AS YOU HELP YOUR CLIENTS grow their businesses, you might want to investigate an often untapped source for asset acquisition that frequently offers bargain-basement prices: bankruptcy court auctions. At bankruptcy auctions your clients can purchase anything from small fixtures and fittings-the hard assets of a restaurant for example-to entire companies and large pieces of real estate.
Bargains are not limited to hard assets. Bankruptcy auctions often include the sale of patent or trademark rights, which can impart significant potential value and often can be purchased for a fraction of their fair value.
Here are some real life examples of how companies have successfully utilized bankruptcy auctions. A small candy company heard that its competitor's business was in bankruptcy. After thorough due diligence, the candy company bought out the failing company at a fraction of the going-concern value, eliminating the competition and then doubling its own asset base. A California automobile parts manufacturer heard through the industry grapevine that its East Coast competitor had gone into bankruptcy. The West Coast company structured a deal to purchase the competitor out of bankruptcy, establishing a new regional presence for a relatively nominal amount.
PREPARING FOR THE PURCHASE
You can buy assets via a bankruptcy in one of two ways. First, assets can be sold through a confirmed Chapter 11 reorganization plan. Typically this is laborious, cumbersome and time-consuming. The approach most buyers favor is the sale procedure under Sec. 363 of the Bankruptcy Code which applies to all sales under Chapter 7 and 11. Chapter 7 is a liquidation either of a company or an individual's assets, and a Chapter 7 trustee is always appointed to liquidate the assets. Chapter 11 is a reorganization of a business or an individual. Typically a trustee is not appointed in a Chapter 11, and the reorganization is controlled by existing management, known as a debtor-in-possession (DIP). In Chapter 11 reorganizations, a trustee is appointed only if a debtor mismanages the business or engages in other prohibited conduct.
Sec. 363 controls sales by corporate, sole proprietor or individual debtors. Sales may be simple or complex and need not be limited to outright transfers of title. A transaction may combine elements of a sale, lease, license or other rights to use property. For example, a buyer may purchase a debtor's manufacturing plant, lease from the DIP specialized equipment, assume the equipment leases and obtain a continuing license of technology and patents needed to operate the plant.
Under Sec. 363(b), a debtor may sell the estate's property, other than in the ordinary course of business, only after notice and a hearing. The concept of "after notice and hearing" is flexible, allowing a court to expedite or dispense with the notice and hearing in appropriate cases. For example, in a simple sale such as that of an automobile or single piece of equipment having a relatively insignificant value compared to the entire estate, the sale may be completed without a hearing, provided creditors are notified and have no objections. More complex sales, however, typically do require a hearing.
The property being sold may be subject to security interest liens and third-party encumbrances. The Code provides the framework to protect these security interests and provides in appropriate circumstances, for a sale that is free and clear of liens.
THE PURCHASE PROCESS
The actual purchase process can occur in one of two ways. There can be an open auction in which no particular agreement is yet in place between the debtor and any purchaser. Alternatively, a purchaser can become a "stalking horse" by negotiating in advance an agreement with the debtor to purchase the assets for a specified price, subject to court approval.
Nearly all bankruptcy sales are subject to overbidding. Thus, whether your client should in fact come to the hearing unannounced or contract to become a stalking horse depends upon the nature of the asset being bought and the circumstances of the purchase.
When the asset being purchased does not require significant due diligence and no material time or financial investment is required to determine whether the asset being purchased is appropriate, it may be most flexible for the buyer to simply appear at the bankruptcy court hearing and make the offer.
PROTECTING A STALKING HORSE
If, on the other hand, the purchase requires investigation because either an entire business is bought or other assets are being purchased that require due diligence and a financial investment prior to the purchase, the purchaser may want to enter into a binding agreement with the DIP (or the bankruptcy trustee) subject only to bankruptcy court approval.
Because bankruptcy sales usually receive multiple bids, stalking horse purchasers typically seek a number of protections to ensure that their bid is approved, such as:
1. Break-up fees. A break-up fee is a sum of money that the estate commits to pay to the proposed purchaser if the court does not approve the purchaser's offer. Potential purchasers seek break-up fees to protect them from the time and cost involved in conducting due diligence and drafting the agreement. Typically, break-up fees range anywhere from 2-5 percent of the aggregate purchase price. (A recent decision by the Court of Appeals for the Third Circuit [Calpine Corp. v. O'Brien Environmental Energy, Inc.] should be noted. The court concluded that a contract for the sale of a debtor's assets may order a break-up fee payable to the buyer only when those fees are necessary to preserve the bankruptcy estate's value.)
2. Matching rights. Purchasers often insist that they have a right to match any other offer made at the auction sale and that any other offeror is required to bid at a higher increment than the contracting purchaser's bid. This gives the purchaser the competitive advantage of knocking another offeror out of the box by simply matching the bid.
3. Financial capability. The contracting purchaser usually requires the seller to screen other buyers to ensure that they are financially capable of performing at the bankruptcy court auction. This procedure often requires the other potential buyers to submit financial statements and make a deposit prior to the hearing. The deposit is usually refunded if the other interested party is not the successful bidder.
4. Early sale. Bankruptcy court rules throughout the country provide certain minimum times for when notice must be given regarding an asset sale. If the purchaser has already completed the due diligence, and notice is given to other bidders at large with minimal opportunity for them to complete their due diligence, the purchaser is again left with a competitive advantage.
