September 01, 2002

Big Business in the World of Insolvency: Buying and Selling Businesses and Assets in Bankruptcy

18 min

The United States Bankruptcy Courts are becoming more and more crowded these days, and for every Enron and Global Crossing, there are many potential acquirers of all or part of such companies seeking to benefit from the downturn in the economy by purchasing such companies' assets at bargain prices. Along the way, a potential acquirer of the assets of a bankrupt entity and its counsel must not only structure an acquisition transaction and negotiate a definitive purchase agreement with the debtor/seller, but the acquirer must also navigate through the Bankruptcy Code and Bankruptcy Rules and gain an understanding of how the debtor's creditors and other affected parties impact the sale process. Structure of a Bankruptcy Transaction

Asset Sale. Almost every bankruptcy sale will take the form of an asset sale because an asset sale will enable the acquirer to purchase only desired assets and avoid many of the seller's liabilities, especially unknown liabilities. Typically, the debtor will not object to an asset sale if the debtor expects to liquidate because it is usually the most expedited and therefore cheapest procedure.

Stock Sale. In some limited circumstances, the acquirer might agree to a different structure, such as a stock sale, because a stock sale might enable the acquirer to avoid potential problems. For example, because many government licenses and permits are generally not assignable, an acquirer of stock might avoid the requirement of having to obtain the consent of the related governmental entities to such transfer of stock. In addition, a transaction may be structured, in part, as a stock sale if the transaction includes the sale of non-debtor subsidiaries.The Bankruptcy Process – Alternative Paths

The goal in a Chapter 11 bankruptcy case is to formulate and seek confirmation of a plan of reorganization that will enable the debtor to emerge from bankruptcy as a viable and profitable company. A Chapter 11 debtor may also formulate and seek confirmation of a plan that provides for the orderly liquidation of a company, including possibly a sale of the company or segments thereof as a going concern. In either case, a Chapter 11 plan is the framework or blueprint that provides for the treatment of claims against and interests in the debtor and its property and, if the debtor is reorganizing, a plan for the continuation of the business after confirmation of the plan.

Traditionally, if a Chapter 11 debtor wanted to sell all or substantially all of its assets, it would do so through a plan of reorganization or plan of liquidation. In recent years, however, Bankruptcy Courts have permitted such a sale pursuant to Section 363 of the Bankruptcy Code prior to the plan solicitation and confirmation process so long as the requirements set forth below are satisfied.

In general, Bankruptcy Courts will permit a Chapter 11 debtor to sell all or substantially all of its assets pursuant to Section 363 of the Bankruptcy Code prior to the plan solicitation and confirmation process so long as the transaction represents the reasonable business judgment of the debtor and there is a sound business purpose for conducting the sale prior to plan confirmation. See, e.g., In re Naron & Wagner, Chartered, 88 B.R. 85 (Bankr. D. Md. 1988). The "sound business purpose test" requires a debtor to establish four elements: (1) that a sound business purpose justifies the sale outside the ordinary course of business; (2) that accurate and reasonable notice of the sale has been provided to all parties-in-interest; (3) that the debtor has obtained a fair and reasonable price; and (4) good faith.

As articulated by the Bankruptcy Court in Naron & Wagner, a sale of assets pursuant to Section 363 of the Bankruptcy Code may not be approved by the Bankruptcy Court if the sale constitutes an impermissible sub rosa plan of reorganization. A sub rosa plan is one that is confidential or secret. The rationale behind disallowing a sub rosa plan is that such plans deny creditors the procedural protections of the Chapter 11 plan process, such as: (1) disclosure requirements; (2) voting requirements; (3) the best interest of creditors test; and (4) requirements regarding the priority of distributions to the debtor's creditors.

