Credit Default Swaps – those largely unregulated “side bets” over the likelihood of specific companies defaulting on one or more of their credit obligations, which were all the rage during the beginning of the decade - have become, in light of the 2008 financial crisis, “the financial instrument that scholars, journalists, government officials and even some prominent financiers love to hate.”

The problematic impact of CDS’s on firms in financial distress – and their separate treatment under existing securities “safe harbors” in the US Bankruptcy Code – have likewise provoked further commentary and calls for reform from the insolvency community (some of which has been covered in various posts on this blog, and which is summarized here).

But despite the furor over much-maligned CDS’s, not everyone is casting aspersions.

Last week, Seton Hall’s Michael Simkovic and Davis Polk’s Benjamin Kaminetzky released a paper arguing that CDS pricing at the time of a credit event (such as a loan made in connection with an LBO) can – when combined with other market information about a company’s debt securities – provide important indicators of a company’s solvency at the time of that transaction.

Though it requires 58 pages (plus 12 pages of appendices) to develop, Simkovic’s and Kaminetzky’s basic premise is relatively simple:

Fraudulent transfer analysis is too often susceptible to manipulation by self-interested experts, and too prone to after-the-fact “second guessing” by bankruptcy courts, to be consistently reliable and predictable.  Efficient securities markets are the best contemporaneous guides to the solvency of a debtor with publicly traded debt.  As a result, bankruptcy courts attempting to determine the solvency of a debtor at the time of an alleged fraudulent transfer should use contemporaneous credit-market data as a (or as the) key indicator of the debtor’s solvency.

 The idea is more than an abstract concept: Simkovic and Kaminetzky cite two relatively recent decisions in which bankruptcy courts applied public-market analysis to determine the debtor’s solvency and the resulting avoidability of a fraudulent transfer, each using equity market valuations contemporaneous with the time of the transfers.  Simkovic and Kaminetzky extend this approach, arguing that credit-market instruments and their derivatives – such as credit yield spreads and CDS pricing - provide a more reliable indication of solvency than the debtor’s equity.

The idea of employing public market data is of limited use in cases where the debtor is closely held – or where public credit-market data is not readily available.  But Simkovic’s and Kaminetzky’s research represents yet another recent and important effort by scholars to impose greater uniformity and predictability on the question of whether a debtor is – or has become – insolvent as a result of a pre-bankruptcy transfer for less-than-equivalent value (for another approach to the same general problem, see an earlier post here).

In light of the extensive, highly-leveraged financing that took place between 2004 and 2007 – and the correspondingly high anticipated default rates when that same debt matures over the next several years – Simkovic’s and Kaminetzky’s work also renews the focus on an important question, directly relevant to any inquiry into an alleged fraudulent transfer:  

What did the participants in an allged fraudulent transfer – and all of those responsible for due diligence regarding that transfer – believe about the debtor’s present or resulting solvency at the time the transfer was made?  And what (if anything) was the basis for their belief?  

As the economy lurches forward into an uncertain back half of 2010, the DIP lending market remains in flux.  In a short piece appearing in the Journal of Corporate Renewal last Wednesday, Imran Choudhury and Frank Merola – both of Jeffries & Co., Inc. - offer a concise overview of the factors affecting credit availability and expense over the last two years.

After a sharp contraction in 2008, Choudry and Merola show how DIP funding has increased – both in terms of deal size and in terms of new money . . .

and likewise, how spreads have eased during the same period . . . .

Their walk-away, in light of this data:

“The overall state of the DIP financing market has changed over the last couple of years as the broader credit markets have changed. Lower yields due to improvements in the overall credit markets have resulted in lower rates in the DIP loan market as well.

While it is difficult to say precisely what DIP yields will be over the next year or so, it seems very likely that the worst part of the credit cycle is over and DIP yields are not going to reach the same levels as they did in late 2008 and early 2009. Even though yields on DIP loans are not at their peak levels, the loans will still likely be used for . . . strategic reasons—protecting existing debt positions or controlling restructuring processes or acquiring assets through credit bids.”

