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March 05, 2015 Articles

What Should You Consider When Purchasing Distressed Assets?

Be aware of the pitfalls and benefits before venturing down this path.

By Christopher A. Ward

Purchasing distressed assets has become a niche industry in recent years. Whether you are looking at distressed assets as a strategic investment to enter a new market or you are trolling distressed assets in the hope of finding that hidden gem that can be turned around and sold at a profit, a potential purchaser must be aware of all the potential pitfalls and benefits of purchasing distressed assets before venturing down this path.          

Section 363 of Chapter 11 of Title 11 (the Bankruptcy Code), among other benefits, allows a debtor or trustee to sell substantially all assets free and clear of all liens, claims, and encumbrances. While this is typically a main driver for purchasers of distressed assets, Chapter 11 is not the only available means to accomplish such a sale, although it is clearly the safest and least likely avenue for attack when undertaking the purchase of distressed assets. Let’s take a look at the key advantages and potential disadvantages for the purchase of distressed assets both in a section 363 sale and the available alternatives to such a sale.

Key Advantages of a Bankruptcy Section 363 Sale
The Bankruptcy Code contains several provisions that benefit purchasers of distressed assets. The most highly publicized is the speed at which a transaction may be conducted. However, an asset purchase can be conducted even faster on less notice away from the bright lights of bankruptcy. Therefore, a purchaser needs to look at the other advantages of Chapter 11.

First and foremost, section 363(f) of the Bankruptcy Code will provide a purchaser with an order transferring title of the assets free and clear of all liens, claims, and encumbrances. While other non-bankruptcy alternatives may get you a court order with this same relief (e.g., an assignment for the benefit of creditors in certain jurisdictions or a full court order in a receivership), section 363(f) is the primary (if not only) statutory provision that provides an order with teeth if you are ever confronted with successor liability, fraudulent transfer, or piercing-the-corporate-veil claims. Under certain circumstances, 11 U.S.C. § 363(f) will allow a debtor to sell its assets against a competing claim or objection with that contested claim or objection attaching to the proceeds of the sale. In a situation where any of these potential causes of action or contested claims may be in play, bankruptcy is likely your best option as any properly drafted sale order will contain a “good faith” purchaser finding pursuant to section 363(m).

The right to assume and assign unexpired leases of nonresidential real property and executory contracts under section 365, even if such contracts have anti-assignment provisions, is a clear advantage that can be found only in bankruptcy.

In addition, an official right to credit-bid pursuant to section 363(k) exists for the secured lender in bankruptcy, either in a section 363 sale or in a sale pursuant to a Chapter 11 plan. While there is a school of thought that this right to credit-bid exists outside bankruptcy, the Bankruptcy Code codifies this right for the secured lender.

Disadvantages to Bankruptcy Section 363 Sale
As mentioned, bankruptcy sales may happen very quickly, often to the advantage of the seller, buyer, and lender. But this speed may also be challenged by disgruntled creditors or other parties in interest. However, even the quickest of bankruptcy sales for mid-market companies typically take 45–90 days to complete. Compare this with a private sale under Article 9 of the Uniform Commercial Code, where a sale can be accomplished in a reasonable period of time, which reasonable time is far less than most section 363 sales (sans GM, but that’s a different story). It is also difficult to opine on the speed at which a bankruptcy sale will proceed because it is typically a two-step process. First, the bidding procedures to market the assets must be approved. Second, the sale itself must be approved by the court. And a debtor and purchaser must deal with other constituencies in a bankruptcy case, including an official committee to the extent one is present. These situations may delay any thought of a quick, and uncontested, section 363 bankruptcy sale.

Bankruptcy is also an open and public process, which leaves sales open for attack. A debtor must file all of its financial information in the public realm. In addition, a sale of substantially all of a company’s assets is typically done in an auction, and it will be unlikely that the sale can be accomplished in a private sale because the assets will be subject to a competitive bidding process, which may be avoided in other alternatives.

