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.
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[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.