What Is Collusion in a § 363 Auction?

Recent allegations of impropriety of bidders in the reorganization of Neiman Marcus Group Ltd. LLC should serve as a reminder to study the line between mere auction strategy and collusive bidding. The word “collusion” itself seems to cause confusion whenever it is uttered in the political or legal realms. Fortunately, in the context of bankruptcy sales, the Bankruptcy Code provides some parameters for what constitutes collusion.

Webster’s Dictionary defines collusion as “[a] secret agreement between two or more persons for a fraudulent or deceitful purpose.”[1] In the context of bankruptcy asset sales, § 363(n) of the Bankruptcy Code is the starting point. It does not use the word “collusion,” but it provides a working definition of it, to which courts have often referred. It allows the trustee to avoid a sale when it is shown that “the sale price was controlled by an agreement among potential bidders at such sale.” While this has been utilized as a definition of collusion, § 363(n) does not purport to be an ethical guideline. It merely provides the elements that must be shown for a trustee to obtain relief.

Collusion under § 363(n) can be broken down into three elements: (1) there must be an agreement; (2) that agreement must be among potential bidders; and (3) the agreement controls the sale price.[2]

The first two elements have been interpreted rather broadly. In Sunnyside Timber, the U.S. Bankruptcy Court for the Western District of Louisiana considered a collusion claim where the first two elements were at issue. The court had authorized a § 363 sale of some real estate and timber in Utah. A creditor was entitled to credit bid its claim up to $9.6 million, and ultimately won the auction for that amount and became the prevailing bidder. After the auction, however, the prevailing bidder sold the property to a third party, and the trustee discovered some facts suggesting that the prevailing bidder had colluded with this third party. The trustee filed a claim against both the prevailing bidder and the third party, among other related entities, alleging collusion under § 363.

The allegedly collusive bidders moved for summary judgment requesting dismissal of the collusion claims. They argued that the trustee did not satisfy the first element because there was no showing of an agreement, and it failed to meet the second element because the third party was not a “potential bidder” within the meaning of § 363(n). The court held that the trustee had pleaded sufficient facts to survive summary judgment. The court noted that to satisfy the first element — the existence of an agreement — it is not necessary to prove a written agreement. The court may infer a tacit agreement from circumstances, such as the parties’ behavior.

The circumstances from which the court could infer an agreement were somewhat murky: a pre-bankruptcy letter of intent; some vague deposition testimony about the third party’s decision not to bid; and, of course, the fact that the third party later purchased the property from the prevailing bidder. But the court determined that it was enough to survive summary judgment. The court also rejected the defendants’ argument that the third party was not a potential bidder. The defendants argued that at the time of the auction, the third party lacked sufficient funds to make a qualifying bid. The court held, however, that the “potential bidder” requirement is broad, requiring only that the party have expressed interest in the auction.

The first two elements of the § 363(n) test are objective, but a purely objective analysis can lead to some puzzling outcomes. Imagine, for example, two real estate developers both interested in acquiring land cheaply. After they both independently find an advertisement for a bankruptcy auction of a promising commercial lot, they agree to combine their efforts, reasoning that they can each bring some knowledge and capital to the table, and perhaps get a better deal that way. Under a mechanical application of § 363(n), the two real estate developers arguably check all the boxes for collusion.

Most would probably agree that it would be bad policy to hold those two real estate developers liable for collusion simply because they decided to collaborate. Bankruptcy courts have resisted such harsh results through common-sense interpretation of the statute. The third element, “the agreement controls the sale price,” has a subjective component. In In re New York Trap Rock Corp., the Second Circuit interpreted the “control” language as follows: “To ‘control’ a price is to ‘exercise restraining or directing influence over’ it; to ‘regulate’ or ‘curb,’ ‘dominate,’ or ‘rule’ it. In such context the term ‘control’ implies more than acts causing an incidental or unintended impact on the price; it implies an intention or objective to influence the price.”[3] The court found support for this interpretation in the legislative history of § 363(n), insofar as Congress was specifically targeting collusive bidding, and collusion carries with it the notions of secrecy, fraud and deceit.[4]

Courts have bifurcated this element into two separate questions: whether the agreement actually controls the sale price; and whether the agreement has the intended objective to control the sale price. Under the latter, more subjective prong of this element, the parties’ motivation in combining their efforts may eschew any inference of bad faith. If the two real estate moguls decided to collaborate because each one lacked sufficient funds on their own to make a serious bid, that would go to show that it was permissible “collaboration,” as opposed to collusion.

Another factor that courts consider in evaluating § 363(n) echoes the Webster’s definition: the issue of secrecy. Again, secrecy is not an element of a claim under § 363(n). But courts look at whether the allegedly collusive bidders disclosed their agreement. In fact, many courts have considered it a requirement that any parties who combine efforts to bid must disclose their arrangements with their bid. These disclosures will protect the collaborators from later being accused of collusion. But it is not a safe harbor. The Second Circuit has stated that “full disclosure to the bankruptcy court may not always neutralize conduct that would otherwise constitute bad faith.”[5]

Disclosure is one of several factors that might mitigate a party’s potential exposure for collusive bidding. Good-faith settlement efforts can also mitigate allegations of collusion. In the context of a broader restructuring proceeding, parties in interest may collaborate in connection with an auction in order to reach a favorable settlement agreement of related disputes, as discussed in In re Edwards.[6] This case and cases that follow it offer few guidelines for what is permissive in combining settlement efforts with bidding efforts, so parties would be well advised to tread carefully when mixing the two. Courts have also looked favorably upon collaboration efforts when two or more parties collaborate because each one, independently of one another, could not have afforded a sufficient bid to compete. Similarly, courts appreciate it when parties collaborate because they are interested in different assets or groups of assets that are combined into one lot.

All in all, the § 363(n) treatment of collusion is somewhat circular. It attempts to take an amorphous concept — collusion — and break it down into three objective elements. But then the third element’s subjective prong essentially points back to the subjective dictionary definition. Ultimately, there is no bright-line test. Nevertheless, parties can avoid running afoul of the prohibition on collusion by keeping two things in mind. First, § 363 auctions are designed to maximize estate value, and any arrangements to frustrate that process will not be received well. Second, while disclosure does not insulate any actions from liability, any collaboration among bidders in a bankruptcy auction process — even those forms of collaboration that are considered permissible — should be disclosed as early as possible.