Those seeking to acquire companies in the bankruptcy setting often seek protection in the form of break-up fees. Bankruptcy courts have applied varying standards to determine the permissibility of such fees. Recently, in a decision that continues the judicial trend of scrutinizing proposed break-up fees, the Third Circuit has ruled that the requesting party must show that the fees were actually necessary to preserve the value of the debtor's estate. In re O'Brien Environmental Energy Inc., 181 F.3d 527 (3rd Cir. 1999). O'Brien is significant because it is the first court of appeals decision to address the standards governing an award of break-up fees. The decision is further significant because the court rejected a common-law standard in favor of the standard applied under §503(b) of the Bankruptcy Code to administrative expenses.

Break-up Fees

Assets owned by corporations in bankruptcy are often sold to the highest bidder. Potential purchasers, however, may be reluctant to incur the costs to engage in the due diligence necessary to determine the worth of the debtor's business and prepare the first bid, knowing that other purchasers may rely on that work and make a higher bid. As a consequence, debtors commonly provide economic incentives to the initial bidders. A frequently used incentive is the break-up fee.

A break-up fee in the range of 1 to 2 percent of the proposed purchase price is typically paid by the debtor to a potential acquiring party if the transaction is not completed, most commonly because the debtor accepts a better bid. "A 'breakup fee' is an incentive payment to an unsuccessful bidder who placed the estate property in sales configuration mode...to attract other bidders to auction." In re Financial New Network, 126 B.R. at 152, 154 n.5 (Bankr. S.D.N.Y. 1991). In simplest terms, the fee is designed to compensate a bidder for the risk of being outbid.

Courts recognize that on the one hand, break-up fees may enhance the bidding process by encouraging the first bid. Break-up fees may "be legitimately necessary to convince a 'white knight' to enter the bidding by providing some form of compensation for the risks it is undertaking." Samjens Partners I v. Burlington Industries Inc., 663 F.Supp. 614, 624 (S.D.N.Y. 1988). The debtor may then use this offer to attract higher offers. On the other hand, break-up fees may discourage others from making bids by increasing the cost of the acquisition. Break-up fees outside bankruptcy are commonly used and presumptively valid as an exercise of business judgment. In bankruptcy settings, however, courts disagree as to the appropriate standard for determining whether to approve the fee.

The Modified Business Judgment Standard

Faced with requests for break-up fees, some bankruptcy courts in years past have applied a modified "business judgment rule." In re 995 Fifth Avenue Assocs., 96 B.R. 24 (Bankr. S.D.N.Y. 1989). Under this deferential standard, courts begin with the presumption that the fee is valid so long as it is determined without fraud, bad-faith or self-dealing.

In 995 Fifth Avenue, the court considered whether the proposed break-up fee prohibited or chilled the bidding and whether the amount of the proposed break-up fee was reasonable in relation to the size of the sale and the work and expense involved in negotiating the agreements to determine if the break-up fee met the modified business judgment rule. 995 Fifth Avenue, 96 B.R. at 28-29. The court rejected the idea that the break-up fee should be limited to amounts actually expended by the purchaser. Id. at 29 n.6.

Applying the modified business judgment rule, the court in Official Committee of Subordinated Bondholders v. Integrated Resources Inc., 147 B.R. 650 (S.D.N.Y. 1992), identified three questions for determining the validity of a break-up fee: (1) the relationship of the parties who negotiated the fee must not be tainted by self-dealing; (2) the break-up fee must encourage, rather than hamper, the bidding; and (3) the amount of the fee must be reasonable relative to the proposed purchase price. 147 B.R. at 657. Under the business judgment rule, the party challenging the fee had the burden of proving the fee improper. Id. at 656.

The presumption of validity and the placement of the burden on those challenging the proposed fee make this standard purchaser-friendly. Not surprisingly, both the 995 Fifth Avenue and Integrated Resources courts approved the requested fees.

The "Best Interest of the Estate" Test

Bankruptcy courts have, however, begun to move away from reviewing break-up fees under a modified business judgment rule. The current trend is to determine whether the proposed fee makes economic sense and is in the best interest of the bankruptcy estate and its creditors. These courts reason that the purpose of a bankruptcy sale is to maximize the value of the estate and that the payment of a break-up fee may unnecessarily decrease that value.

