Bankruptcy Sales: The Stalking Horse
Sales of assets pursuant to Section 363 of the Bankruptcy Code or pursuant to a plan of reorganization provide a number of benefits to a purchaser, but they also present a number of potential impediments, particularly to purchasers who are not familiar with the bankruptcy sale process. The benefits include (i) obtaining the assets free and clear of liens, (ii) protection from fraudulent transfer claims, (iii) protection against certain liabilities and certainty with respect to the enforceability of the transaction documents as provided in the bankruptcy court's order, (iv) relief from the need to obtain consent to the assignment of certain contracts, (v) an expedited waiting period under the Hart-Scott-Rodino Antitrust Improvements Act, (vi) exemption from certain state laws, including bulk sales and stockholder approval, and (vii) in the case of sales pursuant to a confirmed plan of reorganization, exemption from transfer taxes.
The factors that purchasers often find unfavorable are primarily those associated with a debtor's duty to obtain the highest and best value for the assets. These factors include, among other things, a longer period of time typically necessary to complete such deals, the need for court approval (including overcoming objections to the sale), and the uncertainty associated with the auction process required to maximize the value to the debtor's estate. Sales pursuant to a plan of reorganization involve even more potential obstacles and longer periods of time, as they are subject to the confirmation of a plan of reorganization, which can be a lengthy and uncertain process.
The initial bidder with whom the debtor negotiates a purchase agreement is called the "stalking horse" bidder. The term is an old hunting term referring to either a real horse or an image of a horse (typically some type of screen) behind which a hunter would hide to conceal himself from, and get closer to, his prey. Potential bidders in bankruptcies should not be misled by the origin of this term, because very little will be concealed in a bankruptcy proceeding, and the purchaser will be forced to disclose much more information about the deal, as well as about the purchaser itself, than in a typical nonpublic deal.
Incentives for the Stalking Horse
Potential purchasers may be reluctant to take on the role of the stalking horse for a variety of reasons, preferring instead to wait for another bidder to negotiate the deal and then participate in the auction. The initial bidder typically has to expend greater resources than other bidders in negotiating the deal, performing due diligence, and otherwise setting the "floor" for the terms of the transaction. To compensate the stalking horse for its time and effort, certain incentives are typically negotiated, subject to bankruptcy court approval. Without receiving these incentives, the potential purchaser might not otherwise agree to be the stalking horse. These incentives may include expense reimbursements, break-up fees, favorable bidding procedures, and exclusivity arrangements. The incentives requested by the stalking horse may be at odds with the debtor's duty to obtain the highest and best value and the requirements of the bankruptcy code. The negotiations between the debtor and stalking horse must strike an acceptable balance, or the bankruptcy court may not approve the stalking horse's proposed terms.
Regardless, the stalking horse likely will face the risk that its deal is publicly announced in the bankruptcy process, but the bankruptcy court has yet to approve the proposed incentives for the stalking horse. This creates the possibility that another bidder, using the diligence and other efforts of the stalking horse, raises the offer for the debtor's assets before the proposed stalking horse incentives even come before bankruptcy court for approval, or that another bidder, again using the efforts of the stalking horse, agrees to purchase the debtor's assets without any bidding incentives at all. Such an offer would make it difficult for the bankruptcy court to approve bidding incentives for the stalking horse in the first place, since another bidder has offered to purchase the assets without such incentives. The only practical way to avoid this result for the stalking horse is to require that the debtor obtain advance bankruptcy court approval of the granting of bidding incentives before the purchase agreement with the stalking horse is announced publicly. That way, the debtor's agreement to bidding incentives is binding on the debtor at the time it signs the purchase agreement, not later upon bankruptcy approval of such incentives. However, advance bankruptcy approval of bidding incentives tends to be the exception in bankruptcy sale processes.
Expense Reimbursement. One of the most common incentives offered to stalking horse bidders is a reimbursement of its expenses related to negotiating the deal. Fees and expenses incurred with respect to legal and financial advisers, due diligence, and other reasonable expenses related to the deal are subject to reimbursement. The amount subject to reimbursement is usually capped at some maximum amount or percentage of the purchase price and may have other restrictions so as not to be perceived as excessive. The bankruptcy court must approve the expense reimbursement, usually pursuant to an order approving bidding procedures and protections. To protect itself from having the reimbursement potentially treated as an unsecured claim, the stalking horse should insist on having the reimbursement treated as an administrative expense.
