Not So Fast Asset Sales Under the New 363

Not So Fast Asset Sales Under the New 363

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Chapter 11 cases now provide a framework for the sale of significant divisions, and often entire companies, as a means of maximizing value. From mid-size businesses, whose enterprise value no longer covers secured debt, to the mega-cases of the new millennium, where a series of divestitures precede reorganization around a nucleus of "core" businesses, sales of entire operations pursuant to §363 of the Bankruptcy Code are an important feature of the restructuring landscape. Several of the amendments to the Bankruptcy Code enacted in April 20052 will have significant effects on these kinds of transactions—few of them beneficial.

What the New Amendments Do Not Do

The new amendments say nothing about the threshold legal issue involving §363 sales, which vexed the courts for several years, namely the propriety of a sale of all, or a substantial portion, of a chapter 11 debtor's assets outside of the procedures and protections of a reorganization plan. Accordingly, the apparently settled case law on the propriety of §363 sales, where necessary to preserve value, where stand-alone reorganization prospects are dim and where the distributive provisions of the plan process are not violated, will remain unaffected by the amendments. The amendments are also silent on another frequently unspoken but disquieting issue to many courts: whether bankruptcy court authorization of a §363 sale of all, or essentially all, of a debtor's assets is appropriate where anticipated proceeds from a proposed transaction will provide no recovery to unsecured creditors. Many bankruptcy judges are of a mind that if a transaction yields nothing to constituencies other than secured creditors, then an Article 9 auction, rather than the bankruptcy court, is the appropriate forum. The amendments' silence on this issue likely means no change in the way in which individual courts continue to address this issue.

The impact of the amendments on §363 asset sales will, however, be strongly felt in three major areas: assumption and assignment of real-estate leases, liquidity and post-petition management incentives.

Assumption and Assignment of Real Estate Leases

Background on Assumption and Rejection. Real estate leases are often significant assets in going-concern sales under §363. In many industries, like retailing, specific desirable locations and/or below-market leases may be the principal value drivers for the entire case. In the chapter 11 case of retailer Edison Brothers Stores Inc., for example, the ability to sell valuable leases, notwithstanding lease provisions that outside of bankruptcy might have precluded such sales, created significant value for the estate and its creditors. Creating value through the assignment of valuable leases, however, is only one side of the coin. Debtors also gain significant flexibility from the ability to reject burdensome real estate leases, and have the claims resulting from such rejection be both capped in amount and classified as general unsecured claims, along with other pre-petition unsecured debt.3 In Carmike Cinemas, the distressed theater operator was able to reject nearly 130 burdensome leases of negatively performing facilities and, through the resulting rent savings and the cap on the unsecured claims arising from rejection, was able to create more than $80 million of incremental value to the reorganized company. Whether extracting value from lease sales or creating value through lease rejections, many cases revolve specifically around the debtor's ability and to take the time to analyze its locations, determine which locations it desires to reject, which it desires to retain and which can be assigned to a third party for value.

Current Law.4 Under current law, bankruptcy courts have been able to grant, for "cause," almost unlimited 60-day extensions of the initial 60-day post-petition period in which a debtor must move to assume or reject a real estate lease, or otherwise seek an extension of time to make that decision. In most cases, bankruptcy courts have given debtors extensions through confirmation of a reorganization plan to make the decision regarding assumption or rejection, provided they remain current on post-petition rent. Thus the assumption or rejection decision has been able to be made concurrently with, and become part of, the overall restructuring strategy.

New Law.5 The latest amendments, like many prior amendments to the Bankruptcy Code, contain significant advantages for landlords, as well as some benefits for debtor tenants. Firstly, the amendments extend, from 60 to 120 days following the bankruptcy filing, the period of time in which the debtor must initially move to assume, reject or seek an extension of the decision period. Offsetting this potential benefit to debtors, however, the amendments also provide that bankruptcy courts in the future may only grant the debtor extensions for making the assumption or rejection decision through the 210th day of the bankruptcy case. Thereafter, further extensions may only be given with the concurrence of the affected landlord—a significant shift in leverage. As a result, landlords will be in a position, seven months after filing, to control many bankruptcy cases in which assumption or rejection decisions had previously been pushed back to plan confirmation.

