This is the fifth in a series of Alerts regarding the proposals made by the American Bankruptcy Institute Commission to Reform Chapter 11 Business Bankruptcies. This alert covers the Commission’s recommendations regarding the now predominant practice of selling substantially all of the debtor’s assets as a going concern, free of all claims, at the outset of a bankruptcy case. The process, known as a “363 Sale” for the Bankruptcy Code section that applies, has been hailed as a job-saving measure and condemned for giving all value to lenders and none to other creditors.
Under Section 363 of the Bankruptcy Code, a bankruptcy court can sell the debtor’s assets free of all claims or liens of any nature. There are some exceptions that have become problems, such as claims for underfunded pension liability. But, at bottom, the 363 Sale allows a buyer to take the company’s performing business without having to pay the debtor’s extensive liabilities. Both Lehman Brothers and Chrysler were cases in which, almost immediately, all of the company’s assets were sold free and clear of liabilities.
The Commission recommended three broad categories of changes to the Bankruptcy Code’s provisions governing 363 Sales. Those were directed to the most problematic and controversial aspects of the process.
First, the Commission recommended that the Bankruptcy Code prohibit, except in extraordinary circumstances, a 363 Sale of substantially all of the debtor’s assets within 60 days after the commencement of a bankruptcy case. Many commentators believe that a bankruptcy sale at the outset of a case benefits insiders without having the company properly marketed. Second, the Commission recommended that 363 Sales of substantially all of the debtor’s assets be governed by a new provision, named Section 363(x), which would require that courts use greater scrutiny when evaluating such sales. Third, the Commission proposed certain miscellaneous provisions to provide greater certainty to the 363 Sale process, such as: (a) confirming a secured creditor’s right to credit bid, (b) providing enhanced protection for buyers in 363 Sales from claims for successor liability, and (c) limiting the ability of a court to enter a “structured dismissal” of a bankruptcy case following a 363 Sale. Each of these proposed changes is discussed in greater detail below.
Timing – 60-Day Moratorium on 363 Sales
Currently, the Bankruptcy Code allows 363 Sales to occur at any time after the commencement of a bankruptcy case. Rapid 363 Sales of substantially all of the debtor’s assets have become a common method by which secured lenders recover money and exit troubled loans. The Commission observed that, especially in cases involving an expedited sale process, many creditors are unable to effectively evaluate 363 Sales because they do not receive sufficient notice of or information regarding the sale. Yet the sale may greatly prejudice creditors by potentially eliminating any recovery for unsecured creditors in the case, and may include third party releases or discharges that impact the parties or property potentially available to pay creditors’ claims.
To give all affected parties a more meaningful amount of time to assess the debtor’s financial situation and viable alternatives, the Commission recommended that the Bankruptcy Code prohibit the conclusion of 363 Sales of all or substantially all of the debtor’s assets in the first 60 days of a bankruptcy case. The Commissioners felt that establishing a standard time period for a sale would allow secured creditors to protect themselves, and unsecured creditors to have an opportunity to review, and perhaps enhance, the sale process. The Commission recommended that exceptions to the 60-day moratorium be granted only when the debtor can demonstrate: (a) a high likelihood that the value of the debtor’s assets will decrease significantly during the 60-day moratorium and (b) that the proposed sale satisfies the requirements of the Commission’s proposed new section governing 363 Sales of substantially all of the debtor’s assets, Section 363(x). In the absence of such extraordinary circumstances, the Commissioners recommended a reasonable, 60-day sales process.
Section 363(x) – New, Planlike Requirements for 363 Sales
In an effort to provide more credibility to the sale process, the Commission recommended the creation of a new Section 363(x) of the Bankruptcy Code. That section would require more notice to creditors and better protections for the estate. Among other things, the new provisions would require that most of the costs of the bankruptcy case be paid out of the sale proceeds. Those expenses must also be subject to court review and approval. The new section would also ensure adequate notice and an opportunity for all parties to be heard, especially when a proposed sale includes a release of claims against insiders or other parties that aren’t actually the debtor (such as the debtor’s officers and directors, who may be employed by the buyer).
These requirements are derived from the Bankruptcy Code’s current statutory requirements for confirmation of a Chapter 11 plan. In effect, Section 363(x) incorporates many (but not all) of the Bankruptcy Code’s plan confirmation requirements into the 363 Sale process.Notably absent from Section 363(x)’s provisions is the requirement that the plan proponent solicit creditors’ votes for or against the proposed sale, as is required under a Chapter 11 plan. Overall, however, the Commission’s recommendations provide for greater court scrutiny of 363 Sales, and more opportunity for creditors to be heard.
Finality of Orders Approving Sales – Final Means Final
Usually, 363 Sales are approved after a court-authorized auction designed to maximize the sale price for the assets. When the auction is concluded, the debtor presents the bankruptcy court with the winning bid, and the court usually enters an order approving the auction, identifying the winning bidder, and confirming the sale of the assets.
