Over the last decade or so, the vast majority of chapter 11 cases not converted to chapter 7 have resulted in sales of the debtors' assets. The sales were accomplished either under § 363 of the Bankruptcy Code or pursuant to a liquidating chapter 11 plan. Although reasons vary, primary motives include the amount and nature of claims held by undersecured senior lenders, which often precluded the confirmation of plans where the debtors’ owners retained their interests. Additionally, secured lenders routinely conditioned the extension of essential post-petition financing upon the debtors’ agreeing to prompt sales under § 363.
The initial objective of most § 363 sale processes is to identify a stalking-horse bidder. The stalking horse agrees to purchase the debtor’s assets at an agreed-upon price unless a higher or otherwise better bid is received. Stalking-horse bids set a floor price and guarantee that the assets will be sold, and, it is argued, induce other competing bids.
To entice a party to become a stalking-horse bidder, various incentives are typically offered, including the ability to exercise some control over the bid process by crafting the asset-purchase agreement, setting the initial overbid amount, and approving the form of the bid procedures, sale motions and order. One of the most important incentives offered to the stalking-horse bidder is a break-up fee.[1]
A break-up fee is an incentive payment offered to a prospective purchaser.[2] It compensates the stalking-horse bidder for its efforts and expenses associated with the due diligence investigation required to make a binding offer to purchase the debtor's assets. If the stalking horse is outbid by a higher or otherwise better bid, the fee is generally paid at closing from the proceeds of the sale. The size of the break-up fee varies, usually ranging between 2 and 5 percent of the sale price (with the higher fees usually being paid in connection with smaller transactions), and averaging slightly over 3%.[3]
Break-up fees in 363 sales are subject to bankruptcy court approval, and at least three separate standards for such approval have emerged. In In re Integrated Resources Inc.,[4] one of the earliest cases to establish a standard, the district court reviewed bankruptcy court approval of a break-up fee between $1.25 million and $6 million.[5] The court noted that few cases had considered the validity of break-up fees in bankruptcy, but that outside of bankruptcy such fees were considered presumptively valid.[6] In affirming the bankruptcy court, the court enunciated three questions that should be considered: (1) is the relationship of the parties who negotiated the break-up fee tainted by self-dealing or manipulation; (2) does the fee hamper, rather than encourage, bidding; and (3) is the amount of the fee unreasonable relative to the proposed purchase price?[7]
After reviewing each question, the court approved the application of the business judgment rule and found that the proposed break-up fee was appropriate. The court defined the business judgment rule as "a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company," citing decisions considering Delaware corporate law.[8] Employing this standard, the break-up fee was appropriately authorized, said the court, even though in this instance the agreement to pay the fee was reached before the purchaser entered into a binding agreement to purchase the debtor's assets.[9]
In re America West Airlines Inc.[10] established the second standard applicable to approval of break-up fees. The court considered approval of an Interim Procedures Agreement that provided for a $4 million to $8 million break-up fee to a stalking-horse bidder that was selected after the debtor was marketed to approximately 100 potential bidders. The court criticized the Integrated Resources decision as failing to adequately address the requirements of § 363(b) of the Code and the differences between transactions inside and outside of bankruptcy.[11] The court rejected the business judgment standard and held that the analysis must entail a determination of what is in the best interests of the estate and all concerned.[12]
Finding that the proposed fee was not in the best interests of the estate, the court concluded that because the debtor's assets were thoroughly marketed, the break-up fee would not induce further bidding. To the contrary, the court observed that the requested break-up fee would unnecessarily chill bidding and potentially deplete the estate of assets that could be used to fund a plan of reorganization.[13] The court found that the break-up fee was not reasonable under the circumstances, and even if it were to apply the business judgment standard, it would not approve the fee.[14]
Finally, in In re Reliant Energy Channelview LP,[15] the Third Circuit considered a bidder's assertion that it was entitled to a $15 million break-up fee (about 3% of the proposed purchase price). The stalking horse was selected as the winning bidder from among 12 parties submitting bids after an extensive marketing effort.[16] At the hearing to approve the sale, an unsuccessful bidder that had previously submitted a contingent bid claimed that if not for the break-up fee, it would have been willing to submit a higher bid if an auction had been held.[17] The bankruptcy court ordered that an auction be held, approved a $5 million overbid and the stalking horse's expense reimbursement of up to $2 million, but declined to approve the $15 million break-up fee.[18]
The stalking horse refused to participate in the auction, at which the objecting bidder was the highest bidder with a non-contingent bid higher than the original stalking horse's bid. The stalking-horse bidder appealed the decision denying the break-up fee as an abuse of discretion.[19] The district court affirmed the decision, and the stalking horse appealed to the Third Circuit.
