Dealing with Corporate Distress 19: Buying & Selling Distressed Businesses in Bankruptcy: An Overview of Bankruptcy Code § 363

The ABCs of ABCs, Business Bankruptcy, & Corporate Restructuring/Insolvency

[Editors’ Note: The prior installment in this series discusses the various ways one can buy or sell a distressed company (and select assets thereof), with buying through bankruptcy but not under a chapter 11 plan being just one way. In this installment, the authors take a deeper dive into the bankruptcy option.]

Bankruptcy Code § 363

A 363 sale (a term derived from the Bankruptcy Code §363 authorizing the sale of assets) is often the preferred approach for buying and selling in a financially troubled situation.

The 363 sale process is quicker, and less expensive than buying pursuant to a chapter 11 plan and may be quicker (though usually more expensive) than buying under state law foreclosure law). It also certainly gives a purchaser greater certainty that the assets it acquires will be conveyed free and clear of liens and other interests.

Bankruptcy Code § 363(b)(1) provides that “[t]he trustee [which also includes a debtor in possession of its assets], after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate” (emphasis added). So, to be clear, a debtor in bankruptcy may continue selling goods or services in the ordinary course of business without seeking court approval but must get court approval to sell assets outside the ordinary course of business.

The Business Judgement Test

Although court approval is necessary to approve a sale outside of the ordinary course, the standard most bankruptcy courts apply in deciding whether to approve is the business judgment test. The result is that most sensible arms-length sales transactions are approved by bankruptcy courts.

A 363 sale can be a sale of a particular asset (or assets) or the sale of substantially all of the assets of a debtor as a going concern. While it is not required under the Bankruptcy Code, 363 sales are commonly conducted in the form of an auction. Sometimes this looks like a traditional auction in which an auctioneer accepts bids in a large room where bidders call out their bids. More commonly, in the business bankruptcy context, it begins with the hiring of an investment banker or other intermediary who conducts a controlled sale process over a period of weeks or months, though it often culminates in a traditional ‘open air’ auction (more on that below).

Many 363 sales are conducted with the debtor’s secured creditors’ blessing since the sale is designed to maximize the ultimate purchase price and return to such creditors. However, often a secured party (or other party with an interest in the assets being sold) objects to the sale. A bankruptcy court’s power to authorize sales free and clear of interests is a powerful tool that allows for the expeditious liquidation of property of the estate despite the existence of certain disputes, thus enabling the bankruptcy estate to realize the maximum value for its assets.

Executory Contracts

Bankruptcy Code § 365 permits a debtor to assume and assign to a purchaser most of its contracts if all defaults are cured, and the purchaser can provide the contract counterparty with “adequate assurance of future performance,” a standard that is relatively easy to meet. And, at the same time, this section permits ‘cherry-picking,’ meaning that a purchaser does not have to take contracts it does not want.

Certain contracts, however, may not be assumed and assigned in this way: Bankruptcy Code § 365(c)(1)(A) restricts the debtor from assuming or assigning an executory contract if applicable non-bankruptcy law would excuse the other party from accepting performance from, or rendering performance to, an entity other than the debtor. Examples include personal service contacts,¹ patent licenses,² and government contracts.³

363(f): Selling Free and Clear

Offering a purchaser clear title to assets is a critical component of maximizing the value of the estate’s assets purchase price. The Bankruptcy Code provides the bankruptcy court the power to order the sale of the assets free and clear of a lien or other interest on the assets, which it often does in the face of an objecting party.

In exchange for the sale of the assets free of an objecting party’s interest, that party is entitled to adequate protection of its interest, which commonly takes the form of a replacement lien on the proceeds of the sale.

Bankruptcy Code § 363(f) authorizes a trustee or debtor to sell property “free and clear of any interest in such property of an entity other than the estate,” but only if:

1. applicable nonbankruptcy law permits the 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.

