Bankruptcy judges have traditionally been loath to approve asset sales outside of a Chapter 11 plan. After all, the statutory framework itself was structured to enable creditors to vote on whether to sell assets that, realistically, belonged to them. And while judges did sometimes grant so-called “Section (§) 363” sales — greatly expedited transactions in which assets sell free of liens and other claims, and with a hearing rather than a full vote — they did so only when the assets in question, in the parlance of late-night used-car salesmen, “had to go right now!” In the early §363 sales, in fact, this literally meant the likes of bananas rotting in warehouses. The reasoning was sound enough — if you hold up the sale until a Chapter 11 reorganization plan is in place, creditors will have had the satisfaction of casting their ballots, but the biodegradable inventory will be long gone.
Over the past decade, U.S. bankruptcy practices have entered a new paradigm regarding §363. Once invoked in only a discrete minority of cases, these expedited sales are fast becoming the preferred way of monetizing assets, and have stayed in the headlines amid the bankruptcies of Lehman Brothers, the Chicago Cubs, Filene’s Basement, Velocity Express, GM, Chrysler, Midway Games and many other cash-strapped companies. Because legal fees and other costs can stack up during a lengthy Chapter 11 reorganization, some asset-based lenders might welcome this trend, reasoning that quicker sales ultimately will translate into maximum return on collateral. In reality, however, §363 is anything but a one-size-fits-all solution.
To be sure, these sales are fast. Even accounting for the time it takes to notify creditors and potential bidders, hold the hearing, run the auction and respond to any objections, a “fast track” §363 sale can be finished in a mere 30 to 60 days. By contrast, even in those rare cases in which all provisions of a Chapter 11 plan are nailed down upfront, the reorganization will take a minimum of 90 days from start to finish, and typically, much longer.
Buyers tend to like quicker sales, too. In a heavily negotiated Chapter 11 plan, they often are exposed to multiple points of leverage where they are under pressure from creditors to make concessions. Nobody enjoys fending off threats, entreaties and ultimatums, such as “Agree to hire these workers and assume these leases or the deal is off,” or “If you want my support, you have to sweeten the pot.”
One advantage of a §363 sale is that it does not require sitting across a table from creditors and hammering out the details of a reorganization plan for months on end. This is part of the reason some buyers — fully aware of §363’s historical role as an exception for the hurry-up “wasting asset” or proverbial “melting ice cube” — overstate the need for a quick sale, telling the court, “I am willing to pay ‘X’ amount today, but if you make me wait for a confirmation hearing, I will pay less or not buy these assets at all.”
Amid the rush to embrace §363, however, secured lenders would do well to pause for a moment to at least consider its potential downsides. In a traditional Chapter 11 reorganization, debtors enjoy protections that prevent competitors from stepping in and filing alternative plans. Yes, the Chapter 11 process tends to be slow. But with a few exceptions, it is quite difficult to upset the plan once it is underway. Section 363, by contrast, is far less tidy.
As debtors race to secure a bid, they might well offer their favorite suitor a few too many bid concessions, like generous expense reimbursements or breakup fees or structural requirements. This can expose the process to charges of being rigged in the bidder’s favor. If the court buys these arguments, it is back to square one for all parties involved. For example, the Polaroid sale process took five months after the court twice set aside the auction results.
Parties’ lingering concerns also are easier to address in a Chapter 11 plan. If you are a pre-petition lender in a §363 sale, it is true that the proceeds are available to you once the assets are sold, but certain issues might come back to haunt the deal, such as whether the lender was partly to blame for the demise of the company. Lawsuits could be filed with a view toward subordinating or disallowing all or a portion of the secured lender’s claim.
Not all §363 sales created equal. Buyers, for example, vary in their level of eagerness to participate in an auction process and their preparedness to close a deal. For some buyers, §363 sales move too fast and they are unable to submit their highest bid on the court-ordered timetable. For others, they are simply unwilling to participate in an unseemly and widely publicized auction for the debtor’s assets. In both situations, the likely result is less value being realized for the debtor’s assets. Further, a §363 bid that is conditioned upon either financing or due diligence makes little sense for creditors, debtors and courts. And yet, some would-be buyers do indeed submit bids despite having plans to spend, say, 30 more days working on the bank loan, or 60 more days finishing up their due diligence.
As secured lenders know better than most, the value of collateral is highly dependent upon a host of factors. If the turnover potential of the inventory is likely to improve during an upcoming selling season, it makes sense to stick with a traditional Chapter 11 plan and liquidate that inventory in stores rather than in a hastily arranged fire sale. This is precisely why debtor-in-possession (DIP) lenders have traditionally allowed distressed retailers to continue operating throughout the holidays.
And that gets to one of the primary drivers of the §363 trend — namely, the extreme caution that has come to dominate lending amid the global credit crisis. It is certainly true that §363 sales, with their speed and efficiency, sometimes are the preferred option for both debtors and creditors in a given bankruptcy. In many other instances, however, banks are essentially forcing the quick-and-easy route.
It would be nice if Chapter 11 companies had pots of cash they could use to pay landlords, make payroll and keep the lights on during their reorganizations. Historically, however, debtors have been able to fund their operations during Chapter 11 only by obtaining DIP loans, which were easy to secure. (Remember the days of easy credit when Chapter 11 plans proceeded at a leisurely pace, lasting two or three years with no stigma attached? Abundant DIP financing made that possible.)
The credit crisis changed all that. A poverty mentality continues to dominate the capital markets, and many banks are still reluctant to make loans even to what they consider to be good credit risks. It is a bad time to be a borrower, of course, but it is an even worse time to be a borrower in bankruptcy. If you are a Filene’s Basement or a Chrysler and you cannot obtain DIP financing, handing the keys to the bankruptcy judge is not an option. You do have to liquidate those assets somehow, and so you are all but forced to hold a fire sale.
In the current environment, it is understandable that many banks are skittish about financing a drawn-out Chapter 11 reorganization. Still, DIP financings have historically been among the safest loans that any financial institution could make. After all, DIP lenders are so high up in the pecking order they get paid even before the attorneys. DIP loans also tend to be characterized by quite-conservative terms: lenders will not provide, say, $100 million against $50 million in assets; the loan will be more along the lines of $30 million against $50 million in assets.
Lenders ought to think twice about their overly conservative approach to DIP loans. In the long run, a larger menu of bankruptcy options is in the best interest of banks, trade creditors and debtors alike. In situations where there is a degree of time-urgency, moreover, a §363 sale might not be the only option. Prepackaged bankruptcies, whereby debtors win the binding consent of creditors prior to filing under Chapter 11, or pre-negotiated bankruptcies, whereby most of the major constituencies are in place prior to the filing, offer many of the same advantages as traditional Chapter 11 reorganizations. And yet, they can be just as fast as §363 sales. CIT’s prepack, for example, only took some 38 days to complete.
Is the argument here that those involved in bankruptcy proceedings should start putting the brakes on §363 in all cases? Absolutely not. But maximizing collateral value at the time of sale is the ultimate imperative for secured lenders. They should never allow that strategic goal to be eclipsed by an irrational “need for speed.”
Terrence Corrigan, managing director of Abacus Advisors, has been involved in bankruptcy and creditors’ rights matters for more than 25 years as an attorney, consultant and lecturer. His restructuring experience covers a wide range of industries, including financial services, transportation, manufacturing, retailing and real estate. With offices in New York, Chicago, Boca Raton, and New Jersey, Abacus Advisors assists companies of all sizes with comprehensive operational turnarounds, Chapter 11 reorganizations, business wind-downs, real estate dispositions and out-of-court restructurings.