It is perhaps stating the obvious that Chapter 11 of the US Bankruptcy Code offers a well-known and very flexible means of extracting the most value from distressed assets.  But in these economic times, it is worth remembering that Chapter 11 is by no means the only avenue for addressing insolvency – nor is it always the best . . . or most appropriate.

Bankruptcy (or “Section 363”) sales have been a time-honored and tested means of moving distressed assets quickly and cost-efficiently from buyer to seller.  But the lack of credit necessary to fund the transition period required for such sales during the recent downturn, combined with a handful of recent appellate decisions which cast doubt on the validity of contested sales, serve as reminders that other transactional structures sometimes work just as well – or even better.

The folks at Turnaround Management Association (TMA) released a spate of articles last week which illustrate the point: Two of TMA’s pieces (one on ABC’s and Receiverships and one on alternative sale structures for distressed acquisitions) compare and contrast federal bankruptcy proceedings with other means of optimizing the transfer of distressed assets. A third focuses on “strict foreclosures” (or “Article 9 sales”).

All three are well worth a read.

The Advisory Committee on Bankruptcy Rules of the Administrative Office of the U.S. Courts has pulled back from its earlier position on the disclosure required of hedge fund and other distressed debt investors participating as ad hoc committees or other, loosely organized creditor groups in Chapter 11 cases.

An earlier version of proposed amendments to Federal Rule of Bankruptcy Procedure 2019 would have required such investors to disclose the dates and prices paid for their purchases of distressed securities.  These changes were resisted by investor groups such as the Loan Syndications and Trading Association, and created some press coverage last year (an earlier post on the amendments is available here).

That said, investors will still be required to reveal the “disclosable economic interest” they each hold in a company, including debt and derivatives. This includes the identity of specific investors and the date such investors acquired their interests.

Morever, Committee notes to the proposed rule indicate that the previously-contested disclosures of pricing and purchase dates may be compelled through discovery or by the Court acting under its own authority outside the proposed rule.

A copy of the proposed rule, along with a summary of comments received on earlier versions and the Committee’s advisory notes, is available here.

Leveraged buy-outs (LBO’s) are a time-honored means of financing the acquisition of companies.  They tend to occur in waves, finding greatest popularity when credit is easy and money is cheap.

Because of their dependence on favorable credit conditions, LBO’s are also rather risky.  When credit markets tighten and asset values drop – as they did most recently during the “Great Recession” of 2008 – the risk is borne primarily by unsecured creditors of the acquisition target. 

LBO’s, popular during the “roaring 80’s” and again during the “go-go” years of the George W. Bush Administration, are once again crashing and burning in significant numbers.  Recent victims include household names like Chrysler, Hawaiian Telcom, Linens ‘N Things, Simmons, LyondellBasell, Capmark Financial Group Inc., and Tribune Co.  Others, including Clear Channel Communications, Harrah’s Entertainment, and TXU, have defaulted on their LBO debt.  Indeed, nearly half of non-financial American companies that defaulted on Moody’s-rated debt instruments in 2009 were reportedly leveraged acquisitions of private-equity funds.

Companies with overburdened balance sheets are forced to “de-leverage” and restructure their debt, typically at the expense of these creditors.  Because the essence of an LBO is the use of secured debt to finance an acquisition, the historical response to ”de-leveraging” has been for unsecured creditors to attempt to unwind the security interests encumbering the company’s assets.  These efforts are typically undertaken through fraudulent transfer claims – which are reportedly on the rise in the wake of last year’s financial turmoil.

The original idea behind fraudulent transfer claims – which trace their roots back nearly half a millenium in Anglo-American commercial law – was that debtors shoudln’t be able to place valuable assets beyond the reach of their creditors.  The idea is a simple one, but proving a debtor’s subjective intent is often far more difficult than it looks.

In light of this difficulty, courts have developed certain “objective tests” to determine whether a transaction is “construtively fraudulent.”  Though a number of modern variations exist, their primary theme is that transfers made (or liabilities incurred) by a debtor in a financially precarious position may be “avoided” (i.e., unwound).