The scope of the free and clear power is not entirely settled. In other words, what is, and is not, an interest is subject to some dispute. Most courts have construed the term broadly to encompass other obligations that may flow from ownership of property and have rejected the narrow approach under which the reach of Bankruptcy Code § 363(f) is limited to in rem property interests (such as liens or security interests) or only those claims that have already been asserted at the time the property is sold.⁴

The Sale Process Under Bankruptcy Code § 363

The 363 Sale process is flexible; it takes different forms depending on the facts and circumstances of the situation.

Most commonly, though, at least in the business bankruptcy context, assets are sold subject to auction.

We say “subject to” because it is common for the debtor (or chapter 11 trustee if the debtor is not a debtor in possession) in chapter 11 (and the chapter 7 trustee in chapter 7) to enter into an asset purchase agreement (“APA”) with a potential purchaser, with the APA explicitly permitting the debtor (or trustee) to try to solicit higher and better bids.⁵ The potential purchaser (the “Stalking Horse”) typically is committed to buying upon signing the APA. The seller’s (that is, the debtor or trustee) commitment, however, is subject to receiving higher and better bids. And if one is received, an auction will be held; if not, there is no auction (thus, why we say “subject to”).

Taking a step back, the 363 Sale process (at least in the context of a going concern sale or otherwise of substantially all of a debtor’s assets) commonly consists of up to six stages that generally occur in the following order:⁶

1. Pre-motion sales efforts
2. APA negotiation and execution
3. Seeking and obtaining approval of ‘bid procedures’ (also referred to ‘sale procedures’)
4. Post-bid procedure approval marketing efforts, executory contact diligence, and working with potential overbidders
5. Auction, if applicable
6. Sale approval hearing

Let’s look at them one at a time.

1. Pre-motion sales efforts

Nothing in the law prevents a company from marketing itself (or parts of itself) prior to filing a motion, and it is common. In fact, debtors commonly take themselves to market even before filing chapter 11.

2. APA negotiation and execution

It is also common for a debtor to negotiate and even execute an APA before filing a motion to sell its assets. The APA is typically binding on the purchaser; the debtor, however, commitment is always subject to bankruptcy court approval which, in turn, is commonly (but not always) contingent on making sure that the assets are exposed to the market with the hope of attracting competitive bidding. Most APAs in the chapter 11 context build in provisions by which the debtor agrees to seek from the bankruptcy court specific bid procedures pursuant to which the competitive bidding is to proceed. While much less common, in some cases, a debtor may seek bankruptcy approval of a sale process without an executed APA and purchaser “in hand.”

3. Seeking and obtaining approval of ‘bid procedures’ (also referred to ‘sale procedures’)

With an executed APA in hand, the debtor will typically move forward and file the motion seeking approval of the bid procedures that the APA delineates. If the court declines to approve the bid procedures contemplated in the APA then the purchaser (by the terms of the APA) typically has the right to walk away (or accept the changes to the sale procedure required by the court).

4. Post-bid procedure approval marketing efforts, executory contact diligence, and working with potential overbidders

The bid procedure, once approved by the court (and assuming they are identical to those in the APA or, if not, that the purchaser has waived its right to walk) will govern how the assets being sold will be marketed, for how long, what bid protections the purchaser under the APA (such protections are commonly referred to as stalking horse protections and the purchaser who enjoys them is commonly called the stalking horse), the actions potential competing bidders must take in order to qualify to bid, and similar matters.

The bid procedures will often contain a process for the ultimate purchaser (often the winning bidder if there is an auction) to choose the executory contracts and leases that must be assumed and assigned to it. This additional procedure includes a short time frame, after the court confirms the sale to a purchaser, for the purchaser to provide notice to the debtor or trustee of the executory contracts and leases it has selected. Once the executory contracts and leases are selected by the purchaser, the debtor or trustee will request the court (upon motion and notice to the applicable parties) to approve the assumption and assignment of such executory contracts and leases. In some cases, the assumption and assignment of certain critical executory contracts and leases are specifically addressed in the APA and may be assumed and assigned at the same time the sale to the winning bidder/purchaser is confirmed.

