Weighing the Benefits of Selling a Company in or out of Bankruptcy

November 2018

David Berliner, Partner, BDO USA, LLP
 
While the economy has been expanding in 2018, the sizable number of bankruptcy filings reflect shifting consumer preferences, continued technology disruption, rising competition, and the decision to take on too much debt. Over the past several years, financially distressed companies have increasingly used bankruptcy as the preferred method to sell significant assets or entire businesses, as it carries numerous benefits. Bankruptcy sales generally enable buyers to obtain assets at more favorable prices than they would pay if the sale was completed outside of bankruptcy.
 
The bulk of these bankruptcy sales have been conducted in accordance with Section 363 of the Bankruptcy Code, which permits assets to be sold free of existing liens and claims and allows the buyer to retain the assets it wants and offload liabilities. The purpose of a Section 363 sale is to maximize value as quickly as possible and ensure all relevant parties have notice of the sale. The scope of assets that can be sold through Section 363 sales is very broad. The assets can be in the U.S. or foreign countries, and can include intangible and tangible assets, such as inventory, equipment, and property. 
 
Section 363 allows a Chapter 11 debtor to sell assets outside the ordinary course of the debtor’s business, and clear of existing liens and claims, if the debtor demonstrates a good business reason for the sale. A Chapter 11 debtor may also sell its assets free and clear of existing liens pursuant to a Plan of Reorganization or Liquidation.  The biggest advantage of purchasing assets from a bankrupt debtor is the buyer’s ability to take only the assets it wants and leave behind undesirable liabilities with the debtor.
 
Comparing Out-of-Court and 363 Asset Sales
There are many similarities and differences between the sale of assets in bankruptcy and out-of-court sales. 
 
First, there are some distinctions between 363 sales and Out-of-Court distressed asset sales. These include:
  • Most 363 sales start with a “stalking horse” purchaser whose bid is a general template for other bids. A “stalking horse” is an interested buyer of a debtor’s assets who is offered incentives for being the first to announce its intent to purchase the assets and sets the baseline for subsequent bids, if any;
  • The buyer and seller conduct negotiations on the asset purchase agreement if the purchaser is the “stalking horse”;
  • The 363 sale is approved by the court and is generally “free and clear” of liens, claims, and interests; and lastly,
  • In 363 asset sales, the debtor is typically required to “shop” for additional bids to participate in auction to maximize value for creditors and bankruptcy estates.
 
Advantages and Disadvantages of Out-of-Court Sales
In some circumstances, conducting out-of-court distressed asset sales may offer advantages over pursuing the Section 363 sales process. For instance,
  • Out-of-court transactions avoid the considerable costs, delays, and public nature of a bankruptcy process;
  • Out-of-court sales are not bound by the Section 363 notice and auction requirements;
  • There is no creditors’ committee to contend with, nor other parties that could seek to block the approval of the sale;
  • The seller and buyer can maintain control of the sales process and the timing of the sale, whereas in a bankruptcy, the creditors have a voice in the process, and the court has the final say on the process, timing of the sale, and must approve the sale; and
  • In a bankruptcy proceeding, two-party negotiations between the buyer and seller may end up as multiparty negotiations with secured and unsecured creditors.
 
On the other hand, out-of-court buyers face two risks that buyers in bankruptcy do not: fraudulent conveyance and successor liability risk. In an out-of-court sale, if the seller subsequently files for bankruptcy, the sale could be attacked, and ultimately avoided, as a fraudulent conveyance, especially if the sale is for less than reasonably equivalent value or is viewed as a means of evading debtor’s creditors. Buyers in out-of-court sales face successor liability risk since they cannot always fully insulate themselves from potential liabilities—and, depending on the particularities of state law, the buyers may be liable for certain liabilities, such as environmental and employment claims.
 
Dissecting the Section 363 Sale Process
When selling assets under Section 363 or pursuant to a plan, a debtor will typically retain an investment banker to market the assets and file a motion to set bid, auction, and sale procedures. After a period marketing the assets, the debtor will typically negotiate a deal with a “stalking horse” buyer. A debtor generally must further market the assets being sold to other potential purchasers for a period of time prescribed by the court to see if another bidder is willing to outbid the stalking horse offer. In theory, the presence of a committed buyer encourages other bidders to look at the assets, even if the sale timeline allows only limited time for other bidders to conduct due diligence.
 