A debtor is generally considered to be in a financially precarious position if it receives less than “reasonably-equivalent value” in exchange for property or debt while the debtor (1) is insolvent at the time of the exchange; (2) is rendered insolvent by the exchange; (3) is left, following the exchange, with “unreasonably small capital” for the business in which it is engaged or is about to engage; or (4) intends to or believes it will incur, debts it would be unable to pay as they matured.

Where an LBO is found to have been a fraudulent transfer, the court’s order that the transfer is avoided may include: (1) stripping the lender of its liens; (2) recovery of loan payments and fees; (3) subordination or disallowance of lender’s claims in bankruptcy; and (4) recovery of fees paid to professionals in connection with a leveraged buyout.

As attractive as all this might sound for unsecured creditors, unwinding an LBO as “constructively fraudulent” is unfortunately only slightly less difficult than establishing subjective fraudulent intent.  As a result, such creditors have little recourse but to settle fraudulent transfer claims very cheaply.  LBO participants, on the other hand, are incentivized to take on risky acquisitions at the creditors’ [potential] expense.

That, at least, is the argument put forth by John Ginsberg in his recently-uploaded draft article entitled “Remedying Law’s Failures to Remedy Fraudulent Transfers in Leveraged Buyouts” (downloadable at SSRN).

Ginsberg, an in-house lawyer at an unnamed federal agency, focuses on the “unreasonably small capital” test (the test most commonly used in attacking an LBO) and argues that the standard for meeting that test – whether insolvency is ”reasonably foreseeable” – requires far greater certainty in order for creditors to realize the protections intended for them by fraudulent transfer law.

In essence, Mr. Ginsberg argues that rather than asking whether insolvency is “reasonably foreseeable,” courts ought to clarify “reasonable foreseeability” in probabalistic terms.  It should be easier to attack (or to defend) a fraudulent transfer if it can be shown, for example, that the “probability” of insolvency at the time of an LBO was 50% – or 60%, or 75%.  Further, courts ought to articulate what, for them, constitutes an acceptable margin of error (say, 40% risk of insolvency with a margin of error of +/- 15%).

Finally, Mr. Ginsberg argues that a “probabalistic” approach eliminates the potential confusion arising when a subsequent “insolvency triggering event” is blamed for sinking a perhaps-somewhat-risky-but-otherwise-perfectly-viable LBO: If the probability of insolvency is established ahead of such a “trigger event,” it is far easier to determine whether or not that event is, in fact, a significant factor in the company’s failure.

Mr. Ginsberg’s article (a working copy of which is available on SSRN) is an interesting read – not least because it offers a succinct and accessible snapshot of recent decisions addressing fraudulent transfers and LBOs.

Mr. Ginsberg’s proposed approach is also not the only one available to those seeking a more “objective” treatment of LBO financing.  A number of authors have suggested that the “foreseeability of insolvency” may be best determined by reference to prevailing industry liquidity and solvency ratios.  These are easily accessible through research databases, and provide some objective benchmarks as to what the participants in an LBO transaction might reasonably have anticipated at the time of the transfer.

That said, even these more “objective” approaches are not without their problems.

For example, if courts in a particular jurisdiction have enunciated a 50% or greater probability as the threshold for “reasonably foreseeable” insolvency, won’t the parties engaging in an LBO simply adjust their forward-looking assumptions to be certain that the “probability” is something less than 50%?  And what level of probability rises to the level of “reasonably foreseeable” in the first place?  Ginsberg’s article acknowledges this last uncertainty, and leaves the matter open for discussion.

Ratio-based tests also have their own problems.  Which solvency ratios are most meaningful to a particular industry?  And which ones is a court most likely to apply to a particular transaction?  Though ratios are comparatively easy to compute, their application has been a subject for juducial hand-wringing and scholarly suggestions for the better part of 8 decades.

Something to think about.

International readers of this blog – and those in the US who practice internationally – are more than likely aware of the doctrine of “comity” embraced by US commercial law.  In a nutshell, “comity” is shorthand for the idea that US courts typically afford respect and recogntion (i.e., enforcement) within the US to the judgment or decision of a non-US court – so long as that decision comports with those notions of “fundamental fairness” that are common to American jurisprudence.

