Breaking Up Is Hard(er) to Do: Priority for Payment of Break-up Fees Post-CXM
A year ago, this column began with a look at decisions in the Third Circuit that took a narrow view of the situations in which break-up fees should be allowed in the context of bankruptcy.1 In particular, that article focused on the Third Circuit Court of Appeal's decision in In re O'Brien Envt'l. Energy Inc., where the Third Circuit held that, under certain circumstances, the payment of break-up fees to a stalking-horse bidder is appropriate only if the fees are among the actual and necessary costs and expenses of preserving the estates and, therefore, qualify as administrative expenses within the meaning of §503(b) of the Bankruptcy Code. See O'Brien, 181 F.3d 527, 535 (3d Cir. 1999). The article also discussed the implications of two subsequent Delaware bankruptcy cases in which the requested break-up fees were denied. See In re Pillowtex Corp., Case No. 03-12339 (PJW) (noting that under O'Brien, break-up fees are only permissible if the company induced an initial bid and finding that such a showing had not been made); In re SHC Inc. (Top-Flite), Case No. 03-12002 (MFW) (court refused to approve a stalking-horse bidder's break-up fees because it had been shown that another viable bidder was willing to make the exact bid, without break-up fees).
Recent bankruptcy court pronouncements on break-up fees and expense reimbursement, particularly one in the Northern District of Illinois, demonstrate that where break-up fees are approved, extreme care must be taken to ensure that the stalking-horse bidder will actually collect its bargained-for reimbursement. On April 1, 2004, the U.S. Bankruptcy Court for the Northern District of Illinois (Hon. Jack B. Schmetterer) rendered an opinion that reminds practitioners that (1) agreements and court orders governing break-up fee payments must explicitly identify what priority of the break-up fee will be affected, and (2) where lienholders may not be paid in full from the sale of the marketed assets, such fees are payable ahead of amounts due to such lienholders. In In re CXM Inc., 307 B.R. 94 (Bankr. N.D. Ill. 2004), Judge Schmetterer held that break-up fees for expenses incurred by an unsuccessful bidder, which were authorized pursuant to a court order by which the debtor's assets were being sold, did not prime an existing lienholder's interest in the same proceeds.
[W]here breakup fees are approved, extreme care must be taken to ensure that the stalking-horse bidder will actually collect its bargained-for reimbursement.
In CXM, the U.S. Bankruptcy Court for the Northern District of Illinois was asked to consider whether an unsuccessful bidder's break-up fees, which were explicitly authorized by the court order approving the sales procedures (sale procedures order), should receive priority over a junior lienholder's claims on the assets that were sold. The court held that (1) the unsuccessful bidder had a valid administrative expense claim for its expenses, but (2) the holder of the junior lien in the assets (who, after the sale, became a first lienholder in the proceeds of the sale) had priority over the bidder's administrative expense claim.
CXM was a chapter 11 case that was converted to a chapter 7 liquidation. The debtor's business assets were subsequently marketed for sale. Baricade Inc. made an offer to purchase CXM's business assets, and that offer was conditional on Baricade being paid up to $200,000 to compensate for its expenses incurred to evaluate the sale assets. The sale procedures order specifically authorized the break-up fees, and it provided that these amounts would become payable if another bidder overbid Baricade at the auction sale. Subsequently, CXM held its auction and, in the words of the bankruptcy court, it was "spirited." Baricade was not the winning bidder, and the winning bidder paid $1,126,000 more than Baricade had initially offered.
Samir Capital was a creditor secured by a junior lien on the sale proceeds. It had originally objected to the sale of the assets, but in light of the large bid and its stated belief that the bid was high enough to allow for payment on its lien, Samir withdrew its objection.2
Subsequently, an order was entered that approved the sale of CXM's assets to the winning bidder. That order stated that Samir's junior lien on the sale assets would attach to the net proceeds of sale. Specifically, it stated that "[a]ny interests that encumber or purport to encumber the purchased assets shall be transferred to and attach to the proceeds of the sale of the purchased assets to the same extent and with the same force, validity, status and effect, if any, as they had against the purchased assets. See Order Approving Sale of Assets Outside Ordinary Course of Business (sale order), dated Sept. 24, 2003, p. 5 at ¶E. The order further provided that $200,000 would be set aside in a debtor-in-possession (DIP)account to cover the maximum amount that could be allowed to Baricade for overbid protection. That sum was placed in such an account.
