Technology Business Asset Sales in Bankruptcy
By
Kimberly Osenbaugh
Marc Barreca
David Neu
Preston Gates & Ellis LLP
Seattle, Washington
Thanks to Ayanna Wooten-Days, Preston Gates & Ellis LLP, for assistance with these
materials.
I.
Introduction
Asset sales pursuant to 11 U.S.C. § 363(b) motions and pursuant to Chapter 11 plans
have traditionally been important tools for maximizing the value of bankruptcy estates.
In recent years, the use of Chapter 11 cases for sale of financially distressed debtors’
business assets has become increasingly common, particularly asset sales approved
through § 363(b) motions followed by post-sale plans of liquidation for distribution of the
sale assets. This method of asset sales has been used especially frequently by start-up
technology businesses long on intellectual property and short on cash.
Sales of technology business assets in bankruptcy almost universally involve the transfer
of intellectual property, requiring careful attention to the rights of non-debtor licensors to
the business and non-debtor licensees of the business. Sales of business assets in the
telecom and cable communication industries or in other heavily regulated businesses, as
well as sales of assets subject to special legal restrictions such as customer lists,
inherently involve the interplay between government regulation and bankruptcy law.
Both intellectual property license agreements and governmental regulatory issues are
outside the scope of this article. This article will instead focus on the bankruptcy sale
process including the use of breakup fees and other “stalking horse” bidder protections,
the use of § 363 sales of substantially all of the assets of a debtor outside of a plan of
reorganization and other procedural issues affecting technology business asset sales.
II.
Sales of Assets Under 11 U.S.C. § 363
11 U.S.C. § 363(c) authorizes a trustee or debtor in possession to use, sell, or lease
property of the estate in the “ordinary course of business.” For example, a Chapter 11
debtor continuing business operations is free to engage in ordinary sales to its customers.
Whether a transaction is in the ordinary course of the business of the debtor is frequently
characterized as a two-step inquiry as to whether (1) the transaction is the sort commonly
undertaken by companies in the industry (the horizontal test); and (2) whether the
transaction subjects a creditor to economic risk of a nature different than creditors would
have typically accepted in deciding to extend credit to the debtor. See In re Roth Am.,
Inc., 975 F.2d 949 (3rd.Cir.1992); Burlington N.R.R.v. Dant & Russell (In re Dant &
Russell, Inc.), 853 F.2d 700, 704-06 (9th.Cir.1988).
If the asset sale in question is outside of the debtor’s ordinary course of business, the sale
may only be consummated with bankruptcy court approval. 11 U.S.C. § 363(b)(1). An
out of ordinary course sale transaction occurring without court approval may be avoided
under 11 U.S.C. § 549 as an unauthorized post-petition transfer.
Section 363(f) of the Bankruptcy Code authorizes sales of assets “free and clear of any
interest in such property”1, outside of the ordinary course of business, following notice
and hearing, under the following circumstances:
1
A recent case has construed this statute to permit a sale of real property “free and clear” of the rights of a
lessee that failed to object to the sale. See Precision Industries, Inc. v. Qualitech, 327 F.3d 537 (7th Cir.
2003), rehearing denied 2003 U.S. App. LEXIS 10626 (2003). In 1998, Debtors entered into a supply
(1) applicable nonbankruptcy law permits sale of such property free and
clear of such interest;
(2) such entity consents;
(3) 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) such interest is in bona fide dispute; or
(5) such entity could be compelled, in a legal or equitable proceeding, to
accept a money satisfaction of such interest.
Bankruptcy courts are normally deferential to the business judgment of the trustee or
debtor in possession when deciding whether to approve a proposed sale. Special scrutiny
will be put to bear for transactions involving sale to insiders or sales benefiting insiders.
Generally, to approve a sale under 11 U.S.C. § 363(b), the court must find that the
proposed sale is reasonable and in the best interests of creditors. Besides requiring
independent proof of the reasonableness of the proposed price, most courts require that
proposed sales are subject to higher and better offers. This results in the reality that most
bankruptcy sales outside of Chapter 11 plans, even if initially framed as private sales to a
single party, are in fact potentially auctions if any overbidders appear.