Alternative Forums for the Purchase of Distressed Assets
Chapter 11 has its distinct advantages and disadvantages for purchasers of distressed assets. But it is clearly not the only available forum to conduct such purchases. As mentioned, a secured lender can use Article 9 of the Uniform Commercial Code to conduct what is colloquially referred to as a “friendly foreclosure.” In sum, after a reasonable notice period under Article 9, the secured lender can foreclose on a company’s assets through either a public or private sale. A private sale can be accomplished in a very tight window (e.g., as short as 10 days).

In addition, a purchaser interested in a distressed company’s assets that are the subject of dispute or infighting among the owners or creditors of the company can suggest that one of the aggrieved parties seek to have a receiver appointed over the company to liquidate the company’s assets. This avenue may alleviate any future contest by the aggrieved parties that the sale was not at arm’s length and on reasonable business terms because a receiver will act as an independent fiduciary for the company in liquidating its assets.

Finally, an assignment for the benefit of creditors (ABC) is an available option for the liquidation and sale of a company’s assets. ABCs have court supervision in certain jurisdictions (e.g., Delaware and New Jersey) and are merely statutory in other jurisdictions (California). In an ABC, all of the assets of a distressed company are transferred to an independent third-party assignee who then liquidates the assets for the benefit of the company’s creditors. A sale can be accomplished either in the ABC or immediately prior to the ABC with the purchaser taking the assets and the assignee receiving the sale proceeds and liabilities of the seller, distressed company. ABCs are typically faster and cheaper than a Chapter 11 case and are a viable alternative for a purchaser under the right circumstances. However, ABC sales may not provide the certainty of a section 363 sale for a potential purchaser of assets.

Being the Stalking Horse
Regardless of the avenue selected to purchase distressed assets, other than a “friendly foreclosure” for a secured lender under an Article 9 private sale, a purchaser of distressed assets should consider serving as a “stalking horse bidder” during the process. The stalking horse is an interested buyer of a debtor’s assets that agrees to certain incentives or protections from the debtor in order to be the initial bidder for the assets. As the initial bidder, the stalking horse bidder sets the “minimum” floor for the assets and generally the other terms of the sale and bidding and auction process by the drafting of the initial asset purchase agreement.

Because the stalking horse bidder is vulnerable to higher and better bids in a bankruptcy auction and ultimately may not be the winning bidder, both the debtor and the initial bidder have an incentivize to negotiate stalking horse protections. Such protections afford the initial bidder with compensation for its fees and expenses associated with due diligence, negotiations, and the sale process, and for the risk of missing other opportunities during the bidding and sale process. Sellers of distressed assets, both in bankruptcy and its out-of-court alternatives, typically demand these types of protections and incentives to encourage initial bids (when competing bids do not exist) and to obtain a strong initial bid and floor price for an auction. The common school of thought is that having a stalking horse bidder will promote competitive bidding and maximize the value of the assets.

Bidding Protections
The primary advantage to serving as a stalking horse bidder is the ability of the purchaser to insulate its exposure through certain bid protections. These bidding protections can include the following:

  • breakup fees (typically 3 percent of proposed purchase price)

  • expense reimbursement (including professional fees)

  • minimum overbids and bid increments

  • bidder prequalifications

  • financial wherewithal of other bidders

  • bid qualifications

  • drop-dead bid deadlines

  • equivalent good-faith deposits

  • rights of first refusal

  • approval of changes to bid procedures

  • deadlines for court approval of bidding procedures and sale

  • no shop provisions

  • debtor-in-possession or alternative financing

A purchaser of distressed assets will want to evaluate all of its options when determining the best restructuring alternative to effectuate the purchase. While section 363 of the Bankruptcy Code has numerous advantages for both the seller and the purchaser of distressed assets, bankruptcy is not the only option available. Depending on your relationship with the debtor, potential claims against the debtor, and financial wherewithal, there may be more cost-efficient avenues available, including ABCs, an Article 9 “friendly foreclosure,” or the appointment of a receiver. Each alternative has its own pitfalls and potential windfalls. Purchasers of distressed assets should be aware of each alternative and weigh the timing, cost, and risk of litigation in each alternative before determining the best means by which to purchase distressed assets.

Keywords: bankruptcy and insolvency litigation, distressed assets, section 363, Article 9, stalking horse, bid protections

Christopher A. Ward – March 5, 2015