From the 9th Circuit last week, a decision providing creditors and their representatives with a potentially new source of preferential recoveries: pre-petition criminal restitution payments.

Jeffrey and Faye Silverman – electrical contractors – were indicted in 2005 for fraud and underpayment of workers’ compensation insurance premiums.  In March of that year, they paid the California State Compensation Insurance Fund $101,531 in restitution as part of a plea agreement and their court-ordered sentence.  Less than 60 days later, they sought relief under Chapter 7.

Their trustee sought recovery of the restitution payment from the State Fund under the theory that the payment was a preferential transfer under Section 547(b) of the Bankruptcy Code.

Both sides moved for summary judgment.  For its part, the State Fund argued that Section 547(b) doesn’t apply to criminal restitution payments, citing Kelly v. Robinson, 479 U.S. 36 (1986) and Becker v. County of Santa Clara (In re Nelson), 91 B.R. 904 (N.D. Cal. 1988).  Kelly held that criminal restitution payments are non-dischargeable under Section 523(a)(7).  Nelson extended Kelly to hold that payments on such non-dischargeable obligations are not recoverable as preferences.

The Bankruptcy Court for the Central District of California was not persuaded – nor was the District Court, which heard the matter on appeal following entry of summary judgment in the trustee’s favor.

The Ninth Circuit agreed.  Finding that criminal restitution payments are, in fact, subject to the preference statute, the Ninth Circuit held that State Fund enjoyed no “judicial exception” to Section 547(b)’s reach.  In the 3-judge panel’s view, an obligation’s non-dischargeability is separate and distinct from recovery of its pre-petition payment as a preference.  Further, the restitution payments to State Fund were “to or for the benefit of” State Fund within the contemplation of Section 547(b)(1) - State Fund’s arguments to the contrary notwithstanding.

The decision is an important one for creditors’ representatives and committees seeking possible additional sources of recovery where the debtor has been attempting to resolve criminal problems pre-petition.

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.”

A recent post over the July 4 holiday weekend offered a “30,000 foot view” of the 2008 world-wide financial meltdown and offered some broad observations about its causes – and remaining challenges to recovery.

From the Federal Bank of New York last week comes yet another broad overview – this one of the “shadow banking” system that has come to comprise a significant portion of the US’s (and the world’s) financial infrastructure – particularly that of the world financial markets.

In Shadow Banking, researchers Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky describe the financial components of this ad hoc banking system, its role in recent asset bubbles, its brittleness under stress, and the role of the Federal Reserve and other federal agencies in relieving that stress.

As described in the abstract:

The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.

Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo.

This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.

We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance.  The liquidity facilities of the Federal Reserve and other government agencies’ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks.  Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.

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.

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.

A number of advanced commercial jurisdictions – such as the US, the UK, Germany, and Japan – permit a debtor’s bankruptcy administrator or trustee to pursue and recover preferential or fraudulent transfers.  Unwinding such transfers, typically made from the debtor to a third party located in the same country, is often an important source of recovery for creditors.

But what happens when the transfer crosses international borders?  More specifically, which country’s avoidance law applies:  The law of the jurisdiction where the transfer was initiated?  Or the law of the “destination” jurisdiction?

An important decision issued last Thursday by the Fifth Circuit Court of Appeals provides a preliminary answer for at least a portion of this question.

 “Before” Chapter 15.

Prior to the enactment of Chapter 15, US bankruptcy courts disagreed on whether – and how – the administrator of a foreign insolvency proceeding could pursue such transfers in the US.  Some courts permitted non-US administrators to pursue such recovery efforts directly (through an ancillary proceeding), under the fraudulent transfer law of the debtor’s home jurisdiction.  Others permitted such recoveries only under US law, and only through a separately filed (and far more expensive and time-consuming) Chapter 11 or 7 bankruptcy case.

“After” Chapter 15.