The purchase agreement typically includes these and other protective requirements. Additionally, the purchaser often will require the DIP seller to bifurcate the sales procedure as follows: First, under the purchase agreement, the seller must approach the bankruptcy court and obtain court order approving the procedure. Once the procedure is approved, the sale hearing is set. Contracting purchasers then know that established procedures they have bargained for will be followed by the court at the sale hearing. Alternatively, if time is limited, the procedures may not be approved in advance, but the purchaser will request that they be enforced at the bankruptcy court hearing.
If the sale procedures are fair and reasonable, the bankruptcy court should approve them at the sale hearing or at a previously conducted hearing for this purpose. The procedures must be designed to yield both the highest value to the estate and also give fair recognition to the buyer's time, effort and expense to reach an agreement with the debtor.
When deciding whether to approve a purchase offer or choose a competing offer, courts generally consider factors besides the highest bid. In Chapter 7 liquidations however, (as opposed to Chapter 11 reorganizations), price is the essential element, assuming that the other offers and purchases are comparable in all other respects. When the sale results from a Chapter 11 reorganization, the court will consider both the benefit to the debtor plus the highest offer.
Generally the court will defer to the debtor's business judgment. For example, if a debtor's sale to an alleged lienor will resolve difficult litigation and eliminate the risks of delay and costs of operating a property to resolve disputes, the court will likely consider those factors in addition to the offer price.
In determining if the sale is in the estate's best interest, the court will balance the interest of the various classes of creditors and interested parties. The purchaser's financial ability to pay or perform the purchase contract is also a relevant consideration. Thus, whether the purchaser is an existing organization or is a newly formed shell corporation without significant assets is relevant, unless the buyer pays full purchase price in cash at closing. The purchaser's financial wherewithal is also relevant if leases are sold and assigned. For example, if the sale is contingent upon a prospective purchaser's ability to obtain regulatory approvals or licenses, the court also must consider those elements.
BENEFITS OF BANKRUPTCY COURT APPROVAL
The most obvious benefit of purchasing through bankruptcy is price. Bankruptcy courts aim to realize the highest price for assets being sold, but because the assets are from distressed businesses, they usually sell for considerably less than going concern value.
When Chapter 7 trustees sell the assets, there is additional price pressure because trustees have a statutory duty to liquidate the assets under their charge. Trustees often do not have the opportunity to fully investigate each debtor's business and industry environment, and therefore cannot know the worth of the assets in each industry. In addition, because a Chapter 7 is a liquidation, asset prices are often much lower than if those assets were valued as part of a going concern. Even in cases where the debtor has an ongoing operation, sales are more often than not the result of pressure to generate cash.
Bankruptcy sales also are beneficial in that they can be structured to be free and clear of all liens, claims and security interests. The court can order that the sale be free and clear of liens and interests by attaching those liens and interests to the cash proceeds. The lienholders and the debtor then get to squabble about the division of the proceeds, while the assets transfer lien-free to the purchaser.
Another benefit is that, notwithstanding restrictions that may be contained in a lease agreement, a debtor who is a lessee may be able to sell and assign the lease to the purchaser. This can be of tremendous benefit in a retail purchase that otherwise may not be subject to assignment of the lease itself.
BEWARE OF TRAPS
Although you can reap significant financial rewards from bankruptcy court auctions, they are not for the faint of heart. They definitely represent caveat emptor: buyer beware.
For starters, bankruptcy court auctions often do not provide the various representations and warranties found in typical purchase and sale agreements.
Second, obtaining information about the assets can sometimes be far more difficult than in a typical purchase. If the seller is out of business and a trustee is selling the assets, there may be no one around with historical knowledge about the assets. To gain information in a bankruptcy sale, purchasers can review financial information from the bankruptcy court docket about the debtor's assets, liabilities and financial condition; obtain information from the Unites States Trustee's Office where Chapter 11 debtors are required to file monthly reports; solicit information from the debtor's officers if they are still available; and obtain information from the trustee if one has been appointed.
Third, in some select cases, even though an asset is sold free and clear of liens, the seller may inherit successor liability. Successor liability is a judicially created doctrine arising under nonbankruptcy law. It is an exception to the common law rule that a purchaser of assets is not liable, absent agreement, for claims against the seller. Successor liability is a legal theory by which claims can be asserted against the buyer of assets even though there is no express agreement to assume such liabilities. Successor liability has been imposed under the following four traditional exceptions to the general rule: where the court has found an implied agreement to assume liability; where there is a de facto merger; where there is a continuation of enterprise (this is similar to the de facto merger exception and relies upon the successor holding itself out as continuing the original business, such as where the successor continues to manufacture and sell the same product using the same trade name, goodwill and cu stomer list); and finally when the transaction is entered into with fraudulent intent or for less than reasonably equivalent value.
A bankruptcy court purchase can be an effective strategy in the right circumstances. If your clients choose to bid on something in bankruptcy court that has a hefty price tag or requires a substantial investment prior to purchase, they would be well advised to consult with a bankruptcy lawyer regarding how to structure the offer, when and where to conduct the specialized due diligence and how to deal with the various constituencies of the bankruptcy arena.
Brian Davidoff is a lawyer with the Century City law firm of Rutter, Hobbs & Davidoff Inc. His practice focuses on corporate reorganization and emerging growth companies.
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|Date:||Nov 1, 2000|
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