United States: Opportunities Exist For Purchasers In Chapter 11 Bankruptcies, But Risks Remain

In the U.S. Bankruptcy Courts, the very laws intended to foster rehabilitation of financially distressed entities also create opportunities for prospective purchasers. Although chapter 11 of the Bankruptcy Code contemplates restructuring through a plan of reorganization, some debtors lack the time and financial backing to go through the often lengthy and expensive process of proposing a plan of reorganization and soliciting creditor approval.

These debtors will instead seek to reorganize through a sale of substantially all of their assets under Section 363 of the Bankruptcy Code. Section 363 affords prospective purchasers certain protections and benefits intended to facilitate the sale of assets in bankruptcy. To fully realize these protections and benefits, however, proper diligence and structuring of the transaction are critical.

How Section 363 Sales Work Section
363(b) of the Bankruptcy Code permits a debtor, with bankruptcy court approval, to sell its assets outside of the ordinary course of business – commonly referred to as a "363 sale." It can be a relatively speedy process and was therefore critical to the success of some of the high profile bankruptcies following the financial crisis, including Lehman Brothers, Chrysler and General Motors, which required nearly immediate resolution.

In most instances, a sale of substantially all of a debtor's assets will involve an auction process. The debtor first negotiates an asset purchase agreement with a "stalking horse" bidder – the initial bidder who establishes the "floor" purchase price. The debtor then proposes bidding procedures for bankruptcy court approval, which will govern the auction of the debtor's assets. To motivate the stalking horse to invest its time and effort in negotiating the sale and setting the floor purchase price, it is typically entitled to certain fees, including "break-up fees," which are generally 1% to 4% of the purchase price, and reimbursement of reasonable expenses. Once a winning bid is established, the debtor seeks final approval of the sale from the bankruptcy court.

Benefits to Purchasers
Section 363 of the Bankruptcy Code ensures that a purchaser acquires clean title to the assets being sold. Specifically, under section 363(f), a debtor is permitted to sell substantially all of its assets to a purchaser "free and clear" of any liens or interests. This section of the Bankruptcy Code prevents lienholders and creditors from pursuing the purchaser, or the assets being purchased, for any claims that arose prior to, and during, the debtor's bankruptcy case. In addition, Section 363(m) provides finality to free and clear sales by making it extremely difficult to reverse a sale order on appeal if the purchaser acted in good faith.

Successor Liability Risks
Although a Section 363 sale may be free and clear, a purchaser may nonetheless be liable under theories of successor liability for harms caused by the debtor that do not become identifiable until after consummation of the sale.

This risk was highlighted in the U.S. District Court for the Southern District of New York's decision in Morgan Olson, L.L.C. v. Frederico (In re Grumman Olson Industries, Inc.). In Grumman, the bankruptcy court entered an order in 2003 approving the free and clear sale of substantially all of the debtor's assets to Morgan Olson L.L.C. In 2008, a FedEx employee was injured when her FedEx truck struck a telephone poll. The FedEx employee commenced a personal injury action alleging that the truck was designed, manufactured and/or sold by the debtor in 1994 and that Morgan Olson was liable under New Jersey's successor liability law. In response, Morgan Olson sought a ruling from the bankruptcy court that the claims were barred by the 2003 sale order. Affirming the bankruptcy court, the district court held that the claims were not barred because the claimant did not receive notice of, or have an opportunity to participate in, the bankruptcy case (i.e., file a claim and receive a potential distribution). As a result, barring the claim would have denied the claimant due process and violated the Bankruptcy Code's requirements of notice and opportunity to be heard.

In light of this risk, prior to participating in a 363 sale, purchasers should confirm that the debtor has provided notice of the bankruptcy case and the sale to all known and potential claimants. Moreover, the structure of the transaction should avoid any suggestion that the purchaser is assuming the debtor's liabilities or merging with the debtor, or that the purchaser is a mere continuation of the debtor. Finally, previous owners of the debtor's assets should not retain any interest in the assets being sold, and, if practically possible, the purchaser should hire new management.

Bottom Line

A 363 sale can present a great acquisition opportunity for potential purchasers. Under section 363 of the Bankruptcy Code, a purchaser can acquire substantially all of a debtor's assets free and clear of any claims or interests and be confident that the bankruptcy court's approval of the sale will not be overturned on appeal. Despite these benefits, however, purchasers should be wary of potential successor liability claims and consult with counsel to determine how best to minimize such risks.

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.

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