Buying and Selling Underperforming Corporate Assets. The New York Law Journal.
By Charles Baker and Kimberly Newmarch
The continuing turmoil in the economy and financial markets has forced directors of distressed companies to find optimum ways to sell underperforming assets. More frequently, companies are selling these assets through court-supervised sales pursuant to §363(b) of the U. S. Bankruptcy Code (§363 asset sales).1 It is important for M&A practitioners to understand the unique aspects of §363 asset sales to ensure that clients can take advantage of their benefits.
This article discusses certain intricacies of the asset purchase agreement and the corresponding auction that is typical of the §363 asset sale process.
Generally, a distressed company has three alternatives to sell its assets. First, it may do so as part of a conventional sale outside of bankruptcy. Given the severity of the current economic downturn, buyers are increasingly wary of purchasing a distressed company's assets via a conventional sale.
Buyers fear that the purchased assets may be subject to significant encumbrances that are unknown or are not readily ascertainable. This risk is especially great if the buyer is purchasing all, or a significant portion, of the seller's assets because the ability to recover from the seller for a breach of contract (e.g., due to undisclosed liens) is often impossible from a practical standpoint.
Second, the company may enter Chapter 11 and sell its assets pursuant to a plan of reorganization under §1123(a)(5) of the Bankruptcy Code.2 Frequently, however, sellers are in such financial distress that they lack sufficient operating capital to continue with ordinary operations and a sale pursuant to a plan will not provide capital at the required speed.
The seller must first negotiate with various classes of creditors to obtain approval of the plan either prior to filing its Chapter 11 case or immediately following the filing. This often takes more time and coordination than is available if seller's business is to remain operational. In addition, confirmation of the plan by the bankruptcy court is never guaranteed and, in any case, may be a long and protracted process.
Third and finally, the company may file for bankruptcy protection and sell its assets pursuant to a §363 asset sale.3 Such a sale can be quick and efficient,4 thereby providing a distressed company with capital on an accelerated basis. It also provides buyers with the opportunity to purchase assets free and clear of all liens and encumbrances.5 As such, §363 asset sales have emerged as the method of choice for many distressed companies.
To begin the §363 asset sale process, a seller markets its assets to potential bidders and selects an initial bidder.6 The initial bidder will serve as the "stalking horse bidder."
The seller then negotiates an asset purchase agreement with the stalking horse bidder. After executing the asset purchase agreement, the seller will file a motion with the bankruptcy court seeking approval for both the sale and the procedures for conducting an auction.
A comprehensive review of each section of the stalking horse asset purchase agreement and the related auction process is beyond the scope of this article. Therefore, the remainder of this article will focus on some of the unique aspects of such agreements and the corresponding auction process.
The Purchase Agreement
Representations and Warranties. One of the unique aspects of a stalking horse asset purchase agreement is the limited number of representations and warranties made by the seller and the limited duration and scope of such representations and warranties.
Section 363(f) of the Bankruptcy Code provides: "[t]he trustee may sell property under (b) or (c) of this section free and clear of any interest in such property."7
Because the bankruptcy court is able to provide clear title to the assets, many of the traditional representations and warranties are superfluous. Instead, the representations and warranties typically only focus on liabilities that may transfer to the buyer (e.g., environmental or product related liabilities).8 Given the enormous protection provided by §363(f), any bidder seeking extensive representations and warranties will be at a competitive disadvantage in becoming the stalking horse bidder or succeeding at an auction.
Forms of Consideration. While the consideration in an asset purchase agreement outside of bankruptcy usually consists of cash, stock or notes, or some combination thereof, the consideration paid in a §363 asset sale may take other forms.
For example, the stalking horse bidder may assume certain of the seller's debts and liabilities, agree to retain the seller's key employees and employee benefit plans, and pay costs associated with curing contract defaults. These items of consideration can provide significant value to the seller and often do not require an immediate outlay of cash on the part of the buyer.
In many cases, the stalking horse asset purchase agreement may even be contingent upon certain of these unique forms of consideration. For instance, it is not uncommon for the agreement to be contingent upon specified employees signing employment contracts with the buyer.
Cure Costs. The costs associated with curing existing defaults in leases and other executory contracts are another unique aspect of most stalking horse asset purchase agreements.9 A typical agreement will include a schedule of executory contracts and leases to be assumed and assigned by the seller to the stalking horse bidder.
