One Business’Crisis is Another’s Opportunity

――Seizing Strategic and Financially Opportunistic M&A Opportunities Under the United States Bankruptcy Code

With increasing numbers of companies who were once thought to be impervious giants of industry and business Lehman Brothers, Delphi, Chrysler and General Motors filing for bankruptcy in the United States, more and more opportunities to purchase important assets are becoming available to savvy buyers looking to expand their business or enter the U.S. market. The United States Bankruptcy Code provides debtors with the ability to liquidate all or a part of their assets through court-supervised sales, to create working capital, pay down debt facilities and re- align and reorganize their business.

Buyers, in turn, are able to pick and choose the assets that best fulfill their business objectives and allow them to obtain assets at, or below, prices they would normally have to pay if the sale were not consummated through a bankruptcy. Therefore, although “bankruptcy” may still carry a stigma, the possibilities for good business deals should not be overlooked.

In fact, many non-U.S. businesses are already taking advantage of this unique tool including:

• Barclays’ acquisition in September 2008 of the investment banking and capital markets operations of Lehman Brothers Holdings, including more than 10,000 experienced staff and human capital, for what has been called the “fire sale price” of US$250 million, plus real property, including Lehman’s New York headquarters and two large data centers in New Jersey, and certain other assets for the aggregate price of approximately US$1.5 billion.

• Fiat’s recent acquisition of a 35% stake in a newly established company called New CarCo Acquisition LLC, which acquired a majority of Chrysler’s operating assets, in exchange for the assumption of certain liabilities and US$2 billion in cash, creating a partnership of sorts that will allow Chrysler to take advantage of Fiat’s technology to create more fuel-efficient, small and midsize cars, as well as providing readymade outlets for distribution of Chrysler-brand cars throughout Europe.

One of the most advantageous aspects for purchasers of assets under the U.S. Bankruptcy Code is that a deal can be approved and consummated relatively quickly. The Bankruptcy Code provides that sales of a debtor’s assets can be approved on as little as 40 days notice (or less in exigent circumstances). In Chrysler, the sale to New CarCo (and Fiat) was approved and closed approximately 40 days after the bankruptcy filing, including the time for two appeals, which allowed the purchaser to quickly implement its business plan and proceed quickly toward operating the business outside of bankruptcy. In the Lehman case, the time frame was even more expedited with entry of a sale order approving the sale to Barclays on September 20, 2008, only three days after the filing of the sale motion on September 17, 2008.

Basic Procedures for Purchasing Assets From a Debtor

The purchase and sale of assets out of a bankruptcy often begins with a “stalking horse” bidder who has agreed to buy the target assets pursuant to a negotiated purchase and sale agreement with the debtor. Purchase and sale agreements with “stalking horse” bidders usually, although not always, follow solicitation of preliminary bids and due diligence review by one or more potential bidders who have signed confidentiality agreements with the debtor. The stalking horse bidder who emerges is often the bidder making the highest bid for the most assets, and who is favored by the debtor as the one most able to complete the purchase and/or require the least amount of time, if any, to undertake a due diligence review.

Once an agreement has been reached and finalized with the stalking horse bidder, the debtor will begin the process of seeking bankruptcy court approval of the asset sale. Section 363 of the U.S. Bankruptcy Code provides debtors with two options for asset sales: private sales or public auctions. In both private sales and public auctions, a debtor seeking to sell property will be required to provide public notice of the sale and time for parties to object.

In a private sale, the debtor will simply make a motion to the bankruptcy court for approval of a previously negotiated sale transaction, setting forth the basis for the sale, the terms of the sale, a proposed hearing date for approval of the sale and a deadline by which any objections to the sale must be filed. Although no auction process is contemplated in a private sale, interested parties may submit competing bids for the target assets by “objecting” or otherwise responding to the sale by the objection deadline. When this happens, it is usually incumbent upon the bankruptcy court to take such a competing offer into consideration so as to “maximize the value” of the asset sold for the benefit of the debtor’s creditors resulting, in essence, in a de facto auction for the assets.

Typically, however, debtors and bankruptcy courts prefer public auctions for selling assets, particularly significant assets of a debtor. Among other things, public auctions provide better protection to purchasers against many successor liability claims, including claims that the debtor failed to maximize value for the benefit of the debtor’s creditors. In addition, in most cases, it is believed that an orderly auction process with a stalking horse bidder will yield a higher sale price for the benefit of creditors.