Chapter 15 resolved at least a portion of this debate.  Section 1521(a)(7) provides that upon recognition of a foreign proceeding, the court may grant “any appropriate relief” including “additional relief that may be available to a trustee, except for relief available under [the avoidance sections of the US Bankruptcy Code].” Section 1523(b) authorizes the bankruptcy court to order relief necessary to avoid acts that are “detrimental to creditors,” providing that, upon recognition of a foreign proceeding, a foreign representative has “standing in [the debtor’s US bankruptcy] case . . . to initiate [avoidance] actions.”  In other words, Congress appeared to clear up the question where recovery efforts are initiated under US law:  A full Chapter 11 (or 7) case is required.

But what about recovery efforts commenced under non­-US law?

Courts visiting this issue under Chapter 15 appear almost as divided as those who looked at it prior to the Bankruptcy Code’s 2005 amendments.

Two cases, both addressing the question in dicta, have gone in opposite directions.  In one, the Bankruptcy Court forbade a sale “free and clear” of an avoidable English lien on procedural grounds – but along the way, acknowledged that avoidance actions under the US Bankruptcy Code are cognizable only if the debtor is the subject of a case under another chapter of the Bankruptcy Code.  In another, the Bankruptcy Court denied a request by the administrator of a Danish insolvency proceeding for turnover of previously-garnished funds on the grounds that such turnover provisions were not applicable in Chapter 15 – but nevertheless went out of its way to note that nothing in Chapter 15’s legislative history – or in prior US cross-border law – prohibited avoidance actions commenced under the law of the debtor’s home jurisdiction.

To date, however, only one case has addressed the issue directly.

Condor Insurance and the Bankruptcy Code’s Deafening Silence.

Condor Insurance, Limited (“Condor”), a Nevis-incorporated insurer and surety bond issuer, was placed into a winding-up proceeding in its home jurisdiction in 2007.  The following year, Condor’s liquidators sought recognition in Mississippi – in part, to pursue alleged fraudulent transfers aggregating more than $313 million to Condor affiliates and principals.

The Bankruptcy Court and District Court Decisions.

The Condor defendants moved to dismiss, claiming the Bankruptcy Court lacked jurisdiction to grant the relief requested. The Bankruptcy Court agreed, and – on appeal, and in a published decision – the District Court affirmed.  Central to the District Court’s reasoning was the idea that, in US courts, “the choice of law that is to be applied to a lawsuit is determined by a court having jurisdiction over the case, and the parties are not permitted to choose whatever law they wish when filing a lawsuit.”  As a result, the District Court found it lacked jurisdiction to hear the avoidance action.  Instead, it suggested that the liquidators commence and resolve the avoidance claims in Nevis – and then, upon procurement of a judgment, seek enforcement under principles of international comity.

The Fifth Circuit Decision.

In a decision issued last week, the Fifth Circuit Court of Appeals respectfully disagreed.  Writing for a 3-judge panel, Judge Patrick Higgenbotham observed Chapter 15’s “international origins” to encompass “international law.”  For the panel, Chapter 15 is not merely a procedural vehicle by which foreign administrators may cost-effectively protect assets domiciled, or control litigation originating, in the US.  Instead, foreign administrators may import the substantive insolvency law of foreign jurisdictions into US courts, which have jurisdiction to apply such law to disputes pending in the US.  See pp. 8-9 (“Whatever its full reach, Chapter 15 does not constrain the federal court’s exercise of the powers of foreign law it is to apply.”).

As a result, the statute’s silence speaks volumes.  Once recognized in the US court system through Chapter 15, foreign administrators have direct access to the panoply of federal judicial powers available to assist their administration of insolvency-related matters in the US, limited only by the specific “carve-outs” for US avoidance actions reserved in Section 1521:

“The structure of Chapter 15 provides authority to the district court to assist foreign representatives once a foreign proceeding has been recognized by the district court. Neither text nor structure suggests additional exceptions to available relief. Though the language does not explicitly address the use of foreign avoidance law, it suggests a broad reading of the powers granted to the district court in order to advance the goals of comity to foreign jurisdictions.  And this silence is loud given the history of the statute including the efforts of the United States to create processes for transnational businesses in extremis.”  Decision at pp. 9-10.

