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Using The Bankruptcy Code To Buy Or Sell A Troubled Company
The Problem
As a robust economy continues its relentless march into the next millennium, we have seen fewer companies requiring the need for reorganization under Chapter 11 of the Bankruptcy Code. However, an expanding economy also means that, as new businesses are started, some will falter due to under-capitalization, redundancy or other competitive forces. In addition, established businesses will find themselves unable to continue to compete in a consolidating marketplace increasingly dominated by “big box” companies.
In situations where a true financial restructuring or business reorganization is not possible, the Bankruptcy Code provides an effective and efficient means of realizing the going concern value of the troubled company. Simply put, often the only exit strategy for a troubled business with no access to capital is a sale to either a strategic or financial buyer. The problems confronting the parties to such a transaction derive from the fact that the seller or target company is insolvent.
The seller will likely have secured debt in the form of an asset based lender, as well as significantly delinquent trade debt. The seller may also be burdened with disadvantageous leases and contracts Even more important, from the buyer’s perspective than the known debt are the unknown problems such as hidden or undisclosed liens and claims which may not come out of the woodwork until after the deal was closed. No amount of due diligence may be enough to give the acquiring company the comfort that it requires. Moreover, representations and warranties from an insolvent company are rarely worth the paper they are written on, and a holdback from the purchase price would have to be so large and for so long that it would make the transaction unattractive from the sellers’ and creditors’ perspective. The value of the seller may exceed the bank debt, but is usually well below the amount needed to fully pay unsecured creditors. In any event, there may be no means to sell the assets without the lender’s lien continuing to attach to the assets.
Under these circumstances, a buyer would be ill-advised to attempt an acquisition in what I will call the real (or nonbankruptcy) world. It is at this point that a firm such as ours, which specializes in bankruptcy law, should be consulted.
The Solution
Fortunately, for both buyer and seller, Section 363 of the Bankruptcy Code provides a legal framework to facilitate the acquisition of an insolvent entity. The concept is one in which the seller files a Chapter 11 and then files a motion to sell substantially all of its assets to a proposed buyer free and clear of liens and claims and interests and, possibly, successor liability. The buyer ends up with a cleaned up business and the creditors end up with the proceeds which can be distributed through a liquidating or “pot” plan. Yet another potential benefit of the bankruptcy process is the ability to also use Section 365 of the Bankruptcy Code. This section empowers the seller/debtor to assume virtually any favorable contract such as a below-market real estate lease or supply contract and assign it to the buyer over the objection of a lessor or contracting party even if the lease or contract is in default. Conversely, unfavorable leases or contracts can be rejected with no adverse consequences to the buyer. The other party to the rejected lease or contract would simply have a pre-petition unsecured claim to the proceeds of the sale, along with the remainder of the seller’s/debtor’s creditor body.
The transaction can be pre-negotiated before the filing or a truly distressed debtor can file for protection before beginning its search for a buyer. In either event, the principal drawback for a buyer is that the transaction will be exposed to the market with the potential for overbidding through court-supervised auction procedure. Another possible negative is that tax loss carryforwards may be lost.
From the sellers’ and creditors’ perspective, the solution is a good one since the protections which can be afforded by a Section 363 sale even if there are no competing bids will be likely to result in a far better price for the assets than if they had to be sold subject to all the problems of the real world, including the inability to sell known or hidden liens and claims, successor and environmental liabilities.
The Process
Rarely will the universe of potential acquisition partners be known in advance. Accordingly, the seller will probably need to engage an investment banker or other financial advisor to put together a package of background and financial information with which to solicit buyers. These packages can be sent to interested parties in exchange for appropriate confidentiality agreements.
If more than one interested party is still around after contacts have been made, packages sent out and the due diligence process has commenced, the seller will negotiate the best deal it can.
Although beyond the scope of this article, special considerations will be involved if the company is closely held and the principal is actually needed on an ongoing basis or simply wants to be needed. This will involve the separate negotiation of a consulting or employment contract for which the principal or principals will require separate counsel. Any agreement will be scrutinized by the creditors’ committee appointed in the debtor’s bankruptcy case which will be suspicious that the consulting agreement is nothing more than a means of allocating value to the equity holders in preference to debt.
In any event, once the best deal is negotiated, the buyer becomes what is known in the insolvency industry as the “stalking horse.” Being the stalking horse has significant benefits when a business has several suitors because the first thing that we do after writing the motion to approve the sale itself is to draft a motion to approve bid procedures and a “breakup” or “topping” fee. The motion can also require that any overbid be in substantially the same form as the initial bid to avoid having to compare apples and alligators to determine which is the “highest and best” bid. The breakup fee can be in the range of 5% of the value of the bid and is payable to the stalking horse if it is overbid at the bankruptcy court sale. Another benefit we frequently obtain for buyers when I represent them is the right to simply match any overbid rather than having to affirmatively up the ante each time a bidder overbids.
We bring the bid procedures motion on for hearing on an expedited basis to that the playing field will be striped (if not leveled) and all parties will know the rules before the game begins.
At the hearing, which in the absence of truly extraordinary circumstances justifying an emergency hearing, will be held about 30 days after the sale motion is filed, the stalking horse bid is the opening bid. If other bidders appear, an auction will be held. The successful bidder will obtain a federal court order (suitable for framing) which will delineate the terms of the deal and provide all the benefits that Section 363 can bestow: that the assets acquired are free and clear of any lien, claim or interest whatsoever, including environmental liability. Under appropriate circumstances, the Court may be willing to immunize the buyer from successor liability. As mentioned, the order can also provide for the assumption or rejection of executory contracts and leases.
There is a 10-day appeal period, but the sale can close virtually immediately. This is so because of the last but not least significant benefit of Section 363 is the one contained in subsection (m), which provides that when the sale is to a purchaser in good faith, not even a reversal on appeal will affect the sale. From a buyer’s perspective, it just doesn’t get any better than this.
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