The first court to apply the alternative "best interest of the estate" test was In re Hupp Industries Inc., 140 B.R. 191 (Bankr. N.D. Ohio 1992). The fee at issue in Hupp was unusual in that it contemplated payment to the proposed bidder regardless of whether the bidder was successful in acquiring the debtor. The court held that although break-up fees are "presumptively appropriate" in non-bankruptcy sales, courts in the bankruptcy context "must be necessarily wary of any potential detrimental effect that an allowance of such a fee would visit upon the debtor's estate." 140 B.R. at 194. The court rejected the proposed fee because it was unrelated to any costs incurred by the potential purchaser and because the fee was to be paid regardless of whether the bidder ultimately acquired the debtor.

Likewise, the court in In re American West Airlines Inc., 166 B.R. 908 (Bankr. D. Ariz. 1994), expressly rejected the business judgment rule as the sole standard for review. Instead, the court held that the proper analysis must "include a determination that all aspects of the transaction are in the best interests of all concerned." 166 B.R. at 912. In rejecting the proposed $4-8 million break-up fee, the court reasoned that the debtor "had been thoroughly marketed" and thus "a proposed break-up fee would not induce further bidding or bidding generally." Id. at 913. In so ruling, the court also placed significance on the fact that the debtor was attractive to potential purchasers because it had been profitable over the last three quarters. Id. at 914. Nevertheless, the court approved an agreement to reimburse certain expenses of the bidder, of up to $250,000 per month, with a total cap of $3,000,000.

The court similarly invalidated the proposed break-up fee in In re S.N.A Nut Co., 186 B.R. 98 (Bankr. N.D. Ill. 1995), under the "best interest of the estate" standard. Applying this standard, the court reasoned that break-up fees are generally not valid because they are rarely needed to encourage bidding on the assets. Not only can debtors increase the amount of information available about themselves, thus decreasing the cost of due diligence, but purchasers in bankruptcy enjoy additional benefits, such as the certainty that the company is for sale and the power to reject certain executory contracts. These benefits are not always available outside bankruptcy. According to the court, "the prime criterion for assessing the interests of the estate is the maximization of its value." 186 B.R. at 104. The court found that the break-up fee did not maximize the estate's value since the initial bid not induce a bid that the court deemed reasonable. In fact, the debtor's assets were ultimately sold piecemeal through a plan of liquidation. Id. at 106.

Finally, the court in In re Tiara Motorcoach Corp., 212 B.R. 133 (Bankr. N.D. Ind. 1997), continued this recent trend when it expressly adopted the "best interest of the estate" test, reasoning that a bankruptcy sale is not in the ordinary course of business, and thus "the business judgment of the debtor should not be solely relied upon." 212 B.R. at 137. The court invalidated the proposed fee on the grounds that it lacked sufficient information about the purchase price to compare it to the proposed fee, there was no evidence that the party requesting the fee had conducted due diligence that other entities have benefitted or could benefit from, and that the debtor had failed to create post-petition bidding procedures or to solicit post-petition bids. Id. at 138. Regarding the size of the fee, the court cited a case that rejected a 10 percent break-up fee ostensibly because it greatly exceeded "the 1 to 2 percent fees found to be reasonable in the majority of cases approving such fees." Id. at 138 n.6 (citing In re Twenver Inc., 149 B.R. 954, 955 (Bankr. D. Colo. 1992)).

O'Brien Adopts a Third View: The §503(b) Standard

Although the Third Circuit in O'Brien clearly follows the trend of those courts that have reviewed break-up fees under the "best interest of the estate" test, the court stressed that no previous court had offered a compelling justification for treating an application for break-up fees and expenses differently from other applications for administrative expenses under §503(b). 181 F.3d at 535. Consequently, the court held that the determination whether to allow break-up fees or expenses must be made in reference to "general administrative expense jurisprudence."

