The COVID-19 pandemic and the drastic measures taken in an effort to mitigate its adverse impact have sent shock waves throughout the US and global financial systems. COVID-19 and related measures including travel bans, shelter-in-place orders and widespread business closures have caused precipitous changes in customer spending and demand, supply chain disruptions, sharp declines in revenue, and other operational issues across a wide range of economic sectors. Businesses worldwide now confront unprecedented and mounting challenges and distress.
As in prior periods of economic distress, vanishing earnings and cash flows, as well as crunched credit and equity markets, are leading to payment and covenant defaults under debt obligations. In an attempt to stem the rising tide of defaults, the US government has committed trillions of dollars in business stimulus programs intended to provide liquidity and maintain the flow of credit to companies and individuals affected by the COVID-19 pandemic. However, for a significant number of businesses, such aid is proving insufficient to weather the current economic storm. Consequently, lenders and landlords are coping with a deluge of requests from borrowers and tenants for forbearance arrangements, waivers, and amendments to existing facilities.
This increasing economic turmoil will undoubtedly result in a dramatic rise in bankruptcy filings over the coming months and a concurrent increase in distressed M&A activity, including asset sales under Section 363 (“Section 363”) of the United States Bankruptcy Code (the “Bankruptcy Code”). For many strategic purchasers and private equity firms with relatively strong cash positions, the new wave of Section 363 auctions will present significant opportunities to purchase assets at discounted prices. Section 363 sales also offer purchasers protections that are generally not available outside of a bankruptcy context.
This update provides an overview of the Section 363 sales process and outlines key advantages and risks for prospective purchasers in distressed asset sales under Section 363, including COVID-19-specific implications.
Section 363 Sale Process
A typical Section 363 sale process begins with the debtor’s professional advisors (i.e. investment bankers, brokers, and/or consultants) marketing the target assets to potential purchasers to identify a “stalking horse bidder”—the bidder submitting the highest and best initial bid. The stalking horse bid sets the floor price for the assets to be sold at a subsequent bankruptcy auction.
The timing of execution of the stalking horse asset purchase agreement (“APA”) and auction bid procedures varies. Large publically traded companies usually attempt to finalize the stalking horse APA and bid procedures prior to filing for bankruptcy protection, whereas middle market companies often undertake some of these steps after the bankruptcy filing. It is not uncommon for small companies to file for bankruptcy protection and seek approval of bid procedures prior to identification of a stalking horse bidder. Regardless, the debtor must provide creditors with 21 days’ advance notice of the bankruptcy court hearing seeking approval of the stalking horse APA, the bid procedures, and the sale process. If creditors or other parties-in-interest object during the notice period, the bankruptcy court will decide whether the contemplated sale is in the debtor’s best interest.
Following bankruptcy court approval of the bid procedures, the debtor’s professional advisors will solicit higher and better offers. To the extent the debtor receives competing bids that satisfy all requirements, the debtor’s professional advisors or the bankruptcy court will conduct a formal auction. After completion of the auction, the debtor will seek bankruptcy court approval of the sale to the winning bidder. As part of the approval process, all the transaction documents are submitted to the bankruptcy court for review and approval. The sale transaction typically closes shortly following entry of the bankruptcy court’s sale order and the expiration of any applicable stay period. Moreover, to the extent that the bankruptcy court makes a finding that the successful bidder at the auction is a good faith purchaser, any appeal seeking to challenge the sale is statutorily moot.
There are both pros and cons to acting as the stalking horse bidder. Key among the potential disadvantages is that, after being selected in the initial auction process as the winning bidder, and investing significant time, effort, and money in diligence and purchase agreement negotiations, the stalking horse bidder may be outbid by higher and better offers at the public auction stage of the process prior to the bankruptcy court’s approval of the sale. Some potential purchasers accordingly will prefer to refrain from participating in the process until the bankruptcy auction stage and make a topping bid, piggybacking on the efforts of the stalking horse (though a purchaser that decides to “wait and see” will bear risks associated with a less thorough diligence investigation).
In terms of benefits, as noted above, the stalking horse’s bid will set the floor price, and the debtor and the stalking horse bidder will negotiate the terms of the APA, which will then serve as the standard form of APA that other bidders may be required to conform their offers to when submitting bids. The stalking horse bidder will also have a role in negotiating the bankruptcy bid procedures which will set the timelines for the auction schedule, including marketing, due diligence, and bid deadlines (often 60 to 90 days after bankruptcy court approval of the bid procedures). Stalking horse bidders are often able to negotiate break-up fees (commonly between 2% and 3% of the transaction value) to cover anticipated due diligence and professional fee expenses in the event that the stalking horse bidder is not the successful bidder at auction and overbid amounts. Stalking horse bidders also have more time to complete due diligence than potential purchasers who wait to engage a debtor until formal bid procedures are established.