In the bankruptcy context, “comity” forms the backbone for significant portions of the US Bankruptcy Code’s Chapter 15.  Chapter 15 – enacted in 2005 – provides a mechanisim by which the administrators of non-US bankruptcy proceedings can obtain recogntion of those proceedings, and further protection and assistance for them, inside the US.

But in at least some US bankruptcy courts, “comity” for non-US insolvencies only goes so far.  Last month, US Bankruptcy Judge Thomas Argesti, of Pennsylvania’s Western District, offered his understanding of where “comity” stops – and where US bankruptcy proceedings begin.

Judge Argesti currently presides over Chapter 15 proceedings commenced in furtherance of two companies – Canada’s Railpower Technologies Corp. (“Railpower Canada”) and its wholly-owned US subsidiary, Railpower US.  The two Railpower entities commenced proceedings under the Canadian Companies Creditors’ Arrangement Act (“CCAA”) in Quebec in February 2009.  Soon afterward, their court-appointed monitors, Ernst & Young, Inc., sought recogntition of the Canadian Railpower cases in the US.

Railpower US’ assets and employees – and 90% of its creditors – were located in the US.  The company was managed from offices in Erie, PA.  Nevertheless, it carried on its books an inter-company obligation of $66.9 million, owed to its Canadian parent.  From the outset, Railpower US’ American creditors asserted this “intercompany debt” was, in fact, a contribution to equity which should be subordinate to their trade claims.  Judge Argesti’s predecessor, now-retired Judge Warren Bentz, therefore conditioned recognition of Railpower US’ case upon his ability to review and approve any proposed distribution of Railpower US’ assets.  After the company’s assets were sold, Judge Bentz further required segregation of the sale proceeds pending his authorization as to their distribution.  Finally, after the Canadian monitors obtained a “Claims Process Order” for the resolution of claims in the CCAA proceedings and sought that order’s enforcement in the US, Judge Bentz further “carved out” jurisdiction for himself to adjudicate the inter-company claim if the trade creditors received anything less than a 100% distribution under the CCAA plan.

Railpower US’ assets were sold – along with the assets of its Canadian parent – to R.J. Corman Group, LLC.  Railpower US was left with US$2 million in sale proceeds against US$9.3 million in claims (other than the inter-company debt).  The Canadian monitor indicated its intention to file a “Notice of Disallowance” of the inter-company debt in the Canadian proceedings, but apparently never did.  Meanwhile, approximately CN$700,000 was somehow “upstreamed” from Railpower US to Railpower Canada.  Finally, despite the monitor’s assurances to the contrary, Railpower Canada’s largest shareholder – and an alleged secured creditor – sought relief in Quebec to throw both Railpower entities into liquidation proceedings under Canada’s Bankruptcy and Insolvency Act.

Enough was enough for Railpower US’ American creditors.  In August 2009, they filed an involuntary Chapter 7 proceeding against Railpower US, seeking to regain control over the case – and Railpower US’ assets – under the auspices of an American panel trustee.

The Canadian monitor requested abstention under Section 305 of the Bankruptcy Code.  Significantly re-drafted in the wake of Chapter 15’s enactment, that section permits a US bankruptcy court to dismiss a bankruptcy case, or to suspend bankruptcy proceedings, if doing so (1) would better serve the interests of the creditors and the debtor; or (2) would best serve the purposes of a recognized Chapter 15 case.

Judge Argesti’s 14-page decision, in which he denied the monitors’ motion and permitted the Chapter 7 case to proceed, is one of apparent first impression on this section where it regards a Chapter 15 case.

Where the “better interests of the creditors and the debtor” are concerned, Judge Argesti’s discussion essentially boils down to the proposition that because creditors representing 85% – by number and by dollar amount – of Railpower US’ case sought Chapter 7, those creditors have spoken for themselves as to what constitutes their “best interests” (“The Court starts with a presumption that these creditors have made a studied decision that their interests are best served by pursuing the involuntary Chapter 7 case rather than simply acquiescing in what happens in the Canadian [p]roceeding.”).