At issue in O'Brien was whether the court should approve a break-up fee of $2 million and expenses up to $2.25 million in connection with a proposal by Calpine Corp. to purchase O'Brien Environmental Energy, the debtor in a chapter 11 bankruptcy proceeding. Calpine and O'Brien entered into a purchase agreement that conditioned Calpine's obligation to perform on the bankruptcy court's approval of the break-up fee and expenses. The court refused to approve the agreement, however, expressing concern that approval may chill the bidding process, but indicated that it would permit Calpine to seek the fee and expenses at the end of the bidding process. An auction followed in which NRG Energy Inc. submitted the highest bid. Calpine then resubmitted its claim for break-up fees and expenses.

The bankruptcy court listed nine factors that it deemed relevant in determining whether to award Calpine the requested fee and expenses: (1) whether the relationship of the parties is tainted by self-dealing or manipulation; (2) whether the fee hampers, rather than encourages, bidding; (3) whether the amount of the fee is unreasonable relative to the proposed purchase price; (4) whether the unsuccessful bidder placed the estate property in a sales configuration mode to attract other bidders to the auction; (5) whether the request for a break-up fee serves to attract or retain a potentially successful bid and establishes a bid standard or minimum for other bidders; (6) whether the fee requested correlates with a maximization of value to the estate; (7) whether the principal unsecured creditors and the official creditors's committee is supportive of the concession; (8) whether safeguards beneficial to the debtor's estate are available; and (9) whether there was a substantial adverse impact on unsecured creditors, where such creditors are in opposition to the break-up fee.

Applying these factors, the bankruptcy court again rejected Calpine's request. Although there was no evidence of self-dealing, the fee was reasonable in proportion to the purchase price and unsecured creditors would still be paid in full, the court ultimately rejected the request because it found no evidence that the fee had induced bidding or furthered the bidding process. Specifically, the court found that the fee had not induced bids because O'Brien, not Calpine, had gathered much of the information needed to evaluate itself at its own expense, and because O'Brien had solicited bids from several companies before Calpine emerged. The bankruptcy court also noted that Calpine's bid did not serve as a standard for other bids given that its and NRG's bids increased substantially over the bidding process. The district court for the District of New Jersey affirmed.

On appeal to the Third Circuit Court of Appeals, Calpine challenged the bankruptcy court's pre- and post-sale decisions denying its requests for the break-up fee and expenses. At the threshold, the Third Circuit held that Calpine lacked standing to challenge the pre-sale denial because, at that time, Calpine was not a "person aggrieved." According to the court, because Calpine was not a creditor and did not have a binding contract with O'Brien, the court's invalidation of the purchase agreement containing the break-up fee did not diminish Calpine's property, increase its burdens or impair its rights. Id. at 531. Calpine did, however, have standing to challenge the bankruptcy court's subsequent denial of its motion for the break-up fee and expenses.

The Third Circuit began its review by rejecting Calpine's and the lower courts' analysis of the legal basis of Calpine's request. Calpine had framed its request "under the applicable case law setting forth standards for approval of break-up fees and break-up expenses." Id. at 532. The cases relied on by Calpine, however, all involved pre-sale requests for break-up fee provisions that arguably fall under a bankruptcy court's authority to approve sales outside of the ordinary course of business. 11 U.S.C. §363(b). Because of the bankruptcy court's earlier ruling delaying the break-up fee issue until after completion of the sale, Calpine lost the ability to argue §363 as a basis for allowance of the break-up fee. The Third Circuit expressly declined the invitation "to develop a general common law of break-up fees," reasoning that courts may not create a right to recover from a bankruptcy estate where no such right exists under the Bankruptcy Code. Id.

The court instead selected §503 as the most likely source of authority. The court reasoned that claims that arise after a debtor petitions for bankruptcy protection are generally allowed, if at all, only as an administrative expense under that section. In relevant part, §503 states:

(a) An entity may timely file a request for payment of an administrative expense, or may tardily file such request if permitted by the court for cause.
(b) After notice and a hearing, there shall be allowed administrative expenses...including—
(1)(A) the actual, necessary costs and expenses of preserving the estate, including wages, salaries or commissions for services rendered after the commencement of the case...

