When a company faces financial distress and seeks to sell its assets, both the seller and the buyer may prefer to implement the transaction through a Section 363 sale in a Chapter 11 bankruptcy case of the seller. A Chapter 11 sale process provides certain protections to the buyer from fraudulent transfer and other claims of the seller’s creditors, and a seller may be able to maximize the purchase price of its assets through a Section 363 auction process.
But even before the COVID-19 crisis, Section 363 asset sales also came with disadvantages. The Chapter 11 process can be costly, and it does not scale down well for transactions with lower purchase prices. In addition, a Section 363 sale can take several months to implement after the filing of the Chapter 11 case, and that time can also be costly in terms of the seller’s operating costs and the potential diminution in value of the seller’s assets while its Chapter 11 case runs its course. And for a buyer, even where it is a “stalking horse” purchaser with a breakup fee and other bidding protections, a Section 363 auction may invite competition for the seller’s assets that the buyer would prefer to avoid.
In the face of the COVID-19 crisis, when a greater level of financial distress among companies is anticipated, the balance of factors that may push buyers and sellers toward or away from a Chapter 11 sale process may shift. For reasons of risk tolerance, court access, and time and cost, buyers and sellers may be more likely to attempt non-bankruptcy distressed asset sales as a result of the crisis. Here we explore these reasons and analyze why they may cause sellers and buyers to favor out-of-court transaction options such as private sales, Article 9 secured party sales and sales by assignees for the benefit of creditors.
1. Risk Tolerance. Often, buyers and sellers will look to consummate a sale of assets through Chapter 11 because of the advantages afforded by the Bankruptcy Code. Most notably, Section 363 of the Bankruptcy Code allows a buyer to purchase assets “free and clear” of the seller’s exiting liabilities and certain types of successor liability claims. This gives buyers comfort that, even in the absence of extensive diligence, they will be able to realize the value of the assets without being saddled with attendant liabilities. In addition, because bankruptcy sales are accomplished through a bidding and auction process that ensures a market test of the purchase price, and because they are ultimately approved by the court, they insulate a buyer from fraudulent transfer claims by the seller’s creditors. A bankruptcy sale may also offer advantages with respect to the seller’s contracts, potentially allowing the buyer to take assignment of those contracts notwithstanding restraints on assignability that outside of bankruptcy would prevent assignment without the counterparty’s consent.
While not all of these advantages can be replicated exactly in an out-of-court sale, buyers and sellers can take steps to achieve many of the same results and otherwise minimize risk. For example, buyers can overcome concerns about assuming the seller’s liabilities by conducting robust diligence to understand the scope of those liabilities and, in some cases, implementing an escrow to limit their total exposure. Concerns about contract assignment can often be addressed by engaging directly with counterparties to obtain consents where needed. This typically works better when there is a limited universe of contracts that do not depend on a particular expertise of the seller, but given the economic disruption occasioned by COVID-19, contract counterparties may be more flexible in consenting to assignments, lest they be saddled with unprofitable contracts and the prospect of having those contracts dealt with in a seller’s bankruptcy case.
A robust marketing process for the assets can also be helpful in mitigating risk by market testing the sufficiency of the ultimate purchase price. But there are other mechanisms to mitigate fraudulent transfer concerns as well, including obtaining solvency opinions (concerning the seller’s solvency) and fairness opinions (concerning the fairness of the consideration). These sorts of opinions are not a panacea—and sometimes give rise to litigation—but they can be helpful in defending against future challenges, particularly in less unique transactions. Sellers, and especially their directors and officers, may take comfort from these same mitigation measures given their fiduciary duties to maximize the value of the enterprise for stakeholders. While a buyer in an out-of-court sale may not receive the same sorts of stalking horse protections as it might in a Chapter 11, it may also benefit from the absence of a convenient forum for potential challenges by other parties (like creditors’ committees, the US Trustee and other organized groups of the seller’s creditors) and from a decreased risk that it will be outbid on the eve of consummating the transaction.