The sale of Lehman’s assets to Barclay’s provides a good example of how private sales are utilized in certain circumstances, but are not necessarily favored by the courts. In that case, although the sale was not specifically called a private sale, the sale of Lehman’s assets to Barclays was undertaken without an auction process being proposed by the debtors or being implemented by the court. In approving the sale on an extremely expedited time frame without any competitive bidding procedure, the bankruptcy court noted that the sale had been approved under a unique set of extraordinary circumstances, in an emergency situation, and that the transaction was approved without auction procedures because it was clear that the sale to Barclays was the only available transaction. Accordingly, the court made it clear that the process implemented in that case would not have precedential value and should not necessarily be repeated. In addition, because the sale of Lehman’s assets to Barclays was so highly publicized at the time of its proposal, any potential competing bidder or other interested party could have objected to the sale and offered a higher or better deal at the hearing on the sale. No such offer was made.

In the context of a public auction, it is generally advantageous to be the stalking horse bidder, as opposed to a subsequent competing bidder, because the stalking horse bidder will have some control over the terms of the auction and will negotiate the form of the purchase and sale agreement upon which any future bidders will be required to base their bids. This allows the stalking horse bidder to set its terms, where competing bidders will have to accept terms already agreed upon. On the other hand, competing bidders who are able to work within the terms of the stalking horse purchase and sale agreement, can end up as the successful purchasers of a debtor’s assets at the auction, thereby reaping the rewards of a stalking horse bidder’s labors. In order to offset the risk to the stalking horse bidder that another bidder may win the assets at the auction, and induce a stalking horse bidder to negotiate and create a competitive market for the debtor’s assets despite the potential “loss” of the assets in an auction, the stalking horse bidder’s purchase and sale agreement often includes a “break-up” fee and/or expense reimbursement provisions. Break-up fees and expense reimbursements are intended to cover the stalking horse bidder’s costs and, in order to be approved, must be reasonable. In most cases, courts have agreed to approve break-up fees equal to anywhere from 2% to 4%, on the very high end, of the overall purchase price, or which are based on the actual, reasonable expenses incurred by the stalking horse bidder. Courts usually will not approve break-up fees, or bidding increments (discussed below), which are exceedingly high or unreasonable since such provisions may “chill” the bidding.

In a public auction, a debtor will make a motion or motions to the bankruptcy court describing the basis for the sale, the terms of the sale, the procedures for accepting “higher and better” offers and a proposed time and place for the auction of the assets, which will require two separate orders from the bankruptcy court. The first order will be a “procedures order” approving the form of the purchase and sale agreement that the debtor has entered into with the stalking horse bidder and the procedures for competing offers and the auction, e.g. break-up fees, bid increments, competitive bid qualification requirements, the manner of advertising and giving note of the auction date, the auction date and the sale approval hearing date. The second order will be the “sale approval order”, which will be entered after the auction has been conducted and the debtor has evaluated all the bids, will authorize the sale of the assets to the stalking horse bidder or to the bidder making the “highest and best offer” for the assets. Each order will be subject to separate objection deadlines and hearing dates. Accordingly and typically, the motion or motions will seek approval of, among others things, the following specific items:

• limitations on the debtor’s solicitation of competing bids;

• a deadline for the submission of competing bids and a provision that there will be no auction unless qualified competing bids are submitted before the deadline;

• minimum overbids above the initial purchase price;

• incremental bids over the minimum overbid;

• permission for the stalking horse bidder to match any qualifying bid;

• full or partial expense reimbursement in the form of a “break-up fee” payable to the stalking horse bidder in the event it is outbid;

• a requirement that any competing bid must be made on the same or substantially similar terms as the purchase and sale agreement entered into by the debtor and stalking horse bidder; and

• a requirement that bids be evaluated on the basis of the most net cash provided to the debtor, including after taking into account payment of any break-up fee or expense reimbursement to the stalking horse bidder.

Ultimately, the precise process for competitive bidding and for the auction is in the debtor’s discretion, with input from the stalking horse bidder and certain other interested parties, provided it is reasonably designed to maximize value under the circumstances at hand. The terms should be reasonable and should not have the effect of “chilling” the bidding process taking into consideration the purchase price offered by the stalking horse bidder, the value of the asset and the costs actually incurred by the stalking horse bidder.