Absent objection, bankruptcy courts can authorize sales of assets even where the sale
proceeds are insufficient to satisfy claims of all parties secured by the sale assets.
However, if a secured party objects, the court must determine under § 363(f)(5) whether
agreement with Precision Industries that required Precision to construct a supply warehouse on Debtor’s
property and to provide on-site supply services for a period of ten years. The property was leased to
Precision for ten years for nominal rent. One year later, Debtor filed a Chapter 11 bankruptcy petition. All
of Debtors’ assets, including the property leased to Precision, were sold at auction “free and clear” of all
liens, claims, encumbrances, and interests, except for specifically enumerated liens. Although Precision
had notice of the sale and of the hearing, it did not object. Thereafter, the purchaser took possession of
Precision’s warehouse by changing the locks. Precision sued the purchaser asserting a right to the leased
property pursuant to § 356(h), which grants a lessee the right to maintain possession of property after a
lease is rejected. The Bankruptcy Court held that § 363(f) allows the sale of property free and clear of any
interest so that under the terms of the sale order, the purchaser obtained title free and clear of Precision’s
possessory rights under the ground lease. The District Court reversed holding that § 356(h) and § 363(f)
conflicted and that the more specific terms of § 356(h) trumped.
The Seventh Circuit Court of Appeals reversed the District Court, holding that Precision’s interest was
terminated by the sale “free and clear” of other interests. The term “interest” in § 363(f) is sufficiently
broad to include a lessee’s possessory interest under a lease.
Courts frequently struggle to define what interests may be eliminated under § 363(f), including product
liability claims, unexercised options, rights of first refusal, and other rights not clearly covered by the term
“interests.” See, e.g., Folger Adam Sec., Inc. v. DeMatteis/MacGregor, JV, 209 F.3d 252 (3d.Cir. 2000)
(any interest in property that can be reduced to money satisfaction attaches to proceeds of sale); United
Mine Workers of Am. 1992 Benefit Plan v. Leckie Smokeless Coal Co. (In re Leckie Smokeless Coal Co.),
99 F.3d 573 (4th.Cir.1996) (benefit plan).
“such entity could be compelled, in a legal or equitable proceeding, to accept a money
satisfaction of such interest.” Courts have struggled with what this subsection really
authorizes, reaching often creative conclusions. See, generally, In re Canonigo, 276 B.R.
257 (Bankr.N.D.Cal. 2002) (discussing cases and concluding that § 363(f)(5) only applies
to interests, not liens); see, also, In re Heine, 141 B.R. 185 (Bankr.D.S.D. 1992); In re
Terrace Chalet Apts. Ltd., 159 B.R. 821 (N.D.Ill. 1993); In re Healthco Int’l., Inc., 174
B.R. 174 (Bankr.D.Ma. 1994).
At a §363 sale, “unless the court orders otherwise”, the holder of a claim secured by a
lien on the property may credit bid. §363(k)
An appeal from an order authorizing a sale of assets may be moot if the appellant has not
obtaining a stay pending appeal provided that the purchaser has acted “in good faith”;
knowledge of objections and the appeal do not affect the validity of the sale nor the good
faith of the purchaser. §363(m)
Potential buyers of assets out of bankruptcy sales should be mindful of restrictions under
11 U.S.C. § 363 prohibiting collusive bidding. 11 U.S.C. § 363(n) provides
(n) The trustee may avoid a sale under this section if the
sale price was controlled by an agreement among potential
bidders at such sale, or may recover from a party to such
agreement any amount by which the value of the property
sold exceeds the price at which such sale was
consummated, and may recover any costs, attorneys’ fees,
or expenses incurred in avoiding such sale or recovering
such amount. In addition to any recovery under the
preceding sentence, the court may grant judgment for
punitive damages in favor of the estate and against any
such party that entered into such an agreement in willful
disregard of this subsection.
See, generally, Lone Star Industries, Inc. v. Compania Naviera Perez Companc (In re
New York Trap Rock Corp.), 42 F.3d 747 (2nd.Cir. 1994); Licensing by Paolo, Inc. v.