-          What About “Section Shopping?”

The Fifth Circuit recognized the appellees’ concern over “section shopping” – i.e., the strategic use of Chapter 15 (rather than Chapter 11 or Chapter 7) by foreign administrators to leverage the benefits of foreign avoidance law in US forums.  But where Congress had not taken further steps to guard against this threat, the Fifth Circuit overruled the District Court’s own efforts to do so.  In fact, Judge Higgenbotham and his colleagues did not appear bothered by the spectre of “section shopping,” noting that in the case before it – that of a foreign insurance company – Chapters 7 and 11 were not eligible relief.  Moreover, the District Court’s suggestion that the foreign administrator should simply obtain an avoidance judgment in Nevis, then seek enforcement of that judgment in the US, was “no answer.  Not all defendants are necessarily within the jurisdictional reach of the Nevis court.”  Decision at p.14.

-          What Of “Mixing and Matching?”

Instead of “section shopping,” Judge Higgenbotham saw the danger of “mixing and matching” foreign insolvency proceedings with US avoidance law, arising in connection with a Chapter 11 or Chapter 7 case.  See p. 11 (“When courts mix and match different aspects of bankruptcy law, the goals of any particular bankruptcy regime may be thwarted and the end result may be that the final distribution is contrary to the result that either system applied alone would have reached.”).  The Fifth Circuit traced the development of the UNCITRAL’s efforts to address choice of law in avoidance actions while drafting the model law that forms the basis for Chapter 15, concluding:

“The application of foreign avoidance law in a Chapter 15 ancillary proceeding raises fewer choice of law concerns as the court is not required to create a separate bankruptcy estate.  It accepts the helpful marriage of avoidance and distribution whether the proceeding is ancillary applying foreign law or a full proceeding applying domestic law—a marriage that avoids the more difficult depecage rules of conflict law presented by avoidance and distribution decisions governed by different sources of law.”  Decision at p.13.

The Fifth Circuit panel also found its own approach more consistent with that of US cross-border law that pre-dated Chapter 15, noting Bankruptcy Courts could – and sometimes did – apply either US avoidance law or foreign avoidance law to an action pending in an ancillary case under former Section 304.  At least one court, however, had criticized this approach for the same “mixing and matching” of foreign and domestic insolvency law noted by the Fifth Circuit.  See p.16 (citing and discussing In re Metzeler, 78  B.R. 674, 677 (Bankr. S.D.N.Y. 1987)):

“In sum, under section 304, avoidance actions under foreign law were permitted when foreign law applied and would provide for such relief.  Congress essentially made explicit In re Metzeler’s articulation of the bar on access to avoidance powers created by the U.S. Code by foreign representatives in ancillary proceedings.”  Decision at p.16.

-          Wholesale Importation of Foreign Avoidance Actions?

As for concerns that US insolvency courts – and US businesses – might find themselves awash in avoidance claims arising under non-US law, the Fifth Circuit again reverted to the international policies undergirding the legislation:

“Providing access to domestic federal courts to proceedings ancillary to foreign main proceedings springs from distinct impulses of providing protection to domestic business and its creditors as they develop foreign markets. Settled expectations of the rules that will govern their efforts on distant shores is an important ingredient to the risk calculations of lenders and corporate management. In short, Chapter 15 is a congressional implementation of efforts to achieve the cooperative relationships with other countries essential to this objective.”

The Unanswered Question.

The Fifth Circuit’s Condor decision leaves unanswered the question of whether avoidance actions commenced under Section 544 of the Bankruptcy Code – which itself references “applicable [non-bankruptcy] law” – includes foreign law.  Section 1521, by its terms, excludes avoidance actions predicated on this section.  But the Bankruptcy Court, the District Court, and the Fifth Circuit all ducked this issue.

One Manhattan bankruptcy judge recently observed, in dicta, that Section 544(b) gives the trustee the standing of a judgment lien creditor.  Because a preference action under foreign law would not appear to depend on status as a judgment lien creditor, this section would appear inapplicable to preference claims. A preference action under foreign law might therefore be available as “additional assistance” under § 1507.  See In re Atlas Shipping A/S, 404 B.R. 726, 744 at n.16 (Bankr. S.D.N.Y. 2009).

