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Section 363 Sales: New Stalking Horse Strategies
Practical Law Article 6-385-9854 (Approx. 8 pages)
Section 363 Sales: New Stalking Horse Strategies
by Nadia Khattak, PLC US
| Published on 28 Apr 2009 • USA (National/Federal) |
This Article discusses new strategies for stalking horses in section 363 bankruptcy sales.
The economic downturn has dramatically increased the number of companies filing for bankruptcy protection. Corporate bankruptcies increased from 28,322 in 2007 to 43,546 in 2008, according to the American Bankruptcy Institute.
For investors, this presents opportunities to buy the assets of distressed companies at bargain prices. To help them seize and protect these opportunities, investors are using new strategies in sales of assets under section 363(b) of the Bankruptcy Code (section 363 sales) (see Box, Section 363 Sales).
The Stalking Horse Advantage
Investors already have a strong incentive to become the prospective buyer selected by the debtor company to act as the stalking horse in a section 363 sale, as the stalking horse has traditionally been in the strongest position to win the court-supervised auction of the company's assets. Now, new strategies are putting the stalking horse in an even more powerful position.
The approach of courts in recent cases has been largely 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 debtor-in-possession (DIP) financing available to help distressed companies stay afloat," says Brian Greer, counsel at Dechert LLP (see Box, DIP Financing).
For example, despite approving a motion submitted by the unsecured creditors of Chesapeake Corporation to investigate documents exchanged between the stalking horses and the bankrupt company, the court approved the sale on March 22, 2009. The unsecured creditors suspected that the deal was designed to benefit the buyers, the secured lenders and the debtor's senior management, to their detriment.
In addition, courts have been prepared to facilitate ever quicker section 363 sale timetables, which also benefit the stalking horse. According to Shai Waisman, partner at Weil, Gotshal & Manges LLP, bankruptcy courts, viewing themselves as guardians of the bankruptcy process, have traditionally been wary of quick sales. "Now, the same courts are recognizing that every case is an emergency in the current market. If they don't approve the sale, all the creditors will lose," says Waisman.
In some instances, courts have allowed expedited sales notwithstanding objections from creditor groups. For example, in the proposed sale of BearingPoint Inc. to Deloitte LLP as stalking horse, unsecured creditors claimed that the sale was moving too quickly and they had not been given enough time to investigate the bidding procedures.
However, the bankruptcy court refused the creditors' request to slow down the auction process. Ultimately, Judge Robert Gerber of the Bankruptcy Court for the Southern District of New York approved the sale of the company to its stalking horse on April 17, 2009, less than a month after BearingPoint filed its bidding procedures (see Box, Recent Section 363 Sales).
Stalking Horse Gets Better Protection
The stalking horse may be chosen from bids submitted in a mini-auction or it may have a prepetition relationship with the debtor. As part of the process for the section 363 sale, the stalking horse and debtor company negotiate the threshold price for the assets, the contractual terms (including deal protections), the transaction structure and bidding procedures. These must be approved by the bankruptcy court and entered into an order.
The bankruptcy courts will generally permit moderate deal protections to compensate the stalking horse for time and money spent conducting due diligence on the debtor in the event that the deal does not proceed.
Typical protections include break-up fees and expense reimbursement if the debtor terminates the transaction and the assets are sold to a competing bidder.
However, bankruptcy courts will not generally approve deal protections that may have the effect of inhibiting or "chilling" competing bids. For example, a disproportionately high break-up fee can chill the bid because it sets an unreasonably high floor for competing bids. The market standard for break-up fees in section 363 sales is around 1% to 3% of the deal value.
In addition, the stalking horse negotiates bidding procedures for the auction with the debtor and in practice this also works to the stalking horse's advantage.
The bidding procedures include the timetable for the sale, but can also include provisions dealing with the treatment of late bids, a right of first refusal for the stalking horse and requirements for a competing bid and bidder to meet certain qualifying criteria.
For example, to qualify, a competing bid must typically exceed the stalking horse bid by the amount of the break-up fee and a minimum overbid (a certain amount above the total of the stalking horse bid and break-up fee) and be on no less favorable terms. The bidder must prove it has the ability to close the transaction, which in this market means having cash-on-hand.