The more interesting aspect of the decision concerns Judge Argesti’s discussion of whether or not the requested dismissal “best serve[d] the purposes” of Railpower’s Chapter 15 cases.  For guidance on this issue, Judge Argesti turned to Chapter 15’s statement of policy, set forth in Section 1501 (“Purpose and Scope of Application”) – which states Chapter 15’s purpose of furthering principles of comity and protecting the interests of all creditors.  Then, proceeding point by point through each of the 5 enunciated principles behind the statute, he arrived at the conclusion that the purposes of Chapter 15 were not “best served” by dismissing the involuntary Chapter 7 case.  As a result, Railpower US’ Chapter 7 case would be permitted to proceed.

Judge Argesti’s analysis appears to focus primarily on (i) the Canadian monitors’ apparent delay in seeking disallowance of the inter-company debt in Canada; (ii) the “upstreaming” of CN$700,000 to Railpower Canada; and (iii) the monitors’ apparent failure, as of the commencement of the involuntary Chapter 7, to “unwind” these transfers or to recover them from Railpower Canada for the benefit of Railpower US’ creditors.  It also rests on the fact that Railpower US was – for all purposes – a US debtor, with its assets and creditors located primarily in the US.

In this context, and in response to the monitors’ protestations that comity entitled them to judicial deference regarding the Chapter 15 proceedings, Judge Argesti noted that:

comity is not just a one-way street.  Just as this Court will defer to a [non-US] court if the circumstances require it, so too should a foreign court defer to this Court when appropriate.  In this case it was clear from the start that [this Court] expressed reservations about the distribution of Railpower US assets in the Canadian [p]roceeding . . . .  The Monitor has [not] explained how this [reservation] is to be [addressed] unless the Canadian Court shows comity to this Court.

Judge Argesti’s decision may be limited to its comparatively unique facts.  However, it should also serve as a cautionary tale for representatives seeking to rely on principles of comity when administering business assets in the US.  In addition to his more limited construction of “comity,” Judge Argesti also noted that recognition of Railpower US’ Chapter 15 case was itself subject to second-guessing where subsequently developed evidence suggested that the company’s “Center of Main Interests” was not in Canada, but in the US.

For anyone weighing strategy attendant to the American recognition of a non-US insolvency proceeding, this decision is important reading.

A great deal of scholarly ink has been spilled over last year’s well-publicized sales of Chrysler and GM, each authorized outside a Chapter 11 plan.  Some of that ink is available for review . . . here.

It’s worth noting that both Chrysler and GM have enjoyed a considerable presence in Canada.  Indeed, the Canadian government participated in the automakers’ Chapter 11 cases.  Yet their bankruptcy sales were not recognized under Canadian cross-border insolvency law, nor were Canadian insolvency proceedings ever initiated.

Why not?

Seton Hall’s Stephen Lubben and York University’s Stephanie Ben-Ishai collaborated last month to offer an answer to that question.  The essence of their article, “SALES OR PLANS: A COMPARATIVE ACCOUNT OF THE ‘NEW’ CORPORATE REORGANIZATION“ comes down to two points of difference between the Canadian reorganization process and US Chapter 11 – speed and certainty – and is captured in the following excerpt:

[B]oth the United States and Canada have well-established case law that supports the “pre-plan” sale of a debtor’s assets.  The key difference between the jurisdictions thus turns not on the basic procedures, but rather the broader context of those procedures . . . .   [I]n the United States it is generally possible to sell a debtor’s assets distinct from any obligations or liabilities associated with those assets.  Indeed, the only obligations that survive such a sale are those that the buyer willing[ly] accepts and those that must survive to comport with the U.S. Constitution’s requirements of due process.

[I]n Canada the debtor has less ability to “cleanse” assets through the sale process.  Particularly with regard to employee claims, a pre-plan sale under the CCAA is not apt to be quite as “free and clear” as its American counterpart.

