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Bankruptcy court: No longer the bargain basement

The reasons behind how the number, financial significance and strategic importance of bankruptcy sales has skyrocketed

Four decades ago, when I began my legal career, bankruptcy sales were held in low regard. They were regarded, and often referred to, as “fire sales” that were almost certain to attract no interested parties other than bottom feeding liquidators seeking to pay only a fraction of the value of the marketed assets. For this reason, potential sellers steered clear of bankruptcy.

Much has changed in the ensuing decades. The sheer number, financial significance and strategic importance of bankruptcy sales have skyrocketed. There are several probable reasons for this phenomenon: changes in the bankruptcy law itself, as it applies to sales of assets; the expansion of the doctrines of successor liability and fraudulent transfer, and the concomitant recognition by would-be purchasers that a bankruptcy court order is the most effective way of avoiding potential claims under these doctrines; and other bankruptcy “benefits” enjoyed by the seller.

Changes in the bankruptcy law

Prior to the adoption by Congress of a new and comprehensive bankruptcy statute in 1978, a company could not sell all or substantially all of its assets in a bankruptcy case absent a showing of emergent circumstances necessitating immediate sale. The prototypical example of such an emergency involved either a rapidly deteriorating asset (i.e., rotting bananas sitting in a warehouse) or a rapidly declining market for the company’s products (i.e., buggy whips after the invention of the automobile).

The enactment of the Bankruptcy Reform Act of 1978 (which provided that a plan of reorganization could provide for “sale of all or any part of the property of the estate”) and a succession of cases that almost immediately followed such enactment opened the door to such bankruptcy sales. In a few years, the sale hurdle was lowered from a showing of “emergent circumstances” to a showing that the proposed sale was within management’s “sound exercise of business judgment.”

Today, it appears that there is no legal hurdle at all. Most chapter 11 cases begin, or end, with sales of all or substantially all of the assets of the chapter 11 debtors. Sales are more the rule than the exception to the rule. True financial reorganizations (in which the company’s ownership remains in place) are the rare exception. Parties in interest rarely question the right of the debtors to initiate such sales, whether such sale are pursuant to so-called “section 363 motions” or plans of reorganization. Moreover, bankruptcy courts rarely require parties to provide proof of compliance with the business judgment test.

The successor liability and fraudulent transfer doctrines

Coincidentally, during the same time frame (particularly during the 1970s and 1980s), the doctrines of successor liability and fraudulent transfer also significantly evolved. The evolution of those theories of liability, and the resulting fear by would be purchasers that they will become the targets of litigation under those doctrines, has contributed mightily to the utility of bankruptcy sales.

I refer to the doctrine of successor liability as if it were a single legal theory of liability or cause of action. It is not. It is a group of legal theories or causes of action under which the holder of a claim against one entity seeks to assert its claim against a purchaser of that entity’s assets. Under long-settled black letter law, absent special circumstances (i.e., an express assumption of liabilities), an asset purchaser, as distinguished from a purchaser of the stock of the debtor entity, takes the assets free and clear of claims against the seller. In recent decades, however, in order to protect creditors (particularly, unintentional creditors like tort victims) from schemes to shield assets from such creditors’ claims, many courts have imposed liability upon successor entities in a variety of circumstances including, but not necessarily limited to, circumstances in which: (i) the purchaser has many of the characteristics of the seller — overlapping ownership, overlapping management, same office or manufacturing facility, use of same trade name or trademark, use of same sales and distribution network, or (ii) the purchaser and seller have historically acted as the “alter egos” of one another, or (iii) the sale is a fraudulent transfer in the sense that the purchaser paid less than fair consideration for the assets.

It is not the purpose of this article to explain and analyze these successor liability doctrines in any detail. Suffice to say, the assertion and application of these doctrines has multiplied exponentially in recent decades. As this has occurred, an increasingly savvy universe of potential business acquirers have insisted that proposed acquisitions be accomplished pursuant to bankruptcy court orders declaring, among other things, that a proposed sale is “free and clear of any and all claims and liens of any type” and that the sale is for “fair” or “reasonably equivalent” consideration. Absent showings of fraud or bad faith, such orders are non-assailable.

In other words, the buyers (not the sellers) have insisted that the sales be accomplished under the auspices of the bankruptcy court. The purchasers often pay a price for their insistence that the sale be accomplished in bankruptcy for the reason that bankruptcy courts routinely require, as a condition of any such sale order, that there be an appropriate marketing process (calculated to attract other potential purchasers and create an auction) for the subject assets. While the initial buyer, labeled a “stalking horse,” can achieve certain protections in any such auction such as a “break-up fee” and reimbursement of expenses, if its real goal is to be the successful purchaser, these protections are offer scant consolation if the assets are ultimately sold to the stalking horse at an enhanced price or are sold to an alternative bidder. Nonetheless, the protection from successor liability often motivates the purchaser to insist on a bankruptcy sale.

Other benefits realized by the seller

Finally, the accomplishment of a sale in the context of a chapter 11 case provides the seller with a host of additional benefits. These benefits include a number of benefits that are utterly unique to the bankruptcy process including, without limitation:

  • The ability to accomplish the marketing process and sale without interference from creditor lawsuits and collection activities
  • The ability to reject above-market unexpired leases that are of no interest to the would-be purchaser and, at the same time, to limit or cap the lessor’s resulting “rejection damages”
  • The ability to reject above-market or unneeded executory contracts
  • As a consequence of the rights of rejection, the potential to renegotiate existing unexpired leases and executory contracts upon more favorable terms
  • The potential ability to negotiate an agreement or plan of reorganization under which the agreed upon sale of the business is exchanged for a discount of debt

In recent years, many large “Blue Chip” companies have been sold under the auspices of the bankruptcy courts. Such sales are no longer regarded as fire sales. Indeed, often the bankruptcy sale process gives rise to spirited bidding by multiple suitors that drives the sale price well beyond any expected ceiling.

Contributing Author

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Neal L. Wolf

Neal L. Wolf, co-chair of the Creditors’ Rights, Insolvency & Bankruptcy group at Chicago-based law firm Much Shelist, provides creative solutions for corporate...

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