Break-up fees1 remain difficult for initial (or so-called “stalking horse”) bidders to obtain in the Third Circuit. In Kelson Channelview LLC v. Reliant Energy Channelview LP (In re Reliant Energy Channelview LP), No. 09-2074 (3d Cir. Jan. 15, 2010), the Third Circuit Court of Appeals held that courts must determine whether a break-up fee is an actual and necessary expense of the estate even (i) when the fee is requested by a solvent debtor, (ii) when the fee is consented to by all creditors and the sole equity holder, and (iii) where the initial bid would provide a 100% recovery to all unsecured creditors.
This case is important for all bidders in bankruptcy auctions. The Third Circuit had previously held that break-up fees should be allowed only if the requesting party can prove to the bankruptcy court that the fee is an “actual and necessary cost and expense” of preserving a debtor’s value.2 The Third Circuit has held that a break-up fee is permissible to induce an initial bid (provided the fee doesn’t deter other bidders), but is impermissible if a bidder would participate in an auction regardless of whether it was offered a break-up fee.3 There is no bright-line rule, however, on whether or when a break-up fee is an actual and necessary expense of a debtor’s estate, and bankruptcy courts have broad discretion in determining whether to approve such fees.4
In Kelson v. Reliant, the Third Circuit affirmed its prior holding in O’Brien regarding when a break-up fee is permissible, but also stated that approving a break-up fee to secure an initial bidder’s adherence to its bid would also be permissible. Thus, it appears that bankruptcy courts in the Third Circuit may grant bidders a break-up fee even when the bidder’s initial bid is not expressly conditioned on approval of a such a fee.
The Third Circuit’s decision emphasizes that bidders must strategize early regarding bid structures in order to maximize the likelihood of approval of any requested break-up fee.
Reliant Energy Channelview LP and a subsidiary filed for Chapter 11 protection in August 2007 and decided to sell substantially all of its assets. Reliant hired consultants and conducted a thorough sale process that produced over 100 potential purchasers and ultimately 12 bidders. Kelson Channelview LLC submitted the best offer and entered into a binding asset purchase agreement, subject only to bankruptcy court approval.
Reliant moved the bankruptcy court for an order permitting the sale and seeking certain negotiated bid protections for Kelson’s benefit should the bankruptcy court require an auction. Kelson’s requested bid protections included reimbursement of its expenses up to $2 million, a $5 million minimum overbid in any auction, and a $15 million break-up fee (which was approximately 3% of Kelson’s bid).
While the bankruptcy court ruminated on whether to require an auction, Reliant, with the support of its creditors and sole shareholder, requested that the court authorize Kelson’s bid protections. Fortistar LLC, which had previously submitted a losing bid during the initial sale process, objected to the proposed Kelson bid protections, asserting that it was willing to make a higher and better bid at an auction, but that the $15 million break-up fee would be a deterrent to it doing so. The court conducted a hearing to consider whether to order (i) that an auction be held, and, if so, (ii) whether to approve Kelson’s bid protections. At the hearing, Reliant’s consultants testified that Kelson’s bid was fair and would provide a 100% recovery for creditors.
Bankruptcy Court Denies Break-Up Fee
In spite of this testimony, on March 18, 2008, the bankruptcy court ordered that an auction be conducted and denied Kelson’s requested $15 million break-up fee.5 Because there were other bidders, the bankruptcy court reasoned that the break-up fee was unnecessary in this instance and could potentially harm the estate by driving away bidders like Fortistar. Further, the fee was not necessary to lure Kelson’s bid since the asset purchase agreement only required that Reliant seek approval of the break-up fee, thus, the bankruptcy court found that Kelson’s offer was not conditioned on obtaining approval of the fee.
Despite being party to a binding asset purchase agreement, Kelson did not participate in the auction and asserted that its bid was no longer available. Fortistar won the auction with a bid that exceeded Kelson’s by $32 million. The bankruptcy court approved the sale on June 9, 2008, and Reliant did not pay Kelson the break-up fee (although it did reimburse Kelson for its expenses).
Kelson Appeals Bankruptcy Court Order
Kelson appealed the March 18 order denying its break-up fee, making two arguments. First, Kelson argued that the bankruptcy court abused its discretion in denying Kelson the fee. Kelson asserted that the break-up fee was necessary to entice its bid, and that it was entitled to the fee as a matter of fundamental fairness. Kelson also asserted that the bankruptcy court should have applied the business judgment rule6 to Reliant’s request for a break-up fee because Reliant was solvent and none of its creditors and equityholders objected. Second, Kelson contended that Reliant could not oppose its appeal as a matter of law because it had supported Kelson’s request for the break-up fee in the first instance. The District Court denied Kelson’s appeal and affirmed the Bankruptcy Court’s March 18 and June 9 orders. Kelson then appealed to the Third Circuit.
On appeal, the Third Circuit held that the bankruptcy court had not abused its discretion denying the break-up fee. The court went on to describe two circumstances under which Kelson’s break-up fee would have been permissible. First, approval of the fee would have been appropriate if the fee had induced Kelson’s initial bid. Because Kelson had not conditioned its bid on the break-up fee, however, the Third Circuit found that the fee was not necessary to induce Kelson’s initial bid.
Second, a break-up fee would have been permissible had it been necessary to compel Kelson to participate in the auction. If a court believes that a bidder would abandon its bid without a break-up fee and it is not clear whether other bidders would participate in an auction, then granting a break-up fee is worthwhile. The Third Circuit acknowledged that determining whether to grant a break-up fee under these circumstances is difficult. The court however, saw no reason why a bidder that had made a full and complete bid would necessarily abandon its efforts if a break-up fee were denied.7
The Third Circuit also reaffirmed that the business judgment rule should not be applied to a debtor’s decision to grant a break-up fee, even in these circumstances. While a consensus among creditors should not be lightly dismissed, the Third Circuit held that unanimity among creditors did not authorize a court to ignore the Bankruptcy Code’s requirement that a break-up fee be an actual and necessary cost of maintaining a debtor’s value. The Third Circuit further held that Reliant could oppose the break-up fee, even though it earlier had moved to approve the fee, because it had a fiduciary duty to maximize the value of its assets. Had Reliant adhered to its earlier position that Kelson should receive the fee in the face of changed circumstances, it would have violated that fiduciary duty.
Bidders should assume bankruptcy courts will require debtors to conduct auctions if multiple parties have expressed interest in the debtor’s assets and demonstrated an ability to finance the acquisition. Bidders seeking to obtain the protections a break-up fee affords should expressly condition their bids on the bankruptcy court’s approval of the fee. Bidders also should be prepared to work with their sellers to provide the bankruptcy court with fact-specific evidence as to how their bid is likely to produce other bids and how it will not dissuade other bidders from participating in the process. As with any auction, bidders must be prepared to walk away from the deal if the price is not right, but working with counsel early in the process will provide bidders with their best chance of obtaining a break-up fee or other bid protections.