Two concepts are at the core of sales pursuant to §363 of the Bankruptcy Code. First, a sale process should be designed and should operate to select and facilitate the highest and best offer. Second, the determination of which offer is the highest and best is not determined by price alone, but is also influenced by factors such as the certainty of closing. In the recent case of A123 Systems, there was strong evidence that the highest price bid was part of an offer that, although not certain to close, was structured to protect the Chapter 11 debtors’ estate from risk of loss if the purchaser failed to close. Accordingly, without closer examination, one might assume that the bankruptcy sale process had met the goals set out under §363, and further inquiry should end.

Yet Bankruptcy Judge Kevin Carey was confronted with allegations, which, if proven, suggested that the extraordinary efforts of the parties to achieve a price almost double the originally selected bid would also enable the disgruntled, losing bidder to take advantage of the sale structure, claim its break-up fee, and still gain the assets at a lesser price. Not surprisingly, the stalking-horse bidder argued that it had served its role of stimulating a higher bid and thus benefitted the estate, eliminating any further questions regarding its entitlement to the break-up fee. After all, the deal structure protected the Chapter 11 debtors from loss, arguably ending the authority of the bankruptcy court. Yet, Carey directed the break-up fee to be held pending further order. 1

At least preliminarily, the concern that a bidder might utilize the process and deal structure to advantage itself merits further consideration to the extent that the integrity of bankruptcy sales process is implicated, even if there is no direct monetary loss to the estate. While no final determination has been made in A123, there is strong support for the proposition that the bankruptcy court has authority to act if there are concerns over a potential abuse of the bankruptcy process.2

The case of A123 Systems has been closely watched for many reasons, primary among them are the concerns over the interaction of bankruptcy sales with government contracts and national security, especially when the potential buyers include foreign nationals, such as Wanxiang here, a substantial Chinese company. As a result of these concerns, the A123 sale is subject to approval by the Committee for Foreign Investment in the United States (CFIUS). 3 Carey took issue with the conduct of Johnson Controls, long-time suitor with respect to A123′s assets, after it lost at auction and then allegedly lobbied the U.S. government to block the sale. Johnson, having served as an unsuccessful stalking-horse bidder for the sale, claimed its break-up fee pursuant to the bidding procedures order governing the A123 Systems sale process. The Official Committee of Unsecured Creditors objected based upon allegations that Johnson was acting to defeat Wanxiang’s CFIUS approval while maintaining Johnson’s interest as a potential buyer.

Background 4

A123 Systems designs, manufactures and sells advanced lithium-ion batteries and energy storage systems, focusing on developing new generations of lithium-ion batteries for use in the transportation, electric grid and commercial markets. A portion of A123′s business arises out of U.S. government military contracts. A123′s first commercial batteries began shipping in February 2006, and in 2007 the company expanded its operations to include production in China. In December 2009, A123 was awarded $249.1 million in government grants under the American Reinvestment and Recovery Act to support domestic manufacturing expansion in Michigan. In 2010, A123 expanded its domestic manufacturing capacity by establishing vertically-integrated plants in the United States that handled every stage of the manufacturing of batteries and battery systems.

A123′s business suffered a series of set-backs from 2010 to 2011. The company discovered technical issues in the manufacturing of certain of its batteries and various safety problems. Just as this was happening, one of the company’s largest customers unexpectedly reduced its orders. In Spring 2012, A123 launched a costly campaign to replace the faulty products. As a result, the company anticipated incurring substantial losses and negative operating cash flows, and, in March 2012, A123 retained investment bankers to explore the possibility of selling its assets in order to stay viable.

Restructuring and Potential Sale

Prior to filing for bankruptcy, A123 evaluated various options including new financing, refinancing and the sale of some or all of its assets. A123 employed an extensive marketing process, soliciting 74 entities to serve as partners, equity investors, or buyers. It was determined that strategic buyers, rather than strategic investors, would be more interested in acquiring A123′s assets. Ultimately, 10 parties conducted full-scale due diligence on A123, and of those, seven visited the company’s facilities and received management presentations. This process led to an offer from China’s largest auto-parts maker and prepetition lender to A123, Wanxiang Group, which would invest in A123 as a going concern. A123 had also received three non-binding offers to purchase or invest in a more limited subset of A123′s assets.