Sinatra (In re Gucci), 126 F.3d 380 (2nd.Cir. 1997); Landscape Properties, Inc. v. Vogel,
46 F.3d 1416 (8th.Cir.), cert. denied, 516 U.S. 823 (1995).
Sales of assets pursuant to section 363 of the Bankruptcy Code are often conducted
pursuant to sophisticated bidding procedures which may include stalking horse
agreements, bidder qualifications, irrevocable bids, minimum bidding increments, deposit
requirements, variables on the package of assets to be sold, matching bids and the like.
One of the issues of continuing interest and controversy is break-up fees and topping
fees.
III.
Sales of Assets Outside of a Plan under §363 of the Bankruptcy Code
Bankruptcy courts have been traditionally cautious about approving sales of substantially
all of the assets of a Chapter 11 debtor through a § 363(b) sale where there is not the
extensive disclosure provided in a Chapter 11 plan and disclosure statement or the
procedural safeguards provided in the plan confirmation process. See, generally, In re
Lionel Corp., 722 F.2d 1063 (2nd.Cir. 1983); In re Braniff Airways, Inc., 700 F.2d 935
(5th.Cir. 1983). Courts have expressed a fear that such sales dictate essential terms of a
future reorganization plan. This is variously described as the “sub rosa,” “de facto” or
“creeping” plan problem.
In Lionel, the court determined that if there is a good business reason to approve a
§ 363(b) sale of substantially all of the assets, a finding of an emergency for sidestepping
the protections of a Chapter 11 plan is not necessary. See, generally, Craig A. Sloane,
The Sub Rosa Plan of Reorganization: Sidestepping Creditor Protections in Chapter 11,
16 Bankr.Dev.J. 37, 39-40 (1999). See, also, In re Walters, 83 B.R. 14, 19
(Bankr.9th.Cir. 1988).
Most courts appear to now allow sales of substantially all of the assets of a business
outside of a Chapter 11 plan, especially where, absent sale of assets within a short time
the debtor would risk running out of funds and be forced to cease operations, severely
reducing the value of the business assets. This problem is especially common with
struggling technology companies. However, in situations where it is less clear that a sale
of substantially all of the assets will in fact be necessary to preserve and maximize value
for creditors, the sub rosa plan discussion becomes more relevant. Where the motion
includes both sale related provisions and complicated or controversial provisions for
distribution of the sale proceeds, the sub rosa plan objection is also still relevant. See,
generally, In re Airbeds, Inc., 92 B.R. 419, 423 (Bankr.9th.Cir. 1988) (§ 363 sale motion
included provisions for disbursement of sale proceeds on specific tax claims over the
objection of an administrative claim creditor).
One court has articulated the relevant factors as follows:
(1) Has the debtor articulated a business justification for the request?
(2) Is the debtor exercising sound business judgment in proposing to enter into the
subject transaction?
(3) Will the proposed transaction further the diverse interests of the debtor,
creditors, and equity holders alike?
(4) Is the asset increasing or decreasing in value?
(5) Does the proposed transaction specify terms for adoption of the reorganization
plan?
(6) Will approval of the proposed transaction effectuate a de facto reorganization
in such a fundamental fashion as to render creditors’ rights under the other provisions of
Chapter 11 meaningless?
In re Work Recovery, 202 B.R. 301, 304 (Bankr.D.Ariz. 1996). See, generally, R. Tilton,
Bankruptcy Business Acquisitions, Section 5.04(2) (2002).
IV.
Break-Up Fees and Topping Fees
A.
History and Standard of Review
Break-up fees and topping fees are commonly used outside of the bankruptcy context.
Beginning with the so-called “mega-cases” of the late 1980s and early 1990s, break-up
fees and topping fees in bankruptcy asset sales have become an increasingly utilized
tools, ostensibly to attract potential purchasers.
Break-up fees are fees paid to the potential purchaser of the assets if the sale is not
consummated for reasons detailed in the purchase agreement, including the debtor’s
acceptance of another bid. In re APP Plus Inc., 223 B.R. 870, 874 (Bankr. E.D.N.Y.
1998).
Topping fees, in contrast, are paid only in the event another bidder is the successful
purchaser.