Due to a scarcity of DIP loans and prospective buyers in the current market, bankruptcy courts have been more lenient in approving bidding procedures submitted by debtors that give stalking horses greater protections.
New Stalking Horse Strategies
Two key new strategies have emerged for the new stalking horses.
The first has been for investors in distressed assets to position themselves strategically by acquiring secured debt. This enables the investor to "credit bid" (see below, Credit Bidding Strategy).
It is also now common for a stalking horse bidder to provide DIP financing to the bankrupt company (see Box, DIP Financing) as a method of asserting more control over the sale process and to help keep the company afloat until the sale closes. This strategy was first implemented by American Airlines in its bid to purchase TWA in 2000. Waisman says that although he has seen the strategy used since then, it has never been as prevalent as today.
Credit Bidding Strategy
Credit bidding in a section 363 sale allows the secured creditor to bid for the debtor's assets and set off the full par value of its claim, including any unsecured portion, against the purchase price of the assets (section 363(k), Bankruptcy Code). This is the case even where the debt is trading at a discount in the secondary market, or was purchased for less than par.
In practice, this means that an investor can acquire a debtor company's assets at a significant discount to their current market value by first acquiring a loan trading at a discount in the secondary market (typically such loans are trading at 50 cents to 70 cents on the dollar).
For example, a loan purchased at 50 cents on the dollar translates into a 50% discount on the purchase price up to the par value of the loan. This gives the credit bidder much greater flexibility in pricing than cash-only bidders.
The investor will want to position itself as stalking horse to give it a greater likelihood of winning the auction and profiting from its investment in the distressed company's secured debt through a credit bid.
Several recent section 363 sales have involved credit bidding, including sales of Chesapeake Corporation and Propex Inc.
DIP Financing Strategy
A credit bidding strategy is sometimes combined with the other important trend, which is for investors in distressed assets to use the additional incentives and more favorable position of a DIP lender to help them win the auction, by offering DIP financing to the debtor company. These loans typically include terms that are more favorable to the lender than traditional loan agreements (see Box, DIP Financing).
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 financing, the DIP lender may demand exit fees or prepayment penalties if the loan is repaid from the proceeds of an acquisition by a competing bidder. These fees can double the 1% to 3% break-up fee that the stalking horse is entitled to under its purchase agreement. Although DIP loans must be approved by the bankruptcy court, they are expected to have terms that are onerous for the debtor and are not subject to the restrictions imposed on bidding procedures.
The terms of the DIP loan can also affect the bidding procedure. DIP financing with a short maturity will shorten the timeline for the sale process and increase the likelihood of closing the deal with the stalking horse. For example, failing to satisfy milestone deadlines such as submitting bidding procedures and obtaining a sale order by a certain date can constitute an event of default under the DIP loan, causing the loan to become due immediately.
The Future
Bankruptcy courts are likely to be willing to affirm ever increasing protections for the stalking horse, even in highly-structured arrangements, until markets become more liquid, DIP financing is more readily available, and companies are healthy enough to survive a timely reorganization.
In the meantime, unsecured creditors seem to be the real losers, though no doubt they will continue to form groups to challenge arrangements that work against their best interests.
There is evidence that, at least in egregious situations, creditor pressure can be effective. In response to pressure from creditors, who complained of a conflict of interest, Frank Stronach, chief executive officer of Magna Entertainment Corp. as well as of its stalking horse, secured lender and largest shareholder, MI Developments Inc., transferred control of the debtor company to Greg Rayburn, the turnaround expert. MI Developments Inc. later withdrew its stalking horse bid.
Nadia Khattak, PLC US
Section 363 Sales
After a company files for bankruptcy, it must obtain court approval to sell its assets outside the ordinary course of business. Section 363(b) of the Bankruptcy Code provides a procedure for the company to obtain this approval on a motion and a hearing (a section 363 sale).
Section 363 sales may involve a double auction process designed to generate the highest and best offer. After marketing its assets, the debtor enters into an asset purchase agreement with a prospective buyer, usually selected in an unofficial mini-auction. The prospective buyer acts as a stalking horse, setting the floor for the bidding in the second, court-supervised auction that follows. The court then authorizes the sale to the winning bidder in the second auction.
