Expert Q&A on Representing Potential Purchasers in Bankruptcy Acquisitions

Practical Law Article w-009-2172 (Approx. 9 pages)

Expert Q&A on Representing Potential Purchasers in Bankruptcy Acquisitions

by Practical Law Bankruptcy & Restructuring

Why should investors consider buying companies or assets through bankruptcy?

The Chapter 11 bankruptcy process presents a significant opportunity for investors to purchase healthy assets at attractive prices and acquire troubled companies after they have deleveraged their balance sheets and shed burdensome lawsuits, contracts, leases, liens, encumbrances, and other liabilities. Depending on the form of the transaction, an acquisition of a company in bankruptcy, rather than out-of-court, may also provide buyers with certain tax and security law exemptions, preservation of net operating losses, and enhanced protections from successor liability. The ability to navigate the bankruptcy process becomes an essential tool and strategy for the savvy investor (see Practice Note, Bankruptcy: Overview of the Chapter 11 Process).

What steps can a potential purchaser take to purchase distressed assets?

Purchasing secured debt, either prepetition or postpetition can be an effective first step to acquiring a distressed company in bankruptcy. As a holder of secured debt or a third-party interested in purchasing distressed assets, an investor has two common means of acquiring a company:

A plan sponsor transaction. A plan sponsor invests new money in connection with a plan of reorganization or serves as the backstopper in a rights offering. Being a plan sponsor typically allows the investor to take control of the company when it emerges from Chapter 11 (see Practice Note, Loan-to-Own Strategies in Bankruptcy: Sponsoring a Plan).
A section 363 sale. An investor may purchase the company's asset through a section 363 sale, which offers many important benefits not available to buyers in asset sales conducted outside of bankruptcy. The buyer may negotiate to be the debtor's stalking horse purchaser and obtain certain deal protections. Alternatively, an interested buyer may participate in the sale process by submitting a qualifying bid at or before the auction (see Practice Note, Buying Assets in a Section 363 Bankruptcy Sale: Overview).

What considerations should investors keep in mind when deciding whether to purchase secured debt?

There are numerous benefits to buying secured debt either before the filing of the bankruptcy case or after, including the potential to purchase the debt at a discount to par value. Opportunities to buy secured debt at a steep discount in the secondary market arise when existing lenders either:

Prefer to take a "haircut" on their investment upfront rather than to go through a potentially lengthy and complicated workout or bankruptcy case.
Have "deal fatigue" or face pressure from other investors (or as a matter of internal policy) to remove unprofitable loans from their books.
Are in the business of making loans, but not owning companies.

Before buying the secured debt, potential acquirers should take the following measures:

Obtain an accurate understanding of the consequences of buying the specific loan, including exposure to the risks and costs of a lengthy or contested bankruptcy process. The potential acquirer should also assess the risks of a loan-to-own strategy, including the potential for vote designation in the context of a confirmation cramdown fight.
Understand the events that led to the bankruptcy filing, the debtor's proposed course of action for the bankruptcy case, and the dynamics among potentially competing stakeholders, including the debtor, equity holders, secured creditors, bondholders, and competing bidders. When the potential upside and gain on the transaction is high, it is more likely that other parties will be willing to engage in a fight to obtain a piece of the company.
Determine the scope and perfection of any liens on the debtor's collateral, any potential lender liability issues, or other legacy liabilities (for example, environmental liabilities) that may travel with the loan. Counsel should advise how to address possible complications, including correcting deficiencies or negotiating indemnities.

Provided that the investor has performed this due diligence, assessed the risks associated with the debt, and determined the value of the collateral relative to the price of the debt, purchasing the secured debt may help position the investor in its efforts to acquire the company or, at a minimum, receive a healthy return on its investment.

How can purchasing secured debt be part of a strategy to acquire a company in bankruptcy?

A primary advantage of purchasing a secured claim is that the Bankruptcy Code's priority scheme provides that secured creditors are always paid first from the collateral securing their claims (see Practice Note, Order of Distribution in Bankruptcy). Because of their priority treatment, secured creditors may hold significant influence over the debtor's exit strategy. Owning secured debt also permits the secured creditor to credit bid up to the face value of its allowed claim against the purchase price in a section 363 sale. Credit bidding allows a secured creditor to treat its secured claim as if it were cash and reduce the purchase price of the secured assets on a dollar-for-dollar basis by the amount of the claim. By credit bidding its claim in this manner, it is possible for a secured creditor to purchase assets without paying any actual cash for them or, if outbid, receive payment on its claim from a sale to the successful bidder.

