COVID-19 has turned the world and U.S. economy upside down. As the number of bankruptcies in the United States increases due to impacts from the coronavirus pandemic, stakeholders in distressed industries facing bankruptcy have concerns about losing their investments. Unfortunately, many will. This article offers an alternative, and suggests that there are potential opportunities for those with the vision and staying power to participate in rebuilding a new economy using pre-existing mechanisms under the U.S. bankruptcy framework via an often overlooked procedure—the repurposing and reuse of distressed assets through Section 363 of the U.S. Bankruptcy Code (“Section 363”). The decisive player and early mover can use Section 363 to seize opportunity in distressed industries and combat the current economic skid. Here, we provide an overview, insights, and pro tips in the use of Section 363.*
The U.S. Bankruptcy Landscape
There can be no real dispute that we are experiencing an economic downturn due to COVID-19 and that this crisis is causing an increase in bankruptcy filings. The financial crisis of 2008 witnessed a similar pattern. According to the American Bankruptcy Institute, following an all-time low in business bankruptcies in 2006 of approximately 20,000 filings, the number of bankruptcies doubled in the midst of the 2008 financial crisis to approximately 40,000. The next year, the number of filings increased another twenty thousand to 60,000. It was not until 2014, 6 years after the 2008 crisis, that the number of bankruptcy filings dropped to pre-crisis numbers ranging in the 20,000s. Now, due to the coronavirus pandemic, the trend is reversing and more businesses are looking for the protections of bankruptcy.
Bankruptcy as Opportunity
For the everyday observer, bankruptcy may appear to mean one thing: lost value. While this can be true in some instances, bankruptcy can also provide opportunity. For the entity filing for bankruptcy, it may mean the liquidation or re-organization of the business, which could mean a blow to its market perception. On the other hand, bankruptcy also provides a company with the ability to satisfy debts, shed liabilities, and continue as a going concern. For creditors, it may mean not realizing the full return of a commercial relationship with a debtor but also the chance to receive some return on an investment as opposed to no return at all. For equity holders, it may mean a loss of ownership in a company but also the prospect of repositioning in the debtor’s estate to realize some return. For a company’s management, it may mean being displaced and lost compensation but also the possibility of working with future owners and creditors. For the market, it may mean the reduction or loss of a good or service but also the reabsorption of valuable assets into the economy and the continued functioning of capital markets.
Thus, a sophisticated party understands that bankruptcy provides opportunity. One such opportunity exists for first movers purchasing assets under Section 363 of the U.S. Bankruptcy Code— the “Stalking Horse” transaction.
Stalking Horse Transactions
Section 363 concerns the sale of a debtor’s assets in federal bankruptcy proceedings through an auction process. Section 363 auctions enable an initial bidder, the “stalking horse,” to place an initial offer for the purchase of some or all of a debtor’s assets. As a reward for being the initial bidder, the stalking horse can structure an initial asset purchase agreement and set deal protections that govern the auction process and compensate the stalking horse for being an initial bidder, if the debtor sells the assets to a subsequent bidder. “Stalking horse” is a term used to describe a guise (often a horse) that a hunter uses to lure in prey. A Section 363 “stalking horse,” however, is more akin to a hunter than a guise, because it seeks to acquire a debtor’s assets as a first mover. As a reward for being the first mover, the stalking horse is compensated whether or not the stalking horse ultimately obtains the asset(s). Therefore, if a party is concerned about its investment in a distressed company, or is seeking to acquire more assets but wants to mitigate the risk of acquiring a distressed asset, a stalking horse transaction may be the best solution.
Although a stalking horse transaction confers considerable first mover advantages on the initial bidder, there are potential pitfalls if the transaction is not executed well. Moreover, understanding the procedure and intricacies of the transaction are essential. But if done well, use of Section 363 could enable the stalking horse to come out of the COVID-19 economic downturn with more assets than before.
What Is the Process for a Section 363 Stalking Horse Transaction?