Before this assumption and assignment can take place, all existing defaults under the assigned contracts must be cured10 and the assuming party must provide adequate assurance that it can and will perform all future obligations due under the contract or the lease.11 There are often intense negotiations between the seller and the stalking horse bidder in connection with who will cure these defaults.
Furthermore, if the amount of a monetary default is disputed by a counter-party to a contract, it may be necessary to place large amounts of the purchase price into an escrow account until the dispute is settled by the bankruptcy court or the issue is resolved by the parties.
Additionally, if the seller and the buyer fail to ensure that counter-parties to assigned contracts are comfortable with the buyer's ability to perform future obligations under the contract, such counter-parties may file objections to the assignment, thus jeopardizing the ability of the seller and buyer to complete the sale.
Closing Conditions. A §363 asset sale is also distinguished by its limited closing conditions. Typically, the main condition associated with such a sale is that the transaction is approved by the bankruptcy court. In fact, at signing, the asset purchase agreement is binding on the buyer and, in many cases, cannot be terminated but for the failure of the parties to obtain court approval of the agreement.12
The Auction Process
The auction process associated with a §363 asset sale bears little resemblance to a traditional sheriff's sale or foreclosure auction.
The auction is conducted pursuant to bidding procedures that are negotiated by the seller, the stalking horse bidder and often the committee of unsecured creditors and the seller's secured lenders. These bidding procedures, although not specifically contemplated by the Bankruptcy Code, have developed over time and are a fundamental feature of a §363 asset sale.
The purpose of these procedures is to create a highly competitive bidding environment that maximizes the value of the assets for the benefit of creditors, a fundamental tenet of the Bankruptcy Code. Given their importance in maximizing value, these procedures are heavily scrutinized by the bankruptcy court.
Bidding procedures set the timetable for the transaction, specify the manner in which other bidders may take part in the auction and outline the effect of choosing a bidder that is not the stalking horse bidder. Most notably, typical bidding procedures include provisions to protect the stalking horse bidder.13 These protections include items such as breakup fees, expense reimbursements, minimum bid increments and qualification criteria for competing bidders.
Break-up Fees. Break-up fees are often included in the bidding procedures as a way to compensate the stalking horse bidder in the event the seller accepts a competing bid and terminates the original agreement. Sellers agree to pay break-up fees, which generally range from 1 to 3 percent of the purchase price, in exchange for certainty that at least one party will execute an asset purchase agreement.
This certainty is critical to sellers that may be in desperate need of liquidity or who may own undesirable assets. From the stalking horse bidder's perspective, break-up fees are paid to ensure that it is compensated for the risk associated with entering the sale process at such an early stage.14 The stalking horse bidder often motivates the seller to organize its due diligence materials and often expends considerable time and effort in negotiating the purchase agreement, which will become the measuring stick for all other prospective bidders participating in the auction.15
Expense Reimbursements. Expense reimbursements are also used to at least partially compensate the stalking horse bidder for the costs associated with negotiating and preparing the asset purchase agreement that will be the basis for negotiating an agreement with other bidders at the auction. Similar to break-up fees, expense reimbursements must be approved by the bankruptcy court and are typically capped at a set amount or qualified by a "reasonableness" standard.
Qualified Bidder and Qualified Bid Provisions. It is critical to understand the manner in which bidders become qualified to participate in the auction of a §363 asset sale.
Bidding procedures require a potential bidder to signal its true intention to purchase the assets in a §363 asset sale and to prove its ability to consummate the purchase of the assets quickly. These requirements are intended to eliminate bidding by parties that are not capable of closing a sale within the specified price range or time frame, or by competitors that are simply attempting to gain access to material non-public information of the distressed company.16
In the vast majority of cases, a qualified bidder must demonstrate the financial ability to close the transaction without a financing condition. To this end, potential bidders may be required to submit audited financial statements with their bids or other proof of financial wherewithal. In most cases, the determination of who has met the applicable standards for becoming a qualified bidder is made not only by the seller, but by the seller in consultation with the committee of unsecured creditors and perhaps the seller's secured lenders.
Assuming that a prospective bidder can meet the criteria to become a qualified bidder, such a party must also typically deliver to the buyer a cash deposit and a signed and irrevocable asset purchase agreement with substantially the same terms and conditions as the stalking horse asset purchase agreement, but with a minimum topping amount (that is, an amount in excess of the consideration to be received in connection with the stalking horse's proposed transaction).