As described by one court, the rationale for the use of break-up and topping fees is as
follows:
Purchaser's Rationale:
•
Such fees compensate the initial bidder for its legal and other professional
fees and expenses incurred in connection with obtaining financing
commitments, completing legal due diligence and negotiating and drafting
agreements with the seller;
•
Compensate an initial bidder for the expenditure of its time, efforts and
resources;
•
Compensate for the risk that the potential purchaser's offer will be used as
a "stalking horse" to induce other purchasers to top the initial bidder's
offer; and
•
Compensate the unsuccessful bidder for the risk of losing other business
and investment opportunities while the bidding process unfolds.
Seller's Rationale:
•
Such fees may encourage the making of an initial "stalking horse" offer at
a point where there are no competing bidders;
•
May discourage a bidding strategy designed to hold back competitive bids
until late in the process;
•
Aid the seller in negotiating an initial bid that may be the offeror's highest
bid;
•
May establish a high floor early in the bidding process; and
•
May enhance the bidding process by creating momentum towards the
consummation of a sale.
Id. at 874.
Outside of the bankruptcy context, the use of break-up or topping fees is governed only
by the business judgment of the corporate officers and directors, and such fees are
presumptively appropriate. See, e.g., Cottle v. Storer Communications, Inc., 849 F.2d
570 (11th Cir. 1988). In the bankruptcy arena, however, break-up and topping fees have
been criticized as adding unnecessary administrative expense and chilling the bidding
process. Accordingly, bankruptcy courts have developed standards for scrutinizing
break-up and topping fees.
1.
The Business Judgment Test.
In the early 1990s, the seminal case on the use of break-up and topping fees was In re
Integrated Resources Inc., 135 B.R. 746 (Bankr. S.D.N.Y. 1992), aff’d 147 B.R. 650
(S.D.N.Y. 1992), a case in which the debtor sought court authorization to enter into a
break-up fee and expense reimbursement agreement with a prospective funder of its plan
of reorganization. Per the agreement, a maximum $6,000,000 break-up fee would be
payable to the proposed funder if the funding agreement was abandoned or if the debtor
entered into a funding agreement with another suitor. Although the Subordinated
Bondholder’s Committee objected to the break-up fee, the bankruptcy court approved the
agreement.
In analyzing the break-up fee agreement, the Integrated Resources court relied heavily on
non-bankruptcy law and adopted the business judgment rule, which "is a presumption
that in making a business decision the directors of a corporation acted on an informed
basis, in good faith and in the honest belief that the action taken was in the best interests
of the company." 147 B.R. at 656. On appeal, the district court identified three factors
that a court should consider in deciding whether to approve break-up fees:
•
•
is the relationship of the parties who negotiated the break-up fee tainted by
self-dealing or manipulation;
does the fee hamper, rather than encourage, bidding;
•
is the amount of the fee unreasonable relative to the proposed purchase
price?
Id. at 657. Addressing the second question directly, the court stated, “[b]reak-up fees are
important tools to encourage bidding and to maximize the value of the debtor's assets.
The usual rule is that if break-up fees encourage bidding, they are enforceable; if they
stifle bidding they are not enforceable. In fact, because the directors of a corporation have
a duty to encourage bidding, break-up fees can be necessary to discharge the directors'
duties to maximize value.” Id. at 659-660. The district court affirmed the bankruptcy
court’s deference to the debtor’s business judgment.
2.
The Benefit to the Estate Test.
Faulting the Integrated Resources court for acting in a “non-bankruptcy mode,” the
Bankruptcy Court for the District of Arizona rejected the business judgment test, and
focused on the benefit to the bankruptcy estate. In re America West Airlines Inc., 166
B.R. 908 (Bankr. D. Ariz. 1994). See also In re Tiara Motorcoach Corp., 212 B.R. 133
(Bankr. N.D. Ind. 1997) (“the business judgment of the debtor should not be solely relied
upon”). In the words of the America West court, “the Court in Integrated went as far as
to recognize there exists a difference between acquisitions in bankruptcy and outside of
bankruptcy, but went no further.” Id. at 911. The America West court ultimately held
that a proper analysis must include a fact-specific determination that all aspects of the
transaction are in the best interest of the estate, and that the transaction “will ‘further the
diverse interests of the debtor, creditor and equity holders alike.’” Id. at 912 (quoting In
re Lionel Corp. 722 F.2d 1063, 1071 (2nd Cir. 1983)).