The following types of provisions in a sale transaction have been held to constitute a sub rosa plan and, therefore, the sale transaction was not approved: (1) provisions that controlled specific distributions of assets in a future plan; (2) provisions that required secured creditors to vote in favor of a plan; and (3) provisions that provided for the release of claims held by all parties against the debtor, its officers and directors, and secured creditors. In general, if a sale transaction merely transforms the composition of the debtor's assets into cash, and does not dictate the terms of a future plan or attempt to restructure the rights of creditors, the Bankruptcy Court will likely determine that the sale transaction constitutes an impermissible sub rosa plan.

There are several advantages to selling all or substantially all of the debtor's assets pursuant to Section 363 prior to the plan solicitation and confirmation process. Because the plan solicitation and confirmation process typically takes a considerable amount of time and occurs at or near the end of a Chapter 11 case, a sale of assets can be accomplished more quickly by motion pursuant to Section 363 prior to the plan process. This can be particularly helpful if the acquirer of the assets is demanding a prompt closing. Furthermore, the inherent delay that would be associated with a sale of assets through a plan may cause the acquirer and/or the debtor to incur additional costs and expenses (i.e., interest charges), and in some cases, lost opportunities.

A sale of assets pursuant to Section 363 may also avoid certain risks and uncertainty that would be associated with a sale of assets through a Chapter 11 plan. If the sale of assets is included as part of a plan, there is a risk that the plan may not receive the necessary votes for confirmation and, therefore, the sale may likewise not be approved. When a sale of assets is pursuant to Section 363, parties-in-interest are not entitled to vote on the sale (although parties-in-interest are given an opportunity to object to the sale).

One final point is worth noting. Pursuant to Section 1146(c) of the Bankruptcy Code, a transfer of assets pursuant to confirmed Chapter 11 plan that would otherwise be subject to stamp or similar taxes is exempt from such taxes. Other types of taxes included in this exemption are recordation and transfer taxes. Bankruptcy Courts in the Third Circuit have construed this provision broadly to include sales and transfers which occur outside a Chapter 11 plan and before or after plan confirmation, provided that such sales and transfers are essential to, or are an important component of the plan process. See, e.g., In re Hechinger Inv. Co. of Delaware, Inc., 254 B.R. 306, 320 (Bankr. D. Del. 2000) (the Section 1146(c) exemption applies regardless of whether the transfer occurs before or after plan confirmation, provided a confirmation occurs and the sale was essential to or an important component of the plan process). Courts in the Fourth Circuit, however, have taken a different approach and have concluded that transfers of assets that take place prior to the date of plan confirmation are not covered by the tax exemption in Section 1146(c). See, e.g., In re NVR, LP, 189 F.3d 442 (4th Cir. 1999). Accordingly, an acquirer desiring to obtain the benefits of Section 1146(c) in the Fourth Circuit cannot do so through a Section 363 sale.Advantages of Purchasing Troubled Company Assets In Bankruptcy

Sale "Free and Clear" of All Liens. The first and foremost advantage of selling assets in bankruptcy is the potential cleansing effect of sale authorized by order of the Bankruptcy Court. Section 363(f) of the Bankruptcy Code provides that a debtor may, under certain circumstances, sell all or substantially all of its assets free and clear of all existing liens, encumbrances and interests (collectively, "Liens"), with such Liens attaching to the cash proceeds of the sale. These circumstances are the following: (1) where applicable nonbankruptcy law permits the sale of such property free and clear of such interest; (2) where such entity consents; (3) where such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property; (4) where such interest is in bona fide dispute; or (5) where such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest. In any such event, the acquirer of such assets obtains clear title to the property without the burden of the Liens that were attached to the property prior to the 363 bankruptcy sale.

Sale Free and Clear of All Claims – Successor Liability. As stated above, Section 363(f) permits a debtor to sell assets free and clear of any existing Liens to such assets, but it is not entirely settled to what extent Section 363(f) affects state successor liability claims that have not arisen as of the date of sale. Whether an acquirer of a debtor's assets will take such assets free and clear of successor liability claims is dependent on the facts of each case and depends on whether a particular claimant received adequate notice of the sale and bankruptcy proceeding. Brilliant, 1034 PLI/Corp 657, 677 (noting that one court precluded successor liability claims where a lienholder received notice and failed to bring its claim during the bankruptcy proceeding, but the another court stated that Section 363(f) offers no protection from future product liability claims). Thus, practitioners should be aware that a sale free and clear of all claims may not absolve the acquirer of certain claims, including certain successor liability-type claims and claims where the claimant failed to receive adequate notice.

