After lining up a stalking horse bidder and holding on auction, a chapter 11 debtor sought court approval of a sale of substantially all of its assets prior to confirming a plan of reorganization. The bankruptcy court approved the sale over the objections of the losing bidder.
The debtor was a material innovation company. A year after it was formed it entered into a Co-Marketing and Distribution Agreement with another company (Mission) that granted exclusive distribution rights to certain products in the United States and a “non-exclusive, irrevocable, royalty-free, perpetual, worldwide, fully-transferable license to, inter alia, freely exploit the Debtor’s intellectual property.”
Notwithstanding sales, the debtor was not profitable. To address its liquidity needs it obtained a $350,000 secured line of credit from a bank. A private company (S & S) also made “millions of dollars” of loans to the debtor on an unsecured basis. After the bank called the line of credit, S&S acquired the secured loan and increased the cap from $350,000 to first $4 million, and then $6 million. After acquiring the bank’s loan S&S used it to convert its pre-existing unsecured loans to secured debt.
The relationship with Mission deteriorated and the parties ended up in arbitration, where it was determined that the debtor’s termination for cause was ineffective so that the agreement remained in full force and effect. In the meantime, the debtor agreed to convert a portion of S&S’s unsecured debt to equity with the result that it became the majority owner.
When it became clear that a workout was necessary, the debtor and S&S negotiated a forbearance agreement pursuant to which S&S agreed to provide an additional $1.4 million in secured financing on the condition that the debtor file for bankruptcy and seek to sell substantially all of its assets in a section 363 sale.
The investment banker retained by the debtor contacted S&S to begin stalking horse negotiations after five other potential purchasers declined. The original agreement that was negotiated by counsel for the debtor provided for a bid of $7 million that mostly consisted of a credit bid of S&S’s prepetition secured loans.
The debtor then filed bankruptcy, listing S&S as holding a secured claim of $5,550,000. It then immediately filed a motion seeking approval of procedures for the sale of substantially all of its assets, and a second motion to reject executory contracts, including the agreement with Mission. S&S also made an initial advance of $250,000 under a court approved debtor-in-possession financing.
In connection with obtaining court approval of the sale procedures, S&S agreed to lower its bid to $1,050,000, consisting of (1) a credit bid of $750,000 of the postpetition financing and (2) assumption of $300,000 in liabilities consisting of ~$130,000 in prepetition payables and ~$150,000 in cure costs for certain contracts that the debtor elected to assume.
With respect to rejection of the Mission agreement, Mission asserted rights to continue to use the debtor’s intellectual property under section 365(n) of the Bankruptcy Code. The court determined that Mission was entitled to retain certain nonexclusive rights, but no exclusive rights under the agreement.
One week before the auction S&S advanced an additional $500,000 under the DIP financing bringing the total to $750,000, as contemplated by the stalking horse bid. The debtor contended that this additional advance was necessary to fund the carveout for professional fees and expenses.
Although the investment banker contacted 164 potential buyers, only four parties other than S&S signed nondisclosure agreements and accessed the data room, and only Mission submitted a qualified overbid. Concerns raised by potential buyers included:
- the opportunity was too small;
- the Debtor’s history of losses and lack of sales;
- market saturation of similar products;
- lack of confidence in the defensibility of the Debtor’s patents, particularly in light of Mission’s assertion of exclusive rights; and
- the potential of S&S to credit bid a substantial amount.
At the auction S&S responded to Mission’s overbid with a new credit bid of $1.4 million, which included prepetition debt. Mission protested the credit bid, but continued the auction by submitting increased bids consisting of the debtor’s cash and cash equivalents (i.e. cash and cash equivalents would be left in the estate and excluded from acquired assets). In evaluating these bids the debtor announced that it would use the liquidation value of receivables and inventory, which meant reducing value from $100,000-$80,000 and $1.2 million $220,000 respectively.
As the bidding continued S&S incorporated a similar strategy in order to make it easier to compare bids. It also included assumption of $657,000 in prepetition liabilities, while reserving the right to try to renegotiate a lower amount directly with the claimants. Ultimately the debtor determined to accept S&S’s bid as the highest and best.
Against this background, Mission filed objections to the request for approval of the sale asserting:
- the S&S Bid was miscalculated and inferior to the Mission Bid;
- S&S’s credit bidding rights should be denied and its claim recharacterized as equity;
- the sale was conducted in bad faith; and
- the sale must be denied as a sub rosa plan.
The court did a detailed review of the underlying facts before overruling the objections and concluding that it was appropriate to approve the sale. The analysis was made more difficult by the fact that the chosen bidder was an insider of the debtor.
The challenge that the sale was a sub rosa plan is of particular interest. The concern is that the 363 sale procedures do not necessarily provide creditors with all of the protections that they would otherwise receive through the plan confirmation process. In effect the sale constitutes a de facto plan that does not comply with the Bankruptcy Code. Notwithstanding this concern courts typically will give due consideration to approval of a sale because there is a recognized tension between the debtor’s need for flexibility and speed in some cases and the rights of creditors in a Chapter 11 case.
The bankruptcy court’s resolution was to (1) take a close look at whether there was a good reason to proceed through a sale, and (2) confirm that creditors would receive appropriate protections, including the right to a disclosure statement, the right of an impaired class to vote, entitlement of dissenting creditors to receive at least as much is they would receive in a chapter 7 liquidation, compliance with the “absolute priority rule,” and the ability of all parties-in-interest to be heard.
In this case the court found that the 363 sale hearing process provided the functional equivalent of many of the required rights, and the rest of the requirements were met based on the specific terms of the sale. Consequently, the court overruled mission’s objections and approved the sale to S&S.
The challenge that a 363 sale should be disapproved as a sub rosa plan reflects a common theme in these types of cases. Many if not most courts find the issue of whether to approve the sale of substantially all of a Chapter 11 debtor’s assets in a section 363 sale rather than through a confirmed plan of reorganization troubling.
Vicki R Harding, Esq.