The Bankruptcy Code facilitates asset sales in chapter 11 by offering incentives to buyers and flexibility in structuring and timing the sale. A buyer can acquire assets free and clear of liens and is permitted to "cherry-pick" the debtor's contracts and leases to select only those it wants to keep. The assets and sale process can be structured in many ways, including auctions, private sales, lot or bulk sales, and going concern transactions.
The Key Parties
In a chapter 11 case, the seller is the debtor-in-possession (DIP) unless the court has appointed a chapter 11 trustee. Although the DIP is considered a distinct legal entity from the pre-petition company, for all practical purposes it is the same insofar as management, corporate governance and business operations are concerned. The DIP, however, does not operate in a vacuum when it comes to asset sales or other major transactions under chapter 11. Typically, a committee of unsecured creditors will play an active role in all aspects of the sale process, including marketing the sale or transaction, establishing bidding procedures, and obtaining acceptance and court approval of an offer. The committee comprises representatives of the creditors in a chapter 11 proceeding, and its members generally hold the largest unsecured claims and act as a body to represent the interests of all general unsecured creditors. Among their functions is to ensure that any sale maximizes the value of the DIP's assets for the benefit of creditors as a whole. Ultimately, any asset sale must be approved by the bankruptcy court after notice and opportunity for a hearing. The court will approve the highest and best offer, which is not necessarily the highest in terms of dollars and may also consider security of payment and payment terms.
Statutory Provisions Governing Sales
In a chapter 11 bankruptcy case, asset sales can be accomplished in one of two ways. Pursuant to § 1123 of the Bankruptcy Code, certain sales are proposed as part of a reorganization or liquidating plan, i.e., the procedure by which the bankruptcy case pays creditors and closes. All other chapter 11 asset sales are governed by § 363 of the Bankruptcy Code. A § 363 sale is made by motion and requires only a relatively short, twenty-day notice period. Under certain exigent circumstances, an even shorter notice period may be approved. By contrast, a sale pursuant to a plan involves a prolonged notice period and a two-step approval process, first of a disclosure statement (similar to a prospectus) and then the plan itself. Confirmation (court approval) of a plan is further subject to creditor voting rights.
Given the extended time period for sales proposed as part of a plan, DIPs, committees and prospective purchasers generally prefer to effectuate a sale pursuant to § 363. However, a number of courts have held that a debtor must articulate a sound business justification for proceeding outside of the plan confirmation process.
The process typically begins with a marketing effort to solicit interest from one or more potential buyers. There is no fixed set of rules governing the manner in which the DIP markets the assets for sale, except that the effort must be tailored to the specific assets offered and aimed at producing the highest and best offer. The marketing effort will, of course, vary depending on the type of asset. Often the DIP or creditors' committee will solicit interest among targeted prospects through advertisements or private contacts in order to stimulate bidding interest and offers. Large debtors often hire investment bankers or other professionals to assist in the sale process.
An interested buyer will typically make a contingent offer or provide a letter of intent outlining the parameters of an acceptable deal, subject to higher and better offers, court approval and a host of other conditions. Generally, one of the conditions is the approval of acceptable bidding procedures for any subsequent round of competitive bidding. The initial bidder or "stalking horse" will seek to impose substantial restrictions on subsequent bidding, while the DIP and creditors' committee will negotiate for as much competition as possible. The parties typically reach a compromise that is memorialized in proposed "bidding procedures" that are presented to the bankruptcy court for approval. Among other things, bidding procedures generally address the timeline and form for the submission of competing bids.
In many cases, the conditions on subsequent bidding also include (1) a breakup or termination fee that is paid to the stalking horse if another offer is ultimately approved by the court; (2) restricting the time period in which potential upset bids can be made—the shorter the period, the less likely an upset bid will be made; (3) restricting offers to cash or other consideration, and eliminating other contingencies, such as financing, depending on how the stalking-horse bid was structured; (4) restricting bids to the exact same assets included in the stalking-horse bid (sometimes the stalking-horse ties in less attractive assets to discourage further bidding); (5) fixing deposits and establishing financial and other criteria in order to qualify as a bidder; (6) setting the bidding increments high enough to prevent nominal upset bids; (7) requiring any upset bid to exceed the initial offer by at least the amount of the breakup fee and bid increment; and (8) requiring that, absent a qualifying higher bid, the stalking-horse offer will become the accepted offer and be submitted for approval to the court.
Though it depends greatly on the facts and circumstances of a particular case, bankruptcy courts are generally receptive to granting some protections for the stalking-horse bid because of the risk and expense incurred in making the first bid and the interest it generates for the assets. Typical breakup fees range from 1% to 3% of the total purchase price of the assets. However, the court will not approve a breakup fee or any other bid procedures that chill, rather than enhance, competition or that are the product of a "sweetheart deal" or other inappropriate conduct by the DIP.
