Trending In Bankruptcy: Quick Section 363 Sales

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1 NOT FOR REPRINT Click to Print or Select 'Print' in your browser menu to print this document. Page printed from: Corporate Counsel From the Experts Trending In Bankruptcy: Quick Section 363 Sales Brian L. Davidoff, Corporate Counsel October 29, 2014 Over the last several years, the nature and way that Chapter 11 bankruptcy filings are being handled has changed. Gone seem to be the days of traditional restructurings in which a company filed a Chapter 11, worked its way through the issues that caused it to file in the first place, and ultimately filed a plan of reorganization some nine months to two years later, all the while being funded either by the company s existing lender or by a new debtor-in-possession (DIP) lender. More and more cases these days are being disposed of by way of a relatively quick Section 363 sale. A 363 sale is so named because it is authorized under Section 363 of the U.S. Bankruptcy Code. It provides a fast way for a distressed company to sell assets to the highest bidder, free and clear of all claims. Speed is important because financially distressed companies can melt like ice cubes every day that a company burns through more cash than it earns, it loses value. In fact, in many instances the filing itself is driven by the desire of a prospective purchaser of the debtor s assets to buy in bankruptcy, thereby obtaining the benefit of a free and clear order from the bankruptcy court. Sometimes, this motivated purchaser is the major secured creditor of the debtor s assets. Below is a graph indicating the trend for the timing of Section 363 sales in large Chapter 11 cases (i.e., cases with assets of over $100 million). This is based on data published by professor Lynn LoPucki at the UCLA School of Law. As is clear from the chart, the timeline to conduct a 363 sale has decreased from about 350 days in 1980 to under 100 days in 2013, with much of the acceleration coming in the last few years. Although the largest cases attract public attention, smaller companies also are engaging in relatively quick all-asset sales. Smaller debtors may have fewer assets to burn, fewer financing options and a weaker corporate infrastructure to help keep the business together.

2 The reasons for this increase in speed are multiple: 1. Greater Judicial Acceptance: It used to be that if one brought a sale to a bankruptcy judge in the first 60 days of a bankruptcy case, many courts would deny approval. Subject to issues noted below, that seems no longer to be the case, and judges now consider whether an early sale in the bankruptcy is appropriate based on the merits of the case. 2. Availability of Capital (or Lack Thereof): Private equity groups, hedge funds and other specialty DIP lenders seem no longer to be interested in the long-term turnaround that a Chapter 11 reorganization offers. Rather, they deploy their capital, often on a secured interim DIP financing basis, with a view toward becoming a credit buyer in a follow-on transaction. This makes much more sense for these capital providers, since the timeline is far shorter and the certainty of the outcome greater. In the absence of long-term DIP financing available to Chapter 11 debtors, the only means to a reorganization is a 363 sale free and clear of the liabilities leaving it to the remaining creditors to fight over the scraps of proceeds from the sale after repayment of the DIP lender and other required obligations to be paid on closing. 3. Cost of Reorganization: The lawyers and other restructuring professionals may have outdone themselves in the last several years with the increasingly enormous cost to turn a company around in a traditional Chapter 11. It takes a bevy of professionals to properly restructure a company: lawyers, accountants, turnaround professionals, valuation professionals and others. The cost of these professionals for a year or two during a bankruptcy case often makes this alternative untenable. On the other hand, a quickly structured Section 363 sale occurring within the first 60 or 90 days of a bankruptcy case substantially reduces this cost.

3 The Basics of a Section 363 Sale Section 363(b)(1) of the Bankruptcy Code provides that the trustee, after notice and hearing, may use, sell or lease, other than in the ordinary course of business, property of the estate... Most important from a seller and buyer s perspective, such a sale may, if certain conditions exist, be free and clear of any interest in such property of an entity other than the estate. The approval of a sale of assets under Section 363 outside the ordinary course of business is left to the sound business judgment of a debtor, subject to court approval. Courts consider a variety of factors, including: (i) whether the debtor exercised its business judgment in deciding to enter into the transaction; (ii) whether adequate and reasonable notice of the sale was given to interested parties; (iii) whether the sale will produce a fair and reasonable price for the property; and (iv) whether the parties have acted in good faith. The Benefits Typically buyers will assess the level of potential liability related to the distressed assets they are acquiring, and as that risk of liability increases, the buyer typically will move up the chain to legal mechanisms that provide more protection. At the bottom of the food chain in providing protection are regular out-of-bankruptcy asset sales. While the laws in each jurisdiction in the United States may vary somewhat on this issue, typically a buyer who is buying assets alone, and not liabilities, should not be liable for the liabilities of the seller. However with the risk of successor liability and de facto merger, a buyer would typically shy away from an out-of-court sale of assets if there is any meaningful level of risk associated with the distressed assets being purchased. The next level of protection is an assignment for benefit of creditors (ABC). In an ABC, a third-party assignee is selected, usually jointly by the seller and buyer. Instead of a regular asset purchase and sale agreement, the seller assigns substantially all of its assets to the assignee who then, in a simultaneous closing, sells these assets to the buyer. The buyer pays the assignee, who then acts in a capacity similar to a trustee, and distributes the proceeds to creditors in a priority scheme that roughly equates to that under the bankruptcy code. ABCs can provide a speedy, effective and private way to transfer the going concern value of a distressed business to a buyer. By operation of law the assets sold to the buyer under an ABC are free of the unsecured claims against the seller. However, an ABC cannot cause removal of a lien or other encumbrance, as is available in a Section 363 sale. An ABC also is not ideal when assets are located in different jurisdictions. Moreover, there is no automatic stay of actions in an ABC as there is in a bankruptcy case, and thus the process often is unworkable when there is ongoing legal action against the debtor/seller. Finally, ABCs are not as well recognized in all jurisdictions in the U.S., and thus depending on where the seller and buyer are located, an ABC may not be the desired alternative. A secured creditor foreclosure is another way to transfer the going-concern value of distressed assets. Here the secured creditor forecloses on the assets under the Commercial Code and then sells the assets to a buyer in a public or private sale. The Commercial Code provides that all junior