If there is no “stalking horse” bidder, then the sale may simply be an auction. In bankruptcy sales, some buyers may be interested in most, or all of the debtor’s assets, whereas others may only be interested in certain assets. If there are competing bids, the court will require that an auction is conducted to determine the highest or best bidder. The auction process is typically governed by court-approved bidding procedures, which regulate the solicitation of potential bidders, the selection of qualified bids, and how the auction is to be conducted. If the bids for individual assets generate more in the aggregate than the “stalking horse,” then the debtor can deem these bids to be higher and better than the “stalking horse” bid.
 
Benefits of Being the Stalking Horse
There are substantial benefits in being the “stalking horse.” First, the “stalking horse” is typically provided with incentives for making the initial bid, including reimbursements for its reasonable expenses incurred in connection with the sale process, as well as a break-up fee (usually 1-5 percent of the “stalking horse” bidder’s purchase price), if another bidder outbids the “stalking horse” at the auction. Thus, if the “stalking horse” loses the auction, it will be compensated for the time and costs associated with setting the floor bid, legitimizing the sale process, and helping to bring competitive bidders to the process.
 
Second, the “stalking horse” may have the ability to participate in determining the proposed terms of the bid procedures (in addition to the incentives described above) to be approved by court, including:
  • The sale timeline, which would dictate the time for marketing and due diligence;
  • Specifying the “qualified” competing bid terms, including bid deposits, bid packages, and the process for qualifying bidders;
  • Setting minimum overbid requirements and bid increments; and
  • The ability to credit a bid if they are a secured creditor.
 
Since the “stalking horse” bid is made with the consent of the debtor, a “stalking horse” may also have both an easier time, as well as more time, accessing information and conducting due diligence. This permits a “stalking horse” to better understand the debtor’s assets and their value. Since the “stalking horse” sets the floor bid, it can also try to underbid and hope that no competing bids are made. In addition, the “stalking horse” may have substantial input over the terms of the Asset Purchase Agreement (“APA”), whereas other bidders may be forced to live with the terms of a pre-negotiated APA and pre-approved bid procedures.
 
Disadvantages of Being the “Stalking Horse”
On the other hand, there are some disadvantages to being the “stalking horse.” One major drawback is that “stalking horse” bids are generally irrevocable. Once the buyer has signed the purchase agreement, it is bound if the buyer is selected as the winner. Even if the buyer is not the prevailing bidder, it may still be tied up as a “back-up bidder” until the closing of the sale. Other negatives include:
  • The buyer may have a significant deposit tied up in escrow during the sale process;
  • There is the potential for delay in the sales process; and
  • Bid protections may not be approved or may be reduced by the court.
 
Pros and Cons of a Bankruptcy Sale
Bankruptcy offers a purchaser several advantages over out-of-court deals. First, bankruptcy offers the ability to buy assets of a debtor free and clear of liens, claims, and interests that cannot be done outside of bankruptcy. As discussed later in this article, a secured creditor can “credit bid” the value of its debt. A sale order will be issued by the bankruptcy court, which is advantageous since once the sale order is final, it cannot be undone at a later time. Second, it allows the buyer to choose which contracts and leases it does not want to take and which ones it wishes to have “assumed” and “assigned” to it by the debtor. The buyer does not have to take any contract it believes is above-market or contains onerous provisions, but can assume any favorable contracts.
 
One of the primary disadvantages of a 363 sale in bankruptcy is the compressed timeframe typically allotted for these sales by the debtor’s secured lenders, which limits the amount of time available to conduct due diligence on the assets being sold. Another disadvantage is the lack of exclusivity involved in the open auction process, and having to deal with the multiple players in the process, including the DIP lenders, trustee, creditors committee, and parties asserting liens on any of the assets being sold. Also, a bankruptcy sale is on an “as-is, where is” basis, so there are no meaningful post-closing protections for the buyer.
 