Advantages of Section 363 Sales
While Section 363 sales require compliance with the formalities of the bankruptcy process and can be more time intensive and costly than non-bankruptcy sale transactions, asset sales under Section 363 provide significant advantages and protections that are not otherwise available to purchasers outside of the bankruptcy context.
One key attractive feature of Section 363 sales for purchasers is that, with limited exceptions, the purchaser can acquire the assets of the business “free and clear” of liens, claims, and encumbrances, and, in some instances, creditors can be enjoined from asserting successor liability claims against the purchaser. Further, to the extent that a creditor attempts to assert claims against a Section 363 sale purchaser, the purchaser may be able seek protection from the bankruptcy court. The ability to purchase assets “free and clear” may prove extremely attractive to potential purchasers in the COVID-19 market who are faced with an entirely new set of diligence risks and a myriad of actual and potential impacts that the pandemic has had and may have on the assets or business subject to the sale. Moreover, COVID-19 quarantine orders, travel restrictions, and social distancing protocols will further impair the ability of potential purchasers to conduct due diligence. Potential purchasers should begin exploring new methods and processes for conducting efficient and comprehensive legal and financial diligence investigations of likely targets.
In addition, sales by a corporation of all or substantially all of its assets, when accomplished outside of bankruptcy, necessitate majority stockholder approval, whereas stockholder consents to a sale are not required in the Section 363 context, although stockholder approvals of the bankruptcy filing may be required under the corporation’s charter or other contractual arrangements.
Further, asset sales outside of the bankruptcy context generally require a number of contractual counterparty consents, which may be even more difficult to obtain while third parties are displaced due to office closures and addressing their own business needs in the face of COVID-19.1 In contrast, purchasers of assets pursuant to Section 363 sales are able to take assignment of most executory contracts and unexpired leases pursuant to Section 365 of the Bankruptcy Code notwithstanding most contractual restrictions on assignment. This is a significant differentiator because purchasers in private M&A and other non-bankruptcy transactions cannot compel contractual counterparties (including customers, suppliers, and lease parties) to consent to the assignment of contracts and leases, thus forcing purchasers into a series of one-off negotiations that can be costly and time-consuming. Likewise, debtors and purchasers in Section 363 sales are able to negotiate the rejection of burdensome contracts.2 The ability to “cherry pick” contracts with favorable terms and reject contracts for which better terms can be obtained will be particularly valuable to many purchasers in light of current market upheaval.
Purchasers of assets in the Section 363 sale context are also protected from fraudulent conveyance claims by creditors (i.e., claims that the sale was made with an intent to hinder, delay, or defraud creditors, or for less than “reasonably equivalent value”).3 Whereas, purchasers of assets in private M&A transactions, particularly those involving distressed assets, face greater risks from fraudulent transfer claims, which, whether or not successful, can be costly for purchasers as a result of litigation- and settlement-related expenses. Parties in the private M&A context can obtain solvency opinions (if applicable) and fairness opinions to help mitigate the risk of fraudulent conveyance claims, but these alternatives are not as protective as a bankruptcy court order approving a Section 363 sale.
Purchasers of assets in private M&A and other non-bankruptcy transactions also face heightened risk in that the underlying purchase agreement, or related contracts, such as transition services agreements, could be rejected in a pre- or post-closing bankruptcy, leaving the purchaser with an unsecured claim for damages in respect of unfulfilled obligations—a fate that can be prevented with a Section 363 sale. Similarly, post-closing purchase price adjustment and similar payments contracted for in a non-bankruptcy sale context may be subject to clawback in a subsequent bankruptcy filing. Particularly for purchasers concerned about the solvency of the seller and the impact that the rejection of transaction agreements containing seller obligations would have on the value of the acquired assets, these are significant risks that make the Section 363 sale process an attractive alternative to private acquisitions of distressed assets outside of the bankruptcy context.
Finally, the bankruptcy automatic stay helps protect the going concern value of the target by preventing a counterparty from terminating contracts essential to the operation of the business.
Disadvantages of Section 363 Sales
Although Section 363 sales offer many protections to distressed asset acquirers, potential purchasers and sellers should be aware of attendant drawbacks as well, including new COVID-19 related considerations.
