The economic downturn of recent years has provided opportunities for buyers to acquire operating assets at low prices, and those sales often occur through pending bankruptcy cases. This happens so frequently that Chapter 11 bankruptcy cases now typically involve the sale of all or significant parts of a business’s operating assets.
The appeal of buying assets through bankruptcy may appear obvious. With a stroke of a judge’s pen, assets are transferred "free and clear" of liens and other interests in the property acquired. Such sales, commonly known as "363 sales" because they occur under section 363(f) of the Bankruptcy Code, often provide great value and protection to buyers. Still, prospective buyers need to carefully assess what claims may attach to assets purchased through a 363 sale, even if a sale order contains broad provisions intended to insulate buyers from such liabilities. With this in mind, potential buyers should also consider alternative mechanisms for buying assets from financially distressed businesses.
A sobering reminder that 363 sales may not be as free and clear as the buyer would like emerged last year in In re Grumman Olson Industries Inc. (2012). The court, citing due process protections, held a 363 buyer liable to a plaintiff in a product liability action for damages sustained years after the sale occurred. The damages were allegedly caused by defective goods made by the seller prior to the 363 sale.
Unsurprisingly, the buyer argued that the 363 sale order barred such claims because the assets were acquired free and clear of all claims and liabilities of the seller. The pertinent order contained broad language intended to shield the purchaser from any such claims. The plaintiff argued that she could not be bound by the sale order as it was entered without notice to her and before she was injured by the goods at issue. Sitting as an appellate court, the U.S. District Court for the Southern District of New York essentially found that the plaintiff’s constitutional right to due process trumped the language of the 363 sale order, since an unknown future tort claimant could not be given adequate notice of the sale and an opportunity to be heard.
While one may credibly argue that cases like Grumman Olson are the rare exception and narrowly apply only to matters like product lines, evolving case law might mean that this rationale can be extended to other scenarios. As a result, buyers’ counsel must recognize that a 363 sale order may not completely bar successor liability claims, regardless of how forcefully the language of the sale order may be framed.
Another surprising decision has haunted practitioners over the last few years. In Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), the bankruptcy panel of the U.S. Court of Appeals for the Ninth Circuit overruled a bankruptcy court and held that a Chapter 11 debtor’s assets could not be sold "free and clear" of liens held by nonconsenting junior lienholders under section 363, and ruled that the objectors’ liens would follow the sold assets. Bankruptcy appellate panel decisions are not binding on bankruptcy courts, and multiple courts in and out of the Ninth Circuit have expressly rejected the Clear Channel holding, or have gone to great lengths to limit its effects. The panel’s holding has also been roundly discredited in much scholarly commentary. But some courts have followed the reasoning in Clear Channel, so the decision remains a threat that buyers and their counsel need to be aware of.
Potential buyers and their coun sel should also keep in mind that most bankruptcy sales (whether through a preconfirmation 363 sale or the terms of a Chapter 11 plan) are subject to a public auction, often with a "stalking horse" bidder making the first bid and having the benefit of a "breakup" or similar fee. And parties holding liens on the assets to be sold typically have the right to "credit bid," effectively giving them the right to bid their debt against other parties’ money.
The 363 sale issues noted here can cause uneasiness among prospective buyers who wish to rely on the sale process to eliminate exposure to legacy liability. This has rekindled a debate over whether transactions outside of bankruptcy serve as viable alternatives to the 363 sale process. One example is a "friendly" foreclosure (one where the debtor cooperates with a sale commenced by the secured creditor under article 9 of the Uniform Commercial Code).
In a friendly foreclosure, the debtor/seller, secured creditor, and purchaser (which may be the secured creditor or its affiliate) all work together to facilitate a quick sale in which the secured creditor forecloses and sells to the purchaser. However, as this typically is a private sale with limited notice, the risk of a suit by disgruntled creditors over the commercial reasonableness of the transaction remains real, as does the potential for an involuntary bankruptcy filing prior to completion of the foreclosure, among other risks. In addition, the lack of a detailed court-approved sale order in any friendly foreclosure ought to make one give additional pause.
Further, a UCC article 9 foreclosure cannot be used to sell real property. Instead, a state real property foreclosure process is necessary, creating delay and the risk for the prospective purchaser of being outbid at the sheriff’s sale in jurisdictions that require a public foreclosure auction. Only a minority of states permit real property foreclosures without the entry of a court order authorizing the sale. So while business people may find opportunities to buy assets through a friendly foreclosure appealing, counsel should warn them of these risks and the alternatives discussed here.
Receiverships are another non bankruptcy alternative for accomplishing a transfer. You can seek the appointment of a receiver through the commencement of an action in state or federal court. Once appointed, a receiver may be empowered to sell the assets of the business in receivership. Such sales sometimes involve overbids and credit bids, similar to bankruptcy sales.
Unlike a bankruptcy case, which is subject to a complex statutory scheme and a plethora of (sometimes inconsistent) case law, a receivership typically is a flexible process tailored to each case, though applicable laws vary from state to state. This lack of defined playing rules in receiverships can enhance their appeal, but should also warn of potential difficulties. Where cooperation among creditors is lacking, receiverships may not be practical. Counsel should alert clients to this early in the process.
In a few states, such as California, assignments for the benefit of creditors are increasingly common. In an ABC, the distressed business (the assignor) enters into a contract with a selected assignee that takes control of the assignor’s assets. The assignee sells them, then distributes the sale proceeds to the assignor’s creditors, in accordance with the priorities established under applicable state law. Often the purchaser is selected prior to the official commencement of the ABC. To be effective, ABCs typically require the consent of secured creditors.
Like receiverships, ABCs provide asset purchasers the benefit of buying assets from an independent fiduciary charged with protecting the best interests of the creditors of the distressed entity. This promotes a finding that the sale occurred at arm’s length for a fair price under the circumstances and that, in turn, helps protect against successor liability claims. Corporate counsel should look at the debt structure and at whether secured creditors are willing participants when clients are considering an acquisition out of a receivership or ABC.
Foreclosure, receivership, and ABC alternatives must be weighed against the backdrop of often-increased costs and delays in the 363 sale process and other related risks. At the same time, purchasing assets with the protection of a free and clear order continues to have substantial value, and bankruptcy sales typically remain the best way to purchase assets owned by entities with a complex capital structure and by those confronting divergent creditor positions. Corporate counsel to a potential purchaser of assets from a distressed business need to evaluate each of these options to determine the best way to close a sale under the circumstances presented.
Sara L. Chenetz and John E. Lucian are partners in Blank Rome’s business restructuring and bankruptcy practice group.