Break-Up Fees and Other Overbid Protections. Another advantage of a sale in bankruptcy is the existence of certain overbid protections that are available to a potential acquirer. A "break-up fee" is typically paid to an unsuccessful stalking horse bidder to reimburse such bidder for its due diligence and related transaction expenses (including professional fees, bank fees and other related expenses) in connection with the signing of a definitive purchase agreement. A break-up fee is designed to encourage a stalking horse bidder to come forward with a higher initial bid and to compensate such bidder if another party is the successful bidder at auction. Any break-up fee set forth in a purchase agreement must be reasonable and requires the approval of the Bankruptcy Court. Break up fees are typically based upon one percent (1%) of an approved bid and generally do not exceed three percent (3%).

The rationale behind a break-up fee is to provide incentive to bidders to come forward and make an initial bid, and to compensate the initial bidder in the event that a subsequent bidder (who presumably spent less time and energy conducting due diligence and negotiating the definitive purchase agreement) outbids the initial bidder. Payment of a break-up fee attempts to jump start the bidding process and to offset the risk that a subsequent bidder will "freeload" at the expense of the initial bidder.

Outside of the bankruptcy context, many courts apply a three-part test for deciding whether a break-up fee is appropriate: (1) whether the relationship of the parties that negotiated the break-up fee involved self-dealing; (2) whether the fee discourages or encourages bidding; and (3) whether the amount of the fee is reasonable in relation to the purchase price. In the bankruptcy context, some courts have used the business judgment test as a starting point, but have also analyzed other factors, including whether (1) the fee correlates with the maximization of value to the debtor's estate, (2) the purchase agreement is an arms' length transaction, (3) the main secured creditors and the committee of unsecured creditors support the fee, (4) the break-up fee constitutes a reasonable percentage of the purchase price, and (5) the dollar amount of the break-up fee is so substantial that it would "chill" other potential bidders.

Another test for determining whether a break-up fee will be allowed was articulated by the Third Circuit Court of Appeals in In re O'Brien Envtl. Energy, Inc., 181 F.3d 527 (3d Cir. 1999). Under the O'Brien test, the party requesting a break-up fee must demonstrate that payment of such fee should be treated as an administrative expense of the bankruptcy estate under Section 503(b)(1) of the Bankruptcy Code. In other words, the requesting party must demonstrate that payment of the break-up fee is actually necessary to preserve the value of the estate's assets. Under the facts of O'Brien, the Court of Appeals concluded that the stalking horse bidder was not entitled to the break-up fee because: (1) the debtor, not the stalking horse bidder, incurred the expense of arranging most of the due diligence materials; (2) the break-up fee was not necessary to induce or retain the stalking horse's bid; and (3) the stalking horse bidder failed to show that its bid served as a catalyst to higher bids. It is important to note that in O'Brien the break-up was not pre-approved by the Bankruptcy Court. Accordingly, counsel for the stalking horse bidder should be aware of the stringent tests that Bankruptcy Courts may apply in its evaluation of a break-up fee's reasonableness and should be wary of demanding a break-up fee that will not pass muster.

