Who Wins in the Race to Get Break-up Fees Approved

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Oct 2003

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Editor's Note:Most experienced practitioners will agree that what happens in the early days of a bankruptcy case often shapes the rest of the case. This is the first in a series of columns that will focus on current issues and trends in the early days of chapter 11 cases—whether in the first days or the first weeks of the case.

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Chapter 11 cases that contemplate a sale of all or a substantial portion of a
debtor's assets under §363 of the Bankruptcy Code have become
routine. In fact, chapter 11 cases that involve sales of assets seem to be more
common than those that involve "stand-alone" reorganization plans.
Thus, bankruptcy courts have become accustomed to seeing sale-related pleadings
and requests for relief at the outset of a case. Often, the debtor signs an
asset-purchase agreement on the eve of a bankruptcy filing and immediately
seeks approval of bid and auction procedures and an asset sale. There was a
time when motions to establish bidding procedures were filed and heard at the
"first-day" hearing.<a href="#1" name="1a">1</a> This is no longer the general practice.
Except in the extraordinary case, nearly all bankruptcy courts require noticed
sale-procedures hearings, recognizing that notwithstanding the
"procedural" name tag, sales "procedures" have an
impact on substantive rights. And, although notice requirements might be
modified in response to the exigencies of a particular case, most courts will
wait until a creditors' committee is appointed and can be heard.

Nonetheless,
provided that a reasonable amount of notice is given, sale procedures are
routinely approved. Among these "routine" sale procedures is the
granting of a break-up fee to an unsuccessful purchaser. It is unusual to come
across a buyer that doesn't demand a break-up fee when contracting to buy
assets that will be tested in a bankruptcy auction. And, so long as the
break-up fee is within the 2-3 percent range, it is unusual for the break-up
fee to be denied. Some courts apply the "administrative expense"
test articulated by the Third Circuit in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Corp. v. O'Brien Envt'l. Energy Inc. (In re O'Brien
Envt'l. Energy Inc.), 181 F.3d 527 (3d
Cir. 1999)</a>,<a href="#2" name="2a">2</a> while other courts continue to apply a business
judgment standard such as that articulated in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Committee v. Integrated Resources Inc. (In re Integrated Resources Inc.), 147 B.R. 650, 657</a> (S.D.N.Y.) 1992)
(discussed below). Under either test, however, bankruptcy judges are looking
more carefully at the circumstances under which break-up fees are granted and
are requiring an appropriate evidentiary showing. Thus, without a stalking
horse or an evidentiary showing of the benefit to the estate, it is difficult
to obtain bidding protections for an open auction. Also, as is demonstrated by
the Top-Flite case discussed below, even
a signed stalking-horse agreement might not be enough if there are other
bidders willing to move forward without break-up fee protection.

Prior to O'Brien, courts considering the
propriety of a proposed break-up fee typically considered "(1) whether
the relationship of the parties who negotiated the fee is marked by
self-dealing or manipulation; (2) whether the fee hampers, rather than
encourages, bidding; and (3) whether the amount of the fee is reasonable in
relation to the proposed purchase price." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Twenver Inc., 149 B.R. 954, 956 (Bankr. D.
Colo. 1992)</a>. Accord, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Bidermann Indus. U.S.A. Inc., 203 B.R. 547,
552 (Bankr. S.D.N.Y. 1997)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Committee v. Integrated Resources Inc. (In re Integrated Resources Inc.), 147 B.R. 650, 657 (S.D.N.Y. 1992)</a>.

In O'Brien, however, the Third
Circuit held that under the circumstances of the particular case, the payment
of a break-up fee was appropriate only if the fee was among the actual,
necessary costs and expenses of preserving the estate and therefore qualified
as an administrative expense within the meaning of §503(b) of the <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Code. O'Brien, 181 F.3d at 535</a>. The Third Circuit distilled
the inquiry to whether awarding break-up fees was necessary to preserve the
value of the debtor's estate. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 536</a>.

Because O'Brien did not involve a request
to approve the payment of a break-up fee prior to consummation of an auction,
and instead involved a post-auction payment request by a disappointed bidder
under §503(b) of the Bankruptcy Code, O'Brien is somewhat distinguishable
from the case where approval of a break-up fee is sought before an auction.<a href="#3" name="3a">3</a>

In two recent Delaware bankruptcy cases, Judge Walsh and Judge Walrath refused to
approve break-up fees.<a href="#4" name="4a">4</a> While neither ruling is published, they serve to remind
practitioners that notwithstanding how often such fees are granted, an
appropriate factual showing must support such fees.

