Break-up Fees Not Improper Intrusion on Chapter 11 Voting Process
May 2002
The continuing vitality of break-up or termination fees payable in connection with the sale of a chapter 11 debtor’s business or assets was recently affirmed by a Delaware district court in In re Fruit of the Loom, Inc. The court ruled that a termination fee payable to a prospective purchaser if the chapter 11 debtor was unable to confirm a plan of reorganization effecting the sale did not constitute an improper intrusion on the chapter 11 plan confirmation process.
Bankruptcy Sales
The Bankruptcy Code authorizes a bankruptcy trustee or chapter 11 debtor-in-possession to sell assets or property without bankruptcy court approval, provided the sale is within the ordinary course of the debtor’s business. Non-ordinary course asset sales are permitted only if the debtor is authorized to do so by the court after notification to creditors and a hearing. The bankruptcy court will approve the sale if it concludes that the debtor’s "business judgment" in entering into the transaction is sound. A debtor may also sell its entire business in bankruptcy. In most chapter 11 cases, the sale transaction will form the basis for a plan of reorganization. If this is so, creditors are entitled to full disclosure of the proposed sale transaction as well as the other terms of the plan of reorganization. Creditors whose claims are not paid in full under the plan will also have an opportunity to vote to accept or reject it, leaving open the possibility that they could prevent the sale if enough creditors voted against the plan.
However, under certain circumstances a debtor may sell all or substantially all of its assets without making the sale part of a plan of reorganization. Where a chapter 11 debtor proposes to sell its assets or business "outside of a plan of reorganization," creditors are entitled to notice of the sale and an opportunity to voice any objections they may have with the court. However, the sale will not be subject to the same creditor disclosure and voting rights attendant to a sale as part of a plan of reorganization. Moreover, the proposed sale will be subject to the less exacting "business judgment" standard of review. For this reason, some courts refuse to approve a proposed sale outside of a plan of reorganization if it appears that the transaction is really a "sub rosa" or "de facto" plan because the terms of the sale will necessarily dictate the provisions of any future plan.
Break-up Fees in General
Break-up or termination fees are the fees paid to a prospective purchaser of a company’s business or assets in the event that the contemplated transaction is not consummated for reasons specified in an agreement, including the seller’s acceptance of a competing bid. The fee may be a fixed amount or a percentage of the purchase price. It is intended both to reimburse a "stalking horse" bidder for costs, including professional fees, incurred in connection with due diligence and to compensate for the time, resources, efforts and lost opportunity costs and risks incurred by a disappointed purchaser.
Break-up fees are common in corporate transactions outside of bankruptcy. In the context of asset sales, such fees are presumptively valid under the business judgment rule, absent self-dealing. They are subjected to more exacting scrutiny when approved in connection with struggles for corporate control. When the enforceability of a break-up fee is challenged, a court’s principal inquiry will be whether the offer of the party to whom the fee is payable has enhanced or impeded the bidding process and whether the fee agreement is in the best interests of the seller’s shareholders. Underpinning these determinations is the fundamental premise that a corporate fiduciary has an obligation to maximize the amount of any sales proceeds for the benefit of the company’s shareholders.
Break-up Fees in Bankruptcy
The premise remains the same when a company files for bankruptcy, but its beneficiaries do not. Thus, the officers and directors of a bankrupt corporation may use break-up fees to satisfy their fiduciary obligations to obtain the highest possible price for the debtor’s assets, but they do so for the benefit of the debtor, its creditors and shareholders. Given this expansion of the universe of beneficiaries to encompass the bankruptcy estate, bankruptcy courts very carefully scrutinize the fees themselves and the circumstances under which they are payable.
Some bankruptcy courts considering whether to approve a break-up or termination fee payable in connection with a proposed sale examine whether the fee was tainted by self-dealing or manipulation, whether the proposed fee would "unnecessarily chill bidding and potentially deplete assets that could be better utilized to help fund a plan of reorganization" and whether the amount of the fee is reasonable relative to the proposed purchase price. Other courts assess whether payment of a break-up fee is within the "best interests of the estate." Finally, some courts scrutinize a termination fee just as they would consider any other post-bankruptcy expense to determine whether the fee was actually necessary to preserve the value of the estate.
The Termination Fee in Fruit of the Loom
Fruit of the Loom, Inc. and certain of its affiliates (collectively referred to herein as the "debtor" or "Fruit of the Loom") filed petitions for relief under chapter 11 of the Bankruptcy Code in late December of 1999. Two years later, the debtor entered into an agreement with Berkshire Hathaway, Inc. ("Berkshire") providing for the sale of substantially all of the debtor’s assets for $835 million, subject to higher and better offers. The agreement made the closing of the transaction contingent upon confirmation of a chapter 11 plan of reorganization implementing the sale. It further provided that Berkshire would be entitled to a termination fee in the amount of approximately $22.5 million if its bid were topped by another purchaser at auction, or if Fruit of the Loom’s chapter 11 plan implementing the sale was not confirmed. The bankruptcy court approved the termination fee, stating that if "you want to keep a purchaser on the hook for an extended period of time, you are going to have to pay the price . . . [a]nd under the circumstances . . . the price is appropriate."