For example, a number of contractual protections that a purchaser typically obtains in a private non-bankruptcy driven M&A transaction are unavailable or significantly limited in Section 363 sales (and other distressed transactions involving a seller in the zone of insolvency). For instance, in a Section 363 sale, assets are often sold “as is, where is,” and asset purchase agreements contain a significantly scaled back set of representations and warranties, which usually terminate at closing. Though representations and warranties ("R&W") insurance can help bridge this gap, such coverage may not cover COVID-19 issues, as most R&W insurers have begun stipulating at least some degree of exclusion relating to COVID-19 exposures.4
Section 363 sale purchasers also typically have limited indemnification rights with little or no escrow holdbacks (and only to the extent approved by the bankruptcy court). While R&W insurance can blunt to some extent the limited indemnification, it will not provide coverage for “known” or otherwise disclosed potential liabilities. Due to the relative lack of post-close remedies for a purchaser in a Section 363 sale, even greater stress is placed on the purchaser’s due diligence investigation to uncover issues which can be priced into their offer prior to signing an APA. Further, APAs in Section 363 sale transactions typically contain few closing conditions beyond certain regulatory5 or licensing approvals, so purchasers have much less wiggle room to attempt to walk away from a deal post-signing. Moreover, purchasers in Section 363 sales typically must pay all cash at closing, thus preventing the use of deferred/contingent consideration or earnouts. In addition, the existence and terms of a Section 363 APA and transaction are made public, which can result in an unwanted spotlight on a purchaser and the distressed nature of the target business (though perhaps less of a reputational hazard in the current economic environment given that so many businesses are similarly situated).
Another key reason that potential purchasers may prefer a private sale outside of bankruptcy to a Section 363 sale process is the heightened execution risk inherent in the Section 363 sale context, including risk as a result of stakeholder and other third party challenges and interference in the process which can significantly delay and negatively impact the value of the transaction.
Although bankruptcy courts generally have remained open during the COVID-19 crisis (as discussed here), transaction parties must adapt to the new normal of telephonic and/or video conference hearings, as many bankruptcy courts have suspended in-person hearings for health and safety reasons. Moreover, bankruptcy courts have greatly reduced evidentiary hearings. These changes have impacted the efficiency of bankruptcy courts and may result in backlogs when bankruptcy courts resume normal operations. Further, the expected increase in bankruptcy filings across all industries and sectors of the economy will likely result in additional backlog. As such, M&A participants in Section 363 sales should expect to encounter at least somewhat costlier and lengthier sale processes as compared to pre-COVID-19 scenarios. For some purchasers and sellers, the potential delays may necessitate additional consideration of out-of-bankruptcy alternatives given the need for expediency to preserve going concern value of a “melting ice cube.” It remains to be seen what other changes to the Section 363 sale process may lie in store in light of the COVID-19 pandemic.
In the new economic reality brought on by the COVID-19 pandemic, businesses are facing unprecedented challenges, and many will seek bankruptcy protection. For capital-rich purchasers, Section 363 sales inevitably will present interesting opportunities to acquire attractive assets at significantly reduced valuations. While potential purchasers will want to consider the range of available acquisition strategies (including out-of-court asset sales, Article 9 sales, sales following an assignment for the benefit of creditors, and sales pursuant to a Chapter 11 plan of reorganization) with their professional advisors, the Section 363 option can certainly offer value to purchasers.
1 Given the widespread economic distress caused by COVID-19, however, counterparties may be more inclined to provide consents if doing so could enhance the value to be obtained by them through the sale or preserve a beneficial contractual relationship that might otherwise be rejected if the seller files for bankruptcy.
2 Exceptions include contracts pursuant to which the non-debtor counterparty would, under applicable non-bankruptcy law, be excused from accepting performance from a person or entity other than the debtor, including personal service contracts and government contracts. Note also that, based on recent US Supreme Court case law, a third party’s continued right to use licensed intellectual property may survive a debtor’s rejection of a trademark license.
3 The statutes of limitations on fraudulent conveyance claims can be as long as six years and can be extended even longer by subsequent bankruptcy filings.
4 Bill Monat, The impact of COVID-19 on representations & warranties insurance coverage: Transactional insurance solutions update, (April 16, 2020) https://www.willistowerswatson.com/en-US/Insights/2020/04/the-impact-of-covid-19-on-representations-and-warranties-insurance-coverage (last visited April 28, 2020).
5 Of note, the waiting period for Hart Scott Rodino Act filings is shortened to 15 days (from the usual 30 days) in the Section 363 sale context.