After the sale order is entered, however, parties have the right to appeal. Sometimes appeals are pursued by bidders who lost at the auction. And, some courts have reopened completed auctions simply because renewed bidding may result in a higher offer. While this does not often occur, many commentators believe the possibility that an auction can be “reopened” results in bidders not putting forward their best offer, for fear they will have to come back and bid again.
The Commission disapproved of reopening a completed auction. It proposed an amendment to provide certainty for asset buyers by reinforcing the finality of orders approving sales. The new provision would prohibit a court from reopening an auction absent “extraordinary circumstances or material procedural impediments to the auction process.” The proposed amendment would also explicitly state that a new auction that could potentially generate a higher value for the assets does not, in itself, constitute extraordinary circumstances.
Free-and-Clear Sales – Certainty as to Those Claims That Are Eliminated (and Those That Survive)
In most Chapter 11 cases, the debtor’s assets are encumbered by liens. Section 363(f) permits a debtor to sell those assets “free and clear” of all liens or interests claimed in the property.
The sale proceeds are held pending the court directing them, usually to the secured lender. Most courts interpret Section 363 to allow a sale of assets free and clear of all liens, claims, interests, or encumbrances of any kind. Some courts, however, are unsure about which claims may properly be bound by a “free and clear” sale order. This has become a problem especially with so-called “successor liability” claims, such as for unfunded pension liabilities and product defect injuries. A buyer facing these kinds of liabilities wants certainty about whether it will be forced to pay them, even though it did not create the liability in question. Creditors, including impoverished retirees and injured consumers, believe the buyers should pay.
The Commission recommended that the Bankruptcy Code be amended to provide that entry of a “free and clear” sale order bars claims against the buyer, including successor liability claims and requiring that the court explicitly identify those claims that would survive the sale. Claims that the Commission believes should survive would include: (a) easements and other covenants or restrictions that “run with land”; (b) federal labor law successor liability claims, such as the obligation to negotiate with a union; and (c) competing or disputed ownership interests.
Credit Bidding – Confirming a Secured Creditor’s Right to Credit Bid
The Commission also proposed reinforcing a secured creditor’s right to “credit bid” the value of its allowed claim in a 363 Sale. Section 363(k) allows a court to eliminate a creditor’s statutory right to credit bid “for cause.” A line of case law developed where bankruptcy courts eliminated a creditor’s credit-bid rights, usually because the credit-bid rights would have a chilling effect on the auction process. The Commission recommended that the Bankruptcy Code be amended so that the chilling effect of a credit bid alone does not constitute “cause” to eliminate a credit bid. Instead, the Commission suggested that courts encourage competitive bidding for the debtor’s assets by closely scrutinizing and modifying (as necessary) the auction process itself.
Eliminating Structured Dismissals of Chapter 11 Cases
In general, a debtor exits Chapter 11 via a confirmed plan, a dismissal, or a conversion of the case to a chapter 7 liquidation. When a company has sold all its assets, however, none of these three options truly fits the circumstances. A chapter 11 plan requires that all administrative expenses of the case be paid and that some money goes to unsecured creditors. Since a sale of assets often has all proceeds going to secured lenders, it is not clear a plan can be confirmed.
A conversion of the case to chapter 7 creates a new set of administrative expenses and costs, because a trustee who has no prior knowledge of the case is put in place and must hire new professionals.
Last, a dismissal of the case invokes Section 349 of the Bankruptcy Code, which provides that on dismissal certain liens and actions are reinstated and property reverts to its prepetition owner: the debtor that sold those assets. Obviously, there is a problem.
A growing number of “sales cases” now conclude through a “structured dismissal.” A structured dismissal is essentially an order that dismisses the Chapter 11 case while also approving additional provisions, such as making distributions to creditors, granting third-party releases, enjoining actions by creditors, and often avoiding the effect of Section 349. The terms of a structured dismissal are generally the result of a settlement arrangement between the debtor and various key stakeholders.
The Commission referenced evidence that the increased use of structured dismissals was directly linked to the rise in 363 Sales of substantially all of the debtor’s assets outside the context of a Chapter 11 plan. The Commission’s report details some of the advantages and disadvantages of structured dismissals in the Chapter 11 context.
In the end, however, the Commission recommended that a Chapter 11 case be resolved in one of only three ways: (1) confirmation of the plan, (2) conversion of the case, or (3) dismissal of the case subject to Section 349. The Commission reached this conclusion largely because its proposals for changing the 363 Sales process make it far less likely that a structured dismissal would be required. So long as the Commission’s suggested changes are adopted in full, this logic holds. But if Congress were to pass any legislation in the form originally proposed, it would likely be a first in United States legislative history.
The Commission’s recommendations for the sale process recognize that most business bankruptcy cases will end with a sale of all assets, often early in the case. The Commission’s proposals are directed toward providing a reasonable chance for all parties to be heard about the sale, and test whether it is being carried out in an appropriate manner. But sales with assets under Section 363, so that the business survives with new ownership, will certainly continue.