5. Auction, if applicable

The bid procedures will include a bid deadline. If no third party completes the actions that the bid procedures mandate a third party must complete by the bid deadline (for example: a signed conforming APA, earnest money deposit and/or evidence of financial wherewithal to close the transaction), then there will be no auction and the stalking horse. If there is an auction, the debtor has wide latitude (subject to what the bid procedures mandate and what local rules may mandate) to hold it in any way that is reasonable. The auction is typically conducted before a stenographer or is video recorded. Many bankruptcy auctions culminate in live open bidding, starting with the stalking horse bid. Then overbids are taken based on minimum bid increments (which are announced in advance and are often made a part of the court-approved sales procedures). Other auctions are sealed-bid auctions, with each bidder asked to provide the auctioneer with its bids in a sealed envelope. Yet others involve putting each bidder in a separate room, with the auctioneer shuttling between them. Many auctions use a combination of these approaches.

6. Sale approval hearing

There will typically be one more hearing after the auction (or the date the auction would have been had there been at least one qualified bidder). This hearing is when the debtor seeks court approval of the sale (as opposed to the bid procedures, which typically will have occurred in step #3).

The standard that bankruptcy courts generally apply is whether a sound business reason supports the sale, together with whether interested parties were provided with adequate and reasonable notice; the sale price is fair and reasonable; and the purchaser is acting in good faith.

Bankruptcy Code § 363(m) provides that a purchaser or lessee of property of the estate is protected from the effects of a reversal on appeal of the authorization to sell or lease so long as the purchaser acted in good faith and the appellant failed to obtain a stay of the sale.

As noted above, at the sale approval hearing, the court will often also be asked to approve the assumption and assignment of certain executory contracts and lease.

Following entry of the bankruptcy court’s order approving the sale to one or more successful bidders and subject to any further conditions to closing, the closing will occur.

Loan to Own / Credit Bidding Strategies

We’re not going to get into either of these more advanced topics in this article. We’ll simply say this: (a) senior secured creditors can bid the amount of their debt in 363 sales; (b) this means there is a viable strategy whereby a party interested in acquiring a company can do so by purchasing the secured debt of the company and then credit bidding; and (c) it is also possible to effectively acquire a company through a chapter 11 plan by purchasing unsecured debt. These are advanced topics that would make this article too long; to read more about them, we recommend:

• Restructuring for Reporters: What Does it Mean to be the “Fulcrum Security?”
• Limiting Credit Bidding in Section 363 Bankruptcy Sales Post-In Re Aéropostale, Inc.
• Meridian Sunrise Village: Risks of Loan-to-Own Strategy
• Dealing with Corporate Distress 09: All About “Claims” in Bankruptcy

The Stalking Horse APA – from the Stalking Horse’s Perspective

A well-drafted asset purchase agreement will set forth procedures and protections to the purchaser, including:

• That the bankruptcy court will first approve the sale process pursuant to a motion and agreeable form of Sales Procedure Order and will then enter an order approving the sale to the ultimate winning bidder/purchaser (if there is an auction). This allows a purchaser to lock in certain protections (i.e., See Bid Protections below) in the event there is an auction.
• That the purchaser can select the assets it wants to purchase and specify that it must take title “free and clear of liens, claims, and interests.” The purchaser can also specify any liabilities it has agreed to assume, if any. The bankruptcy court’s order that the sale is free and clear of all other liens, claims, and interests, allows the purchaser to better insulate itself against the risk of successor liability claims.
• That the sale and sale process are approved by order of the bankruptcy court upon notice and a hearing. Such orders afford officers and directors of the debtor protection from shareholders and creditors attacking the sale.
• That the purchaser can designate the assignment of certain executory contracts and unexpired leases as a part of the sale. Often the parties agree upon a process for the purchaser to pick certain contracts and leases to include in the sale.
• That the bankruptcy court’s order will contain a finding that the purchaser is a good faith purchaser, which finding can help defeat future challenges of the sale.
• Bid Protections: Most Stalking Horse APAs contain a very limited due diligence period and no financing contingency, but they often afford protections to the stalking horse bidder in the form of (a) bid increments (i.e., a minimum purchase price increase above the initial offer and the number of increases thereafter during the auction) and (b) break-up fees (an amount paid to the stalking horse bidder from the sale proceeds) and expense reimbursement in the event the stalking horse bidder is not the winning bidder at the auction.