When evaluating whether to acquire secured debt as part of a credit bidding strategy, investors must assess the risk that a bankruptcy court may curtail their credit bidding rights to prevent them from using their secured status to exert excessive control over debtors or the bankruptcy process. Bankruptcy courts are courts of equity and have the discretion to deny secured creditors the opportunity to credit bid on a showing of "cause" (§ 363(k), Bankruptcy Code). Although the Bankruptcy Code does not specify what constitutes "cause," the concept is flexible and case law provides some guidance about the circumstances where courts may exercise their right to deny a creditor the ability to credit bid (see Practice Note, Credit Bidding in Section 363 Bankruptcy Sales: Inability to Credit Bid "For Cause").

Some courts have found cause to prevent credit bidding where there is a bona fide dispute regarding the validity of the secured creditor's claim or lien or where the creditor engaged in misconduct (see In re Akard St. Fuels, L.P., , at *3 (N.D. Tex. Dec. 4, 2001); see Legal Update, In re L.L. Murphrey Co: Secured Creditor Loses Liens and Credit Bidding Rights Over Failure to Perfect its Interests). Courts in several cases have also found cause to limit the credit bidding rights of loan-to-own investors to better foster a competitive bidding environment.

Distressed investors and strategic buyers commonly use credit bidding as a strategy to take ownership of all or some of a bankrupt company's assets by acquiring the secured debt claim at a steep discount and then using the value of the claim to launch a credit bid for the assets once the company is in bankruptcy. Bankruptcy judges are aware that buyers implementing this strategy have an advantage over other buyers that are bidding for the assets with real dollars. This strategy failed in the Fisker Automotive bankruptcy case, where the US Bankruptcy Court for the District of Delaware capped the secured lender's credit bid "for cause" to the amount it purchased the debt on the secondary market in an effort not to chill bidding (see In re Fisker Automotive Holdings, Inc., 510 B.R. 55 (Bankr. D. Del. 2014); and see Legal Update, In re Fisker Automotive: Delaware Bankruptcy Court Caps Credit Bid to Amount Paid for Claim).

Investors must recognize that the bankruptcy process is designed to maximize value for creditors and they should therefore encourage a robust bidding process. While the secured creditor may not ultimately be the winning bidder at auction, supporting a robust process reduces the chance that the bankruptcy court caps the secured creditor's claim and increases the chances that the secured creditor receives a full recovery on its claim from the sale proceeds.

While it is beyond the scope of this Q&A, secured creditors should be aware that the debtor or other stakeholders may seek to attack the validity of their secured creditor's position by trying to subordinate the claim (see Practice Note, The Risk of Equitable Subordination in Bankruptcy).

From a purchaser's perspective, is it better to acquire a Chapter 11 company through a section 363 sale or a plan of reorganization?

This question does not have a one-size-fits-all answer. However, investors must analyze several bankruptcy-specific factors to determine which transaction is most advantageous to achieve their goals.

What are some advantages and disadvantages of acquiring a debtor's assets through a section 363 sale?

Section 363 asset sales have gained in popularity over the years as a result of the relative ease, quick pace, and inexpensive nature of the transaction. Debtors typically employ an investment banker to market the company's assets for sale through a fulsome, transparent process designed to achieve the highest possible market price for the assets. The section 363 sale is typically conducted at an auction, subject to higher or better bids.

Investors often favor purchasing assets through a section 363 sale rather than through a plan for various reasons, including:

The relative certainty and finality of a section 363 sale, subject to court approval, as opposed to obtaining the requisite creditor support necessary to confirm a plan of reorganization.
The ability to purchase the assets free and clear of liens and most liabilities, provided certain conditions are satisfied under section 363(f) of the Bankruptcy Code.
The ability to choose to assume certain favorable executory contracts and leases despite anti-assignment clauses, which are generally unenforceable in bankruptcy.

However, the advantages of buying assets in a section 363 sale must also be carefully weighed against the following disadvantages:

The informal and potentially disruptive process by interested parties objecting to the sale.
A lack of confidentiality because the bankruptcy process is transparent and the asset purchase agreement and terms of sale must be filed with the court.
A shorter due diligence period for prospective buyers without a guarantee of succeeding as the winning bidder.

For more information on the advantages and disadvantages of section 363 sales, see Practice Note, Buying Assets in a Section 363 Bankruptcy Sale: Overview.

What should a buyer consider when determining whether to act as a stalking horse bidder?

In the section 363 sale context, the potential acquirer may have the opportunity to become the stalking horse bidder. Selected by the debtor as the initial bidder, the stalking horse sets the threshold price, contract terms, and transaction structure. In return, the stalking horse receives moderate deal protections to compensate it for its significant time and expense investments and the risk that it may be outbid by a competing bidder in the later auction supervised by the bankruptcy court.