The jurisdictions also differ on the point at which the reorganization procedures – and the sale process – can be invoked.  Canada, like most other jurisdictions, has an insolvency prerequisite for commencing [a reorganization] proceeding, whereas Chapter 11 does not.  And the Canadian sale process is tied to the oversight of cases by the [court-appointed] monitor: without the monitor’s consent, it is unlikely that a Canadian court would approve a pre-plan asset sale.  In the United States, on the other hand, there is no such position.  Accordingly, a [US] debtor can seek almost immediate approval of a sale upon filing.  Finally, there remains some doubt and conflicting case law in Canada about the use of the CCAA in circumstances that amount to liquidation, particularly following an asset sale.  In the US, it is quite clear that Chapter 11 can be used for liquidation.

[T]hese latter factors are the more likely explanations for the failure to use the CCAA in [GM's and Chrysler's] cases . . . .  [I]t is the questions of speed and certainty that mark[] the biggest difference between the two jurisdictions . . . .  In the case of GM and Chrysler, where the governments valued speed above all else, these issues came to the fore.

The article offers a very interesting perspective on the strategic use of specific insolvency features of different jurisdictions to effect cross-border bankruptcy sales, and is well worth the read.

Many readers of this blog understand the importance of asset and enterprise valuation at a number of stages of the bankruptcy process.  Whether it be specific collateral (to address a secured creditor’s concerns) or enterprise value (to determine the viability of a Chapter 11 plan), or for purposes of a fraudulent transfer or an asset sale, the discipline and methodology of valuation forms a fundamental touchstone of business insolvency practice.

A recent Delaware Bankruptcy Court decision highlights the use of valuation in yet another context:  The appointment of equity committees.  In the Chapter 11 cases of Spansion, Inc. and its affiliates, Judge Kevin Carey reviewed the request of an ad hoc equity committee’s request for official sanction and appointment by the Office of the US Trustee.  To evaluate the committee’s request, Judge Carey turned to case law holding that the appointment of an equity committee depends upon:

- the substantial likelihood of a distribution to equity holders after all creditors are paid; and

- equity holders’ inability to represent themselves without such an official committee.

Central to Judge Carey’s decision was a detailed analysis of the anticipated distribution to equity holders.  Spansion’s disclosure statement, submitted with its proposed Chapter 11 plan, valued the debtors’ enterprise value at less than the amount of creditors’ claims and therefore left nothing for equity.  The ad hoc equity committee (not surprisingly) believed enterprise value after payment was sufficient that equity holders should have a collective voice with respect to the proposed plan.

Both sides submitted extensive evidence in support of their positions.  Unlike the debtors’ “full-blown” valuation, however, the ad hoc equity committee submitted a “sensitivity analysis” based on the debtors’ numbers and including an analysis of “precedent transactions,” comparable trading multiple analysis, and a discounted cash flow (DCF) analysis.

A substantial portion of Judge Carey’s 20-page decision denying the ad hoc equity committee’s request revolves around a careful weighing of the parties’ competing valuation evidence.  The ad hoc equity committee’s valuation evidence ultimately faltered on four points:

- The future of the debtors’ market:  For Judge Carey, the ad hoc equity committee’s analysis was not sensitive enough.  It inferred growth estimates based on the broader semiconductor and memory markets rather than for the debtors’ smaller (and much less healthy) specific memory market.

- The estimated DCF terminal value:  The ad hoc equity committee’s valuations assumed constant cash flow growth (a view not shared by the debtors), higher EBITDA multiples, and higher terminal values.  By contrast, the debtors’ valuation assumed flat to negative growth, and a lower terminal value.

- Valuation of specific assets:  The ad hoc equity committee claimed certain valuable assets – such as cash, litigiation claims held by the debtors, and net operating losses - were not accounted for in the debtors’ estimate of enterprise value.  While acknowledging that cash ought to be included in enterprise value, Judge Carey nevertheless found that the ad hoc equity committee offered no support for its valuation of the litigation claims at issue.  He found, further, that ambiguity surrounding the effect of the debtors’ net operating losses was not sufficiently resolved by the ad hoc equity committee to assign it any value for the committee’s analysis.

- Total amount of claims:  The ad hoc equity committee’s claimed equity stake derived at least in part from its estimate of claims.  However, Judge Carey found that the committee had neglected to include administrative claims and cash requirements necessary to exit from Chapter 11.  The committee also had neglected to estimate the value of claims from as-yet-to-be-rejected contracts.