It is typical for the bid procedures to require that any break-up fee or expense reimbursement be payable to a bidder at the closing and directly out of the sales proceeds (also free and clear of liens and interests). Combined break-up fees and expense reimbursements are typically limited to 3-4% of the purchase price (which is usually covered by the initial bid increment).

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[Editors’ Note: This article, while written to be read and understood on a standalone basis, is part of a series. To read Installment 1, which includes a table of contents and links to every article in the series, click here.

The authors are corporate restructuring and insolvency attorneys. Read more about them at the end of Installment 1.

To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

• Opportunity Amidst Crisis- Buying Distressed Assets, Claims, and Securities for Fun & Profit
• Representing Asset Purchasers in Bankruptcy
• Single Asset Real Estate Cases

©2023. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.]

1. E.g. In re Lil’ Things, Inc., 220 B.R. 583, 590-91, 32 Bankr. Ct. Dec. (CRR) 793, 40 Collier Bankr. Cas. 2d (MB) 54 (Bankr. N.D. Tex. 1998) (all courts agree that 365(c) applies to personal services contracts).
2. E.g. In re CFLC, Inc., 89 F.3d 673, 29 Bankr. Ct. Dec. (CRR) 520, 36 Collier Bankr. Cas. 2d (MB) 297, 39 U.S.P.Q.2d (BNA) 1518 (9th Cir. 1996) (federal patent policy warrants finding that federal law governs assignability of patent licenses; federal common law precludes such assignments).
3. E.g. Matter of West Electronics Inc., 852 F.2d 79, 18 Bankr. Ct. Dec. (CRR) 287, Bankr. L. Rep. (CCH) ¶ 72351, 34 Cont. Cas. Fed. (CCH) ¶ 75526 (3d Cir. 1988) (government contract could not be assigned because a federal statute barred the assignment of such contracts without the permission of the government).
4. See In the Matter of Motors Liquidation Co., 829 F.3d 135 (2nd Cir. 2016); In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003); UMWA 1992 Benefit Plan v. Leckie Smokeless Coal Co. (In re Leckie Smokeless Coal Co.), 99 F.3d 573 (4th Cir. 1996); Precision Industries v. Qualitech Steel SBQ, 327 F.3d 537, 545 (7th Cir. 2003) (The Code itself does not suggest that ‘interest’ should be understood in a special or narrow sense; on the contrary, the use of the term ‘any’ counsels in favor of a broad interpretation).
5. While not specifically required under the Bankruptcy Code, most sales of substantial assets involve an auction or some opportunity for the debtor/trustee to accept a higher and/or better bid. This process helps the parties show that the assets are being sold for their full value and that the sale is in the best interest of the bankruptcy estate. In addition, an auction process will help the bankruptcy court to enter a finding in the ultimate order approving the sale that the assets were sold at a “fair and reasonable” price, which may insulate a purchaser from fraudulent transfer attacks by creditors.
6. Many articles speak of the process consisting commonly of two stages. See, e.g The Legal Considerations of Acquiring Distressed Businesses: A Primer by James H.M. Sprayregen and Jonathan Friedland, 11 Journal of Bankruptcy Law and Practice 3 (November/December 2001). While this is not wrong, 20+ years later, we think it is easier to understand the typical 363 Sale of substantially all of a debtor’s assets by breaking the two stages many commentators speak of into six smaller parts.