask approval for the winning bid and completes the sale.
MR. ROSENBLATT: People may not appreciate how important the bidding procedures are and how important it is to go into an auction understanding the rules of the auction. Here are two examples of what I mean.
Last year, I was involved in the VeraSun Energy bankruptcy and a section 363 auction that was held in that case. The debtor was selling substantially all of its assets. The assets were ethanol facilities. There were numerous bidders. Some bid on discrete assets; they wanted particular ethanol facilities. You had another bidder that was bidding on all the assets, and you also had secured lenders who were bidding on the collateral for their loans, which were individual plants.
The mix of bidders made it difficult for VeraSun to evaluate the competing bids. The bidder who bid on all the assets refused to allocate its purchase price among the individual plants; that made it difficult for secured lenders to “credit bid,” or bid against the collateral for their loans. The process was less transparent than it might have been with clearer rules. There were a lot of angry bidders. At least two filed objections complaining about the bidding procedures. The auction took 40 hours to complete, which is an unusually drawn-out process.
In another case last year, Chadbourne acted for a secured lender bidding on two businesses that secured its loan to the debtor. The lender had reached a tentative deal with the creditors’ committee before the bidding. It agreed to credit bid the entire amount of its secured claim so that it would not have any unsecured deficiency claim left over that would dilute what the debtor would realize from the sale.
The lender really wanted to acquire only one of the businesses, and it wanted the other business to be sold. There was a buyer who wanted that other business.
We made clear at the very beginning of the auction that the credit bid by the lender was a conditional bid — it was conditioned on the lender being the highest bidder for both businesses — and if the lender was not the highest bidder for both, then it reserved the right to allocate its offer price between the two businesses. The other bidder complained the approach was unfair. However, we were careful to make sure the bidding procedures allowed this approach. We had advised the debtor of our planned approach before the auction, and the debtor was fine with it. In the end, we were able to reallocate our bid, until the bid got to a price that we were willing to let the asset go. If the other side had read the bidding procedures with more care, it might have done something to prevent our running up the price of the asset it wanted by continuously reallocating our price between the two assets.
Role of Stalking Horse
MR. ALPERT: Talk a little more about the role of a stalking horse bidder and why anybody would ever want to play that role.
MR. DEUTSCH: The stalking horse bidder has the ability to dictate the terms of the sale. It negotiates the asset purchase agreement. Its bid sets a floor price. The stalking horse bid defines what due diligence is done. The stalking horse bidder gets in early and should have the ability to complete all the due diligence it wants. The stalking horse bidder wins the asset in the end about 70% of the time.
MR. ALPERT: What termination fees or breakup fees are paid to the stalking horse bidder if it is outbid?
MR. DEUTSCH: The typical fee is between 1% and 3% of the final sales price.
MR. ALPERT: Does the fee ever exceed 3%?
MR. GEORGE: Yes. I am sure there are members of the audience who have seen that, although I have not seen it for a long time. Judges lately have been trying to hold fees to 1% to 3%.
MR. ALPERT: Can anyone participate in the bidding process or are there minimum requirements?
MR. ROSENBLATT: It depends, but most bidding procedures limit participation in an auction to qualified bidders and usually what qualifies someone is fairly standard. A bidder must make an irrevocable offer that exceeds the price proposed by the stalking horse. A bidder usually must submit an asset purchase agreement or a term sheet or a markup of the stalking horse’s asset purchase agreement. The terms cannot be less favorable than the stalking horse bid. A bidder must submit evidence that it has the financial wherewithal to close the transaction. It must usually make a good faith deposit. It must sign a confidentiality agreement with the debtor.
MR. ALPERT: Do you see bidders using the form of the asset purchase agreement submitted by the stalking horse or does that vary widely?
MR. ROSENBLATT: It depends on the timing of the auction and bidding process. If it is a fairly complex transaction and there is not a lot of time, most bidders mark up the stalking horse’s asset purchase agreement. If time is really not an issue, then a bidder might submit an entirely new asset purchase agreement. Mind you, though, that those cost a lot of money, and unlike a stalking horse who is reimbursed if it loses the auction, other bidders do not have that benefit.
