Part I
This article is the first in a series of articles discussing §363(n) and collusion in bankruptcy sales. Subsequent articles will discuss the fine line between collusion and collaboration, and will explore the application of the specific elements of a §363(n) action.
Since the enactment of the Bankruptcy Abuse and Consumer Protection Act of 2005 (BAPCPA) approximately two years ago, bankruptcy commentators have speculated on exactly how this legislation would change the administration of bankruptcy cases. It was clear from enactment that several changes in the law made chapter 11 reorganization cases more complicated and more costly. As a result, it appears that more and more debtors are avoiding a “full blown” reorganization under the Bankruptcy Code in favor of selling all or a portion of the business in bankruptcy. Such a sale is authorized under §363 of the Bankruptcy Code and is commonly referred to as a “§363 sale.”
A §363 sale is usually conducted via a public or private auction. The debtor frequently obtains court authorization for the bidding procedures. Parties bid on the assets for sale pursuant to the court approved procedures and the debtor sells the assets to the highest and best bidder, conditioned on court approval of the sale.
The debtor sets out the procedures for the auction process in its court-approved filing. These procedures are supplemented by the provisions of the Bankruptcy Code. One of the most important of such provisions is the prohibition on collusive bidding in Bankruptcy Code §363(n). Generally speaking, §363(n) prohibits potential bidders at a §363 sale from colluding, thereby stifling the bidding process and denying the debtor the true value for the assets.
The importance of complying with §363(n) is illustrated by the remedies that are available under the section for violating its provisions. The specific text of the section provides that the sale may be avoided, or that the debtor (or other party bringing the action) may recover consequential damages (i.e., the amount the assets should have sold for minus the amount they actually sold for), costs, attorneys’ fees, and punitive damages. However, the list of damages listed in §363(n) is not exclusive. Parties found liable for collusive bidding could also be prosecuted criminally under certain provisions of title 18 of the U.S. Code.
Given the significant liability that is at stake, it would be comforting to know that bankruptcy case law provides clear guidance on how to avoid liability under the section. Unfortunately, that is not the case. Very few courts have discussed the section at any length. However, the few cases that are on point provide some helpful broad guidelines.
First, the elements for liability under §363(n) are as follows: (1) there must be an agreement; (b) among potential bidders; (3) that controlled the price at bidding.
An “agreement” among potential bidders need not be in writing. The court may infer such an agreement from the conduct of the parties. However, if the circumstantial evidence of the allegedly collusive behavior could just as easily be construed as resulting from innocent behavior, then a court likely will not infer that a collusive agreement existed. A common example of such innocent behavior involves joint bidding. Potential bidders may submit a joint bid if, for example, each party is unable to afford a competitive bid on its own. In other words, collaboration is permitted, but collusion is not.
In addition, disclosure of any agreement between potential bidders will weigh heavily against a finding of collusion. But, note that if an agreement truly is collusive (i.e., it seeks to control the ultimate sales price), disclosure will not relieve the parties of liability.
The second element of liability under §363(n) relates to whether the agreement is among “potential bidders.” This element has been interpreted very broadly. The general rule for parties considering bidding at a bankruptcy sale is that this consideration alone likely makes you a “potential bidder” for the purposes of §363(n).
The last element of liability under §363(n) is whether the agreement controlled the sale price. The leading case on this issue has held that an agreement does not run afoul of §363(n) if it affects the sales prices, as long as it does not control the sales price. Like the issue of collusion versus collaboration, the court will scrutinize the motivation of the parties. If the parties are entering into the agreement for the purpose of stopping the bidding or of keeping the sales price low, then the court likely will hold that the agreement violates §363(n). Any other motivation that has a secondary effect on the sales price is permissible.
Therefore, the best bet for avoiding liability under §363(n) is to disclose the agreement and to make it clear that the agreement is motivated by something other than a desire to control the sales price.
Please note that this article was created in cooperation with the Commercial Fraud Task Force committee.
This article is the second in a series of articles discussing 363(n) and collusion in bankruptcy sales. It will discuss the fine line between collusion and collaboration, and will explore the application of the specific elements of a 363(n) action.
Part I of this four-part series discussed, in general terms, the prohibition of collusion in bankruptcy sales under §363(n) of the Bankruptcy Code. As a short review, §363(n) prohibits collusion among potential bidders at a bankruptcy sale (also known as a 363 sale). The elements for liability under §363(n) are: (1) the existence of an agreement; (2) among potential bidders; (3) that controlled the price at bidding.