Several of Fruit of the Loom’s creditors appealed. They sought to vacate the bankruptcy court’s order approving the termination fee, contending that the "coercive effect" of the fee on creditors voting to accept or reject Fruit of the Loom’s proposed chapter 11 plan was an "improper intrusion" on the chapter 11 plan confirmation process. According to the creditors, the termination fee enabled the debtor "to lock [its estate] into a particular plan mode — one that favors [the debtor’s plan] over all other plan alternatives." While they did not oppose the sale to Berkshire, the creditors objected to certain other provisions of Fruit of the Loom’s proposed plan of reorganization, including broad releases benefiting various non-debtor third parties and certain non-compete covenants.
The Delaware district court denied the appeal. Concluding that "rather than impinge on the chapter 11 plan confirmation process, the transaction at bar promotes the process," the court emphasized that unlike other asset sales proposed by a chapter 11 debtor that are scrutinized under the less exacting "business judgment" standard, the anticipated sale to Berkshire and the ramifications to Fruit of the Loom’s chapter 11 reorganization were fully disclosed and subject to the approval of creditors through the plan voting and confirmation process. The court agreed with the objecting creditors that the termination fee would be one factor considered by creditors when they voted to accept or reject Fruit of the Loom’s plan of reorganization. However, it emphasized, the risks and costs associated with the proposed sale to Berkshire as they pertained to the plan confirmation process did not justify depriving Berkshire of its termination fee. As a "stalking horse" bidder, the court stated, Berkshire was "entitled to the same or equivalent consideration" that it would enjoy in a non-ordinary course asset sale subject to the approval of the bankruptcy court. Given that presumption, the court concluded that "the only question is whether [the debtor] and Berkshire reached a reasonable accommodation between the amount of the Termination Fee and the interests of the creditors." The district court found that the bankruptcy court had not erred in answering that question in the affirmative.
Analysis
The significance of the Delaware district court’s holding in Fruit of the Loom lies principally in its recognition of the importance and validity in bankruptcy of break-up fees and other transactional incentives routinely employed outside of bankruptcy. The aim in both contexts is to obtain the best price possible for the seller’s assets or business, while at the same time compensating the purchaser for costs incurred in making its offer and for serving as a target for competing bidders. Given the keen interest of a bankruptcy estate and the company’s creditors in the outcome of a sale, a bankruptcy court will understandably subject any proposed termination or break-up fee to exacting scrutiny to determine whether it encourages rival bidders and is not excessive. Prospective purchasers of a debtor’s assets in bankruptcy almost always obtain bankruptcy court approval of a termination fee up-front in connection with the debtor’s motion for an order approving auction and bidding procedures before the sale ever takes place. In this way, the purchaser can cut off most subsequent challenges to the payment of its termination fee.
Fruit of the Loom is also important because it rejects the notion that termination fees are somehow incompatible with the chapter 11 plan confirmation process. Certain Fruit of the Loom creditors argued that the threat of having to pay Berkshire’s termination fee coerced creditors into voting in favor of the plan and that the fee itself effectively dictated the terms of the plan since any alternative would necessarily involve significantly lesser distributions to creditors. By rejecting this "sub rosa" plan argument, the Delaware district court recognized the practicalities of asset sales in bankruptcy. The only way to ensure that a debtor realizes the maximum value from its assets or business in connection with a bankruptcy sale is to offer the same bidding incentives to prospective purchasers that they can obtain outside of bankruptcy.
Still, by insisting that the presence of the break-up fee not chill additional bidding on the debtor’s assets, many courts appear to have placed undue emphasis on the role of the fee in attracting subsequent bidders and have overlooked the role it plays in attracting the initial bidder. Although the former may be an important factor, it is no more important than the effect of the fee in attracting an initial bidder. Placing too much emphasis on the role of the fee in attracting subsequent bidders is problematic for two reasons. First, because the court has the benefit of hindsight, it can subject the decision to enter into a break-up fee agreement to rigid scrutiny. Second, it forces courts to become mindreaders who have to determine what effect, if any, the presence of the agreement had on the decision-making process of potential bidders.
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DDJ Capital Management, LLC v. Fruit of the Loom, Inc. (In re Fruit of the Loom, Inc.), 274 B.R. 631 (D. Del. 2002).