In America West, the court rejected the debtor’s proposal to include a four to eight
million dollar break-up fee in an agreement for the sale of the debtor’s business, stating
that “[n]o funds of the estate should be used to pay break-up fees in a transaction that . . .
would appear to yield a large profit to the top bidder. Instead, the estate should be
preserved because as much money as possible should be available to the creditors,
bondholders, and shareholders under a consensual plan of reorganization.” Id. at 913.
See also In re S.N.A. Nut Co., 186 B.R. 98 (Bankr. N.D. 1994) (“the proper standard for
evaluating a breakup fee should be whether the interests of all concerned parties are best
served by such a fee.”).
Other courts employing the “benefit to the estate” test have articulated a number of
factors that the court should consider, including:
•
Whether the underlying negotiated agreement is an arms-length transaction
between the debtor's estate and the negotiating acquirer;
•
Whether the principal secured creditors and the official creditors committee are
supportive of the concession;
•
Whether the subject break-up fee constitutes a fair and reasonable percentage of
the proposed purchase price;
•
Whether the dollar amount of the break-up fee is so substantial that it provides a
"chilling effect" on other potential bidders;
•
The existence of available safeguards beneficial to the debtor's estate;
•
Whether there exists a substantial adverse impact upon unsecured creditors, where
such creditors are in opposition to the break-up fee. Whether the fee requested
correlates with a maximization of value to the debtor's estate.
In re Hupp Indus. Inc., 140 B.R. 191, 194 (Bankr. N.D. Ohio, 1992).
3.
The O’Brien Administrative Expense Test.
Only the Third Circuit has addressed the issue of break-up fees at the circuit court level.
In In re O’Brien, 181 F.3d 527, 535 (3rd Cir. 1999), the Third Circuit addressed the
break-up fee provision in a guaranteed purchase agreement entered into by the debtor and
Calpine Corporation, in which Calpine agreed to purchase the debtor’s business and
accept the transfer of $90 to $100 million of the debtor’s liability. The agreement was
conditioned on the bankruptcy court’s approval of a $2 million break-up fee and up to $2
million in expense reimbursements. The bankruptcy court, however, refused to approve
the break-up fee and expenses provision, expressing concern that the allowance of the
provisions would chill or complicate the competitive bidding process. On appeal,
Calpine argued that, as in the non-bankruptcy context, break-up fees should be left to the
business judgment of the debtor.
After careful analysis of both the Integrated Resources and America West opinions, the
Third Circuit rejected both the “business judgment” and the “best interest” tests, stating
that neither approach “offers a compelling justification for treating an application for
break-up fees . . differently from other applications for administrative expenses” under
Bankruptcy Code §503(b). In the words of the court:
[w]e therefore conclude that the determination whether break-up fees or expenses
are allowable under § 503(b) must be made in reference to general administrative
expense jurisprudence. In other words, the allowability of break-up fees, like that
of other administrative expenses, depends upon the requesting party's ability to
show that the fees were actually necessary to preserve the value of the estate.
Therefore, we conclude that the business judgment rule should not be applied as
such in the bankruptcy context. Nonetheless, the considerations that underlie the
debtor's judgment may be relevant to the Bankruptcy Court's determination on a
request for break-up fees and expenses.
Id. at 535. Unconvinced that the award of break-up fees and expenses to Calpine was
necessary to preserve the value of the bankruptcy estate, the Third Circuit affirmed the
bankruptcy court’s decision.
B.