Part I also discussed the fact that there are serious sanctions for violating §363(n), including the possibility of punitive damages and even criminal liability. Potential bidders should therefore be very interested in avoiding behavior that is deemed collusive in a 363 sale. It is easy enough to avoid entering into a backroom agreement that is expressly designed to limit competitive bidding so that the debtor’s assets are sold for next to nothing. However, situations rarely arise where agreements between potential bidders consist solely of such nefarious (and obvious) efforts to fraudulently derail the bankruptcy process. Rather, in the rough and tumble chaos that often accompanies 363 sale auctions, complicated alliances among potential bidders may be made. Such alliances may be motivated by any number of factors. The difficultly for potential bidders and ultimately, for the courts, lies in identifying the fine line between agreements that are impermissibly collusive, and those that are merely collaborative.
Part II
Parties have been concerned over the fuzzy line between collusion and collaboration since before the enactment of §363(n). In fact, this was the very issue that led the Commission on the Bankruptcy Laws of the United States to initially oppose the enactment of §363(n) in 1978. Section 363(n) was proposed by the National Conference of Bankruptcy Judges and the section was included in the final version of the Code only after a broader compromise was reached between the two groups. In the end, however, it appears that the Commission’s concerns were legitimate. Since the enactment of the Code, very few courts have addressed the issue of collusion versus collaboration.
At this point, it would be entertaining to present a collection of bankruptcy attorney “war stories” on creative agreements between potential bidders that the parties managed to get approved by bankruptcy courts. It is more instructive, however, to take a look at how a court ruled when it was presented with this issue. This article will briefly analyze the holding in one such case. As discussed below, the key issue to take note of is the potential bidders’ motivations when they entered into a collaborative agreement.
The Bankruptcy Court for the Eastern District of Pennsylvania was presented with this issue in In re Edwards, 228 B.R. 552 (Bankr. E.D. Pa. 1998). In re Edwards involved the chapter 7 bankruptcy case of Joe Edwards. Edwards owned one third of the stock in a company called Pilot Corporation (Pilot). This stock and the debtor’s interest in a partnership (collectively, the assets) were the only significant assets in the case. The chapter 7 trustee soon realized that the only interested buyers of the assets would be other Pilot stockholders. The trustee initially filed a motion to sell the assets to the CEO of Pilot (Phillips) for $3.4 million. Phillips submitted his bid in his individual capacity, but was also supported by Pilot and an individual named Drescher (Phillips, Pilot, and Drescher were referred to as the Pilot Group). Included in Phillips’s bid was an agreement by Pilot and Drescher to waive millions of dollars of claims they had against the debtor’s estate. The terms of the sale also included an agreement by the trustee to waive any claims the estate had against Pilot and Phillips.
At a hearing on the trustee’s motion, the court heard evidence that the assets were worth $2.745 million. This valuation was premised on sale of a minority interest in Pilot. However, an individual named Wesley Wyatt believed that he held a sufficient interest in Pilot to be able to assert a majority interest by purchasing the assets. Wyatt argued that he owned 45 percent of the Pilot stock through the exercise of certain stock options. The extent of Wyatt’s holdings in Pilot stock was the subject of on-going litigation in New Jersey state court between Wyatt, Edwards and Phillips. Wyatt initially attempted to get the bankruptcy court to decide the disputed ownership issue. The court refused, holding that it did not have jurisdiction, but also recognizing that the uncertainty of whether a controlling interest was at stake was benefiting the estate.
After the court’s ruling on the ownership issue, Wyatt tendered a bid for $3.6 million for the assets. Wyatt’s bid did not, and could not resolve any of the claim issues between Phillips, Drescher, Pilot and the estate. The trustee sought to accept the Phillips offer, even though it was lower than Wyatt’s offer, because of the releases included in the Phillips offer. Wyatt later increased his bid to $5 million in cash, supplemented by a $3 million bond to secure payment of Pilot Group claims when litigated. After Wyatt submitted his increased bid, a “new” bidder emerged. Phillips had collaborated with various employees and franchisees of Pilot in order to make a bid of $5.1 million, complete with a full settlement of the mutual claims among the parties. At this time, the three bids submitted were from the Pilot Group, Wyatt and Phillips and the employees/franchisees.