After the bidding procedures are approved, a subsequent bid round, auction or both will take place. If the second round or auction results in additional offers, the DIP (with input from the creditors' committee) will choose the highest and best offer and enter into an asset purchase agreement with the buyer, subject to court approval. The DIP then commences the process for court approval of the sale and the asset purchase agreement by filing a motion with twenty-days notice to creditors and parties of interest. If no party objects to the sale, the court may approve the sale with or without a hearing. If an objection is filed, the bankruptcy court will conduct a hearing to determine whether the sale constitutes the highest and best offer and is in the best interests of the estate.
The Benefits Sales Free and Clear of Liens
§ 363(f) of the Bankruptcy Code provides that a sale of assets may be approved free and clear of liens and other interests if one of five statutory conditions are met. The conditions are:
- Applicable nonbankruptcy law permits a sale free and clear of interests;
- The interest holder consents to the sale;
- The interest is a lien and the sale price exceeds the total value of all liens on the property;
- The interest is in bona fide dispute; or
- The holder could be compelled in a legal or equitable proceeding to accept money satisfaction of its interest in the property.
This provision strikes a balance between the property rights of interest holders and the policy of the Bankruptcy Code's goal of maximizing value for the estate. Outside bankruptcy, a buyer cannot acquire clear title until all liens and clouds are resolved, and a lienholder cannot be compelled to accept less than the full amount of its claim. By contrast, the bankruptcy court may approve a sale even if there are disputed liens on the assets or the sale proceeds will not be sufficient to satisfy the claims of all lienholders. A typical sale order will provide that the liens attach only to the proceeds of sale, leaving the DIP free to consummate the sale and sort out lien disputes later. This way, the buyer and its title to the assets do not become embroiled in or hinge on the outcome of the dispute.
Assignment of Valuable Leases and Contracts; Rejection of Others
In addition to the ability to acquire the assets free and clear of all liens, a § 363 sale also allows the DIP to assign contracts and leases to purchasers, even though these contracts or leases are in default or prohibit assignment. The buyer will identify in the asset purchase agreement the specific contracts and leases to be included in the sale. Closing will be contingent upon court approval of the assumption and assignment of those contracts. Pursuant to § 365 of the Bankruptcy Code, in order to assume and assign a contract, the DIP must:
- Cure or provide adequate assurance that it will promptly cure any defaults;
- Compensate the other party for any pecuniary loss resulting from the debtor's default, or provide adequate assurance that it will promptly do so; and
- Provide adequate assurance of future performance of the contract or lease.
Typically the cure and compensation requirements are satisfied from the proceeds of the sale or through an adjustment in the purchase price. The adequate assurance component is satisfied by showing that the buyer is at least as financially capable of performing the contract as the DIP. Security deposits and the like, if required by the contract, will also be required from the buyer, because the DIP can only assign a contract or lease in its entirety and without modification. However, this rule does not prohibit consensual modifications to a lease or contract before or after it is assigned—and such modifications are quite common. Finally, the buyer is not burdened with the loss occasioned by rejection of unwanted contracts. Those losses simply become claims against the bankruptcy estate and are not the buyer's concern.
Bankruptcy Code § 363(m) provides peace of mind to a buyer in the event the order approving the sale is appealed. Even if the sale order is ultimately overturned or modified, the sale itself cannot be "undone," so long as the buyer acted in good faith. Knowledge that an appeal is pending does not constitute bad faith, unless a stay pending appeal was in effect when the sale closed. In other words, an appeal of a sale order becomes moot upon closing of the sale, unless the buyer did not act in good faith or a stay was in effect.
Successor liability is a non-bankruptcy doctrine that operates as an exception to the general rule that a purchaser is not liable for claims against its predecessor. It is a common myth that bankruptcy sales cut off all potential successor liability claims. This is not the case, although a bankruptcy sale can substantially reduce the pool of potential claimants and does nothing to increase exposure. The Bankruptcy Code expressly cuts off the claims of existing lien and interest holders (§ 363) and existing creditor claims, at least in the context of a reorganization plan (§ 1141-discharge provisions). However, creditors who do not have notice of the proceedings and future claimants whose claims are not provided for in the plan of reorganization may be beyond the reach of an injunction barring successor liability claims against a purchaser.
Nonetheless, a purchaser can be proactive in taking steps that may reduce its exposure to successor liability claims. For example, a purchaser can confirm that proper and timely notice of the sale is served upon all known and potential claimants. Persons without notice of the sale may not be bound by its provisions. Publication of both the sale and the deadline for filing proofs of claim ("bar date") is also advisable. Publication of the bar date provides constructive notice to unknown and potential claimants so that their claims can be discharged upon confirmation of a reorganization plan.
As a general rule, future claims are not discharged by confirmation of a plan. Therefore, when future claims are a foreseeable risk, the purchaser should require the debtor to incorporate in its reorganization plan adequate provisions to notify and compensate future claimants, including provisions for the appointment of a representative and the creation of a trust fund from which to pay claims. With these protections in place, the bankruptcy court may enjoin future claimants from bringing successor liability claims against the purchaser.