A Section 363 sale begins with an initial interested buyer—acting as the stalking horse—who sets a price floor for the asset. The stalking horse is sometimes determined through an initial mini-auction. The debtor and stalking horse negotiate over the price of the assets as well as the initial bid protections that the stalking horse will receive in setting the price floor. Typically, the bid protections include a break-up fee if the debtor sells to another bidder and control over the auction process by setting the time period for bidding and the minimum bidding increments for auction participants. The bid protections are not guaranteed, however, as the bankruptcy court must approve them.
Once the stalking horse is determined and initial terms are memorialized in a written asset purchase agreement, the debtor must give at least twenty-one days’ prior notice to all creditors to give them an opportunity to express objections. If there are no objections to the Section 363 sale, the court can approve the plan to sell the assets without conducting a hearing. If there are objections (usually from creditors), the court must decide if the sale is in the debtor’s best interest. As part of its review, the court determines if the bid protections afforded to the stalking horse are fair and equitable. If the bankruptcy court approves the sale process and bid protections, the court supervises an auction to ensure that the debtor obtains the “highest and best” price for the assets. Notwithstanding the terminology, the “highest and best” price, as elaborated below, is not only about price as other factors such as the reputation of the purchaser and the interests of the bankruptcy estate are considered.
If the stalking horse is out-bid, it will not obtain the assets but will receive the break-up fee and other compensation it secured as bid protections for being the initial bidder. If there are no other bids, or the stalking horse is not out-bid, the stalking horse wins the auction. All of the transaction documents are then submitted to the court for approval and the court enters an order authorizing the sale. The sale order is automatically stayed for fourteen days, giving any objecting parties time to seek a further stay while they appeal the sale order. (Courts can waive or reduce the appeal period, upon request, if there is reason to close early.)
The transaction is closed after the sale order has become final and non-appealable. Although the exact timing depends on the jurisdiction in which the bankruptcy occurs, the process can take around two months. If there is a pressing need for the debtor to generate capital, the process can be fast tracked, making stalking horse sales fast paced transactions.
What Are the Advantages and Disadvantages of a Section 363 Stalking Horse Sale?
The advantages of being the stalking horse in a Section 363 auction include:
- Bankruptcy sales present an opportunity to buy valuable assets at below-market prices because there are generally fewer prospective buyers competing for the assets. Buyers can participate in the asset redistribution process provided by the bankruptcy code.
- Assets sold pursuant to Section 363 are free and clear of liens and encumbrances. Consequently, due diligence concerning asset liabilities is generally less of a concern.
- The final sale is approved through a bankruptcy court order so the validity of the transaction is generally immune to later legal challenges like prepetition transactions can be in bankruptcy (i.e., fraudulent transfers and claw-backs).
- The stalking horse has more time to conduct due diligence and has greater access to information of the debtor in real-time (as opposed to other bidders doing due diligence through data rooms—virtual repositories of documents and information about the companies involved in the asset purchase). Because the stalking horse often has more information and time for due diligence, competing bidders may have difficulty submitting bids that are more attractive because they do not have as much information.
- The stalking horse has the first opportunity to set the floor price, basic contract terms and structure of the deal. Because it negotiates an asset purchase agreement to which the debtor has agreed, the agreement serves as the template for other bidders. This means the stalking horse can prioritize terms that are most important to it and compel others to follow suit because the debtor has already accepted certain terms.
- In a regulated industry, the stalking horse has more opportunity to work with regulators to develop a plan to obtain approval of the sale, and therefore has a head start on seeking necessary and often time-consuming approvals.
- The stalking horse’s early entry into the process provides a chance to develop strategic relationships with management and key players in the bankruptcy estate, such as the debtor, creditors’ committee, secured creditors, and other stakeholders. Obtaining their support and commitment can give the stalking horse a competitive edge over competing bidders.
- As compensation for acting as the initial bidder and expending the time and resources to determine an initial valuation, stalking horses are provided incentives, such as break-up fees, should the stalking horse lose out in the auction.
