The stalking horse in a section 363 sale has traditionally been in the strongest position to win the court-supervised auction of the bankrupt company’s assets. This is primarily because the stalking horse is able to obtain moderate deal protections (such as a break fee of 1-3% of the deal value) to compensate it for the time and expense of acting as the stalking horse if it ultimately loses the bid.

Now, stalking horses are seeking to put themselves in an even more powerful position, for example by dictating very short timetables for the bidding process in the court auction. The response of the courts so far has largely been to affirm this position.

"In the current market, bankruptcy courts have been a lot more flexible than previously in relation to section 363 sales, because they know there is a dearth of financing available to help distressed companies to stay afloat," says Brian Greer, counsel at Dechert LLP.

The main advantage of a section 363 sale is that the buyer receives the assets free and clear of liens, encumbrances and most liabilities with few procedural and substantive impediments.

However, another key advantage of a section 363 sale is the ability of secured creditors that bid in the auction to set off the full par value of their claims (including any unsecured portion) against the purchase price of the assets, even if the debt is trading below par or was bought at a discount (known as a credit bid).

Several recent section 363 sales have involved credit bidding, including those of both Chesapeake Corporation and Propex Inc.

This illustrates one key current strategy for investors seeking to acquire the assets of a debtor company, which is to first enter the company’s capital structure by purchasing first lien secured debt of the company (that is, the most senior secured debt).

In practice, this means that the investor can acquire the debtor company’s assets at a significant discount to their market value. In a credit bid, a loan purchased at 50 cents in the dollar for example, translates into a 50% discount on the purchase price up to the par value of the loan.

The other important strategy is for investors in distressed assets to offer bankruptcy financing (known as debtor-in-possession, or DIP, financing) to the debtor, and to use the additional incentives and more favorable position of DIP lender to help win the auction.

As with holding first lien secured debt, the DIP lender can credit bid its DIP loan against the purchase price. In addition, if the stalking horse is a DIP lender, it has an array of ways to exert pressure on the debtor, and can even make it fatal for the debtor not to close the deal, according to Richard Hahn, partner at Debevoise & Plimpton LLP.

For example, in negotiating the terms of the DIP loan, the DIP lender may demand exit fees along with imposing prepayment penalties if the loan is repaid from proceeds of an acquisition by a competing bidder. These fees can double the 1% to 3% break fee that the stalking horse is entitled to under its purchase agreement.

The terms of the DIP loan can also affect the terms of the bidding procedures. DIP financing with a short maturity will expedite the timeline for the sale process and increase the likelihood of the deal closing.

The US courts are unlikely to be willing to affirm ever-increasing protections for the stalking horse indefinitely. Unsecured creditors are generally the real losers and they will continue to form groups to challenge arrangements that work against their best interests. Where court challenges fail, there is evidence that in egregious situations even the mere fact of creditor pressure can be an effective deterrent.