Prospective buyers must assess whether it is more advantageous to compete for the stalking horse position or to enter the competition later. The advantages and disadvantages of acting as the stalking horse should be carefully considered because the stalking horse is bound to its bid even though the debtor is not bound until the sale is approved by the court. Benefits of acting as the stalking horse include:

The ability to conduct more thorough due diligence and have real-time access to management (while other bidders conduct due diligence through virtual data rooms and on a shorter time frame).
The opportunity to set the floor price, basic contract terms, initial form of the asset purchase agreement, and other deal documents that become the baseline terms of the transaction.
Obtaining bid protections, such as break-up fee and expense reimbursement (subject to approval by the bankruptcy court).
Formulating and negotiating the procedures governing bidding in the auction and the fundamentals terms of the auction, such as timing of the process and the nature and form of qualifying bids.

Disadvantages of being a stalking horse bidder include:

The significant time, expense, and effort conducting due diligence, negotiating the deal, and preparing documents for a transaction that will be shopped for a higher and better offer.
Risk of changes to the form of the transaction or late, non-conforming bids. Because courts want to give debtors the latitude to accept a bid that maximizes value to the estate, the stalking horse can be outbid even when it is preparing to close if a higher and better offer emerges.

What are the advantages and disadvantages of attempting to acquire the debtor through a Chapter 11 plan?

Through the Chapter 11 process, debtors have the ability to restructure and deleverage their balance sheets, shed burdensome contracts and leases, reject collective bargaining agreements, discharge liens and judgments, and assume and assign valuable executory contracts and unexpired real property leases. While a section 363 sale provides many benefits for the purchaser, acquiring a company through a confirmed plan also has advantages that buyers must consider. These include:

Obtaining a discharge from most prepetition liabilities (with the exception of environmental liabilities), protection from successor liability, and the ability to enjoin or channel future claims and causes of action.
Flexibility in structuring the sale, such as recapitalization, mergers, and consolidations (§ 1123(a)(5)(C), (J), Bankruptcy Code), and limitless ways of funding a plan through a combination of cash, secured financing, rights offerings, debt-for-equity swaps, reinstatement of debt, and litigation trusts. The flexibility allows complex cases to be resolved with creative solutions.
Less competition because the Bankruptcy Code does not require an auction process for sales under a plan, allowing plan sales to be structured as private transactions (subject to requisite creditor and court approvals).
Exemptions from the requirement to pay stamp or transfer taxes (§ 1146(a), Bankruptcy Code; and see Fla. Dep't. of Revenue v. Piccadilly Cafeterias, Inc., 554 U.S. 33 (2008)).
Preservation of net operating losses (NOLs) that may be sizeable and valuable.

Bankruptcy judges often prefer to sell substantially all of a company's assets through a Chapter 11 plan rather than through a section 363 sale because:

Section 363 sales are generally subject to the debtor's sound business judgment, while plan confirmation requires the plan proponent to satisfy the disclosure and solicitation requirements of section 1125 of the Bankruptcy Code and the creditor protection safeguards of sections 1123 and 1129 of the Bankruptcy Code.
The Bankruptcy Code requires payment of all priority claims, including administrative costs of the bankruptcy, as a condition of confirmation. However, payment of priority claims is not a ground for approval of section 363 sales.

Because of the creditor safeguards associated with plan confirmation, a plan confirmation process carries risks and evidentiary burdens that are not required in connection with section 363 sales. The plan process, therefore, may:

Take longer to complete than a section 363 sale.
Require the purchaser to provide additional post-petition financing to fund the debtor's operations, bankruptcy-related expenses, and carry the parties to confirmation.

For a further discussion on purchasing assets through a plan, see Practice Note, Buying Assets Under a Chapter 11 Plan.

Looking ahead, do you see a trend in the market regarding asset sales in Chapter 11 cases?

The trend over the last decade has favored asset sales for the reasons discussed above, including the efficiency, speed, and inexpensive nature of the transaction. Section 363 buyers often prefer the relative certainty of a section 363 sale because they must only pay the highest or best price for the assets, subject to court approval, without concerning themselves with whether the debtor can garner sufficient creditor approvals to confirm a plan of reorganization.

Recent bankruptcy filings in the retail sector have relied heavily on section 363 sales of inventory and other assets, such as real estate, below-market unexpired real property leases, and intellectual property. Given the weak brick-and-mortar retail environment as consumers increasingly shift to online shopping and the brand-insensitivity of many modern consumers, reorganization prospects of retail debtors are often limited. In this situation, buyers favor section 363 sales or liquidations because they allow for the option to cherry pick valuable assets, while leaving behind liabilities and weak assets.

For more on retail bankruptcies, see Practice Note, Bankruptcy: Retail Case and Distressed Company Tracker and Retail Industry Bankruptcies Toolkit.

Expert Q&A on Representing Potential Purchasers in Bankruptcy Acquisitions | Practical Law