- In connection with its negotiation of the asset purchase agreement, the stalking horse is involved in formulating and negotiating the procedures governing bidding in the auction. Bidding procedures include the timing of the process, who can participate in the auction, and the standards for qualifying bids.
- Unlike other liquidation processes in bankruptcy, the sale of an asset through Section 363 does not require approval of the debtor’s creditors.
- As part of the asset purchase agreement, stalking horses can pursue broad releases from liability relating to the asset sale and thereby protect themselves from future legal challenges.
The disadvantages of being the stalking horse include:
- The stalking horse invests a significant amount of effort and expense conducting due diligence, negotiating the deal, and preparing documents for a transaction. Later bidders can “free ride” on the efforts of the stalking horse to research and conduct due diligence in setting the initial purchase price. If not adequately negotiated and memorialized in writing in the asset purchase agreement, break-up fees may not adequately reimburse the stalking horse for its transaction expenses, such as professional fees, bank fees, and other related fees incurred in negotiating the asset purchase agreement.
- Secured creditors can credit bid (i.e., apply the outstanding value of their claim against the debtor as part of a bid) and therefore the stalking horse may need to pay more to absorb the potential credit bid of a secured creditor.
- The bankruptcy court must approve deal protections and bidding procedures. Courts carefully scrutinize these terms to ensure the winning bid is the highest and best, which requires an element of fairness and equity, as explained below. Other interested players also scrutinize deal protections and bidding procedures to ensure they do not unreasonably favor the stalking horse.
- The bankruptcy process can be informal and unpredictable. Courts may entertain late and nonconforming bids despite court-approved bidding procedures. Thus, while unusual, it is possible that the stalking horse can be out-bid even while it is preparing for closing if a higher and better offer arises before court approval.
- If no other bidders participate in the auction, the stalking horse’s offer may have been too high. Additionally, there is a risk that because of the shortened time frame for due diligence, the stalking horse misses important issues.
- The bankruptcy process does not provide for confidentiality. The terms of an asset purchase agreement are made public. The asset purchase agreement must be filed in the bankruptcy court along with the sale motion explaining the terms of the agreement.
What Are Some Best Practices When Considering a Stalking Horse Transaction?
- Act Early – Even Before a Bankruptcy Filing
Although a Section 363 sale is part of the bankruptcy process and therefore requires a debtor to file a bankruptcy petition, many deals are negotiated before the filing and the seller only files after signing an asset purchase agreement. A stalking horse can identify assets of a distressed company in advance of a filing and seek to negotiate for the assets with the understanding that the company will file for bankruptcy once a deal is struck. In acting pre-petition, however, a stalking horse must be careful to avoid collusive bidding practices which may subject an asset sale to future legal attacks. The bidding process must comply with the bankruptcy code and the identity of bidding parties and the terms of a stalking horse agreement must be disclosed to the bankruptcy court for approval.
- Build Consensus With Other Stakeholders
Often the competitors in a Section 363 auction are not outside investors but the existing stakeholders in the debtor. Creditors of the debtor often make bids on the debtor’s assets. If the creditor is secured, the creditor can credit bid the value of their loan, making it difficult to out-bid a secured creditor that enters the auction process. This can be avoided by building consensus with other stakeholders before entering the initial bid. Creditors should be reassured that the assets being auctioned will not affect the value of the creditor’s stake in the bankruptcy estate. Some winning bidders offer creditors equity ownership in the sold assets. This incentivizes creditors to support the stalking horse and disincentivizes them from spending the time and expense to engage in an auction.
