Indian companies looking to expand can benefit from buying distressed assets in US bankruptcies, say Tyson Lomazow, Sanjeet Malik and Bradley Scott Friedman of Milbank Tweed Hadley & McCloy.

The recent economic downturn has created increased opportunities to acquire assets from distressed US companies. Judicial proceedings under chapter 11 of the US Bankruptcy Code can provide an ideal setting for a purchaser to capitalize on advantages that are not otherwise available in a sale of distressed assets, while still availing itself of attractive purchase prices.

US bankruptcy basics

Under the US Bankruptcy Code, a company that files for bankruptcy is entitled to remain in control of its affairs as a debtor-in-possession, and is afforded a unique set of tools to help generate liquidity and reorganize its businesses. One important tool is the "363 sale", which refers to section 363(b) of the Bankruptcy Code. This permits the debtor to sell its assets "free and clear" of mortgage liens, pledges and other encumbrances that might otherwise diminish the asset's sale value.

A 363 sale enables a debtor to maximize the value of an encumbered asset while the purchaser acquires the asset free and clear, and with additional safeguards that are available only in a US bankruptcy.

This is no small benefit, as purchasers in ordinary (i.e. out-of-court) transactions must rely simply on contractual indemnities from the seller as to the nature of, and the absence of, any encumbrances on the assets. Such purchasers also face the risk of future challenges to the transaction. A 363 sale can minimize these risks, and make the transaction more attractive to the purchaser.

To make sure that a debtor does not sell its assets at fire sale prices to the detriment of its creditors, the Bankruptcy Code imposes safeguards. First, the debtor must obtain judicial approval for a 363 sale. For this, the debtor will typically show that there is a good business reason for the sale and conduct an auction to demonstrate that the sale price is fair and reasonable. Second, creditors and others having an interest in the debtor's bankruptcy case are allowed to review the terms of the sale and to object to it at a hearing.

What are the risks?

Such procedural safeguards present risks to prospective purchasers as the debtor will customarily subject the transaction to higher or better offers, and interested parties may object to the transaction. These risks arise during the three customary stages of the 363 sale process: first, the bankruptcy court will conduct an initial hearing to consider approval of the ground rules for the bidding (known as the "bid procedures") and of the sale agreement with the initial bidder (commonly known as the "stalking horse"); second, the debtor will conduct the auction and select the winning bidder; and third, the debtor will return to the bankruptcy court to get the final asset purchase agreement approved and obtain the bankruptcy court's final approval of the sale.

A purchaser must recognize that creditors or other interested parties may try to prevent the sale by raising objections to the bid procedures, the asset purchase agreement, or other aspects of the sale. Moreover, the entire sale will be closely scrutinized at a public hearing, and although the purchaser may submit the winning bid at the auction, the transaction can be struck down by the bankruptcy court.

In short, there is no assurance for the prospective purchaser – whether the stalking horse bidder or a subsequent higher bidder – that its substantial time and expense invested in the process will yield the prize it seeks.

What's your strategy?

Despite these risks, a well-advised purchaser can capitalize on the bankruptcy court's power to enter a binding order conveying title to a debtor's assets free and clear of encumbrances. Here are a few key ways a purchaser can take advantage of a 363 sale:

  • Strive to become the stalking horse, as it tends to be in the best position to acquire the assets. It sets the floor price for the assets and is often entitled to valuable "bid protections" described below. The stalking horse will typically have the best opportunity to conduct due diligence, structure the deal, and negotiate effective bid procedures. Prospective bidders who enter the game at a later stage can be at a disadvantage.
  • Negotiate bid protections. Bankruptcy courts routinely authorize bid protections for the stalking horse that may be advantageous at the auction. These may include a break-up fee (a sum of money – usually a percentage of the final sale price – to be paid to the stalking horse if a higher bidder is selected), reimbursement of expenses, and a "no-shop" clause (an agreement that the debtor will not initiate discussions with other potential bidders for a defined period of time).
  • Negotiate the final judicial sale order. The purchaser should carefully negotiate terms that help protect it from potential future challenges to its ownership of the assets.

A 363 sale presents a unique opportunity to acquire distressed assets from a US company. While some bidders are deterred by the complexity of the transaction, a well-advised purchaser can mitigate the risks and benefit from the substantial safeguards available under the Bankruptcy Code.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.