Other Bid Protections. Other bid protections may include the following:

  • Topping Fees. A topping fee is similar to a break up fee in that it is paid to a stalking horse bidder only if the Bankruptcy Court approves another bid. However, a topping fee is typically based on a percentage of the excess of the approved purchase price over the stalking horse bidder's initial bid.
  • Required Overbid Increments. In order to facilitate an orderly bidding process and to increase the value of the debtor's assets, most debtors will require as part of the bidding procedures that the bidders make overbid in minimum increments.
  • Deposits; Financial Wherewithal. Most Bankruptcy Courts require bidders to post deposits as a sign of good faith that such bidders are capable of meeting their bid obligations. In addition, debtors may require bidders to prove their financial wherewithal (by way of bank letter or otherwise) in connection with a potential bid.
  • Subsequent Bids Contain No Contingencies. Another way to protect the stalking horse bidder is a requirement that all subsequent bids contain no contingencies or, at the very least, be no more contingent than the initial bid.
  • Bid Deadlines. Although not typically viewed as a bid protection, the bid deadline acts as a screening mechanism for eliminating potential bidders which are not capable of obtaining financing or otherwise being organized to make a viable bid.

Section 365 of the Bankruptcy CodeAnother unique aspect of the sales of bankrupt companies is the debtor's power to assume certain attractive (and presumably valuable) contracts and reject those contracts that are less so. Section 365 of the Bankruptcy Code provides that, subject to court approval and certain other limitations, a debtor may assume or reject any executory contract or unexpired lease.

The Bankruptcy Code does not define the term "executory contract". Many courts have adopted the so-called "Countryman" definition: "a contract under which the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other." Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L.R. 439, 460 (1973). The Countryman definition was adopted by the Fourth Circuit in Lubrizol Enters, Inc. v. Richmond Metal Finishers, Inc. (In re Richmond Metal Finishers, Inc.), 756 F.2d 1043 (4th Cir. 1985). Contracts where performance remains substantially due on both sides are clearly executory. However, a contract where one party has no post-petition obligation will not be deemed to be an executory contract.

Under Section 365, leases present their own issues. Bankruptcy courts recognize the distinction between "unexpired" and "terminated" leases under state law, but some courts permit the assumption of leases that were previously terminated. Section 365(c)(3) makes clear, however, that a terminated lease of non-residential real property cannot be assumed. In addition, Section 365(d)(3) provides that, during the postpetition, pre-rejection/assumption period, the debtor is required to "timely perform all obligations" of a lease of non-residential real property. These sections were designed grant to commercial landlords special rights when their tenant files for bankruptcy protection. In fact, some courts have gone to even greater lengths to protect landlords. In re Geonex Corp., 258 B.R. 336 (Bankr. D. Md. 2001), the court granted the landlord's demand of payment of counsel's fees and interest under Section 365(d)(3) based on the theory that Section 365(d)(3) was intended to protect commercial landlords and place them in no worse position than they would have been in if the debtor's bankruptcy never occurred.

Assumption Generally. In anticipation of a prospective asset sale transaction, a debtor may assume an executory contract by motion to the Bankruptcy Court at any time before confirmation of a plan, subject to the approval of the Bankruptcy Court. Parties-in-interest are given an opportunity to object to the debtor's decision. (Section 365(d)(4), however, provides that, if a nonresidential real property lease in which the debtor is the lessee is not assumed within 60 days of the date of petition, then such lease is deemed rejected.) In a summary proceeding to assume an executory contract, the debtor must show, among other things, that all defaults relating to such contract have been cured by the debtor (or the debtor has provided adequate assurance that it will promptly cure such defaults).

Section 365 does impose certain limitations on the debtor's ability to assume an executory contract. The debtor must not only cure pre-petition and post-petition defaults (or provide adequate assurance of a prompt cure), it must also compensate the non-debtor party for pecuniary loss caused by such default (including, but not limited to, interest charges) and provide adequate assurance of its ability to satisfy future obligations. In addition, Section 365 excepts out certain contracts that, under non-bankruptcy law, are not assumable or assignable. 11 U.S.C. &#sect; 365(c)(1). While the scope of this exception is subject to controversy, it is generally acknowledged that state permits and licenses are covered under this exception. As discussed above, in circumstances where state permits and licenses constitute the debtor's primary assets, this exception may lead the acquirer of bankruptcy assets to structure the transaction as a stock purchase in order to avoid the requirement that the permits and licenses be individually assumed and assigned.