- Define and Limit the Assets You Pursue
Although Section 363 sales can involve the sale of all or substantially all the debtor’s assets, such sales will almost certainly involve the participation of secured creditors, who are seeking to ensure a return on their investment and are the senior claim holders in the bankruptcy estate. Accordingly, a stalking horse that pursues all or substantially all of a debtor’s assets will almost certainly face stiff competition from other stakeholders. If, however, the stalking horse can pursue a limited and clearly defined set of assets, the likelihood of competition may not be as high. There is no restriction on the kind of asset sold (e.g., intellectual property, real estate, equipment, etc.) and not all assets will be as important to creditors. For an outsider or lower stakeholder, to maximize the chance that one secures the asset as a stalking horse, it may be best to pursue assets not central to the bankruptcy estate and with clear boundaries so as to discourage competition.
- Ensure Any Bid Protections Are Strategically Built Into the Asset Purchase Agreement
The purchase of a debtor’s assets comes with risks for the stalking horse, such as uncompensated due diligence. This is why the stalking horse is given bid protections so that it is compensated if the debtor chooses another bidder. Bid protections, however, should also be viewed as a way to maximize the chances of closing the deal. The stalking horse’s bid protections should be strategically memorialized into the asset purchase agreement to both provide the stalking horse the benefit of the bid protections but also to minimize later competition. For example, the stalking horse will often seek a break-up fee should the debtor award auctioned assets to a later bidder. If the asset purchase provision controlling the break-up fee simply states that the debtor shall pay the stalking horse a break-up should the debtor sell the assets to another bidder, the stalking horse will have missed an opportunity to mold the auction process in its favor. Rather, in addition to granting the stalking horse a break-up fee, the asset purchase agreement should specify that the break-up fee will come directly out of the proceeds of any sale of the assets to another bidder. As a result, the stalking horse will have raised the price of the assets for subsequent bidders because they will have to add the value of the break-up fee to their bid in order to compete on price. If later bidders do not absorb the break-up fee into their offers, the debtor would receive more value from the stalking horse because the debtor would have to pay the break-up fee from the proceeds of the later deal. Thus, careful and strategic drafting of the asset purchase agreement maximizes the stalking horse’s chances of closing the deal. All bid protections are subject to court approval, however, and courts reject bid protections that overly stifle the auction process. So, in addition to being strategic, stalking horses need to seek bid protections that the bankruptcy court would approve.
- Price Is Important but Not Everything – Winning Bids Are the “Highest and Best”
In valuing the highest and best bid, the debtor balances its two main goals of maximizing value to the bankruptcy estate and the certainty of closing. Therefore, the highest bid may not always be the best bid. For example, if the debtor is under pressure to close the sale for liquidity reasons, a higher bid with a financing contingency may be worth less than a lower bid with no such contingency. The debtor can also attribute value to non-tangibles, such as whether regulatory approvals have been obtained and whether various creditor constituencies support the sale. Finally, the court must approve the sale and courts do not always go with the highest bidder. For example, some courts have awarded the sale to lower bidders with proven track records of increasing the value of distressed assets. Similarly, even though a stalking horse’s bid may be the highest in value, if it is harmful to the overall bankruptcy estate and stakeholders, a court is not likely to approve the bid. Thus, price, while important, is not determinative and other factors need to be considered in structuring a stalking horse transaction.
The bankruptcy code is designed to facilitate the dissolution and redistribution of distressed assets among debtors and creditors. This situation can be a zero-sum game and many interested parties may lose on their investment. However, all need not be lost. If you have invested in a company that has become distressed and may face bankruptcy and wish to explore relief through Section 363, you need to act decisively and quickly. Likewise, you may see an opportunity to expand into a distressed competitor’s business or industry. Being the “stalking horse” in a Section 363 asset purchase may be your best bet to realize gain in the down economy.
*Required Disclaimer: This alert is provided for informational purposes and does not constitute, and should not be considered legal advice. Specific facts and circumstances will differ. Neither the transmission nor the receipt of this information shall create an attorney-client relationship between the transmitter and the recipient. You should not take, or refrain from taking, any action based upon information contained in this alert without consulting legal counsel of your own choosing. Under applicable professional rules of conduct, this informational publication may be considered attorney advertising.