The Perils of Sell-Side 363 Sale Engagements: Protecting Your Success Fee in Underwater Situations

I am not an investment banker, so I’ve never had the benefit of really knowing what goes on in the head of one when deciding whether to take a particularly risky sell-side 363 sale engagement.  But I have been through a few of these situations as an observer (or an attorney for one party or another), and, over time, I’ve seen something of a theme emerge: investment bankers underestimating—or completely overlooking—the risk of forfeiting a success fee if the assets simply do not yield enough money at auction to satisfy the senior secured debt.

Underwater section 363 sales transact all the time, sometimes with and sometimes without the senior lender’s outright consent.  And in many of these deals, the investment banker gets its success fee at closing (albeit a small one) without a hitch.  But this does not mean that an iron-clad engagement letter with the debtor-seller is all that’s needed to ensure payment in an underwater, minimum-fee scenario. 

The bottom line is this: if the secured lender has not clearly and expressly bound itself to pay a success fee from the proceeds of the sale of its collateral, the success fee is in real jeopardy if the sale price is less than the secured debt.  With certain limited exceptions, the magic wand of bankruptcy does not change the fact that a perfected first lienholder has a first property right in its collateral—one that’s absolutely senior to the debtor’s interest in the collateral.  This means that if you cut a deal with the debtor, but neglect to sign up the secured creditor, you are at risk.  Plain and simple.
 
So what precautions should (or can) be taken?  Consider the following (and in doing so, bear in mind that the hypothetical client we are talking about is a mid-market, privately held company operating as a Chapter 11 debtor-in-possession and selling its assets in a Bankruptcy Code section 363 sale): 

The Red Herring of Bankruptcy Fee Orders and Administrative Priority
Before we can tackle strategies, a little background on exactly what the Bankruptcy Code does and does not do for estate professionals is worth outlining.  (Caveat: this may be a bit pedestrian for ultra-experienced Chapter 11 practitioners—bear with me.) 

At the most basic level, a professional working for a debtor-in-possession in Chapter 11 bankruptcy will need at least two court orders before any kind of compensation can be paid: (i) an order under Bankruptcy Code section 330 permitting the debtor to use its cash to pay the professional [1] and (ii) an order under Bankruptcy Code section 327 permitting the debtor to retain the professional in the first place. [2]

The thing is, even if you have both of these orders, you don’t necessarily have any right to be paid from the proceeds of the sale of fully encumbered collateral.  True, a section 330 fee order will elevate the debtor’s obligation to pay the professional fees to “administrative expense” status.  But administrative expenses, while senior to almost all unsecured claims against the Chapter 11 debtor, are nonetheless junior to secured claims. [3]

How can this be possible?  It’s actually a matter of constitutional law; in particular, the takings clause of the Fifth Amendment.  The Fifth Amendment prohibits the federal government from “taking” individual property without due process. [4]  A perfected security interest is a form of an interest in property—the property pledged as collateral in the security agreement or mortgage—that belongs to the holder of the security interest.  To make a potentially very long story short, bankruptcy courts are therefore constitutionally barred from forcibly “taking” collateral away from a secured lender for someone else’s benefit, absent fair compensation to the secured lender. 

Privity of Contract: The Lender Needs to Sign
So how can you best protect your success fee in an underwater sale?  Have the secured lender sign your engagement letter (otherwise known as pressing the “Easy Button”).  Or, more precisely, have the lender sign an engagement letter that specifically obligates the lender to set aside (carve out) the fee, even if the ultimate sale price is less than the secured debt. 

If the lender is a party to the engagement letter, then the engaged investment banker will have the right to enforce the terms of the letter against the lender directly (because the investment banker and the lender are, as a matter of contract law, in “privity” with one another). [5] For sure, there is a bit of ice breaking involved in making this kind of rock-hard demand on an institutional lender who may otherwise be content to sit back and see what happens at its borrower’s auction.  But the time to find out that the lender is unwilling to carve out for a success fee is sooner rather than later.   There is no shame in forcing the lender to show its true colors by requiring a crystal clear sign-off on your success fee before you make a substantial investment of manpower and resources in a patently risky engagement.

But what if you get pushback from the lender? This may be an invitation to negotiate terms and, depending on your need to take the engagement and your internal valuation of the asset, an opportunity to ensure a reasonable, minimum fee while preserving some modicum of upside.  The key in this kind of negotiation is having reliable intelligence on the lender’s view of the world; that is, intelligence on the lender’s valuation of the asset and, to some extent, the internal pressures and objectives facing the special asset officers responsible for the asset (e.g., fiscal year-end/quarter-end portfolio quotas). 

If the lender’s expectations are extraordinarily low, it may be reluctant to commit to carving out a guaranteed minimum success fee without some kind of corresponding floor on the sale price that triggers the carve-out.  The question then becomes whether you are willing to take on some level of success fee exposure in the event of a truly rock-bottom sale. 

Cash Collateral Carve-Outs: Devil’s in the Details
Is it safe to rely on a DIP financing/cash collateral budget for your success fee (and avoid an awkward confrontation with the lender over an engagement letter sign-off)?  Generally, the answer is “no.”  

A DIP/cash collateral “budget” is a cash-flow forecast conceived with a singular purpose: to keep the Chapter 11 debtor on a short leash while it is operating.  A liquidation event, like a 363 sale, will typically terminate the budget.  So, while there should be a line item in the budget for the investment banker’s monthly/weekly retainers (make sure it’s there!) pending sale, a reserve for a success fee won’t show up anywhere as a mechanical matter.

In many cases, a material question arises as to what happens to professional fee carve-outs in DIP/cash collateral budgets after there has been some kind of DIP default.  The key here is to scrutinize the DIP/cash collateral order itself, as there is always some potential for the debtor to continue operations and conduct a sale after a DIP default.

Fairness and The 506(c) Surcharge: Last Ditch Efforts
Bankruptcy Code section 506(c) gives the debtor-in-possession the right to “surcharge” otherwise fully liened assets to pay the “reasonable, necessary costs and expenses of preserving, or disposing” of the collateral.[6]  So this means that an investment banker can comfortably rely on 506(c) as a fall-back to guaranty a success fee in an underwater sale, right?  Wrong.

Section 506(c) presents two huge problems for the fee-starved investment banker: (i) the statute only gives the debtor, not the investment banker, standing to request the surcharge and (ii) the agreed success fee may not be the same as what is considered “reasonable” or “necessary” under the statute.

On the issue of standing, the liquidating post-363 sale Chapter 11 debtor may simply have no interest or ability to prosecute a 506(c) claim for a jilted investment banker.  On the question of reasonableness/necessity, it is safe to say that this can be a very expensive and time-consuming issue to litigate.

In Summary
In a perennially competitive environment, it is pretty difficult to turn away a potential engagement simply because of the prospect of an underwater transaction.  But without the senior lender signing off, your success fee will be in real peril.  Ultimately, the savvy investment banker will recognize that, in these situations, the debtor-client is talking the talk, but only the senior lender can walk the walk.  If the lender doesn’t clearly and unequivocally communicate its desire to pay you to shop the asset, then don’t shop it (or, at least, watch your back very carefully).