2. Court Access. The COVID-19 crisis has the potential to generate a dramatic increase in Chapter 11 filings in the near term—both by causing financial distress or liquidity constraints in previously healthy companies and by accelerating Chapter 11 filings of companies that were already experiencing distress. This anticipated wave of Chapter 11 filings, combined with a surge in consumer and small-business filings, could strain the capacity of the bankruptcy courts to provide expeditious relief.1 Prepackaged bankruptcies may be a viable solution in some scenarios, but they generally are not helpful in facilitating asset sales, which require a court-approved bidding and sale process in accordance with timelines mandated by the Bankruptcy Code and Bankruptcy Rules.
While out-of-court sales may not offer all the potential benefits that come with Chapter 11 sales, they also do not require access to the bankruptcy courts. This, along with other factors, may prompt sellers and buyers to consider these alternatives more seriously than they otherwise might have before the COVID-19 crisis.
3. Time and Cost. The typical timeline for a Chapter 11 Section 363 sale can be in the range of 55 to 75 days if everything goes according to plan. While bankruptcy courts will sometimes allow parties to deviate from the timelines established by the Bankruptcy Code and Rules, that is not guaranteed, and it is uncommon for the process to be shortened considerably. While in prior economic crises courts approved sales on dramatically expedited timelines (e.g., the GM sale of 2008) because of the extraordinary circumstances present in those cases, it is not yet clear whether and how the courts, or Congress, may adjust the historic Section 363 process for this crisis.
Chapter 11 sales also impose significant costs, in part due to extended timelines, during which the seller must be able to continue funding its operations, and in part due to the additional costs imposed by the Chapter 11 process (e.g., professional fees, creditors’ committee fees, US Trustee fees). These high costs and longer periods of time required to effect Chapter 11 sales can be cut back in out-of-court transactions. Even with appropriate marketing efforts, the timeline for an out-of-court sale may be substantially shorter than the Chapter 11 timeline. Indeed, Chapter 11 sale processes are often commenced after a robust pre-bankruptcy marketing process in any event, and therefore the post-filing marketing period may be incremental to what would occur in an out-of-court scenario. Chapter 11–specific advisor fees and expenses, for all parties, can also be avoided in out-of-court transactions. Also, the time saved in an out-of-court process, especially if the courts are not proceeding at their usual capacity, will provide cost savings and, in some cases, savings in reduced diminution of asset value. However, if the seller is a public company or otherwise requires shareholder consent or other consents that are difficult to obtain and may not be required in a Chapter 11 transaction, the Chapter 11 option may nevertheless be the fastest and cheapest on an overall basis.
When these reasons cause buyers and sellers to pause before moving ahead with a Chapter 11 asset sale strategy, there may be alternative transaction paths. For some sellers, privately negotiated sales with no special legal process may be possible. Certain buyers may be willing to take the risks that these sales pose, given the potential advantages, especially in time, cost and potentially price.
For sellers with secured debt that is in an amount in excess of the value of the assets being sold, the parties may be able to implement secured party sales under Article 9 of the Uniform Commercial Code, in cooperation with the seller’s lender. Or, a seller may choose to make an assignment for the benefit of creditors under state law, and a buyer may be able to purchase the assets from the seller’s assignee in that “ABC” proceeding. An Article 9 or ABC sale may make available risk mitigation measures that are similar to, if certainly not as robust as, the measures available in a Chapter 11 Section 363 sale.
In sum, the choice of a process for the sale of assets by a financially distressed seller always involves a balancing of factors that may or may not favor a Chapter 11 filing and a Section 363 sale. That balancing is likely to play out differently in the months ahead, and buyers and sellers should be aware of the difference that the current environment may make in how their analysis in this area proceeds.
This analysis is fact-intensive and requires consideration of multiple factors. Please reach out to the authors listed or to your regular contact at WilmerHale if you have questions or to analyze your company’s particular situation and make the decision best suited to your goals.