One of the issues likely to be debated between the stalking horse and debtor will be the circumstances under which the stalking horse is entitled to receive the reimbursement and when the payment is actually due. A typical formulation is that the stalking horse becomes entitled to the payment when the debtor accepts a "higher and better offer" for the assets. What constitutes a "higher and better offer" will likely be the subject of negotiation, especially if the purchase price includes components other than cash. The stalking horse will want to be paid as soon after the higher and better offer is accepted, while the debtor will typically insist that the payment not be due until the deal with the new buyer actually closes, ensuring that proceeds of the sale rather than operating or other funds are available to make the payment.
Break-Up Fees. Break-up fees or topping fees are also common protections offered to stalking horse bidders. Such fees, however, can be controversial in many jurisdictions, and it is important to be familiar with a jurisdiction's position on these fees before requesting them. Break-up fees are more controversial than expense reimbursements because they provide payments to the stalking horse that are either unrelated to amounts expended negotiating the deal or, in some instances, in addition to a negotiated expense reimbursement. The break-up fee is essentially additional compensation to the stalking horse to induce it to be the initial bidder and lay the groundwork for other potential bidders in an auction. Theoretically, the initial bidder is setting the "floor" for the purchase price and other terms of the transaction, and the break-up fee is one of the incentives offered to induce the stalking horse to set a higher "floor." While break-up fees may not always result in higher floors being set, in most bankruptcy sales a break-up will likely be requested by a potential stalking horse and, at a minimum, whether a break-up fee will be included as part of the transaction will be one of the issues negotiated between the parties.
If the break-up fee is excessive, it may be viewed as having a chilling effect on potential bidding. As a general rule in most jurisdictions, combined break-up fees and expense reimbursements in excess of approximately 3 percent of the purchase price may be viewed with heightened scrutiny. In addition, if the buyer is an insider of the seller, a break-up fee will likely be viewed with higher scrutiny. The parties most likely to object to break-up fees are the creditors' committee or the U.S. trustee, typically objecting that the proposed fee has a chilling effect. Ordinarily, a disgruntled potential bidder has no standing to object to the proposed break-up fee.
Bidding Procedures. Perhaps the most important piece of leverage a stalking horse may have is its ability to negotiate favorable bidding procedures. In some instances, the debtor will attempt to take this leverage away by agreeing to bidding procedures with the creditors' committee, the secured lenders, and other relevant parties before a stalking horse is chosen. Having preapproved bidding procedures in place helps deter a stalking horse from attempting to change the procedures, as any attempted changes will likely be viewed as attempts to chill the bidding process and discourage other bidders from entering into the auction process, even if the requested changes would normally be considered reasonable if presented as part of negotiated bidding procedures. Some judges, however, are reluctant to approve bidding procedures before a stalking horse has been found.
Exclusivity Arrangements. In sales outside the bankruptcy context, the purchaser will often want to enter into an exclusivity arrangement with the seller. Such an arrangement in a bankruptcy context may conflict with a debtor's duty to obtain the highest and best value for the assets, which normally provides that an auction be held. However, it is not unusual for a potential purchaser to negotiate limited periods of exclusive dealing as it attempts to arrive at a stalking horse purchase agreement with the debtor. The debtor may formally or informally agree to such exclusivity in order to maximize the ability to reach a purchase agreement, but the obligation of exclusivity ultimately is not truly binding on the debtor absent bankruptcy court approval.
A potential purchaser unfamiliar with bankruptcy processes initially may find the process to be cumbersome and foreign. However, once the purchaser learns the process, or obtains legal and financial advisers experienced with it, the purchaser can typically use the process to its advantage as a stalking horse. In addition to attempting to negotiate some or all of the provisions described above, the stalking horse can often gain a significant advantage over other bidders simply by virtue of being the bidder with whom the debtor deals while negotiating the purchase agreement. The stalking horse becomes a known quantity and can use the opportunity to get both the debtor and creditor groups comfortable that the purchaser will be able to close the deal quickly and efficiently once the sale is approved.
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Brad B. Erens
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