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. Another key advantage is the ability for 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).
For further information, see Practice Note, Buying Assets in a Section 363 Bankruptcy Sale: Overview and Timeline of a Section 363 Sale.
DIP Financing
DIP financing allows Chapter 11 debtors to continue their business operations during the course of a bankruptcy case. The Bankruptcy Code encourages lenders to provide DIP financing by granting them superpriority claim status, which gives them priority in payment over all other existing debt, equity and other claims. The terms of DIP loans are similar to the terms of traditional loan agreements but they carry larger transaction fees, higher interest rates and more burdensome covenants. DIP lenders have greater control over the debtor and the bankruptcy proceedings than a lender under a traditional loan agreement.
For further information, see Practice Note, DIP Financing: Overview.
Recent Section 363 Sales
Chesapeake Corporation
On March 22, 2009, the Bankruptcy Court for the Eastern District of Virginia entered an order approving the sale of Chesapeake's operating business to its stalking horse bidders that include affiliates of Irving Place Capital Management, L.P. and Oaktree Capital Management, L.P. The two distressed funds were shareholders and secured lenders.
The unsecured creditors' committee, representing ownership of $300 million of unsecured notes, alleged that the deal was designed to benefit only the secured lenders and stalking horses. While the court granted their request to investigate documents related to the purchase, it approved the sale to the stalking horses for $485 million. There were no other qualifying bids. Unsecured creditors will not receive any distributions from the sale.
Legal Advisors to Chesapeake Corporation: Hunton & Williams LLP
Propex Inc.
Wayataza Investment Partners LLC, stalking horse bidder in the section 363 sale of Propex Inc., succeeded in purchasing the assets of the bankrupt company for $81 million in cash. The auction was held March 23-24, 2009, lasting an unprecedented 15 hours. There were 95 competing bids. The distressed investment fund provided a $65 million DIP loan in February, 2009 and held 19% of prepetition secured debt.
Legal Advisors to Propex Inc.: King & Spalding LLP
BearingPoint, Inc.
The bidding rules for the section 363 sale of consulting firm BearingPoint, Inc., filed on March 23, 2009, named Deloitte LLP as the stalking horse bidder for most of its North American assets. The bankrupt company requested the court to approve the sale by April 23, 2009. Despite allegations from the unsecured creditors' committee that the deal was arranged for the benefit of the stalking horse and secured lenders, the request for more time to investigate the deal and the bidding rules was denied. The Bankruptcy Court for the Southern District of New York approved the sale on April 17, 2009.
Legal Advisors to BearingPoint, Inc.: Weil, Gotshal & Manges LLP
Magna Entertainment Corp.
The withdrawal of MI Developments Inc.'s $180 million stalking horse bid for Magna Entertainment Corp. on April 20, 2009 does not signal an end to the on going drama of the section 363 sale for the horseracing track operator.
The controversy centered on the role of Frank Stronach, the chief executive of the debtor and the stalking horse. MI Developments Inc. is the debtor's controlling shareholder, largest secured creditor and affiliate of the debtor's DIP lender, MID Islandi SF. Creditors, banks and investors protested against the conflict of interest. Stronach was replaced by restructuring expert Greg Rayburn as interim chief executive.
MI Developments, Inc. initially offered to credit bid about $134 million in debt owed by Magna Entertainment Corp. and to contribute an additional $44.2 million in cash. MI Developments, Inc. will likely re-enter the bidding process, but in the meantime it plans to reduce the DIP loan from its affiliate, MID Islandi SF, by nearly half and extend the maturity date, among other amendments.
Legal Advisors to Magna Entertainment Corp.: Richards, Layton & Finger PA; Weil, Gotshal & Manges LLP
Foamex International Inc.
Foam maker Foamex International Inc. reached a deal to sell most of its assets to stalking horse distressed investment firm MatlinPatterson and Black Diamond Capital Management, LLC. The sale was approved by the court on 27 May 2009.
Legal Advisors to Foamex International Inc.: Cozen O'Connor; Akin Gump Strauss Hauer & Feld LLP