In the end, Judge Carey found that “[t]he only thing certain . . . is the uncertainty of the valuations” – and that, as a result, the ad hoc equity committee’s “uncertain” estimate had not established the “substantial likelihood” of distribution required for official appointment.

Judge Carey’s valuation analysis is instructive.  Specifically, it highlights the evidentiary burden that can attend valuation fights in a bankruptcy case, as well as the thoroughness with which a court may investigate enterprise value.

Something to consider in a variety of bankruptcy contexts.

With both the global and regional Southern California economies showing early signs of life – but still lacking the broad-based demand for goods and services required for robust growth – opportunities abound for strong industry players to make strategic acquisitions of troubled competitors or their distressed assets.

Ray Clark, CFA, ASA and Senior Managing Director of VALCOR Consulting, LLC, is no stranger to middle-market deals.  His advisory firm provides middle market restructuring, transactional and valuation services throughout the Southwestern United States from offices in Orange County, San Francisco, and Phoenix.

As most readers are likely aware, distressed mergers and acquisitions can be handled through a variety of deal structures.  Last week, Ray dropped by South Bay Law Firm to offer his thoughts on a process commonly known in bankruptcy parlance as a “Section 363 sale.”

In particular, Ray covers the “pros and cons” of this approach.

The floor is yours, Ray.

Today’s economic environment has created an opportunity to acquire assets of financially distressed entities at deeply discounted prices, and one of the most effective ways to make those acquisitions is through a purchase in the context of a bankruptcy under Section 363 of the Bankruptcy Code (the “Code”).  When purchasing the assets of a failed company under Section 363, there are distinct advantages to being first in line.  Depending on the circumstances, however, it may be best to wait and let the process unfold – and then, only after surveying the entire landscape, submit a bid.

The 363 Sale Process

A so-called “363 Sale” is a sale of assets of a bankrupt debtor, wherein certain discrete assets such as equipment or real estate – or substantially all the debtor’s business assets – are sold pursuant to Section 363 of the Bankruptcy Code (11 USC §363).  Upon bankruptcy court approval, the assets will be conveyed to the purchaser free and clear of any liens or encumbrances. Those liens or encumbrances will then attach to the net proceeds of the sale and be paid as ordered by the Bankruptcy Court.

A Section 363 sale looks much like a traditional controlled auction.  Basic Section 363 sale mechanics include an initial bidder, often referred to as the “stalking horse,” who reaches an agreement to purchase assets – typically from the Chapter 11 debtor, or “debtor-in-possession” (DIP).  The buyer and the DIP negotiate an asset purchase agreement (APA), which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to “higher and better” or “over” bids.  The Bankruptcy Court will approve the bidding procedures, including the incentives, i.e., a “bust-up” fee, for the stalking horse bidder, and will pronounce clear rules for the remainder of the sale process.  Notice of the sale will be given, qualified bids will arrive and there will be an auction.  The sale to the highest bidder will commonly close within four to six weeks after the notice and the stalking horse will either acquire the assets or take home its bust-up fee and expense reimbursement as a consolation. 

Advantages for the Stalking Horse Bidder

Bidding Protections - During negotiations with the debtor for the purchase of assets, the stalking horse will also typically negotiate certain protections for itself during the bidding process.  These bidding protections, which include a bust-up fee and expense reimbursement, will be set forth in the 363 sale motion and are generally approved by the bankruptcy Court.  As a result, stalking horse bidders seek to insulate themselves against the risk of being out-bid.  To do so, proposed stalking-horse bidders commonly require that any outside bidder will typically have to submit not only a bid that is higher than that of the stalking horse, but will also need to include an amount to cover the stalking horse’s transactional fees and expenses.

Bidding Procedures – The stalking horse will also negotiate certain bidding procedures with the debtor, which will be set forth in the 363 sale motion that will be evaluated, and most likely approved, by the Court.  The sale procedures generally include the time frame during which other potential bidders must complete their due diligence and the date by which competing bids must be submitted.