Details of the Purchase and Sale Agreements in the Bankruptcy Context

In addition to providing for a break-up fee and/or expense reimbursement, a purchase and sale agreement in a bankruptcy case differs in certain other material respects from a purchase and sale agreement in a sale outside of the bankruptcy context. First, a purchase and sale agreement in a bankruptcy case will provide that its effectiveness is conditioned upon the entry of the sale approval order by the bankruptcy court, in a form satisfactory to the purchaser. In addition, the sale of a debtor’s assets is usually made on an “as is, where is” basis, with the representations and warranties that a debtor is willing or able to provide being fairly limited and surviving only until the closing of the sale. Indemnification by a debtor is rare. The principal reasons for these differences are as follows:

• the debtor is generally not an economically viable entity and its representations and warranties are thus of limited value;

• the debtor will ultimately be discharged from most of its liabilities as part of the bankruptcy case (and upon confirmation of its plan of reorganization or liquidation), including claims under the purchase agreement; and

• the creditors of the debtor desire finality and do not wish to have ongoing exposure that may diminish the assets of the debtor available for distribution.

A potential purchaser of assets should not, however, let these differences and limitations deter them. The fact is that a properly drafted sale order will provide the purchaser of distressed assets with essentially the same or better protection as a purchaser would have under a “normal” purchase and sale agreement outside of the bankruptcy context. Specifically, a properly drafted sale order will state that the assets are sold free and clear of any liens, claims, encumbrances or other interests in the asset resulting in what many refer to as a “cleansing” of the debtor’s assets (subject only to certain, very specific exceptions) and that the purchaser is a “good faith” purchaser. This language will generally protect a purchaser from, and be enforceable against, any claims that a third party or the debtor may have in connection with the assets, release any liens or other encumbrances on the assets and remove any other interests. Any such liens, claims, interests or other encumbrances of a third party on or related to the assets will instead attach to the proceeds from the sale of that asset.

The Auction

In some cases, the bidding can be very lively, with an auction often taking hours and, in rare cases, days. In others, there may be no bidding at all, with the auction, if not canceled, lasting no more than 10 minutes so as to create a complete record stating that no competing bidders came forward, and that the stalking horse bidder is, therefore, the winning bidder. There have been auctions where two bidders, including the stalking horse bidder, will bid on assets for hours, increasing the price ultimately paid for the assets by millions of dollars over the original price proposed by the stalking horse bidder, and other auctions where a number of entities combine to pool their resources against another bidding factions.

In the case of Riverstone Networks, involving the sale of assets of a debtor in the business of providing networking switching hardware, two bidders emerged Lucent Technologies and Ericsson. Lucent and Riverstone had originally signed an asset purchase agreement for $170 million on February 7, 2006. At the auction, held over 2 days on March 20 and 21, 2006, and through numerous rounds of bidding, Lucent, the stalking horse bidder, ultimately, outbid all bidders with a final bid of $217 million in cash and cash equivalents. As a result of Ericsson’s competing, but ultimately unsuccessful, bidding there was a $47 million dollar increase in value to the estate.

Meanwhile, in the bankruptcy cases of Chrysler and numerous other debtors, although an auction process was proposed and carefully crafted, and the assets being sold were substantial and extremely valuable, no other bidders emerged, leaving the debtor’s estate with the value originally proposed by the stalking horse bidder and the stalking horse bidder with an intact agreement and little worry as to their right to purchase the assets.

Accordingly, each auction is different depending on the type of assets and the market for the assets no two are exactly the same.

Closing Thoughts

Each sale of assets by a debtor in bankruptcy is unique. The fundamental principle in all sales is that the sale be conducted in a manner that is reasonably calculated to maximize value for the debtor’s creditors and estate, and that each sale be negotiated and conducted on an arms’ length basis in “good faith” by the debtor and purchaser. These general rules apply equally to all bidders, both foreign and domestic, providing all potential buyers with the same protections, but also submitting all buyers to the jurisdiction of the bankruptcy court.

In addition, the scope of the assets that can be sold through section 363 sales is extremely broad the assets can be in the U.S. or outside the U.S., and they can be tangible assets like inventory, equipment, real property, fixtures etc. and they can also include intangibles such as stock, leases, mortgages, loan portfolios and intellectual property. Such sales can be particularly advantageous to foreign buyers since they can quickly establish a working business presence in the U.S. for distribution, research and design, and sales. Consequently, they can be an effective tool to expanding a company’s business and enable them to meet their strategic and financial objectives without going through many of the difficulties of a start-up operation in a country far from the purchaser’s headquarters.

Therefore, although the current economic crisis has widespread implications, many of the bankruptcy filings that have resulted from the crisis have created numerous opportunities for businesses to acquire important assets to expand their businesses at fair prices and through an efficient process. These are, in many cases, once in a lifetime opportunities that can be taken advantage of by purchasers.

(Edward H. Tillinghast, III is a partner in Sheppard Mullin Richter & Hampton, LLP’s New York and Shanghai offices, specializing in insolvency-related matters in the U.S. and Asia.)