Impact of the Changes. In fast-moving cases in which a §363 sale of essentially all of the debtor's operations is the principal objective, the impact of this time compression of the assumption/rejection decision may be minimal. In other cases, however, sales of a particular operation or division, including related leases, may be the result of an overall restructuring strategy in which some operations are to be divested through a §363 sale, while others will form the core of a restructured business. In large and complex cases, such overall restructuring strategies are seldom developed, negotiated and confirmed within seven months. In these cases, decisions regarding lease assumption and rejection may have to be made early in the case, perhaps without the benefit of adequate information and analysis.

Presumably in recognition of this possibility, the amendments address specifically the issue of leases assumed during the case, but subsequently rejected. In the future, debtors who wish to escape the obligations of a lease, improvidently and prematurely assumed in the new "rush to judgment" occasioned by the amendments, may do so by rejecting the previously assumed lease. The amendments soften the blow of this change of heart by the debtor by limiting the damages arising from the "post-assumption rejection" to a two-year administrative claim (mitigated by rents actually received or to be received—presumably under a new lease—during such two-year period) plus a capped general unsecured claim under §502(b)(6) for the balance of the lease period. While this limitation certainly helps minimize the adverse effects of a prematurely assumed lease, it by no means eliminates the potentially significant adverse consequences of poor decisions made necessary by the compressed assumption/rejection timeframes dictated by the amendments.

Pre-petition Strategic Implications on Lease Practice. In terms of strategy, this compression of the lease-assumption-and-rejection timetable may give tenants reason for encapsulating leases in "special-purpose" real-estate subsidiaries. Such subsidiaries may be kept out of bankruptcy until the assumption or rejection issue is ripe for decision in the case in chief. This structure may be particularly attractive in those jurisdictions where even if the underlying lease is required to be guaranteed by the corporate parent of the "special-purpose" real-estate entity, claims arising under the parent guaranty are afforded the same limitations under §502(b)(6) as the lease obligations themselves. In these cases, the ability to control the timing of the bankruptcy filing of the "special-purpose" real-estate entity can facilitate the assumption or rejection decision—free of the timing constraints created by the amendments, while the debtor-guarantor can still derive the dollar cap and unsecured claim classification benefits of §502(b)(6) in the event of rejection.

Liquidity Issues and §363 Sales Liquidity issues, particularly in the immediate post-petition period, are critical in all chapter 11 cases, including those in which one or more §363 sales will be the focus. Whether a "stalking horse" bidder is signed up pre-petition, or the sale process is conducted primarily during the post-petition period, ensuring adequate liquidity for operations—from filing through transaction consummation—is crucial to the success of a §363 sale.

Changes contained in the amendments in two areas will have a significant effect on liquidity issues: (1) reclamation and expanded administrative priority for pre-petition claims of goods suppliers, and (2) the provision of adequate assurance of post-petition payments to utilities.

Reclamation and Expanded Administrative Priority for Pre-petition Claims of Goods Suppliers

Current Reclamation Law. The current reclamation provisions of §546(c) of the Code enable sellers of goods to an insolvent bankruptcy debtor to exercise their statutory and common law rights to reclaim such goods. These reclamation rights are subject, under the current provisions of the Code, to such sellers giving notice of the exercise of such rights within 10 days following the debtor's receipt of the goods or, if such 10-day period expires post-petition, then within 20 days of the commencement of the bankruptcy case. Also, currently bankruptcy courts can deny actual turnover of reclaimable goods by granting an administrative expense equal to, or a lien to secure payment of, the value of those goods. Thus, under current law the Code tips its hat to current nonbankruptcy law, gives a limited notice or look-back period and eases the immediate impact of actual reclamation by facilitating the alternative remedy of a lien or administrative expense priority. Neither of these alternative remedies requires payment until much later in the case, generally following confirmation of a reorganization plan, thereby avoiding the creation of any additional liquidity issues in the early days of the case.