<h3>Pillowtex: Pre-approval of Bid Procedures</h3>

Pillowtex filed a chapter 11 case in Delaware on July 30, 2003. One of the first-day
motions filed in the Pillowtex bankruptcy case was the "Motion of Debtors and Debtors-in-possession for
an Order (A) Approving Global Bidding Procedures and (B) Authorizing Debtors to
Grant Pre-Approved Bid Protections to Prospective Purchasers" (the Global
Bid Procedures Motion). The Global Bid Procedures Motion was heard on Aug. 20,
six days after a creditors' committee was appointed in the case. Through
the Global Bid Procedures Motion, Pillowtex sought pre-approval of certain
bidding procedures and bid protections to apply to certain asset sales
involving the transfer of more than $1 million in aggregate consideration. The
global bidding procedures would allow Pillowtex to (1) review initial
expressions of interest and accept initial bids, (2) negotiate and enter into purchase
agreements with bidders, (3) solicit additional bids and conduct an auction and
then (4) submit the final bid to the bankruptcy court for approval. The global
bidding procedures also would authorize Pillowtex to offer initial bidders
certain bid protections, including the payment of break-up fees and the
reimbursement of expenses without first seeking court approval of such bid
protections.

At the hearing on the Global Bid Procedures Motion, the court addressed a
provision in the motion that provided for preapproval of break-up fees and
expense reimbursements. Pillowtex characterized the requested relief as
"standard," noting that a virtually identical order had been
approved in Pillowtex's previous chapter 11 case. Transcript of Hearing
at 28, Pillowtex (Aug. 20, 2003; docket
item no. 261). However, under the standard set out in O'Brien, the bid must be considered in the context of the
marketing process in order to determine whether or not a bidder is entitled to
a break-up fee. As discussed above, if a break-up fee serves to induce an
initial bid, it might be permissible; where it serves to advantage a favored
purchaser over other bidders by increasing the cost of the acquisition to the
other bidders, it is impermissible. Under the procedures proposed by Pillowtex,
the debtor and committee determined the break-up fee was appropriate. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 32</a>.

After
hearing arguments from the parties, Judge Walsh stated that "everybody is
aware that where a bid procedure motion is brought on with a contract with a
stalking horse, it is not a difficult case to make out to get a break-up fee in
most instances. But it is a fact and circumstance decision and authorizing it
in advance simply does not allow for that decision." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 33</a>. Accordingly, Judge Walsh found
that the O'Brien decision precluded
him from giving carte blanche authority to Pillowtex or its creditors'
committee to execute contracts with break-up fees.

<h3>SHC Inc. (Top-Flite Golf): A Competing Bidder Spoils the Break-up Fee</h3>

SHC Inc., a preeminent producer of golf balls worldwide, commenced its chapter 11
cases along with certain affiliates on June 30, 2003, in the District of
Delaware. Top-Flite filed a motion on July 3 seeking approval of bid procedures
and related relief in connection with its asset-purchase agreement with Callaway
Golf Co. ("Callaway" and the "Callaway Bid Procedures
Motion"). Top-Flite had entered into an agreement to sell substantially
all of its assets to Callaway for $125 million. The asset purchase agreement
with Callaway provided for Callaway to receive a break-up fee and expense
reimbursement and did not require Callaway to post a deposit. The Callaway Bid
Procedures Motion was heard on July 23, 2003. Competing bidder Adidas-Salomon
(Adidas) filed an objection to the bidding procedures and appeared at the
hearing. Adidas made an evidentiary showing that it had pursued Top-Flite for
an extensive period of time and argued that Top-Flite did not fully consider
their bid. In its objection, Adidas stated that it was prepared to immediately
execute the same asset purchase agreement that Callaway executed, but without
requiring a break-up fee and with a purchase price increase of $1 million.
Adidas was also prepared to post a $12 million deposit. Objection of
Adidas-Solomon AG to Debtors' Motion at 2-3, Top-Flite (July 16, 2003;
docket item no. 57).

During
the hearing, Top-Flite argued that Adidas had no standing to object to the bid
procedures. Transcript of Hearing at 30-31, Top-Flite (July 23, 2003; docket
item no. 160). Judge Walrath disagreed, finding that whether there is a another
bidder willing to bid without break-up fee procedures is relevant to her
consideration of whether or not the bid procedures are reasonable. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 31-32</a>. Thus, Judge Walrath heard
testimony and argument from Top-Flite and from Adidas.

At
the conclusion of the argument, Judge Walrath issued the following ruling:
"I will in the first instance approve Calloway [sic] as a stalking horse
with no break-up fee whatsoever. In the event Callaway is not interested in
that, I will approve Adidas as the stalking horse on the exact same terms, no
break-up fee. So let's take 10 minute[s] and see who signs first." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 104</a>. Judge Walrath's ruling
appears to be based on her concern that Adidas was not given appropriate
consideration in the stalking horse selection process. She did not imply that
anytime another bidder shows up at the last minute with a better deal that that
bidder can trump the stalking horse.