Back-up Bidder Provisions. Although the auction process is designed to obtain the highest and best bid for the seller's assets, most bidding procedures will provide for a back-up bidder if the first bidder is unable or unwilling to close on the sale. In most cases, the party submitting the second highest bid becomes the back-up bidder.
The back-up bidder is required to close the transaction if the agreement with the first bidder fails and frequently does not receive the return of its deposit until the transaction with the first successful bidder has closed. At the hearing to approve the sale, many sellers will also seek authorization from the bankruptcy court to consummate the transaction with the back-up bidder in the event the transaction with the first bidder does not close.
Practitioners versed in the negotiation of conventional asset purchase agreements outside of bankruptcy should not be daunted by a lack of familiarity with a §363 asset sale. The ability of a buyer to purchase assets at a significantly reduced price, or the ability of a seller to maximize the value of its assets can be beneficial to both sides.
When drafting the asset purchase agreement, practitioners should be aware that items such as representations and warranties (or the lack thereof) and cure costs are just as critical as the purchase price. Likewise, in negotiating the bidding procedures, the seller and the buyer must strike a balance of providing protections such as break-up fees that are high enough to attract the stalking horse bid, but low enough to ensure that other bidders are not frozen out of the process.
Practitioners must also understand that the requirements for qualified bidders must be stringent enough to attract only the most serious candidates, yet relaxed enough to invite as many higher or better qualified bids as possible.
While §363 asset sales are arguably more art than a science, practitioners who understand some of these basic tenets can greatly improve their client's ability to successfully complete such a transaction.
Charles H. Baker is a partner in the New York office of Paul, Hastings, Janofsky & Walker, and Kimberly D. Newmarch is an associate in the firm's Chicago office. Ravi Pillay, Gillian Richards and Dan Philion, associates, assisted in the preparation of this article.
1. 11 U.S.C. §363(b) states: "[t]he trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate."
2. 11 U.S.C. §1123(a)(5).
3. 11 U.S.C. §363(b).
4. Fed. R. Bankr. P. 2002.
5. 11 U.S.C. §363(b).
6. This bidder is selected based on criteria such as the purchase price offered and the bidder's ability to close the sale within the applicable deadline.
7. 11 U.S.C. §363(f) (emphasis added).
However, in Clear Channel Outdoor Inc. v. Knupfer, 391 B.R. 25 (2008), the Ninth Circuit Bankruptcy Appellate Panel reversed the bankruptcy court's order and held that a senior secured creditor's credit bid, in an amount less than the aggregate value of all liens against the property in question, did not satisfy the requirements of §365(f) and thus, did not permit the sale to be "free and clear" of the existing junior liens on the property.
8. To the extent the parties have a specific concern regarding a particular liability, a negotiated amount may be placed in escrow for a limited duration.
9. See 11 U.S.C. §365, which governs the seller's ability to assign, and buyer's ability to assume, certain contracts.
10. Issues regarding the ability to cure non-monetary defaults can become quite contested with contract counter-parties who do not wish to have their contract assumed and assigned to a buyer. See e.g. In re Fleming Cos., 48 Bankr. Ct. Dec. 188 (3d Cir. 2007).
11. See 11 U.S.C. §365(b)(1)(A).
12. The standard for approval of a proposed sale under §363 is essentially a "business judgment" test. Some courts have used the standard of "good faith," whether the transaction is "fair and equitable," still others, whether the sale is "in the best interest of the estate." See Collier on Bankruptcy ¶363.02.(f).
13. Bid protection measures are approved by the bankruptcy court if they are negotiated in good faith and do not chill the bidding process. See The Official Committee of Subordinated Bondholders v. Integrated Resources Inc. (In re Integrated Resources Inc.), 147 B.R. 650 (S.D.N.Y. 1992).
14. Break-up fees are outside the ordinary course of a seller's business and must be approved by the bankruptcy court pursuant to 11 U.S.C. §362(f). The bankruptcy court will typically approve break-up fees so long as they are negotiated in good faith and do not chill the bidding process.
15. As the stalking horse asset purchase agreement becomes the agreement to which all others are compared.
16. A qualified bidder usually must sign a confidentiality agreement to ensure that all material non-public information discovered during the diligence process will be kept private.
This article was reprinted with permission of the New York Law Journal.