Other delineated procedures typically included in the motion include the amount of any deposit accompanying a bid and the incremental amount by which a competing bid must exceed the stalking horse bid.  In addition, if the sale procedures provide for an abbreviated time frame in which to complete an investigation of the assets, a competing bidder will be at a distinct disadvantage and may be unable, as a result, to even submit a bid.

Deal Structure – As the first in line, the stalking horse bidder will also negotiate all of the important elements of the transaction, including which assets to acquire, what contracts – if any – to assume, the purchase price and other terms and conditions.  In doing so, it establishes the ground rules by which the sale process will unfold and the framework for the transaction, which will be difficult, if not impossible, for another outside bidder to change. 

“First Mover” Advantage – The stalking horse bidder will typically be viewed by the Court as the favored asset purchaser in that it will have negotiated all of the relevant terms and procedures, and established its financial ability and intent to acquire the assets.  As a result, short of an overbid by an outside party, which typically involves an additional amount to cover the stalking horse’s bust-up fee and expenses, the stalking horse bidder will prevail.

Cooperation of Stakeholders – As the lead bidder, the stalking horse also has an opportunity to negotiate with other key stakeholders in the process and establish a close relationship with those parties that may prove advantageous when all offers are evaluated.

Bust-up Fee and Expense Coverage – Lastly, if an outside party happens to submit the high bid, the stalking horse will typically receive its bust-up fee and expense reimbursement. This generally includes items such as due diligence fees, legal and accounting fees, and similar expenses, but is limited by negotiation. 

Disadvantages to the Stalking Horse Bidder

Risk of Being Outbid – As noted, the stalking horse will expend a great deal of time, energy, and resources analyzing and negotiating for the purchase of the assets.  All a competing bidder must do is show up to the sale and submit an over-bid.  If the competing over-bidder prevails, the stalking horse runs the risk of walking away with only its bust-up fee and expense reimbursement.

Risk of Bidding Too High – After negotiating the APA, the stalking horse then participates in the 363 sale process.  If no other bidders materialize, it may be because the stalking horse effectively over-paid for the assets. 

Inability to Alter Terms – If some new information comes to light that would otherwise suggest a reduction in the price or alteration of the terms, the stalking horse may have difficulty altering either of these and may be locked in to the negotiated structure.

Questions?

Contact rclark@valcoronline.com or mgood@southbaylawfirm.com.

Meanwhile, happy hunting.

While some global economic indicators suggest an economic recovery is getting underway in earnest, research released earlier this month by global accountancy Grant Thornton LLP (and co-sponsored by the Association for Corporate Growth) argues that a fresh wave of business bankruptcy is nevertheless about to wash over US Bankruptcy Courts.

In “The Debt Effect“, a white paper addressing the present state of private equity, Grant Thornton’s Harris Smith – Los Angeles-based head of the firm’s Private Equity practice group – agrees that ”[a] global recovery is under way, albeit slowly, and there are reasons to be cautiously optimistic about 2010 and beyond.”  Against that backdrop, however, he cautions the arrival of a nascent global recovery does not mean deal-making and the lending supporting it will immediately return to its prior levels – or that it will all look the same as before when it does.  More importantly, he demonstrates that additional corporate distress is likely on the way.

Specifically, Harris notes that mergers and acquisition activity remains at levels that are a mere fraction of what the same activity was during 2006 and 2007.  Moreover, a significant portion of deals done earlier in the decade are now in jeopardy:  According to Moody’s, over 50 percent of the deals done between 2004 and 2007 by big private equity funds are now either in default or distress.  Many of these situations have been addressed – at least temporarily – through debt extensions and other types of forbearance.  But many of these temporary fixes are set to expire.  Moreover, Harris’ research projects that “[t]he number of maturating loans will steadily increase until it peaks in 2013.  The opportunities for distress buyers will continue to grow during this time because many companies will not be able to meet their debt obligations.”

According to Grant Thornton’s Marti Kopacz, national managing principal of the firm’s Corporate Advisory and Restructuring Services, “We expect the restructuring wave to be a three- to five-year wave.  This is only the first year.”