The court held that the appropriate standard to apply when considering approval of a break-up fee is whether the fee qualified under § 503(b) as an actual and necessary cost of preserving the estate, relying on its prior decision in Calpine Corp. v. O'Brien Env't Energy Inc. (In re O'Brien Env't Energy Inc.).[20] The court acknowledged that break-up fees provide a benefit to the estate by setting a minimum price and providing a complete set of offer terms. However, it questioned whether the award of the break-up fee was necessary to preserve the value of the estate as required by § 503(b).[21]
The court stressed that the stalking-horse bid was not conditioned upon approval of the break-up fee, but conditioned only upon the debtor's promise to seek approval of the fee, which was not assured.[22] Even if a bid was conditioned upon court approval and such approval was not forthcoming, the court observed that a bidder may still decide to proceed with its bid, as did the bidder in O'Brien. Although the estate in Reliant could have been substantially harmed if the break-up fee was not approved and the stalking horse withdrew its bid with no other bidder coming forward, the fact that a competing bidder indicated that it would bid more if the fee was not approved, and the likelihood that the stalking horse would proceed to close without a break-up fee if no other party in fact came forward, justified the court's decision to refuse to approve the fee.[23]
Finally, the court rejected the stalking-horse bidder's assertion that the debtor approved the fee and that the business judgment rule would have applied outside of bankruptcy. Relying on O'Brien, the court held that the business judgment rule should not apply in a bankruptcy context and that the appropriate standard is the one required by § 503(b) of the Code.[24]
Reliant formulates the most stringent standard applied by courts to date for approval of a break-up fee.[25]
[1] While this article focuses on break-up fees, the stalking-horse bidder may also request reimbursement of its expenses. Some courts will permit both break-up fees and expense reimbursement, while others will only allow expense reimbursement capped at the amount of the actual expenses incurred. See infra note 15.
[2] The Official Comm. of Subordinated Bondholders v. Integrated Res. Inc. (In re Integrated Res. Inc.), 147 B.R. 650, 653 (S.D.N.Y. 1992).
[3] Id. at 662. See also Joseph Samet, “Use of Break-Up Fees and Topping Fees in Corporate and Bankruptcy Asset Sales,” 918 PLI/COMM 351, 362-363 (2009).
[4] 147 B.R. 650 (S.D.N.Y. 1992). See also In re Metaldyne Corp., 409 B.R. 661 (Bankr. S.D.N.Y. 2009).
[5] In re Integrated Res., 147 B.R. at 655.
[6] Id. at 657.
[7] Id.
[8] Id. at 656.
[9] Id. at 663.
[10] In re America West Airlines Inc., 166 B.R. 908 (Bankr. D. Ariz. 1994).
[11] Id. at 912.
[12] Id.
[13] Id. at 913. In reaching its decision, the court adopted the reasoning enumerated in Bruce A. Markell, The Case Against Breakup Fees in Bankruptcy, 66 Am. Bankr. L. J. 349 (1992), in which the author reviews the importation of break-up fees into bankruptcy cases and argues that, except in rare cases, break-up fees waste estate assets.
[14] Id. Additionally, although the court declined to approve the break-up fee, it found that the requested expense reimbursement of between $250,000 and $3 million was reasonable and approved it.
[15] 594 F.3d 200 (3d Cir. 2010).
[16] Id. at 203.
[17] Id. at 204.
[18] Id.
[19] Id.
[20] 181 F.3d 527 (3d Cir. 1999).
[21] In re Reliant Energy Channelview LP, 594 F.3d at 207.
[22] Id.
[23] Id. at 208.
[24] Id. at 209.
[25] In ARSACO, L.L.C., et al v. Elliott Management, et al (In the Matter of ASARCO L.L. C.), 650 F. 3d 593 (5th Cir. 2011), in approving expense reimbursement for all qualified second-round bidders, the Fifth Circuit rejected the Reliant standard in favor of the business judgment standard articulated in Integrated Resources.