11 U.S.C. §503.

As have other courts, the Third Circuit recognized the fundamental tension underlying break-up fees: Whereas a break-up fee may serve to induce an initial bid by assuring a prospective bidder that it will recover its due diligence costs if its bid is unsuccessful, that same fee may serve to advantage a favored purchaser over other bidders by increasing the cost of the acquisition to other bidders. Id. at 535. The court also stressed that in many instances a break-up fee is not necessary to induce bidding. To illustrate, the court noted that potential purchasers will bid whether or not break-up fees are offered whenever they determine that the cost of acquiring the debtor, including the cost of making the bid, is less than the value the purchaser can expect to gain from the acquisition. Id.

But rather than adopt the nine factors the bankruptcy court had identified as the appropriate test, the court instead looked simply to whether awarding Calpine break-up fees was necessary to preserve the value of O'Brien's estate. Such fees would be necessary, the court observed, if "assurance of a break-up fee promoted more competitive bidding, such as by inducing a bid that otherwise would not have been made and without which bidding would have been limited." Id. at 537. The court ultimately affirmed the bankruptcy court's rulings because the prospect of obtaining the fee did not further the bidding process.

In so holding, the court first rejected Calpine's claim that the prospect of receiving the fee was necessary to retain its bid, noting that Calpine decided to re-enter the bidding despite knowing that it risked not receiving any break-up fee or expenses. This risk exists, of course, whenever a party fails to obtain court approval of a break-up fee before the sale process. The court further reasoned that the large increase from the initial bid to the ultimate sale price suggested that Calpine reentered the bidding because of the prospect of obtaining O'Brien cheaply, not the prospect of receiving a break-up fee.

The court also rejected Calpine's claim that its bid promoted competitive bidding absent some showing that its bid "served as a catalyst to higher bids." Id. at 537. Whereas an estate would arguably benefit from a break-up fee if that fee induced research that in turn led to a value that better reflected the estate's "true worth," the court found that O'Brien, not Calpine, had gathered much of the information needed to evaluate itself at its own expense. In addition, the court found evidence, without stating what that evidence was, that Calpine had strong financial incentives to undertake the cost of submitting the bid even in the absence of any promise of reimbursement. Presumably, this evidence was the hidden value that was ultimately uncovered as the bid amounts increased.

Finally, the court was not persuaded by Calpine's contention that the competitive bidding that occurred during the auction proved that the prospect of paying a break-up fee did not chill the bidding. In the court's view, the bidding might have been even more heated had the bankruptcy court definitively ruled that Calpine was not entitled to the fee. Candidly, the court acknowledged that results of bidding "do not prove what effect the break-up fee and expense provisions had on other bidders' behavior." Id. But that was exactly what the court looked to when it concluded that it was the prospect of obtaining O'Brien on the cheap, and not possible reimbursement, that induced Calpine to re-enter the bidding.

Indeed, O'Brien reflects the general difficulty of obtaining court approval of bidding incentives after the bidding process. With the benefit of hindsight, courts can subject such incentives to the strictest scrutiny. As one court has observed, characterizing a bidding incentive as "a permissible type that promotes bidding, or a harmful strain that discourages bidding, appears to be no more than conclusory judicial labels that are affixed by hindsight after the [bidding incentive] has been scrutinized by the courts." Cottle v. Storer Comm. Inc., 849 F.2d 570. 576 n.7 (11th Cir. 1988) (quoting Leo Herzel, et al., Misunderstanding Lockups, 14 Sec. Reg. L.J. 150, 1177 (1986)). In O'Brien, the court gleaned from robust bidding that the bidders believed they could acquire O'Brien cheaply, and thus the prospect of receiving a break-up fee was unnecessary. Of course, if the bidding had been slow or nonexistent, the court could just as well have blamed the break-up fee. This ability blame a break-up fee after weak bidding, but look elsewhere after spirited bidding, makes predictability impossible. At a minimum, a potential purchaser seeking a break-up fee ought to obtain court approval of the fee before the auction and be prepared to support that request with evidence of benefit to the estate, perhaps in the form of minimum bid increases or "topping" protections.

Conclusion

Overall, O'Brien establishes a standard for the approval of break-up fees that, where applied, will prove difficult to meet. Although closer judicial scrutiny of these fees began several years ago, the Third Circuit's adoption of §503, and the "heavy burden" that section places on a party seeking to demonstrate actual benefit, guarantees that this trend will continue.