Selling Assets Through a Bankruptcy Plan
A Chapter 11 debtor may also sell its assets free and clear of existing liens pursuant to a Plan of Reorganization or liquidation. However, in order to do a plan sale, the debtor has to obtain approval of a disclosure statement, then solicit votes on a plan and obtain confirmation of the plan. As a result, one of the primary disadvantages to a plan sale, compared to a 363 sale, is the carrying cost or cash burn rate of the business during the confirmation process, as well as the cost and time to prepare the disclosure statement, plan, and solicitation materials, and conduct the vote. Other disadvantages include the additional risk that the plan might be delayed or not approved by the court, the potential loss of business and/or customers during the plan process, and the potential heightened scrutiny of the creditors’ committee and other parties-in-interest.
 
On the other hand, there are various benefits of a sale of assets through a bankruptcy plan. For example:
  • The buyer can purchase equity through a plan and use cash flow from its assets to pay the purchase price;
  • There is the potential to obtain releases from third parties;
  • It may be easier for the debtor to retain personnel;
  • There is an ease of acquiring or retaining causes of action; and
  • Transfer and other tax issues may be eliminated.
 
Section 363 Asset Sale vs. Plan Sale
Consideration of the various benefits of a 363 Sale, compared to a plan sale, is key. First, a 363 sale is usually quicker and cheaper and just as effective in acquiring a good title for a buyer. It also mitigates a decrease in value of assets, is more likely to have robust auction process, and provides less time for challengers to mount opposition to the sale. On the downside, in a 363 sale, it is harder to obtain releases, including third-party releases. In addition, the buyer cannot obtain 1146(a) tax benefits, nor obtain equity ownership of debtor in order to preserve and utilize outstanding net operating losses.
 
What is Credit Bidding?
Credit bidding is the use of debt as currency in a bid to purchase assets, rather than paying cash. Bankruptcy Code Section 363(k) expressly authorizes credit bidding by a secured creditor. The secured creditor can bid the full value of its claim (not simply the value of its collateral) and set that amount as the floor for other bids. Credit bidding is also permitted in a plan that calls for the sale of the creditor’s collateral. Essentially, if the secured creditor holds a first lien on the property, it does not have to pay anything to buy the assets up to the face amount of its secured claim. However, the secured creditor has to be prepared to win and own the assets.
 
To illustrate an example, consider that a secured creditor is owed $10 million, and offers to buy the assets for $6 million. If the seller accepts the offer, the secured creditor takes title to the assets and deems that $6 million of the borrower’s $10 million obligation is satisfied. If there are cash bids that exceed the amount of the credit bid, the secured creditor reaps the benefit by being paid in cash. However, if no higher bids are made, the secured creditor obtains the title to its collateral.
 
Other Bankruptcy Sale Considerations
The Bankruptcy Code prohibits collusion among bidders, which could keep the price low. Section 363(n) allows a debtor or trustee to void a sale if the sale price was controlled by an agreement among potential bidders and allows such parties to recover the amount by which the price was depressed, versus the value of the property, attorneys’ fees, costs, and punitive damages. 
 
In a bankruptcy sale, the seller may sell designation rights, or the right to find a potential lease assignee. Particularly, retail debtors may have leases in desirable locations. Purchasers may seek to obtain the exclusive right to locate a potential lease assignee, subject to negotiations with the landlord. The buyer of the designation rights is effectively paying for time and exclusivity to negotiate the lease terms, as well as the lease cure amounts. If the landlord is agreeable to the lease changes, then the debtor will seek to assume and assign the lease. If not, the party holding designation rights will either agree to take the lease as is, or advise the debtor to reject the lease.
 
In Summary
With major bankruptcies sending shockwaves through several industries, fully comprehending the benefits of selling assets in accordance with Section 363 of the Bankruptcy Code to maximize value is key. Meanwhile, it's critical to evaluate the advantages and disadvantages of conducting out-of-court distressed asset sales over pursuing the Section 363 sales process. It's also important to recognize the numerous benefits of a 363 sale versus a plan sale, and the role that credit bidding plays.