Baricade subsequently filed a motion seeking payment of $200,000, as an administrative priority claim, for reimbursement for its expenses incurred in connection with its unsuccessful bid. Baricade argued that it explicitly reserved that sum from the sale proceeds. Samir objected to any part of this amount being paid because its uncontested junior lien attached to the sale proceeds and was superior to the Baricade claim.3
Baricade Had an Administrative Claim for the Break-up Fees
In determining whether Baricade was entitled to the $200,000, the court began by acknowledging that in the context of a bankruptcy sale, an unsuccessful bidder's request for the payment of a break-up fee constitutes an administrative expense request, and its allowability should be determined under 11 U.S.C. §503(b) in the same manner as other administrative expense requests. See CXM, 307 B.R. at 103. Accordingly, the court concluded that, pursuant to the sales procedure order, Baricade was entitled to a $200,000 administrative expense claim for its requested break-up fee.
Samir's Junior Lien on the Assets Attached as a Senior Lien on the Sales Proceeds
The court next considered whether Baricade was entitled to have its administrative expense claim paid from the net sales proceeds remaining in CXM's account—at the expense of Samir, who asserted a senior lien in those same proceeds. The court began its analysis by noting that Samir's lien attached to the net sale proceeds to "the same extent and with the same force, validity, status and effect, if any, as they had against the purchased assets." CXM, 307 B.R. at 104.
The court next considered whether the language in the sale order procedures, which clearly allowed the break-up fee, also vested an interest in those fees that was superior to Samir's (now) senior lien. The court determined that Samir's lien on the proceeds was superior to Baricade's right to receive its break-up fees. The court stated, "Although one of the bidding procedures attached to the sale procedures order states that the fee is to be paid 'out of the proceeds of [the] sale,' that provision, even if enforceable against Samir, does not purport to prime or subordinate any existing liens that would attach to the sale proceeds. In the absence of some enforceable priming lien or right to the sale proceeds, Baricade cannot establish that its claim to the remaining Net Sale Proceeds is superior to the allowed secured claim of Samir." CXM, 307 B.R. at 104.
In this regard, the court also dismissed Baricade's argument that Samir's lien did not attach to the net sales proceeds pursuant to the sale order, which stated that "sufficient funds from the proceeds of the sale (representing amounts for cure costs to be paid at the closing of the sale and $200,000 reserved for break-up fees) shall be deposited into the debtor's account. See Sale Procedures Order, p. 5 at ¶¶W-X. The court acknowledged that this provision "described the use originally anticipated for that portion of the sale proceeds when the sale order was entered," but the court stopped short of finding that this language was meant to "expressly or impliedly strip Samir's lien from those proceeds, alter the [d]ebtors' ownership of those proceeds or vest any superior rights to those proceeds in favor of Baricade." CXM, 307 B.R. at 105.
Structuring Break-up Fees in Light of CXM
As the court noted in CXM, it may be desirable for a debtor's estate to pay break-up fees because such provisions remove disincentives (i.e., costs for lawyers, consultants and investment bankers) that may chill a potential bidder from seeking the debtor's assets. To the extent that (1) the inclusion of break-up fees in a stalking-horse bid encourages that bidder to make a bid, and (2) that bid leads to a spirited auction where the incremental increase in the sales price exceeds the sum of all such costs, a debtor's estate will benefit from such amounts.
CXM serves as a reminder that such amounts may not displace any existing rights that third parties have in the sale assets. In light of this decision, bankruptcy practitioners should be careful to clearly articulate the scope of the rights being transferred in the court-approved sales agreements and/or sales procedures. In particular, in the wake of CXM, stalking-horse purchasers seeking approval of sales procedures should consider including language approving such sales procedures, stating that any such fees will obtain priority (pursuant to §§363 and 105) to any existing lienholders. Further, stalking-horse bidders should consider having any such proceeds paid from the debtor's general estate, not the identifiable proceeds of any such sale, so that existing lienholders cannot assert a superior interest.
2 Specifically, during the hearing to confirm the sale, Samir's counsel articulated its understanding as follows:
Your honor, we had filed an objection to the sale. But based upon the bidding that has taken place today, and I understand now that the adjustments to the contract will make the purchase price...approximately $7.840 million, I also understand there will be a $200,000 potential liability for the break-up fee, leaving a net to the estate of $7.640 million. I also understand...that the current bank debt, without some additional fees from [the senior secured lender] for today and on a go-forward basis, is approximately $7 million, leaving a balance above the bank debt and above the DIP liabilities of about $640,000. I assume there will be some slippage in that, and I assume there will be some fees paid. So we expect there will be approximately $600,000 available for Samir Financial as the second lienholder. Return to article