The Lionel case has long stood as the standard bearer for asset sales in bankruptcy that are outside of the ordinary course of business and outside of a plan of reorganization. The big auto cases later refined the analysis. The decision in Boston Generating1 confirms the option of selling substantially all of a debtor’s assets pursuant to a pre-negotiated sale, outside of a plan, and presented to the court within 48 hours of a Chapter 11 filing. Provided, that is, that

(i) there is a good business reason for proceeding with a sale rather than a plan,

(ii) there is an articulated business justification for the timing,

(iii) the sale reflects an appropriate exercise of business judgment and fulfillment of the debtor’s fiduciary duties, and

(iv) there is no viable alternative that is higher and better.

In Boston Generating, many of the debtors’ constituencies unsuccessfully objected to the sale, including minority members of the first-lien lenders, the second-lien agent and lenders and the Unsecured Creditors Committee, among others. Yet, the decision stands as a well reasoned approach to the Lionel factors (as further refined in the auto cases), which permit such sales outside of a plan of reorganization. The case also deals admirably with the valuation of existing liens as they tie to §363(f)(3) of the Bankruptcy Code. Despite the difficult wording of §363(f)(3), Judge Shelley Chapman determined that the provision applies to a sale otherwise permissible under §363(b), allowing the sale free of liens, claims and encumbrances, provided that there is evidence that the price offered equals or exceeds the value of the collateral.

Background

The debtors in Boston Generating were part of an electricity supply enterprise that provided wholesale electricity to the Boston area. They generated revenues by selling electricity, receiving capacity payments and providing ancillary services. Utilities providing electricity to end-use customers often bought forward contracts in the forward capacity market from the debtors. These forward capacity prices—which are known years in advance—were the most important aspect of the debtors’ asset value. At the time of the debtors’ bankruptcy filings, projections pointed to flat or declining capacity revenue for the debtors for several years to come. As a way to reduce exposure to unfavorable fluctuations in the energy commodity market, the debtors had entered into a series of energy hedge agreements. Over the eight quarters preceding the bankruptcy, energy hedges accounted for 50 percent of the debtors’ EBITDA (earnings before interest, taxes, depreciation, and amortization). Yet, low fuel prices, eroding demand and a significant surplus of future capacity supply had depressed market prices and reduced revenue.

Meanwhile, the debtors had to service approximately $2 billion in prepetition debt, including two tranches of secured debt: a $1.45 billion first lien term credit facility, of which approximately $1.13 billion was outstanding, and a $350 million second-lien term loan facility. These debt obligations were secured, respectively, by first and second priority liens on substantially all of the debtors’ property. The debtors also had approximately $422 million of unsecured debt. Given their revenue profile, the debtors had undertaken a substantial restructuring effort to see if their balance sheet could be remedied out of court. Ultimately, they concluded that a sale would best maximize values.

The Prepetition Sale Process

More than a year before the bankruptcy filing, Boston Generating was engaged in a restructuring effort, relying upon Perella Weinberg Partners. Once the debtors determined to pursue a sale, they hired JPMorgan to run the sale process. As evidence later demonstrated, the sale process began in earnest in April 2010. JPMorgan contacted nearly 200 potential buyers, later requesting preliminary letters of interest from 36 of them. They received 10 such letters, and six of the 10 potential buyers gained access to extensive due diligence. Two final bids were submitted. The debtors extensively negotiated with the two bidders, and were able to realize a $100 million increase in the winning bid from Constellation Holdings. The second-lien lenders’ financial advisors, their energy industry expert and their legal advisors were fully engaged in this process, and the debtors paid certain of the advisors’ fees in an attempt to promote a consensual transaction.

On Aug. 7, 2010, the debtors and Constellation signed a prepetition asset purchase agreement (APA) for the sale of substantially all of the debtors’ assets. The cash purchase price was $1.1 billion. The APA required the debtors to seek approval of the sale under §363 of the Bankruptcy Code and set out a timeline for the approval process in bankruptcy. The debtors had to obtain entry of a bankruptcy court sale order by 90 days after the petition date (subsequently, Constellation voluntarily extended this deadline). The sale would allow the debtors to pay approximately 98.5 percent of their first-lien debt, but would leave no recovery for the second-lien or unsecured creditors. The debtors and the first-lien lenders executed a sale support agreement, obligating the lenders to consent to the sale even if they were not paid in full. The agreement also permitted the debtors to pursue alternative transactions that the debtors believed would result in a higher and better offer.

The Bankruptcy Cases

The debtors filed their bankruptcy petitions on Aug. 18, 2010. One day later, they filed a motion to approve the Constellation sale, and among other things, approve stalking horse bid protections for Constellation and bidding procedures for the auction process in bankruptcy. On Oct. 12, 2010, the bidding procedures were approved, pursuant to which any “qualified bids” for the debtors’ assets would have to, among other things, exceed the value of the Constellation bid plus a break-up fee, plus a $10 million bid increment. JPMorgan then contacted the nearly 200 potential bidders it had contacted prepetition, as well as 40 additional potential bidders, to solicit new bids. JPMorgan also oversaw an electronic data site with tens of thousands of pages of information, and set up bidder-specific data sites for information that might compromise an individual bidder’s competitive position.

In early November, the board of members of the parent-debtor, EBG Holdings, voted to establish a special committee and appoint as its sole member William Howard Wolf (the sole independent member of the EBG board).2 The special committee was granted full power to evaluate and approve any and all possible options to maximize the value of the debtors’ estates, including the Constellation sale or any potential alternatives. Pursuant to that end, the special committee retained its own independent legal counsel and financial advisors.

