Stalking-horse Lenders and Good Faith The Availability of Appellate Protection under 363(m) and 364(e) for Asset Purchasers Extending DIP Financing
With the increased prevalence of "Chapter 363" cases, where the chapter 11 case is commenced and prosecuted primarily, if not exclusively, to facilitate a sale of the debtor's assets free and clear of liens, claims, encumbrances and interests, motions to approve bid protections and procedures and asset sales are often found among the "first-day" motions. Increasingly, the financing allegedly necessary to preserve asset value and/or continue operations is being supplied by the stalking-horse bidder with whom the putative debtor-in-possession (DIP) has negotiated both sale and financing terms pre-petition (sometimes referred to in this article as the "stalking horse/lender"). The motion to approve such DIP financing by the proposed purchaser (sometimes referred to as the "DIP-to-buy"), usually on an emergency basis, is also among the first-day motions. Approval of the bulk of the DIP-to-buy financing will be sought—and often obtained—prior to the appointment or activation of any statutory committees. The debtor will seek to justify obtaining financing from the stalking horse on the basis that there is no other source of financing and—without the loans—the debtor will not survive until the approval of the sale, the debtor will be forced to a liquidation, and all creditor constituencies will be harmed by the resulting loss in value of the assets.
At the same time, the stalking horse/lender will seek the usual bid protections, such as break-up fees, minimum bid increments and deposit requirements. In addition, as part of the DIP-to-buy, the stalking horse/lender will want lender protections, such as priming liens, super-priority claims, drop-dead provisions and provisions for the payment of the DIP financing in the event of a sale to another bidder. A major part of the stalking horse/lender's sale consideration may be in the form of a "credit bid" of the DIP financing. The stalking horse/lender may also be tempted to use the terms of the loan to create disincentives for possible competing bidders and find a willing accomplice in the debtor's management, who may perceive few options other than the sale at hand, and possible advantages in dealing with their chosen white knight, or at least "the devil they know." The stalking horse/lender will also want a finding that it is a good-faith lender under §364(e) of the Bankruptcy Code in connection with the DIP to buy, as well as a finding that it is a good-faith purchaser under §363(m) if it is the successful purchaser, in order to protect both arrangements on appeal. Opponents of the borrowing or the sale, or both, will argue that the arrangement must be examined as a whole and that certain terms of the loan or the sale, or the process of reaching agreement and approval on either or both, deprive the stalking horse/lender of "good faith" purchaser or lender status, thus permitting an attack on appeal even in the absence of a stay of the borrowing or sale order.
This article will examine the degree to which the stalking horse/lender can obtain "good-faith lender" and "good-faith purchaser" status, and what facts may deprive the stalking horse/lender of such status.
Section 363(m) and the Definition of "Good-faith Purchaser"
Bankruptcy Code §363(m) provides that:
The reversal or modification on appeal of an authorization under subsection (b) or (c) of this section of a sale or lease of property does not affect the validity of a sale or lease under such authorization to an entity that purchased or leased such property in good faith, whether or not such entity knew of the pendency of the appeal, unless such authorization and such sale or lease were stayed pending appeal.2
Thus, sales under §363 are insulated from reversal or modification on appeal unless the sale order, and the sale, were stayed pending appeal under an order of the bankruptcy or reviewing court or the purchaser was not a good-faith purchaser.3 However, the reviewing court will not presume the purchaser's good faith, and the burden of proof falls on the proponents of the sale to present evidence to the bankruptcy court supporting a finding of good faith and to obtain a specific finding of good faith in the sale order in order to trigger §363(m) protection.4
The Code does not contain a definition of "good-faith purchaser." However, most courts have defined the term as a purchaser who purchases (1) in good faith, (2) for value and (3) without knowledge of adverse claims.5 The purchaser's good faith is a mixed question of law and fact.6 The "good faith" of a buyer—or the absence thereof—concerns the conduct of the buyer prior to and through the sale process.7 "Typically, the misconduct that would destroy a purchaser's good-faith status at a judicial sale involves fraud, collusion between the purchaser and other bidders or the trustee [or DIP], or an attempt to take grossly unfair advantage of other bidders."8 At least one court has stated that the conduct must be "extremely egregious" to affect good-faith purchaser status.9 However, among the kinds of conduct that might affect "good-faith purchaser" status are failure to disclose certain material terms of the purchase, secret side deals between debtor's management and the seller, and manipulation of information such that one bidder was supplied information not generally available to all bidders.10