After a brief recess, Top-Flite advised the court that Callaway was prepared to
remain the stalking horse and would withdraw the break-up fee requirement. On
that basis, the Callaway Bid Procedures Motion was granted.<a href="#5" name="5a">5</a>

<h3>Conclusion</h3>

It has become routine to obtain a hearing and consideration of auction procedures
and bid protections in the early days of a chapter 11 case. However, courts are
not likely to simply rubber-stamp these motions. The lessons from Top-Flite are that debtors must show that the stalking horse
has a deal likely to bring value to the estate and that the O'Brien standard (break-up fee is appropriate only if there
is a showing that the fee is an actual, necessary cost and expense of
preserving the estate) is met. The Top-Flite decision also makes clear that debtors should fully
vet potential offers before selecting a stalking horse with which it will
proceed forward. Pillowtex

reminds us that practitioners should be fully prepared and should not assume
that anything is standard or pro forma. Thus, in open auctions without a
stalking horse, bidding protections will be granted only if the appropriate evidentiary
showing is made.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Although the bankruptcy community commonly uses the term "first-day hearings," the hearing is rarely on the first day of the case; instead,
absent an unusual circumstance, in most jurisdictions the hearing to consider
the motions that are filed on the first day is generally set within 48 hours of
the commencement of the case. <a href="#1a">Return to article</a>

<a name="2">2</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… Inc. v. Iowa Quality Beef Supply Network LLC (In re Tama Beef Packing Inc.), 290 B.R. 90, 98 (BAP 8th Cir. 2003)</a> (showing that administrative claim for break-up fee benefited the estate "in some demonstrable way" required; applies nine O'Brien factors); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… v. Lamb (In re Lamb), 2002 WL 31508913, *2
(Bankr. D. Md. Oct. 11, 2002)</a> (breakout fee request made only
after bidder was unsuccessful not necessary to preserve estate value); cf. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re American Appliance, 272 B.R. 587, 601
(Bankr. D. N.J. 2002)</a> (bank's request to receive
reimbursement of post-petition rental payments if unsuccessful in acquiring
leasehold interest must await sale of interest in order to determine whether it
constitutes actual, necessary cost of preserving value of the estate). <a href="#2a">Return to article</a>

<a name="3">3</a> As one commentator stated:

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Indeed, O'Brien reflects the general difficulty of obtaining court approval of bidding incentives after the bidding process. With the benefit of hindsight, courts can subject such incentives to the strictest scrutiny. As one court has observed, characterizing a bidding incentive as "a permissible type that promotes bidding, or a harmful strain that discourages bidding, appears to be no more than conclusory judicial labels that are affixed by hindsight after the [bidding incentive] has been scrutinized by the courts." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
v. Storer Comm. Inc., 849 F.2d 570, 576 n.7 (11th Cir. 1988)</a> (quoting Leo Herzel, et al., Misunderstanding Lockups, 14 Sec. Reg. L.J. 150, 1177 (1986)). In O'Brien, the court gleaned from robust bidding that the bidders believed they could acquire O'Brien cheaply, and thus the prospect of receiving a break-up fee was unnecessary. Of course, if the bidding had been slow or nonexistent, the court could just as well have blamed the break-up fee. This ability to blame a break-up fee after weak bidding, but look elsewhere after spirited bidding, makes predictability impossible. At a minimum, a potential purchaser seeking a break-up fee ought to obtain court
approval of the fee before the auction and be prepared to support that request with evidence of benefit to the estate, perhaps in the form of minimum bid increases or "topping" protections.

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Kugler, Robert T. and Boettge, Douglas R., "In Search of the Elusive Break-up Fee," <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… Am. Bankr. Inst. J. 14, 37 (Sept. 2000)</a> (emphasis added). <a href="#3a">Return to article</a>

<a name="4">4</a> In re Pillowtex Corp., Case No. 03-12339 (PJW)
(Pillowtex); In re SHC Inc., Case No. 03-12002 (MFW) (Top-Flite). <a href="#4a">Return to article</a>

<a name="5">5</a> On Sept. 4, 2003, Top-Flite announced that Callaway had emerged as the top bidder for its assets. Judge Walrath held a hearing on Thursday, Sept. 11. <a href="#5a">Return to article</a>

Journal Authors

Debra I. Grassgreen

James A. Stempel

James H.M. Sprayregen

Laura Davis Jones

Journal Date

Wednesday, October 1, 2003 - 12:00

Bankruptcy Rule

2003