Recently, a bankruptcy judge with a long tenure on the bench told a group gathered at an insolvency conference that the bench�s role in overseeing modern commercial bankruptcy cases amounts to running a laundry service, as most cases involve little more than putting the debtor in the bankruptcy washing machine to cleanse its valuable assets through a §363 sale. Indeed, these days, the prospect of a successful reorganization in most Chapter 11 cases seems beyond the reach of most debtors.By Rafael Klotz
Gordon Brothers GroupFinancing the ride from filing to plan confirmation has always been an expensive proposition. But we live in times of unusually high leverage and layers upon layers of secured loans, where postpetition DIP liens, adequate protection and administrative costs would all but consume most estates in the time it takes to structure, negotiate and confirm a plan of reorganization.
On the other hand, if structured properly, a sale under §363 of the Bankruptcy Code affords a relatively swift path to maximizing the current value of the estate�s most desirable assets by exposing them to eager buyers within a relatively short period of time, potentially saving significant administrative and other costs while preserving asset values.
The downside, of course, is that secured liens on the sold assets attach to the sale proceeds, generally leaving little (if any) proceeds for unsecured creditors after administrative claims are satisfied. Moreover, beyond their ability to object to the §363 sale as an improper secured party sale (a complex and multifaceted issue that is beyond the scope of this article), unsecured creditors (and often equity holders) have very limited say in whether a sale is ultimately approved, as the debtor�s business judgment is still the key factor in sale approvals.
The end of result of §363 sales� prevalence is that most Chapter 11 reorganizations wind up as Chapter 11 liquidations. Arguably, if a §363 sale maximizes value for the estate, creditors are no worse off (and, in fact, likely better off) than if the debtor were to embark in a costly ride through a futile (or at least speculative) reorganization process. Sales of unwanted assets outside of the ordinary course are often needed in both successful reorganizations and Chapter 7 liquidations, and assets sold as part of an operating business are, in most instances, likely to fetch much greater value than shut down operations. Although it is doubtful that Congress ever intended §363 of the Bankruptcy Code as a substitute to the reorganization process (after all, §363 applies to Chapters 7, 9, 11 and 12), modern bankruptcy practice and procedure is not immune to market forces, and sales of substantially all of a debtor�s assets under §363 are a procedurally acceptable response to economic reality and value maximization for creditors.
Taking this a step further, a recent trend is providing unsecured creditors with a thus far unusual role in the §363 sale process: equity ownership in the sold assets. In 2009 alone, §363 sales in several high profile bankruptcies (most notably, General Motors, Chrysler, and Polaroid) as well as many other cases have provided those bankruptcy estates with ownership interests in the sold assets. This development combines the benefits of reducing the administrative costs associated with a lengthy Chapter 11 case, maximizing a debtor�s most valuable assets by exposing them to the market within a short period of time after the filing, and providing potential upside for the estate if the sold assets, now unburdened from the circumstances that drove the previous owner into bankruptcy, increase in value under new ownership or management.
While the value of this carried interest for the estate is almost never guaranteed, it provides creditors at least a chance (albeit speculative) at a more meaningful recovery down the road than the meager pennies on the dollar most creditors wind up with in the typical Chapter 11 � �schmuck insurance� as a financial advisor to a debtor recently called it during testimony at a sale hearing in which the winning bid included cash and a significant equity stake for the estate in the sold assets.
Undoubtedly, those who view the process through a more purist bankruptcy law lens will be keen to raise some concerns. After all, the Chapter 11 reorganization process offers a quasi-democratic means of protecting priorities among various creditor and equity classes while simultaneously imposing on the plan proponent the burden of showing that the reorganized business is feasible. In contrast, a §363 sale requires little more than fair bid and sale procedures and a debtor�s business judgment. And depending on how the equity grant by the §363 buyer is structured, the sale may raise absolute priority rule issues (e.g., if structured as a �gift� to non-priority unsecured creditors in an administratively insolvent case). Nevertheless, §363 sales are a legitimate tool in the bankruptcy arsenal, and the potential for upside for creditors receiving equity in the sold assets makes this structure more palatable than finality, even if the latter comes in the form of a few extra cents on the dollar.
Rafael Klotz provides strategic, structuring and legal advice on retail disposition and brand acquisition transactions, both in and outside of bankruptcy. He also works directly with all of Gordon Brothers Group’s brand portfolio companies regarding ongoing licensing, general corporate and M&A matters. Klotz has been closely involved in several significant Gordon Brothers Group transactions, including inventory dispositions for Circuit City, Goody’s, Boscov’s, Mervyns and Sportsman’s Warehouse, and the acquisition of the Polaroid, Linens N’ Things, The Sharper Image and The Bombay Company brands. Before joining Gordon Brothers Group, he was a partner at Goulston & Storrs in Boston, where he specialized in insolvency and finance law and in M&A and cross-border transactions. Klotz holds a J.D. from Boston College Law School and a B.M. from Berklee College of Music. He is a frequent speaker at insolvency conferences and is a past co-chair of the Boston Bar Association’s Commercial Finance Committee.