New Reclamation Law.6 The amendments, however, convert the prior law's tip of the hat to nonbankruptcy law into a substantive right under bankruptcy law. Moreover, the new law extends the notice or look-back period from 10 days to 45 days following the insolvent debtor's receipt of the goods, or, if such 45-day period expires post-petition, to 20 days following commencement of the bankruptcy case. The amendments also eliminate the courts' existing ability to soften the impact of reclamation by substituting a lien or an administrative priority expense for actual reclamation.

Impact of Changes in Reclamation Law. All debtors will potentially face significantly greater reclamation claims early in the case, as well as the prospect of possibly only resolving such claims through the use of scarce cash. This problem will likely give rise to a variety of attempts by cash-strapped debtors to reach a compromise with reclaiming sellers. The ingredients of such compromises will probably include some combination of cash, together with the granting of liens and administrative priority claims, each of which are available under current law. Woven into such a compromise may also be an agreement by reclaiming sellers to provide trade credit post-petition, thereby alleviating some of the debtor's liquidity burden during the early days of the case.

Add to that mix the amendments' addition, as an administrative expense claim, of the value of any goods received by the debtor within 20 days prior to the petition date, and you have the seeds of a complex negotiation, promptly following a filing, between cash-strapped debtors on the one hand and goods suppliers on the other hand who will be strongly empowered by these new reclamation and administrative priority rights to cut a deal favorable to themselves and potentially highly damaging to the debtor and other creditors.

Particularly hard-hit by these provisions, whenever they happen to file, will be businesses with ongoing—rather than seasonal—inventory needs, like supply-chain participants in the grocery and other perishables businesses, and in just-in-time manufacturing. As an example, the exit from bankruptcy of The Fleming Cos. Inc., a major grocery distributor and retailer, became almost totally dependent on the lengthy negotiation of a resolution of the rights of reclamation creditors. The increased leverage of such creditors under the new law will make such resolutions even more difficult than they were in Fleming. In contrast, if businesses with more periodic or seasonal inventory acquisition needs (like retailers) are to avoid empty shelves or empty coffers following the commencement of their cases, they will need to give focus on timing a filing late in the inventory cycle in order to minimize reclamation and pre-petition administrative claims.

An additional dilemma for senior secured lenders is created by the amendments' codification of current case law, under which reclamation claims are subordinate to existing floating liens on the same goods. In most bankruptcy cases, the debtor's senior secured lender holds a lien on essentially all of the debtor's assets, including a floating lien on inventory and accounts receivable. In order to be able to claim its entitlement to post-petition interest and other expenses, a senior secured lender will generally assert that it is fully, or over-, secured.7 If the senior secured lender is found to be over-secured, then the "excess" inventory collateral may be subject to reclamation by the inventory supplier, diminishing the senior secured lender's collateral base—clearly, not an exciting prospect for either the debtor or the senior secured lender. The senior secured lender's preexisting dilemma of choosing between claiming to be over- or under-secured is exacerbated by the increased notice or look-back period under the amendments' new reclamation provisions, which can make subject to reclamation even more of the inventory that the senior secured lender regards as its collateral.

The increased leverage of the reclaiming creditor over both the debtor and the secured lender will compound the debtor's liquidity and funding needs during the critical early days of a case. This is the period when business stabilization pending continuing marketing efforts and consummation of a §363 sale is of major importance if the recovery from a going-concern sale transaction is to be maximized.

Adequate Assurance of Post-petition Payments to Utilities

Landlords and suppliers of goods are not the only favored constituencies under the amendments. The influence of utilities, too, is reflected in the revisions to §366 dealing with the debtor's provision of adequate assurance of post-petition payments to utilities at the beginning of a bankruptcy case.