MR. ALPERT: Are there any limitations on qualified bidders who are competitors where the debtor would not want information disclosed to that bidder?
MR. ROSENBLATT: Yes. It plays out in whatever conditions the debtor puts on the diligence that the bidder may do. The debtor usually provides as much information as is required to make an intelligent bid, particularly financial information. If there are trade secrets, if there are things that are highly confidential, then the debtor has every right to restrict parties from seeing that information.
MR. ALPERT: Is there a norm for the amount that the bidder must deposit with the court as a good faith deposit?
MR. ROSENBLATT: We usually see deposits of 5% to 10% of the price offered by the bidder.
MR. ALPERT: Can an auction be conducted on line?
MR. DEUTSCH: There is no reason why not, but we have not seen any yet in substantial cases.
MR. ALPERT: Let’s turn to the perspective of a creditor. You mentioned that assets sold in a section 363 sale are sold free and clear of existing interests. That obviously means that in the sale, the creditors’ liens are extinguished. Why would a creditor consent to the sale, and how are creditors protected in the process?
MR. ROSENBLATT: A secured lender does not have to consent to a sale, and there are many protections in the bankruptcy code that protect secured lenders in the sale context.
First, with limited exceptions, a debtor cannot sell an asset that is encumbered by a lien unless the sale price is sufficient to repay that secured creditor in full. Having said that, a secured creditor generally will consent to a sale of assets by auction. Such sales usually yield high returns; it is a good way to maximize the value. Secured creditors usually don’t want to own the assets, and auction is the best alternative. There is also some benefit to the secured creditor to let an auction proceed; it is a way to test the market to see what the asset is worth. Another reason why a secured creditor usually will not object to the sale is the fact that under section 363, a secured creditor has an absolute right to credit bid for its collateral. That ensures the asset will not be sold to someone other than the creditor for less than the full amount of the secured debt unless the creditor wants to let the asset go.
Lessons from GM and Chrysler
MR. ALPERT: Let’s move on to recent developments and some cases involving bankruptcy sales, starting with the two biggest recent bankruptcies: GM and Chrysler. These cases were handled swiftly through section 363 sales processes. They involved the injections of large sums of money by the US government. Talk about the takeaways from those sales.
MR. DEUTSCH: In Chrysler, the sale was of essentially the valuable assets of old Chrysler to new Chrysler. GM worked the same way. Among the assets left behind were pension liabilities. Some junior creditors appeared to get paid ahead of senior creditors. Specifically, the union pension funds got a majority stake in both companies.
The main takeaway is how fast section 363 sales can proceed. If you have the federal government as a creditor and want to get through bankruptcy quickly, ask it for help. This was a powerful train going down the track, and there was no stopping it.
The second takeaway has to do with the notion of a sub rosa plan. You are not supposed to use the section 363 process to impose a full plan of reorganization. The key is not to determine how much individual creditors will receive from the proceeds of a section 363 sale. You sell the asset. The sales proceeds go into a pot. Then the pot gets divvied up by a plan down the road.
That’s not what happened with GM and Chrysler. What we saw in GM and Chrysler is the government dictated the terms that both the senior and junior creditors would receive up front. Maybe this was good for the country and good for a lot of reasons, but it was a clear departure from existing precedent. The Chrysler decision was appealed and affirmed rather matter of factly by the US appeals court for the Second Circuit, which is considered the most influential court in the country after the US Supreme Court.
MR. ROSENBLATT: The cash component that was being provided in the sale was $2 billion. The court said that was greater than the value of all the assets. The cash was going to the secured creditors. The court said the rest of the consideration that was provided — the equity interest in new Chrysler given to the unions — was really consideration given in exchange for new value created by concessions from the unions.
I think the takeaway from Chrysler and GM is there are often competing policies in a bankruptcy case and the court ended up having to balance them. It maximized value for creditors. It relied on the melting ice cube theory and looked at the alternatives if the sale failed to close. The alternative was liquidation.