The sole bid received in the bankruptcy auction was from MatlinPatterson Global Advisers, one of the second-lien lenders. The proposal involved a recapitalization of $750 million of debt, $200 million of accreting preferred stock invested by Matlin, and several hundred million shares of common equity (par value $1.00 per share) as well as certain warrants for the first lien lenders. Matlin claimed that the proposal reflected a $1.35 billion enterprise value for the debtors. But the proposal lacked a fully backstopped offering that would pay 100 cents on the dollar in cash to first-lien lenders who did not wish to accept a portion of their recovery in stock. Moreover, the debtors’ liquidity was an issue. Their CFO projected that the debtors would run out of cash within six months. Accordingly, the special committee concluded that the Matlin proposal was not a qualified bid and decided to move forward with the Constellation sale.

The ‘Lionel’ Factors3

The court conducted five days of hearings with testimony and argument on the bidding procedures and an additional five days of evidentiary hearings on approval of the sale. Those hearings focused upon the robust nature of the marketing process, both prepetition and postpetition, as well as the absence of any feasible or better alternative. The looming liquidity crisis weighed heavily in the bankruptcy court’s consideration. Although Matlin contended that it had a plan and competing offer, the court found that the term sheet was not confirmable and had the support of none of the constituencies (not even the dissenting first lien lenders). The independent financial advisor for the special committee testified that it would have been “commercially reckless” to abandon the Constellation bid and give Matlin an opportunity to garner support.

As is frequently true, valuation was at the “heart of this case.” The objectors argued that, given certain expected regulatory changes, it was the wrong time to sell and the debtors were not obtaining fair value. There were three reference points:

(i) the value proffered by Constellation;

(ii) the value proffered by the other bidder in the prepetition auction, which was very close; and

(iii) the value proffered by Matlin’s financial expert, which was a quarter billion dollars over the Constellation bid in reliance upon an expected regulatory change.

The bankruptcy court reasoned that in the absence of a clear market failure, the behavior in the market is the best indicator of enterprise value. On these facts, the information about the regulatory upside was appropriately highlighted in a heavily marketed, robust sale process involving sophisticated industry participants.4 Thus, the likelihood of market failure was low, and the sale transaction was the best determination of value of the debtors’ assets. Finally the court determined that, given the debtors’ expected negative cash balance and ensuing liquidity pressures, the debtors were at risk of deteriorating value. There was therefore no basis to conclude that reasonable alternatives existed or could be expected to exist in the future.

Section 363(f)

Section 363(f) of the Bankruptcy Code allows assets to be sold free and clear of all interests held by other entities. This can occur, among other situations, where the sale price is greater than the aggregate value of all liens, or the entity holding the interest may be compelled, in a legal or equitable proceeding, to accept a money satisfaction of its interest.5 The objectors relied upon Clear Channel6 to argue that the term “value” in §363(f)(3) requires that sale proceeds must exceed the sum of the face value of the liens—here, $1.45 billion.

Noting that the language of this subsection was less than perfect, the bankruptcy court rejected the Clear Channel approach, favoring instead the rationale set forth in In re Beker Industries.7 Beker interpreted §363(f)(3) to mean that “the price must be equal to or greater than the aggregate value of the liens asserted against it, not their amount.”8 In turn, the court reasoned that the value of the liens is determined by the value of the collateral, and the best evidence of the value of the debtors’ assets was the $1.1 billion bid. Because the value of the assets was not high enough to furnish the second-lien lenders with a recovery, the value of their lien was essentially zero, and the lenders were not secured. The Clear Channel rationale was also rejected with respect to §363(f)(5). The court reasoned that the second lien lenders could be compelled under state law to accept general unsecured claims if the sale proceeds are not sufficient to pay their claims in full.

Conclusion

Boston Generating is important in a number of respects. While it strengthens a debtor’s ability to sell substantially all of its assets under §363, it also confirms that there is a heavy evidentiary burden to do so. A debtor must establish the record of good business reason, articulated business judgment for timing, faithful discharge of fiduciary duties and no viable alternative. Interestingly, while getting the highest and best offer tends to be the core requirement that guides most §363 sales, there can be little doubt that the sale process, both before the case commenced and after the bidding procedures were approved, was critical in Boston Generating.

In this case, it was not only the breadth of the solicitation of interest. Equally important was the quality of information available in due diligence and the industry experience and savvy of the potential buyers and financial advisors. These factors served to defeat the objectors and their expert on multiple fronts, including on valuation and the fair process and fair price requirements of the entire fairness standard, which was alleged to be applicable. Finally, the lack of a feasible alternative after due inquiry retained its importance as it relates to the Lionel factors and the additional GM factors. Here the looming liquidity crisis and cash burn indicated deterioration in value and conveyed a picture of a debtor with a limited life and limited opportunities.

Corinne Ball is a partner at Jones Day.

Endnotes:

1. 440 B.R. 302 (Bankr. S.D.N.Y. 2010).

2. The remaining directors were officers of the non-debtor parent, and there were no allegations of a lack of disinterestedness except that the tax consequences of the sale would benefit the non-debtor parent more if the sale was completed in 2010, rather than 2011.

3. The preliminary issue of the second-lien lenders’ standing to object to the sale arose in the context of an intercreditor agreement entered with the first-lien lenders establishing the priority of the liens on the debtors’ assets. In brief, the agreement provided that the first-lien lenders would have the exclusive right to enforce rights and exercise remedies with respect to the collateral. The court ultimately found that this provision did not deprive the second-lien lenders of standing.

4. 440 B.R. at 327.

5. 11 U.S.C. §363(f)(3), (f)(5).

6. Clear Channel Outdoor v. Knupfer (In re PW), 391 B.R. 25 (9th Cir. BAP 2008).

7. 63 B.R. 474 (Bankr. S.D.N.Y. 1986).

8. Id. at 476.