Contrast of Current and New Law on Adequate Assurance.8 Unlike current law, under the amendments, courts in the future, when called upon to determine the adequacy of a bankruptcy debtor's required assurance of post-petition utility payments, will not be able to consider any of the following: the absence of security before the date of the filing of the petition, the payment by the debtor of charges for utility service in a timely manner before the date of the filing of the petition, or the availability of an administrative expense priority. Furthermore, the amendments provide that only the following shall provide the required assurance of payment: a cash deposit, letter of credit, certificate of deposit, surety bond, prepayment of utility consumption or another form of security that is mutually agreed upon between the utility and the debtor. In other words, unless an agreement is otherwise reached with the utility, essentially all "cashless" forms of adequate assurance of post-petition utility payments have been eliminated.

Impact of the Changes on Adequate Assurance. The liquidity effects of these changes will be significant on manufacturers and other enterprises for whom utility consumption is a major expense. Moreover, this is an issue that must, under the amendments, be resolved in the first 30 days of the case. Here again, as with landlords and goods suppliers, the increased leverage of a favored class of creditor will further compound the debtor's liquidity and funding needs during the critical early days of a case, when business stabilization pending a going-concern sale is of major importance.

Post-petition Management Incentives (KERPs)

Post-petition management incentives contained in Key Employee Retention Programs (KERPs) have become an important part of the landscape in almost all chapter 11 cases. In cases where a §363 sale of the business is the principal objective, KERPs provide the means for the debtor to retain key personnel whose involvement and support is critical to the stability of continuing operations (and thus the value of the enterprise), as well as to the success of the sale process itself. In addition, the continuing employment of certain key employees pre-, and perhaps even post-, §363 sale may be important deal points for prospective buyers. Successful stand-alone restructurings often provide the prospect of continued employment opportunities for key employees, giving such employees at least some incentive to remain with the company as it reorganizes. Where the company is to be sold in a §363 sale, however, the possibilities of continued employment for key employees are much more uncertain and are frequently unknown prior to the outcome of the sales process itself, and identification of the ultimate buyer. Key employees recognize that many strategic acquirers are motivated in large part by opportunities to profit from operational synergies that could result in the termination of many employees. In the context of a §363 sale, all this results in significant insecurity for many key employees, leading to key employee flight.

In the past, many creditors have been harshly critical of KERP programs that provided incentives for the retention of key members of existing management. Such criticism arose from creditor perceptions that existing management was responsible for the financial distress of the debtor and the resulting hardship to those same creditors. KERP programs struck such creditors as the equivalent of putting the fox in the chicken coop. This adverse creditor sentiment to KERPS clearly influenced Congress as it enacted the amendments. It resulted in the codification of definitive limitations on KERP benefits for insiders (principally officers and directors), while under current law such benefits simply need to meet a business judgment standard.

New Law on Post-petition Management Incentives

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Most KERPs have two components: a retention component and a severance component.

Retention Component. As a threshold matter, the amendments require that the services to be provided by an insider seeking retention benefits under a KERP be essential to the survival of the business. This codified requirement is essentially the same as the business judgment standard under current case law. However, the amendments also codify a requirement that, in order for the court to approve proposed retention benefits, a proposed insider KERP beneficiary must have a bona fide job offer from another business at the same or greater rate of compensation as that provided by the debtor.

This provision is likely to encourage the very kind of key employee flight that retention benefits under a KERP are intended to discourage. This is particularly true where the debtor's business is to be sold in a §363 sale. Key employees, uncertain as to both the outcome of the sale process and the likelihood of continued employment with an acquirer, already have significant reason to focus on seeking alternative employment rather than assisting the debtor to maximize sale transaction value. Affirmatively requiring such employees to actively seek alternative employment at higher compensation in order to be eligible for retention benefits is inherently contradictory—unless the proposed retention benefit is large enough to compensate the employee for foregoing the current and future benefits of a better job offer, as well as for the damaged relationships resulting from using such offer as a "stalking horse" for gaining retention benefits.