MR. DEUTSCH: The court was looking for a way to do what it felt was best for the country.
The third takeaway relates to tort claim release. There was a release not only of normal tort claims of which the debtor had notice, but also of future tort claims.
The best way to understand what the court did is to think of an airplane manufacturer who has been in business for 50 years and has lots of its airplanes in use. It decides to sell the entire business to a new company in a section 363 sale. The buyer wants it free and clear of tort claims. State law does not allow such a release. Normally, if you buy all of the assets of a business, you inherit any liabilities tied to tort claims. What can be done? It is inevitable that one of the planes built by this manufacturer in the last 50 years will fail. The seller does not have enough resources to be able to give a credible indemnity.
One way to deal with the problem is to set up a trust and appoint a trustee to represent all future claimants. There are problems with this, and it is not the way they dealt with the problem in the Chrysler bankruptcy.
In Chrysler, the court said essentially that future claims relating to cars that were manufactured before Chrysler filed for bankruptcy would be disallowed. How do you ensure future claimants are being given due process? They need to be put on notice that their claims are in danger of being denied in the bankruptcy proceeding. Judge Gonzalez, the judge in the case, said the following: “Objections touching upon notice and due process issues, particularly with respect to potential future tort claimants, are overruled as to these issues because, as discussed elsewhere in this opinion, notice of the proposed sale was published in newspapers with very wide circulation. The Supreme Court has held that publication of notice in such newspapers provides sufficient notice to claimants whose interests or whereabouts could not with due diligence be ascertained.”
The appeals court upheld the judge’s decision on this point.
MR. ROSENBLATT: One of the most important bankruptcy policies is the notion that similarly-situated creditors should be treated equally. If you have a case where unsecured creditors and tort claimants are going to recover 5¢ on the dollar, it would arguably be unfair for a future tort claimant to be able to sue a healthier successor to the company and recover 100¢ on the dollar.
MR. ALPERT: So it is better to give them nothing?
MR. ROSENBLATT: No. The way to address the problem is to set up a trust, appoint a counsel for that trust and let the counsel watch out for the interests of future claimants in the bankruptcy proceeding.
MR. ALPERT: Another significant recent case was Lehman’s sale of assets to Barclays, which was also done in section 363 sale. Were there other takeaways from it?
MR. DEUTSCH: This was a case where Lehman sold assets that it worried had dropped in value from $70 billion to $50 billion in the space of weeks before bankruptcy. The sale from start to finish was done in a week. The sale price was $1.7 billion in cash and the assumption of $45.5 billion in liabilities. It was estimated that the cash was equal to the value of the Lehman office building in Manhattan. The lesson from the Lehman case is that section 363 sales can be done extremely quickly and with speed come mistakes. Barclays is now being sued by Lehman over whether some of the assets that Barclays got were transferred to it inadvertently.
AUDIENCE MEMBER: What happens if regulatory approvals are required to conclude the sale?
MR. DEUTSCH: It depends on which agency it is but, generally, the sale would be conditioned upon approval. If the transaction is rejected by the regulatory agency, then the debtor would start over. The bankruptcy court would normally not try to usurp the licensing and other regulatory powers of the government agency with jurisdiction over the sale.
MR. ROSENBLATT: The asset purchase agreement will have a list of conditions to closing. In the auction process, all the bidders agree that the runner up must keep its bid open in case the winning bidder cannot close the sale for any reason, including that the proposed transaction is rejected by a regulator.
AUDIENCE MEMBER: Have you seen any recent cases where the court decided the best offer focused on other aspects besides price, like the ability to close quickly after the sale is approved?
MR. ROSENBLATT: I can’t cite you a specific case, but it is not unusual for a creditors’ committee to have concerns about the ability of the winning bidder to close or finance a deal, and that absolutely goes into the consideration of what is the highest and best bid.
MR. DEUTSCH: The issue is whether the highest bidder is a qualified bidder. That’s why we have bidding procedures. That’s why the runner up is asked to be ready to close if the winning bidder cannot close.