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The current economic environment provides buyers with great opportunities to purchase assets of distressed companies through the bankruptcy process. Section 363 of the Bankruptcy Code provides a useful tool for distressed companies seeking to sell their assets and for buyers looking to purchase assets at potentially bargain prices. These types of sales, commonly referred to as “363 Sales,” are viewed as more efficient than a sale under a plan of reorganization and can present buyers with many benefits that cannot be obtained in a sale outside of bankruptcy. As a result, the trend is for parties to prefer, and courts to permit, sales of a company’s assets in the context of bankruptcy, outside of a plan of reorganization.

This article provides a brief overview of the 363 Sale process as well as the benefits and the risks of this technique. While recent cases highlight certain risks that buyers may face in connection with 363 Sales, these risks can be minimized with an appropriate evidentiary record and careful planning.

Sale Process

Once a company determines that it must sell its assets to maximize value, the sale process in bankruptcy is straightforward. The company first markets its assets to possible purchasers, ideally as many as possible. Assuming one or more potential purchasers submits a letter of intent to purchase the company’s assets, the company, usually with the assistance of an investment banking or marketing firm (depending on the assets being sold), then selects what it considers the highest or best bidder to act as the “stalking horse” bidder. The company and the stalking horse bidder then negotiate an asset purchase agreement. After the agreement is executed, the company files a motion with the Bankruptcy Court seeking approval of the bid procedures governing the conduct of the ensuing auction process and for approval of the sale.

The company and the stalking horse purchaser will typically negotiate bid procedures in connection with the sale. The procedures will provide for the scheduling of an auction, notice of the auction, and a deadline for prospective buyer to submit bids. The procedures are intended to encourage competitive bidding in order to maximize the value of the assets. Simultaneously, the procedures will include provisions to the stalking horse bidder covering the risk of being outbid, such as provisions on a break-up fee, expense reimbursement, and minimum bid increments (e.g., how much higher a subsequent bid must be in order to defeat the stalking horse bidder’s offer). The buyer and seller negotiate these bid procedures, usually with input from secured lenders and the official committee of unsecured creditors (if one is formed).

Companies frequently file a motion for an expedited hearing for the court to consider the bid procedures. If the court grants the expedited relief, the procedures may be approved by the court within several days after the motion. The company will then notify the creditors and potential bidders of the auction. Normally, the time period for submitting bids is 20-30 days after the court approves bid procedures, so that the seller has adequate time to provide bidders with due diligence (the process may be shorter or longer depending on the exigent circumstances that may exist in the case). The auction is normally 1-2 days after bids are due, and the company will select the highest and best bid at the auction. If there are no other bidders, then the auction is cancelled and the stalking horse bidder is deemed the successful bidder.

The company then seeks approval to sell its assets to the successful bidder at a sale hearing before the Bankruptcy Court. The company must establish that there is a sound business purpose for selling the assets.¹ Creditors and other parties in interest are entitled to object to the sale and the bankruptcy judge is required to consider their interests as well.² Perhaps most importantly, the judge will consider whether the asset is increasing or decreasing in value.³

Benefits And Risks

A properly conducted 363 Sale benefits all major parties in a bankruptcy case, as follows:

• Companies in bankruptcy fulfill their fiduciary duty to maximize the value of assets for creditors. In addition, 363 Sales are faster and more efficient than selling assets through a chapter 11 plan of reorganization.
• Secured creditors know the best price has been obtained if the process has been properly conducted. Also, they have the option to “credit bid,” i.e., offer the cancellation of debt as consideration for a bid.
• Unsecured creditors, through the efforts of a creditors’ committee, frequently obtain a carveout from proceeds of the secured creditor’s collateral.
• Under section 363(f) of the Bankruptcy Code, buyers acquire the assets sold in a 363 Sale free and clear of liens or other claims and obtain rubber-stamp approval that the sale was in good faith. Additionally, section 363(m) of the Bankruptcy Code essentially moots appeals of the sale, thereby providing finality to the sale.
• Individual creditors have the opportunity to have contracts assumed by the buyer, and defaults thereunder cured.

Of course, there are certain risks and concerns with respect to 363 Sales. For one, the bankruptcy process operates in a fishbowl. Bankruptcy court filings are publicly available; the terms of the deal are made public and affected constituents such as a creditors committee and secured lenders should be included in negotiations of the stalking horse bid and bid procedures. In addition, even after negotiations with these constituents are complete, buyers need to understand that their offers typically will be subject to higher and better bids, meaning the possible risk of being outbid.

Recent developments in bankruptcy cases show that certain risks involved in 363 Sales remain even after the sale is approved. As stated above, buyers benefit from the ability to buy assets free and clear of liens, and also from the finality of the sale order. In the Clear Channel case discussed below, the Ninth Circuit Bankruptcy Appellate Panel (BAP) issued a decision that calls into question whether a sale can be free and clear of junior liens, notwithstanding the entry of a final sale order. In the Lehman Brothers case, also discussed below, the debtors are conducting discovery regarding the consideration provided by the buyer, even though the sale has already been approved by the Bankruptcy Court as fair.

Clear Channel: Can Assets Be Sold Free And Clear of Junior Liens?

In Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25 (9th Cir. BAP 2008), a trustee sought to sell the debtor’s assets pursuant to section 363 of the Bankruptcy Code. The senior lender acted as the stalking horse bidder and sought to credit bid its debt. A junior secured lender objected to the sale free and clear of its liens. The Bankruptcy Court approved the sale free and clear of the junior lender’s liens, holding that the junior lender’s liens can be crammed down to zero under a plan of reorganization. The Bankruptcy Court also found that the senior lender was a good faith purchaser. The junior lender was unable to stay the order pending appeal and the senior lender closed the sale of the assets.

On appeal, the Ninth Circuit BAP held that while the sale itself was moot under section 363(m), the issue of whether the sale was free and clear of the junior lender’s liens was not. The BAP held that the junior lender’s liens might still attach to the assets and reversed that portion of the Bankruptcy Court’s order that held that the sale was free and clear of the junior lender’s liens. It then remanded the case back to the Bankruptcy Court for further findings required by section 363(f)(5) while allowing the parties to identify a qualifying proceeding under non bankruptcy law that would enable them to strip the junior lender’s lien. The parties to the decision thereafter settled the case, but the BAP decision was not vacated. As a result, the Bankruptcy Court did not have an opportunity to make the fact findings that could have addressed the concerns of the BAP.

The controversial Clear Channel decision had the effect of limiting the use of mootness to defend against appeals of 363 Sales and also of limiting the ability of the parties to a 363 Sale to use of section 363(f) to strip junior liens from the property being sold. Given the BAP’s decision to allow the parties to identify a qualifying proceeding under non bankruptcy law that would enable them to strip the junior lender’s lien, it is possible that, had the parties made a proper showing before the Bankruptcy Court (such as a showing that a state foreclosure proceeding would be the type of proceeding that qualified under 365(f)(5)), then the BAP may never have ruled the way it did.

Lehman Brothers: Did Hasty Sale Provide a Windfall to the Purchaser?

Buyers in a 363 Sale expect finality and do not want to face any risk that a company may reconsider the transaction after a sale is approved and closed. In the Lehman Brothers bankruptcy case, however, debtors are attempting to do just that—reconsider a transaction that has already closed. In that case, the debtors have obtained court approval to conduct discovery under Bankruptcy Rule 2004 relating to the consideration provided by the buyer in connection with Lehman Brothers’ sale of the assets of its North American broker-dealer operations.

Early in the case, the debtors were able to obtain approval of an expedited sale of the broker-dealer unit . In papers filed with the Bankruptcy Court nine months after the sale, however, the debtors stated they had uncovered apparent material discrepancies relating to the liabilities the buyer assumed and the benefits to be received by the debtors in the transaction, which may have resulted in a windfall to the buyer in an amount that could reach billions of dollars. The debtors’ inquiry seeks to focus on the buyer’s assumption of $2 billion in liabilities to pay bonus compensation to Lehman employees who transferred to the buyer, and $1.5 billion in contract cure costs. The Bankruptcy Court took these assumed liabilities into account in assessing the value of the transaction to the debtors. The debtors believe that these assumed liabilities may have been significantly overstated or inaccurate, and that the buyer may have paid significantly less for these obligations. The debtors are also conducting discovery with respect to assets and liabilities transferred to the buyer under certain repurchase agreements.

Naturally, the buyer objected to the debtors’ request for discovery and asserted that the debtors should not be permitted discovery to explore a potential claim regarding the fairness of the consideration. The buyer believes the debtors’ potential claims over the sale have no merit because the Bankruptcy Court already found that the consideration paid was fair. Furthermore, the buyer believes the sale agreement did not require it to pay any specific amounts for bonuses and contract cure payments, but rather only provided estimates for those costs, and the agreement does not entitle either side to a price adjustment. The Bankruptcy Court however, found that the debtors had both a legal and a factual basis for their request to conduct discovery.

The Lehman Brothers sale, of course, was unprecedented. At the time of the sale, Lehman was the fourth largest investment bank in the United States. The sale was a multi-billion-dollar transaction that was negotiated and completed in less than one week. Presumably, not every 363 Sale will be conducted under such extreme circumstances, and the parties would be able to finalize all aspects of the sale more thoroughly. It remains to be seen whether the debtors in Lehman Brothers will successfully have the court address the fairness of the consideration, or whether their efforts ultimately will be seen as an attempt to reexamine a deal that already was upheld by the Bankruptcy Court as fair.

Conclusion

The current economic climate offers opportunities to buyers who understand the sale process in bankruptcy. The flexibility and efficiency afforded by a 363 Sale is not without limits or risks, and such risks may be greater in light of recent cases. As a result, one commentator suggests that negotiations over sales of the debtors assets, especially when they are worth less than the secured debt, must now necessarily include additional constituencies such as junior lienholders.⁴ Another commentator suggests that secured lenders may be better off seeking relief from the automatic stay and conducting a state law foreclosure sale.⁵ We believe that 363 Sales will still be widely used and perhaps preferred by distressed companies and buyers⁶due to the benefits the process provides to all parties. However, the Clear Channel and Lehman Brothers cases stand as reminders that even a straightforward and widely accepted procedure under the Bankruptcy Code, such as a 363 Sale, requires an appropriate evidentiary showing and careful planning.