Additional amendment provisions capping retention benefits to insiders exacerbate this potential encouragement of key employee flight. The amendments limit insider retention benefits to 10 times the mean amount of payments of a "similar kind" made to non-management employees for any purpose during the calendar year in which the retention benefit is paid to the insider. In the absence of such a "similar kind" payment, the insider retention benefit is limited to 25 percent of any similar benefit given such an insider during the calendar year preceding the calendar year in which the proposed retention benefit is to be given. Unclear is whether key employee incentives based on the purchase price for the debtor's assets in a §363 sale, and that require key employees to remain employed through the close of such a transaction, are intended to be covered by these new provisions. In addition, one can't help but wonder how many key insider employees will actually be left by the time the court and a flock of creative bankruptcy lawyers have analyzed, briefed, argued and ruled on the meaning of "similar kind" payments, the meaning of "similar" benefits and the time frames described in the amendments!

Severance Component. For those key insider employees that are left, however, the amendments also limit the amount of insider severance benefits to 10 times the mean severance payments given to non-management employees during the calendar year in which the insider severance payment is to be made, and require that such benefits be part of a severance program applicable to all full-time employees.

It is difficult to predict the full extent of the impact of these attempts to satisfy critics of current case law on the debtor's ability to provide incentives aimed at the retention of key employees. Whether management will be tempted to increase retention and severance benefits to nonmanagement employees to raise the bar upon which their own benefits will be calculated, whether courts will come to consistent conclusions regarding the meaning and intent of the amendments, and whether KERPS will simply become unworkable altogether—all remain to be seen. What is certain, however, is that much time, expense and uncertainty has been added to the process—none of which is likely to enhance the ability to maximize the value of the debtor's assets in a §363 sale.

Conclusion

Section 363 sales are likely to continue, if not grow, in importance as a means of maximizing creditor recoveries in situations where stand-alone reorganizations are not feasible, are too speculative or provide overall recoveries less favorable than a sale of the debtor's business as a going concern. Industry consolidations, in addition to other macroeconomic developments, will serve to stimulate this trend. While §363 sale transactions are certainly not made easier by Congress's latest enactments, we are unlikely to see their use decline any time soon.

Finally, since its enactment in 1978 the Bankruptcy Code has gone through multiple amendments. Some have been aimed at codifying prevailing case law, some at resolving conflicts of judicial interpretation, some at streamlining the process based on the actual experience of the courts in administering the Code, and others at catering to the specific interests of influential constituencies. The advent of mega-cases, linked with the corporate scandals of the beginning of the millennium, have aroused public suspicion and concern about the fairness of the Code itself, as well as the manner in which it is administered. Congress has attempted to address perceived abuses of the system, as reflected in the title of the Act implementing these latest amendments. In many areas, however, perhaps in an overreaction to strong opinions from influential constituencies, the amendments are heavy-handed and perhaps even detrimental to the overall goals of the bankruptcy process. Historically, however, judges and lawyers have, on the whole, been able to address the evolution of the Code, and chapter 11 specifically, in ways that foster its reorganization objectives. Their creativity and talent will continue to be tested as these new amendments take effect.


Footnotes

1 Mr. Fishman is a director with Houlihan Lokey Howard & Zukin's Financial Restructuring Group in the firm's San Francisco office. Return to article

2 The amendments referred to throughout are those contained in The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), signed into law April 20, 2005. Return to article

3 See Code §502(b)(6). Return to article

4 See, generally, Code §365(d). Return to article

5 See BAPCPA §404, amending Code §365(d)(4). Return to article

6 See BAPCPA §1227, amending Code §§546(c) and 503(b). Return to article

7 See Code §506(b). Return to article

8 See BAPCA §417, amending Code §366. Return to article

9 See BAPCPA §331, amending Code §503. Return to article

Journal Date: 
Thursday, September 1, 2005