Breaking Up Is Hard to Do

Breaking Up Is Hard to Do

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It's been more than a year since the Third Circuit's decision in Calpine Corp. v. O'Brien Environmental Energy Inc. (In re O'Brien Environmental Energy Inc.), 181 F.3d 527 (3d Cir. 1999), in which bankruptcy courts in that circuit, including Delaware, were instructed to change the standards by which they evaluated the propriety of break-up fees1 in §363 sale transactions.

Prior to O'Brien, most practitioners and courts viewed the appropriate standard to be a more deferential business judgment test where break-up fees would be approved if the agreement to provide such a benefit represented the proper exercise of the debtor's business judgment. In such cases, the court would examine the process by which the break-up fee was negotiated, its affect on bidding and its relationship to the size of the transaction at issue. See In re Integrated Resources Inc., 147 B.R. 650 (S.D.N.Y. 1992). In O'Brien, the Third Circuit held that break-up fees were more properly evaluated under the more rigorous standard governing the payment of administrative expense claims under §503(b)(1)(A) of the Bankruptcy Code. Thus, in the Third Circuit, a break-up fee should only be approved where the agreement to pay a break-up fee was in consideration of a concomitant benefit to the estate.

Since O'Brien, little has apparently changed in the Third Circuit. Buyers of assets continue to routinely insist upon and receive various forms of bid protections, including break-up fees. In order to obtain approval of a break-up fee, the debtor and prospective purchaser must now undertake a two-step process in the bankruptcy court. Step one of that process is an evidentiary hearing in which the parties explain to the court the process by which the buyer was identified, the agreement at issue negotiated, and the benefits that the buyer's willingness to expose its agreement to the marketplace purportedly confers upon the estate. Invariably, the buyer will testify that absent the full panoply of bid protections including the break-up fee, it is unwilling to go forward with the transaction.

For its part, the debtor will testify, either through a manager or expert such as its investment banker, that the "stalking horse" has conferred value upon the estate by its willingness to establish a baseline for the proposed transaction, and that it has created a marketplace in which the minimum acceptable terms on which the proposed transaction can proceed are identified, thereby bringing order to an otherwise disorderly process, forestalling management distraction and potential chaos. Based on this record, the Delaware bankruptcy court routinely approves bid protections, including a break-up fee.

Unquestionably, a bidder for assets in a bankruptcy case exposes itself to deal risks that do not normally exist in out-of-court transactions.

The irony of the foregoing is that in almost every case, the purpose of the break-up fee from the perspective of the bidder is two-fold: (1) compensation for the time and effort put into evaluating and negotiating the deal, and (2) compensation for lost opportunity costs if the bidder does not get the deal. Value to the estate is rarely the issue for the buyer. Nevertheless, and notwithstanding the Third Circuit's admonition that break-up fees must be necessary "to preserve the value of the estate," it remains business as usual.

Unquestionably, a bidder for assets in a bankruptcy case exposes itself to deal risks that do not normally exist in out-of-court transactions. Deals are subject to higher and better offers and ultimately must be approved by a third party, the court, without an economic stake in the outcome of the transaction. However, in deals in which numerous potential buyers are willing to participate in the process and submit bids for an asset, it is unclear why there should ever be a break-up fee awarded to an unsuccessful bidder unless that bidder is creating a market, or improving a market where one did not otherwise exist.

Certainly, there may be merit to expense reimbursement protection for bidders, but there appears to be no value conferred on the estate warranting a break-up fee where multiple bidders are willing to participate and the stalking horse is itself willing to increase its bid in the face of competition at an auction. Indeed, in the situation where a subsequent bidder causes the stalking horse to increase its price, a break-up fee for the subsequent bidder seems to fit more appropriately within the Third Circuit's construct. It is that subsequent bidder who has provided a benefit to the estate.

When advising a debtor with assets it is seeking to monetize and for which multiple bidders are likely to participate, one should consider whether the debtor is not better off providing the stalking horse with reimbursement of its reasonable documented expenses while holding out on the break-up fee to a subsequent bidder. The initial bidder can be "protected" by requiring a minimum bidding increment to upset its bid, at the very least, designed to ensure that the debtor's expense reimbursement obligation is covered. If a market exists for the assets being sold, experience suggests that this should be enough.

A break-up fee provides value when it serves to bring to the table a bidder who otherwise would not be there, or who causes the price of the assets to move in the right direction. Debtors, committees and courts may want to look more carefully at break-up fee proposals. They may find that they are giving away value that could otherwise be preserved for the benefit of the estate or used more meaningfully in the bidding process.


1 Break-up fees are fees paid by the seller of assets to a prospective buyer when the contemplated acquisition is not consummated through no fault of such prospective buyer. Return to article

Journal Date: 
Thursday, February 1, 2001