But Condor’s brief analysis didn’t address preference claims.  It addressed avoidance actions, which – at least in the US – do depend upon judgment lien creditor status.  As a result, the availability of foreign avoidance actions, while resolved in the Fifth Circuit – remains likely unanswered elsewhere.

In light of the tumultuous economic events of 2008 and 2009, a number of proposals for significant bankruptcy reform have surfaced – many of which have been summarized on this blog.

One of last year’s posts focused on the ongoing debate over the impact of credit derivatives on failing companies, and on the continued usefulness of Bankruptcy Code provisions designed to insulate the financial markets from the bankruptcy process.

Last week, Harvard’s Mark Roe added to that discussion with a paper entitled “Bankruptcy’s Financial Crisis Accelerator: The Derivatives Players’ Priorities in Chapter 11”

The essence of Professor Roe’s proposal is set forth at p. 3:

Although several of [the Bankruptcy Code’s safe-harbor super-priorities for derivatives and repurchase agreements] are functional and ought to be kept, the full range is far too broad. Most are more likely to destabilize financial markets than to stabilize them and most need to be repealed.

Professor Roe’s thoughtful analysis is a worthwhile read.

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.”

JSC BTA Bank (BTA), reportedly the second largest bank in Khazakstan, sought protection for its US-based assets through Chapter 15 last Thursday in New York’s Southern District.

The Chapter 15 filing in Manhattan appears to be part of Khazakstan’s own banking bailout for BTA.  In papers submitted to Bankruptcy Judge James Peck, BTA Chairman Anvar Saidenov represented, through BTA’s counsel, that between 2004 and 2007 BTA expanded rapidly with significant increases in its total assets and number of branches and cash offices.  This expansion was primarily funded through short- and medium-term bank borrowings and the issue of securities in the international capital markets.  Khazakstan’s credit-rating downgrade in late 2007 precluded BTA from refinancing its short-term credit lines, which in turn curtailed BTA’s ability to make new loans.

Beyond the Kazakh credit downgrades, BTA allegedly further suffered “significant losses” due to “fraudulent and ulawful transactions entered into by [BTA's] former management prior to February 2009.”

Before last February, the Republic of Kazakhstan and its Agency for Regulation and Supervision of Financial Markets and Financial Organizations (FMSA) had previously announced a proposal to recapitalize BTA as part of a broader plan to stabilize the country’s financial system. The plan involved JSC National Welfare Fund Samruk-Kazyna (Samruk-Kazyna), Kazakhstan’s sovereign wealth fund, providing financial support to struggling financial institutions. At the same time, Samruk-Kazyna acquired a controlling 75.1 % of BTA’s total share capital. BTA also continued to down-size its operating activities in response to the deteriorating market and BTA’s financial condition.

 BTA’s recapitalization triggered “change-of-ownership” clauses and demands for repayment under some of its lines of credit from foreign lenders.  These and other, continuing regulatory problems inside Khazakstan ultimately led to a preliminary restructuring plan in mid-2009.

At the end of August 2009, the Kazakh government enacted banking regulatory legislation which put into place, among other things, an insolvency regime to deal with the restructuring of financial institutions.  BTA sought protection under this new legislation less than 45 days after its enactment, thereby obtaining a stay of all relevant claims of BTA’s creditors and protection of BTA’s property from execution and attachment until completion of the restructuring.

BTA’s restructuing – presently contemplated within the third quarter of 2010 – presently contemplates that creditors of the Bank, including Samruk-Kazyna and certain related parties (excluding depositors and certain government agencies funding special loan programs) will receive a mixture of cash, senior debt, subordinated debt, other forms of debt, equity and so-called “recovery notes” in consideration for the restructuring of their claims.  Payments on the “recovery notes” will be funded by cash recoveries on any provisioned assets, litigation recoveries, and deferred tax recoveries.