4 liens are discharged by a properly conducted foreclosure sale. An alternative method is for the buyer to buy the lender s loan and then foreclose on the assets. While a secured creditor foreclosure also can provide a speedy method for the transfer of assets and protection of goingconcern value, institutional lenders often are very reluctant to engage in a foreclosure for fear of claims by other creditors against the lender. Compared to these alternatives, bankruptcy is a desirable place to sell assets. The court has the power to approve sales of assets free and clear of liens and encumbrances, with these liens to attach to the sale proceeds. The power to transfer clean title backed by a federal court order usually is considerably more attractive to a buyer than the alternatives. A bankruptcy sale under Section 363 provides the buyer with greater certainty and clearer title, increasing the sale price and creating value for the bankruptcy estate. And all this can be accomplished very quickly, before customer lists become obsolete and before the debtor simply runs out of money. Risks to Loan-to-Own Creditors Some new cases have cast doubt on the rights of secured creditors to vote the face amount of their claims, a procedure known as credit bidding. Today there are hundreds if not thousands of special opportunity funds whose mission is to buy company debt at a discount and then leverage that right into payment of the full amount of the purchased debt, and, if not, to acquire the assets securing that debt. The right of a secured creditor to credit bid in a Section 363 sale in bankruptcy is expressly incorporated into the Bankruptcy Code. Generally, a secured creditor in bankruptcy can credit bid the entire face value of its secured claim, whether or not the claim was bought at a discount. The practical rationale for allowing credit bidding is that a secured lender would not outbid a bidder unless the lender believed it could generate a greater return on the collateral than the return for the lender represented by the bidder s bid. On the other hand, if a bidder believed that a secured lender was attempting to swoop in and take the collateral below market value, that bidder presumably would make a bid exceeding the credit bid. Nevertheless, the Bankruptcy Code expressly permits a bankruptcy court to deny credit bidding for cause. Several courts have found cause exists to deny credit bidding when there is a potential dispute as to the validity or the amount of a creditor s claim or lien, and a rapid sale of the assets is important to preserve value. Other newer decisions have suggested that the for cause exception to credit bidding should be applied in situations in which a secured creditor engaged in improper or inequitable conduct. Recently, in In re Fisker Automotive Holdings Inc., the Delaware Bankruptcy Court capped a secured creditor s right to credit bid its claim in a Section 363 sale at the price the secured creditor paid for the loan, not the amount of its claim. The reasons the court articulated included: (i) it found that if it did not limit the credit bid, the auction process would not only be chilled, it would likely not occur at all; and (ii) the court criticized the quick timing of the proposed sale, noting that the debtors provided a mere 24 business days for parties in interest to challenge the sale motion, finding the short timeline was pure fabrication. There have been other cases following the inequitable conduct theory since Fisker.

5 The Bottom Line Properly structured Section 363 sales offer a viable and quick way for debtor/sellers to receive value for troubled assets and to provide buyers with maximum protection. However, proponents of the current trend of rapid Section 363 sales should proceed with caution. A debtor/seller wants to be viewed by a court as the owner of a melting ice cube in true need of a quick Section 363 sale, rather than as someone who turned off the freezer in advance. Courts are also resisting buyers who look to buy debt at a discount and then force a quickie sale through inequitable conduct. Brian L. Davidoff chairs the bankruptcy and financial restructuring group at Greenberg Glusker Fields Claman & Machtinger. He specializes in corporate reorganization, restructuring and bankruptcy law, and is certified as a business bankruptcy specialist by the American Board of Certification. Copyright ALM Media Properties, LLC. All rights reserved.