Rejection Generally. If the debtor decides not to assume an executory contract, the debtor must reject such contract through a motion to reject under Section 365(a) or through a provision in the plan of reorganization pursuant to Section 1123(b)(2). The Bankruptcy Court will approve the rejection of an executory contract only if the debtor satisfies the business judgment test. The Bankruptcy Court will first determine how the rejection will benefit general unsecured creditors and may also look at other factors, including, but not limited to, whether the rejection will result in a large claim against the debtor's estates and whether the resulting benefit to the debtor's estate outweighs the harm of such rejection. As is the case generally with the business judgment test, the Bankruptcy Court will not usurp the judgment of the debtor absent a finding of bad faith or self-dealing.

If the debtor has not previously assumed the executory contract, the rejected executory contract is deemed breached by the debtor immediately before the petition date and the non-debtor party to such contract simply becomes a general unsecured creditor of the debtor's estate. The non-debtor party, however, has a claim against the debtor for breach of contract and a priority administrative claim for any benefits received by the debtor prior to its rejection of the executory contract.

Non-debtor lessors of personal property are afforded more protection under Section 365 than other unsecured creditors. Such protection allows the non-debtor lessor, among other things, to (1) claim an administrative expense of actual costs and expenses of preserving the estate; (2) request adequate protection payments; and (3) request that the court set a deadline for the assumption or rejection of a personal property lease. In addition, Section 365(d)(10) provides that the debtor must timely perform all obligations relating to a personal property lease that arise 60 days or more after the petition date. This requirement is in addition to the administrative expense priority that attaches to lease payments owed during the first 60 days.Finality of a Bankruptcy Sale.

The Bankruptcy Court's approval of a sale of the debtor's assets is subject to appeal by the parties. The uncertainty of potential appeals by unsuccessful bidders or other parties has a potential chilling effect on any acquirer's interest in pursuing a purchase of bankrupt assets. Section 363(m) of the Bankruptcy Code, however, provides that an order authorizing and approving a sale cannot be reversed or modified on appeal unless either the appellant obtains a stay pending appeal or the acquirer lacks good faith. The rationale behind Section 363(m) is that an appeal, in the absence of a stay or bad faith, should be rendered moot in the event that a Bankruptcy Court enters sale order authorizing a sale to a good faith purchaser. This provision is designed to promote the finality of bankruptcy sales and maximize the purchase price of assets by reducing an acquirer's ability to seek a discount based on the threat of endless litigation. See Licensing by Paolo, Inc. v. Sinatra, (In re Gucci), 126 F.3d 380 (2d Cir. 1997). (Please note that under the Federal Rules of Bankruptcy Procedure an order approving a sale is automatically stayed for 10 days unless the Bankruptcy Court orders otherwise.)

Potential acquirers should be careful not to inadvertently waive the protection provided by Section 363(m) by agreeing to condition a sale upon a final, non-appealable sale order or, alternatively, ensure that, if such condition is included in the purchase agreement, the acquirer has the right to waive the condition without notice or consent by the parties in interest or the Bankruptcy Court. A. Brilliant, J. Schwartz and A. Sathy, Buying and Selling Assets in Bankruptcy, 1034 PLI/Corp 657, 669 (1997) (citing In re Brookfield Clothes, Inc. 31 B.R. 978 (S.D.N.Y. 1983) (such provision operates as a consensually imposed stay of the sale, pending the exhaustion of all appeals). Thus, the mere threat of possible appeals should not dampen an acquirer's enthusiasm for pursuing a purchase of assets in bankruptcy.


Despite the fact that purchasing assets in bankruptcy involves an intricate legal process and requires a potential acquirer to negotiate with and manage various constituencies and ultimately obtain approval of the Bankruptcy Court, a potential acquirer of assets in bankruptcy should evaluate the substantial benefits derived from a purchase in bankruptcy and whether such benefits make it time to go bargain hunting.