At the next and final hearing, yet another grouping of individuals emerged to bid on the assets. Wyatt and Phillips had joined together to bid $5.2 million, with complete mutual releases. Evidence was put into record memorializing a global settlement agreement between Wyatt, Phillips and Pilot. The settlement agreement settled all disputes between the parties and provided how the company would be owned and operated once the sale closed. The trustee accepted this bid. The debtor objected, arguing that bid was the result of collusion between Phillips and Wyatt. In response to the debtor’s allegations of collusion, the court analyzed whether the sale was made in good faith. The court acknowledged that Wyatt and Phillips’s joint bid was a result of collaboration among the parties, but held that the issue turned on the motivations of the parties and whether they were seeking to control the sale price. The court concluded that the motivation of the collaborating parties was not to control the price, but rather to obtain a favorable settlement agreement.
The In re Edwards holding provides some measure of assurance to potential bidders. If potential bidders collaborate on a bid, they probably will not run afoul of §363(n) if they can demonstrate that they were motivated to collaborate for innocent reasons. These reasons can include the formation of a favorable settlement agreement, as discussed in In re Edwards. Alternatively, as discussed in other cases, the inability of each party to afford an individual bid is a valid reason to enter into a collaborative agreement. Finally, as discussed in Part I of this series, note that such an innocent agreement can even “affect” the ultimate sales price, as long as the intent of the agreement is not to “control” the sales price.
Therefore, because the parties’ intent is the issue, potential bidders entering into collaborative agreements should take special care to document the (noncollusive) reason for entering into such an agreement. Likewise, these potential bidders should disclose to the court and to all other parties the existence of the collaborative agreement.
Part III
Part I of this four-part series discussed, in general terms, the prohibition of collusion in bankruptcy sales under section 363(n) of the Bankruptcy Code. Part II discussed the fine line separating permissible collaboration from impermissible collusion. In this third part another fine line will be explored: the line between agreements that control the sales price at an auction, and agreements that only affect the sales price. As in Parts I and II, the discussion generally is from the point of view of a prospective bidder and addresses the knowledge such a bidder should have to avoid liability under § 363(n). Part IV will discuss the finality of sale orders, i.e., the time period within which a party must bring a § 363(n) action. That discussion will generally be from the point of view of a § 363(n) plaintiff. Therefore, while the information provided in Parts I through III is helpful to both § 363(n) plaintiffs and defendants, stay tuned for Part IV if you are looking for a roadmap of how to hold a suspected colluder accountable under the Bankruptcy Code.
As discussed in Part I, the elements for liability under section 363(n) are: (1) the existence of an agreement; (2) among potential bidders; (3) that controlled the price at bidding. As to the first element, an agreement among potential bidders need not be in writing. Circumstantial evidence of a collusive agreement is sufficient for a court to hold parties liable under § 363(n).
It should be noted, however, that § 363(n) is not a blanket prohibition on agreements between potential bidders. For example, bidders that cannot afford a competitive bid may enter into an agreement to submit a joint bid. Moreover, as discussed in Part II, potential bidders may enter into collaborative (but not collusive) agreements. The case discussed in Part II (In re Edwards, 228 B.R. 552 (Bankr. E.D. Pa. 1998)) touched on the issue of agreements that control the sale price versus agreements that are motivated by other innocent reasons. The innocent motivation of the potential bidders in the Edwards case was a desire to obtain a favorable settlement agreement that resolved all the on-going disputes between the parties.
The Edwards case provides a helpful example in the context of collaborating parties, but the issue of “controlling” the sales price bears further discussion. What does it mean to control a sales price? And, what if an otherwise innocent agreement “affects” the sales price? Does that mean that § 363(n) has been violated?
These questions were considered by the Second Circuit Court of Appeals in In re New York Trap Rock Corp., 42 F.3d 747 (2d Cir. 1994). New York Trap Rock is likely the most significant case discussing the application of § 363(n). The case is significant because it addressed the “control” versus “affect” issue. But, it is also significant because it is one of the very few circuit level decisions that discuss § 363(n) at all. In other words, no § 363(n) education is complete without a discussion of New York Trap Rock.
New York Trap Rock case involved Chapter 11 debtor Lone Star Industries, Inc. (“Lone Star”). In an effort to liquidate its interest in the South American cement market, Lone Star sought to sell its wholly-owned Argentine subsidiary, Compania Argentina de Cemento Portland, S.A. (“CACP”). CACP, in turn, owned a 50% interest in Cemento San Martin (“CSM”), an Argentine cement producer. The other 50% was owned by Patagonica. Patagonica was the wholly-owned subsidiary of Perez (see the decision at 42 F.3d 750 for a helpful diagram illustrating the relationship between Lone Star, CACP, Perez, Patagonia, and CSM).