The Current Status of Break-Up Fees and Topping Fees
As is apparent in the evolution from deference to management by application of the
“business judgment” standard to the “administrative expense” standard for review,
bankruptcy courts are increasingly reticent to approve break-up and topping fees without
careful scrutiny. A review of recent opinions of courts that employ the “best interest of
the estate” and “administrative expense” standards reveals a number of cases in which
such fees were denied. See, e.g., In re Lamb, 2002 WL 31508913 (Bankr. D. MD. 2002)
(because a bidder submitted a bid presumably based on the supposition that the potential
value of the subject properties outweighed the cost of their acquisition, the expenses he
incurred in the process of bidding were for his own benefit and could not be characterized
as necessary to preserve the value of the estate or as in the best interests of the estate); In
re A.P.P. Plus, Inc., 223 B.R. 870 (Bankr. E.D.N.Y. 1998) (court that approved break-up
fee denied additional topping fee even though there had been no taint of self-dealing or
manipulation, where it did not appear that the fee would enhance bidding or result in
substantial benefit to estate; there was evidence of substantial interest in debtor's assets
and the initial bidder could be adequately protected as "stalking horse" by approval of
break-up fee); In re Tiara Motorcoach Corp., 212 B.R. 133 (Bankr. N.D. Ind. 1997)
(break-up fee was not in best interest of estate, creditors, and equity holders). But see In
re Tama Beef Packing, Inc., 290 B.R. 90 (8th Cir. BAP 2003) (reversing district court’s
denial of break-up fee, stating that the fee conferred benefit on the estate and should, to
the extent reasonable, have been allowed as administrative expense claim against estate.).
Even the Bankruptcy Court for the Southern District of New York, one of the courts that
has adhered to the business judgment test, has shown reluctance to rubber-stamping such
fees. In a recent decision, the district court upheld the bankruptcy court’s vacation of an
order allowing a topping fee in an asset sale. In Gey Associates Gen. P’ship v. 310
Associates, L.P., 2002 WL 31426344 (S.D.N.Y. 2002), the debtor entered into an
agreement with Gey Associates, the stalking horse in an auction for the sale of property,
providing for a $100,000 topping fee if any entity made a higher and better offer than
Gey. The agreement was approved by the bankruptcy court, following which another
entity interested in the acquisition of the property filed a motion requesting that the court
vacate the order. Finding that its approval of the order had been based on a
misunderstanding of the facts, the court vacated the order authorizing the topping fee. It
had not been revealed to the court that the debtor had “two buyers drooling to make [the]
purchase.” Id. In affirming the bankruptcy court’s decision, the District Court for the
Southern District of New York noted that the topping fee “did not encourage bidding.”
The court further found that the fee was both unnecessary, as there were already multiple
bidders, and inappropriate, in that it hampered the debtor’s ability to sell the property to a
higher bidder. Id. at 2.
Despite the seemingly increased reluctance of some bankruptcy courts to approve breakup and topping fees, breakup fee awards remain common in other courts. See, e.g., In re
Philip Services Corp., United States Bankruptcy Court for the Southern District of Texas,
Case No. 03-37718 (June 2003) which involve break-up fees to an insider. The debtor
proposed to borrow $35 million in DIP financing from it’s largest shareholder (“Icahn”),
which would sponsor a plan of reorganization pursuant to which it would acquire
substantially all of the debtor’s assets. The debtor also sought alternative plan
sponsorship bids. The DIP financing facility entered into by the debtor and Icahn
provided for a $5 million break-up fee in the event that an alternative bid was accepted or
if the Icahn-sponsored plan was not confirmed. The motion seeking approval of the
bidding procedures and break-up fee drew strenuous objection from creditors on the
grounds that the break-up fee was excessively large, arguing that court-approved breakup fees tend to be in the range of two to three percent of the purchase price. Moreover,
the creditors argued that the awarding of a break-up fee to an insider of the debtor was
unwarranted and would only serve to discourage competing bids. Despite the fact that
the break-up fee was in excess of 14% of the $35 million DIP financing facility, the court
approved the break-up fee and, at an auction held in September, 2003, Icahn placed the
winning bid.
Other recent breakup fee rulings by Delaware Chief Bankruptcy Judge Walrath have
shown a trend toward tighter judicial scrutiny including In re Astro Power, Inc. (stalking
horse’s combined costs and breakup fee limited to 3% of bid – February 2004); In re Epic
Capital Corporation (denial of breakup fee where other bidders willing to proceed
without one – February 2004); In re Top-Flite Golf (no breakup fee for stalking horse in
already competitive bidding situation).