A chapter 11 debtor sold substantially all of its assets to the successful bidder at an auction. The bankruptcy court order approving the sale was immediately effective. A losing bidder appealed, challenging the sale on a variety of grounds. The losing bidder did not obtain a stay of the sale pending appeal.
Under section 363(m) of the Bankruptcy Code (emphasis added):
The reversal or modification on appeal of an authorization under subsection (b) or (c) of a sale or lease of property does not affect the validity of a sale or lease under such authorization to an entity that purchased or leased such property in good faith, whether or not such entity knew of the pendency of the appeal, unless such authorization and such sale or lease were stayed pending appeal.
The losing bidder raised a number of objections to the sale. However, since it failed to obtain a stay pending appeal, the winning bidder’s good faith became the primary issue.
As background, both bidders had prebankruptcy relationships with the debtor:
S&S (the winning bidder) owned a majority interest in the debtor. Its two principals were on the debtor’s management committee until shortly before the debtor filed bankruptcy. In addition, as the debtor’s financial condition deteriorated, S&S made substantial loans. In 2014 it acquired a bank’s secured line of credit. S&S increased the credit limit from $350,000 to first $4 million and then $5.5 million and used the facility to convert its unsecured loans to secured loans.
In June 2015 S&S and the debtor entered into a forbearance agreement that provided for an additional $1.4 million in funding on the condition that the debtor file for bankruptcy and sell substantially all of its assets pursuant to section 363 of the Bankruptcy Code. The S&S principals stepped down from the debtor’s management committee and had no further contact regarding the debtor’s operations or subsequent bankruptcy.
In September 2015, the debtor filed for bankruptcy under Chapter 11 and simultaneously signed a purchase agreement making S&S the stalking horse bidder. The agreement provided for purchase of substantially all of the debtor’s assets for $6.95 million, consisting almost entirely of a credit bid using pre-petition debt. Because the stalking horse was an insider, an independent examiner was appointed to evaluate the sale.
As for Mission (the losing bidder), almost three years prior to the bankruptcy it entered into a Co-Marketing and Distribution Agreement with the debtor that gave it a nonexclusive, perpetual license to intellectual property of the debtor and exclusive distribution rights for certain of the debtor’s manufactured products. A little over a year prior to bankruptcy, Mission exercised a right to terminate the agreement without cause, which triggered a two-year wind-down period during which its rights remained in place.
In response, the debtor sought to terminate the agreement for cause, which would have terminated the agreement immediately. However, an arbitrator determined that the debtor’s termination was improper, entitling Mission to damages. A hearing to determine the amount of damages was stayed by the debtor’s bankruptcy filing. In connection with the proposed bankruptcy sale, the debtor also moved to reject various executory contracts, including its agreement with Mission.
Based on concerns raised by the examiner and the court, S&S agreed to change its bid to lower the value from almost $7 million to $1 million, consisting of a credit bid of $750,000 in post-petition debt and assumption of ~$300,000 in pre-petition liabilities. Despite the debtor’s marketing efforts, the only qualifying bidders at the auction were S&S and Mission.
There were various bidding skirmishes at the auction. Among other things, Mission objected to S&S’ credit bid of pre-petition debt, and Mission increased the value of its bid by leaving assets in the bankruptcy estate, including inventory and accounts receivable (which the debtor revalued to reflect liquidation value). S&S adopted Mission’s approach of increasing value by excluding assets and became the winning bidder when Mission ceased bidding.
The winning bid was valued at $2.7 million consisting of a credit bid of pre-petition debt, credit bid of post-petition debt, assumption of post-petition accounts payable, assumption of certain pre-petition unsecured debt, and leaving cash, inventory, and accounts receivable in the bankruptcy estate. After the auction, the debtor also sold the excluded inventory to S&S for book value with the approval of the bankruptcy court.
Throughout the sale process the debtor sought to close the sale as soon as possible in order to avoid additional draws on its post-petition line of credit. The court in fact waived the temporary automatic stay of the sale provided in FBRP 6004(h) and 6006(d). In approving the sale, the bankruptcy court:
- Specifically considered the business reasons for proceeding with the sale and found that it made sense and did not subvert Chapter 11 creditor protections.
- Determined that the absolute priority rule was not implicated, and the assumption of some but not all liabilities did not circumvent the prohibition on intra-class discrimination in a reorganization plan.
- Concluded that S&S was permitted to credit bid under section 363(k).
- Further found that there was no evidence of misconduct or collusion and that S&S was a “good faith purchaser” within the meaning of section 363(m).
All of this is a long way of saying that there were a number of issues that could have been raised under the circumstances.
However, on appeal the BAP limited its review to the good faith of the purchaser. Since it did not reverse the bankruptcy court’s good faith finding, the BAP held that it was barred from any further review.
In the further appeal to the First Circuit, the court conducted its own review. It started with the framework that a sale to a good faith purchaser that is not stayed is statutorily moot under section 363(m). Mission argued that (1) S&S was not a good faith purchaser and (2) it was not given a chance to seek a stay, so the court should overlook the fact that the sale is not stayed.
The First Circuit noted the argument that a section 363 asset sale that is effectively a substitute for a chapter 11 plan of reorganization should be subject to heightened scrutiny to determine whether there is a good business reason for the sale and whether the sale adheres to the substantive protections of a Chapter 11 reorganization. However, the court did not decide whether heightened scrutiny was required, but instead rejected Mission’s challenge on the grounds that the bankruptcy court did apply a higher level of scrutiny.
Turning to the question of a good faith purchaser, the First Circuit holds that this requires “one who buys property in good faith and for value, without knowledge of adverse claims.” In this context “good faith” means the buyer must purchase “without fraud, misconduct, or collusion, and must not take ”grossly unfair’ advantage of other bidders.'” The court considered various arguments made by Mission based on the facts described above and concluded by agreeing with the bankruptcy court that S&S acted in good faith.
Next, the court concluded that a purchase in good faith at a fairly-conducted auction for the auction price was sufficient evidence of value. Finally, knowledge of a sale objection does not constitute knowledge of an adverse claim. Thus, S&S was a good faith purchaser.
As for Mission’s argument that there was a violation of due process when the bankruptcy court waived the temporary stay that normally applies to a sale without notice and basis, the court found that the debtor provided adequate justification and notice.
Mission’s final argument was that a Supreme Court case (Czyzewski v. Jevic Holding Corp.) holding that structured dismissals must follow the same priority rules as a plan of reorganization was controlling. Mission contended that Jevic stood for the proposition that priority rules should be applied to all end-of-case distributions including asset sales. The First Circuit declined to even consider this argument. If there is a good faith purchaser and the sale is not stayed, that is the end of the matter.
Accordingly, the First Circuit affirmed the bankruptcy court.
The clear message is that anyone who wants to challenge a bankruptcy sale better obtain a stay pending appeal. There were a variety of facts in this case that could cause second thoughts – including the insider status of the purchaser, certain aspects of the bidding process, and the lingering concern that a 363 sale does not provide protections to creditors that they are entitled to receive in a Chapter 11 case. However, the failure to obtain a stay significantly limited the scope of review.
Vicki R Harding, Esq.