CSM’s by-laws provided that each joint-venturer (CACP and Patagonica) had a right of first refusal in the event that the other joint-venturer sold its 50% interest to a third party. Lone Star marketed its interest, and the only party to submit an initial bid was Perez for $36 million. After more marketing, a company called Loma Negra submitted a bid for $38 million. While Loma Negra’s bid was on the table, and without disclosure to Lone Star or to the bankruptcy court, Loma Negra signed an agreement to purchase Patagonica’s 50% interest in CSM for $55 million. The bankruptcy court later approved the sale of Lone Star’s interest in CSM to Loma Negra.
Several months after the sale, Lone Star filed an adversary proceeding alleging that Loma Negra violated § 363(n) when it failed to reveal its dealings with Patagonica. The bankruptcy court denied summary judgment to Lone Star and granted summary judgment to the defendant on the ground that § 363(n) does not apply when the agreement affects, rather than controls, the sale price. The district court affirmed the bankruptcy court’s decision.
On appeal, the Second Circuit first summarized Lone Star’s position as an argument that Loma Negra violated § 363(n) because its agreement with Patagonica affected the sales price of Lone Star’s interest. More specifically, the effect of Loma Negra’s agreement to Purchase Patagonica was that it took Patagonica out of the bidding. The agreement therefore prevented a competitive bidding process between Loma Negra and Patagonica for the purchase of Lone Star’s interest in CSM.
The court went on to cite the text of § 363(n) which prohibits agreements that “control” the sale price. The court then noted that the common definition of “control” “implies more than acts causing an incidental or unintended impact on the price; it implies an intention or objective to influence the price. The court further provided:
It is most unlikely Congress would have intended to prohibit all agreements that affect a sale price. Such a prohibition would cover a vast range of innocent agreements among potential bidders; it would furthermore be very difficult for the parties to an agreement to recognize that their agreement was unlawful. They would need to make an imaginative exploration of the potential consequence of their agreement to determine whether it had a potential to affect the price of the auction sale.
Id. at 752.
The court rejected Lone Star’s argument and held that to be liable under § 363(n), “[t]he influence on the sale price must be an intended objective of the agreement, and not an unintended consequence . . . .” Id. The court therefore affirmed the district court’s denial of summary judgment in Lone Star’s favor because Lone Star was arguing that an agreement affecting the sale price was a violation of § 363(n).
The New York Trap Rock case sets a high bar that a § 363(n) plaintiff must clear to demonstrate liability. The specific, intended objective of an agreement must be to cause the property to sell for a lower price than it might have sold for had the agreement not been entered into.
Subsequent court decisions analyzing this specific issue have unanimously adopted the “affect versus control” framework. In addition, the Edwards court took this analysis another step by noting that even if the court finds that the parties entered into an agreement to control the price, such a finding is not sufficient by itself to require disapproval of the sale. Rather, a § 363(n) plaintiff must show that the agreement actually diddeprive the estate of fair value for the assets.
From the perspective of potential bidders, the New York Trap Rock framework is good news. As per this framework, bidders are free to enter into a broad range of agreements that affect the sales price, as long as the parties are not entering into the agreement with the intention to influence (or “control”) the sale price. Therefore, any agreement between potential bidders should document the non-collusive reason that the parties have chosen to enter into the agreement. Disclosure of the agreement to the court and to other parties is also a good idea. It should also be noted that Loma Negra did not disclose the existence of its agreement with Patagonica in the New York Trap Rock case. This should not be seen as an endorsement of non-disclosure. Other § 363(n) case law has made it clear that disclosure of an agreement weighs heavily in favor of the defendant’s argument that the agreement did not run afoul of § 363(n).
From the perspective of § 363(n) plaintiffs, New York Trap Rock demonstrates the difficulty of successfully bringing a § 363(n) action. Such a plaintiff must delve into the motivations of the potential bidders to demonstrate that, while the agreement may provide boiler-plate non-collusive motivations, the “real” reason for the agreement was to stifle bidding and to keep the sales price low. This generally will require the collection of circumstantial evidence to demonstrate the intent of the defendants. In addition, the plaintiff may also be required to demonstrate that, but for the intentionally collusive agreement, the assets would have sold for a higher price. This may prove difficult where, for example, the assets are highly specialized and the universe of potential bidders is relatively small. The high bar set by these decisions likely explains why there are very few reported decisions holding parties liable under § 363(n). ____________________________________________________________________________________________
[1] Jason Binford is an associate in the bankruptcy section of Haynes and Boone, LLP. This article is adapted from a law review article to be published in vol. 21, issue 1 of the Emory Bankruptcy Developments Journal.