After extensive negotiations, A123 entered into various agreements with Wanxiang. The parties agreed, as a component to these transactions, that they would submit any sale to CFIUS. Ultimately, it became clear that certain closing conditions would not be met prior to A123′s liquidity falling below operational levels. Even still, the sale of A123 was infused with politics early on as a result of its dealings with Wanxiang, prompting, for example, Senators Chuck Grassley and John Thune to make inquiries to the Department of Energy as to the fate of A123′s stimulus funds and the prospect of the company becoming Chinese-owned.

Chapter 11 and Sale

After the failed attempt at a prepetition sale to Wanxiang, A123 was forced to file for Chapter 11 protection on Oct. 16, 2012 in the Bankruptcy Court of the District of Delaware. On the petition date, A123 had roughly $19 million cash on hand, but was unable to access it due to certain covenants under Wanxiang’s bridge loan facility. Prior to filing, A123 secured a commitment for $72.5 million in DIP financing from rival Johnson Controls at a 15 percent interest rate, with Johnson also concurrently serving as stalking-horse bidder for the sale of A123′s auto-related assets. Before the final hearing on the DIP financing, however, A123 petitioned the court to approve a replacement DIP from Wanxiang—a $50 million facility at 12 percent, which purported to repay any outstanding amounts already borrowed under the Johnson facility. The court approved the Wanxiang facility on a final basis on November 26.

Johnson Controls emerged as the stalking-horse bidder for the sale with a $125 million offer, but Wanxiang America, a wholly-owned subsidiary of Wanxiang Group, objected to the proposed bidding procedures, arguing that it was interested in serving as the stalking-horse bidder for substantially all of the A123′s assets, not just the auto-related assets. Further, Wanxiang America objected to certain stalking-horse protections, including the $3.75 million break-up fee, uncapped expense reimbursement estimated at $4 million and a minimum initial overbid of $2.5 million. 5

On Nov. 8, 2012, the bankruptcy court approved A123′s bidding procedures and stalking-horse bid protections over the objections. A123′s auction began on Dec. 6, 2012 with Johnson Controls, Wanxiang, NEC Corporation and Siemens AG submitting confidential bids. Three days later, Wanxiang was announced as the highest bidder offering $256.6 million for A123′s automotive, commercial and electric-grid assets. The bid came in about $5 million higher than a combined bid by Johnson Controls and NEC. A U.S. company, Navitas Systems, won the auction for A123′s smaller government division. By the terms of the court’s bid procedures order, Wanxiang’s winning bid obligated the company to pay approximately $5 million to Johnson Controls as a break-up fee and expense reimbursement. The debtors expected to close the sale around the middle of January.

Aftermath

A hearing to approve the sale to Wanxiang was scheduled for Dec. 11, 2012, but even if the sale were approved, the deal would still require the approval of the CFIUS. At and prior to the sale hearing, there was evidence that numerous statements of concern from lawmakers and former military leaders were submitted to CFIUS seeking to block the Wanxiang deal. Among them were the Strategic Materials Advisory Council, a group of former military leaders and industry experts who argued that the battery technology used in A123′s electrical grid and automotive businesses, being similar to that used for military purposes, would raise national security issues if sold to a Chinese company. Those pleading with the CFIUS to reject the Wanxiang deal also reportedly included Johnson Controls.

At the sale hearing on December 11, the debtors described their solution to the uncertainty regarding the CFIUS approval, which they said would be alleviated by setting up a trust into which the sale would close. The debtors would receive the proceeds of the sale, and the trust would become the temporary owner of the assets pending CFIUS approval. Once CFIUS approval was obtained, the trust would dissolve and the assets would vest with Wanxiang. If the CFIUS did not approve the sale, the trust would dispose of the assets for the benefit of Wanxiang.

But another interesting issue was raised at the hearing, which piqued the attention of Carey. In response to the proffer of testimony of the A123′s CFO on the appropriateness of the sale, counsel to the creditors’ committee rose to object to the payment of the break-up fee to Johnson Controls. The committee counsel elicited testimony from the CFO to the effect that the CFO was aware that Johnson Controls was actively lobbying the CFIUS to block the sale to Wanxiang. The committee raised the issue again later, arguing that it was “inconsistent with the entire nature of Section 503 [of the Bankruptcy Code]…for a party to be paid $5 million while it’s trying to kill the transaction…it’s being paid to bring about.” 6 The committee proposed to escrow the break-up funds based on Johnson Control’s lobbying efforts, pending depositions of any relevant actors at Johnson Controls with respect to its conduct.

