The biggest trend in Chapter 11 bankruptcies over the past 10 years is to sell assets through a “Section 363 sale,” named for Section 363 of the Bankruptcy Code, which describes the standards for sales in bankruptcy court. Previously, in most Chapter 11 cases, the debtor would propose a Chapter 11 plan. In successful cases, the Chapter 11 plan would be approved by creditors and by the court. If a debtor was selling substantially all of its assets, the sale would be part of the Chapter 11 plan.
With greater and greater frequency, debtors and their buyers have eschewed the more laborious Chapter 11 Plan process, opting to consummate the sale transaction by way of a simple motion under Section 363 of the Bankruptcy Code. In order to obtain court approval of a Chapter 11 Plan, a debtor must first obtain approval of a disclosure statement, must then obtain sufficient votes from creditors, and finally, must meet other stringent Bankruptcy Code requirements. This takes time, generally at least 3 months. It is also expensive, and the outcome is uncertain.
In contrast, a motion to sell assets free and clear of liens under Section 363 can be accomplished upon regular notice—21 days in Southern California—and sometimes on even shorter notice if the Court allows it. In addition, the paperwork is much less onerous and thus less expensive for the bankruptcy estate.
Previously, courts were often reluctant to approve sales of substantially all of a debtor’s assets without a Chapter 11 Plan. Objecting parties would argue that the sale via Section 363 was an improper “sub rosa” plan, which did not meet the Chapter 11 plan requirements discussed above. However, over time, bankruptcy courts have moved away from that position, and today such sales are commonplace.
As a buyer of distressed assets, it is important to understand that bankruptcy sales approved by court order are generally final sales made on an “as is” basis. This means that the buyer’s due diligence must be performed prior to entry into the purchase and sale agreement and prior to court approval of the terms of the sale. Once the court does approve the sale, the buyer is usually obligated to close, or liable for damages for breach of the purchase and sale agreement.
In addition, almost all bankruptcy sales are subject to overbid by third parties. The reason for this is that the debtor is obligated to maximize the value of the bankruptcy estate for the benefit of creditors. In practice, this means that the contracting buyer is not assured of being the party that actually acquires the assets. Instead, the contracting buyer is agreeing to be the “stalking horse” in a court-supervised auction of the assets being sold. A buyer who spends substantial time and money conducting due diligence and negotiating the terms of a purchase and sale agreement with a debtor generally does not like being overbid and losing the assets to someone else. For this reason, stalking horse buyers have demanded, and courts have approved, the payment of a fee to the stalking horse buyer in the event that a third party overbidder is ultimately the winning bidder. Courts approve these so called “break up fees” on a contingent basis in advance of an auction, under the premise that by stepping up as the stalking horse, the contracting buyer has created a floor price for the asset being sold, and “primed the pump” for others who may be interested in buying the asset. This benefits the bankruptcy estate and creditors by helping to create a market and a higher price being paid for the assets. In fact, many potential overbidders rely, in whole or in part, on the due diligence of the stalking horse to give the overbidder confidence to bid on the asset. It is not unusual for bidding at such bankruptcy auctions to be fast and furious.
Thus, the first benefit of being the stalking horse is that if you are not ultimately the winning bidder at the auction, you can be paid a “break up fee,” which is intended to compensate you for the time and expense incurred. As a rule of thumb, courts have tended to limit the amount of a break up fee to 3% of the purchase price. If you are late to the party and the debtor has already entered into a sale transaction with a stalking horse buyer, you may have the right to overbid. However, if you lose at the auction, you will not be entitled to a break up fee.
The second benefit is that the stalking horse can negotiate other terms of the sale, which if approved by the court, will then usually be binding on the overbidders. For example, the stalking horse can set the initial overbid increment, as well as the subsequent minimum overbid amounts. More importantly in some cases, the bidder can influence the rules of the auction. For example, the stalking horse can require that all bids be made for exactly the same assets that the stalking horse is interested in acquiring, and that buyers cannot create a different mix of assets. These types of contractual provisions can make it more difficult for other prospective buyers. However, objecting parties may argue that such rules are too onerous and will “chill the bidding.” For these reasons, the court must ultimately balance the proverbial “bird in hand” versus “two in the bush.” If the court approves the stalking horse’s terms of sale, then the stalking horse will have the advantages described above. However, if the court does not approve the stalking horse’s requirement, then the stalking horse may walk away—creating the risk that there will be no buyer at all, or that any new buyer will only offer less than the stalking horse had offered.
Debtors are realizing that Section 363 sales present a quick, inexpensive alternative to a reorganization or sale through a traditional Chapter 11 plan. Given that Section 363 sales are becoming more common, and taking into consideration the advantages of being a stalking horse buyer, any party looking to buy all or substantially all of the assets of a debtor should give serious consideration to contracting with a debtor to become a stalking horse.