While Carey neither explicitly agreed with the committee’s interpretation of the Bankruptcy Code, nor confirmed that Johnson Controls break-up fee would be permanently held back if depositions revealed that Johnson Controls was actively lobbying to block the Wanxiang sale, he agreed to escrow the break-up fee pending depositions, stating that he was “troubled by the suggestion that somebody who participated in the auction may in fact already be working against the parties being able to satisfy a condition of the sale.” 7 The judge appended his decision to the sale order by hand. 8

Conclusion

On the very day of the sale order, which provided for escrowing the break-up fee, was entered, Johnson Control’s filed notice of appeal on the narrow issue of the break-up fee, not the sale to Wanxiang. Independently, however, Johnson Controls has stated publicly that it remains interested in taking advantage of any future opportunity to acquire the assets of A123. It is possible that the very actions designed to assist the bankruptcy sale process and double the sale proceeds, notably transferring the risk of loss to Wanxiang should it not receive CFIUS approval, now provide the potential for the losing bidder to claim its break-up fee and gain the assets at a lesser price. The circumstances are unique, but there could well be implications for future bankruptcy sales. Will ignoring Johnson’s efforts to undermine the bankruptcy court-approved highest and best offer discourage future buyers from participating in bankruptcy sales? More importantly, once a potential buyer participates in bankruptcy sale process, contributes to the bidding procedures order and loses, should it be able to obtain a second bite at the apple funded by the bankruptcy estate? Does that circumstance amount to an abuse of the bankruptcy process? In A123 Systems, the evidence has not yet been heard. There can be no doubt, however, about the authority of the bankruptcy court to protect the integrity of the bankruptcy process.

Corinne Ball is a partner at Jones Day.

Endnotes:

1. In re A123 Systems, No. 12-12859 (KJC) (Bankr. D. Del. Dec. 11, 2012).

2. For example, Justice David Souter, sitting by designation on the First Circuit, recently held that §105 of the Bankruptcy Code empowered a court to take action mitigating the effects of a debtor’s fraud upon the bankruptcy process even though the Code lacked an explicit statutory predicate for such action. See Malley v. Agin, 693 F.3d 28, 30 (1st Cir. 2012) (“If §105(a) was not meant to empower a court to issue an order like the one before us, it is hard to see what use Congress had in mind for it.”) (citing Marrama v. Citizens Bank of Mass., 549 U.S. 365 (2007) (invoking “the broad authority granted to bankruptcy judges to take any action that is necessary or appropriate ‘to prevent an abuse of process’ described in §105(a) of the Code”)); see also Latman v. Burdette, 366 F.3d 774, 786 (9th Cir. 2004) (affirming bankruptcy court’s power to invoke unstated remedy to protect the integrity of the bankruptcy process); but see In re Scrivner, 535 F.3d 1258, 1264 (10th Cir. 2008) (bankruptcy court’s equitable authority did not include the power to “grant any more or less than what the clear language of the Bankruptcy Code mandates”). Moreover, a bankruptcy court also has authority to modify its own orders where the circumstances justify it. See Montco v. Barr (In re Emergency Beacon), 666 F.2d 754 (2d Cir. 1981) (Bankruptcy Rule 924 empowers a bankruptcy court to modify its orders where appropriate). Judge Andrew J. Peck’s decision, currently on appeal to the Second Circuit, to return approximately $4 billion to the Lehman Brothers estate after the sale to Barclays echoes these themes, where the decision was based in part on a conflict between certain sale documents and the statements and representations of the parties at the sale hearing. In re Lehman Brothers Holdings, 445 B.R. 143 (Bankr. S.D.N.Y. 2011) rev’d in part at 478 B.R. 570 (S.D.N.Y. 2011).

3. CFIUS is a unit of the Department of Treasury tasked with evaluating foreign purchases of U.S. assets for national security implications.

4. The factual material contained herein was taken from bankruptcy court pleadings of the debtors and other parties in interest, as well as other publicly available documents.

5. Both the U.S. Trustee and Fisker Automotive also objected to the Bid Procedures motion on the grounds that the stalking-horse protections were unreasonably high, and would be counter-productive to the sale process.

6. Trial Transcript, In re A123 Systems, No. 12-12859 (KJC) (Bankr. D. Del. Dec. 11, 2012), at 92.

7. Tr. Transcript, at 101.

8. See In re A123 Systems, No. 12-12859 (KJC) (Bankr. D. Del. Dec. 11, 2012), at 11.