Application of "Good Faith Purchaser" Standard to "DIP-to-buy"
Any examination of the application of §363(m) to a "DIP-to-buy" arrangement must begin with the seminal Third Circuit decision in Abbotts Dairies.11 While the decision is best known for imposing the requirement that the bankruptcy court make a finding on the purchaser's good faith, the court also discussed what findings would prevent a finding of good faith in the context of that case. In Abbotts Dairies, the proposed purchaser and the putative debtor had entered into an interim agreement on the eve of the bankruptcy filing, whereby the purchaser (ADC) would "effectively take over Abbotts's business." ADC agreed to purchase Abbotts's existing inventory at cost, lease its trademarks, maintain deliveries to current customers, employ most of Abbotts's employees and collect, on commission, about $6 million in accounts receivable.12 Upon the filing of the chapter 11 petition, the debtor sought approval of the interim agreement on an emergency basis, as well as approval of a sale of all of its assets to ADC.13 Certain creditors and prospective purchasers objected to approval of the interim agreement on the ground, inter alia, that its approval would chill other bidding for the assets. During the hearing on the motion to approve the interim agreement, the debtor's CEO testified that he had reached an "informal agreement" to act as a consultant to ADC during the bankruptcy case at his current salary, provided the court approved the interim agreement. He also testified that he had been offered a senior executive position with ADC for five years, at current salary, and that he "hoped" ADC would relieve him of personal liability for some of Abbotts's obligations, should ADC be the successful purchaser. The court approved the interim agreement with certain conditions apparently designed to lessen any chill on the bidding.14
The notice of sale, inviting counter bids, did not reveal the consultant arrangement or the offer of employment to the CEO. The notice also did not provide details of the interim agreement, although it did mention its approval.15 Three parties objected to the sale motion citing factors, including the interim agreement, that would chill the bidding. Two other parties submitted bids, but conditioned the bids upon obtaining relief from the interim agreement or orders that ADC could not compete. The court refused the requested relief, and the bidders withdrew the counterbids. The court also refused to hear evidence offered by an objector.16 The court then approved the sale to ADC, and certain of the objectors timely filed notices of appeal, but no stay pending appeal was obtained. The debtor filed a motion with the district court to dismiss the appeals citing "mootness" under §363(m), and the district court granted the motion.17
On appeal, the Third Circuit reversed, finding that the bankruptcy court, or the district court independently, should have inquired about and entered a finding regarding the purchaser's good faith, and in the absence of such a finding, §363(m) was not triggered.18
In the course of the opinion, the Third Circuit made it clear that, if certain findings were made upon remand, a finding of good faith was precluded:
[The objectors'] assertion of collusion...concerns, inter alia, the claim that the "emergency" justifying the immediate sale of Abbotts was itself contrived or orchestrated by ADC and Abbotts. For example, they claim that in exchange for a lucrative employment agreement for [the CEO]—Abbotts permitted ADC to manipulate the timing of Abbotts's bankruptcy so that the bankruptcy court had no choice but to approve the interim agreement on Aug. 10, the terms of which were designed to preclude any truly competitive bidding for the assets on Sept. 12. Surely, if [the objectors] substantiated these claims, it would, as a matter of law, constitute "collusion between the purchaser and...trustee [or in this case, the debtor-in-possession], or an attempt to take grossly unfair advantage of other bidders," sufficient to destroy ADC's "good-faith status."19In addition, the court noted the objectors' claims that certain terms of the interim agreement had "chilled" the bidding for Abbotts, and that the interim agreement gave an undue advantage to ADC vis-à-vis other prospective bidders, which significantly depreciated the overall value of the company.20 In chiding the district court, the Third Circuit noted that "considering ADC's lucrative offer of employment to [the CEO], the timing of Abbotts's petitions in bankruptcy and its motion for approval of the interim agreement, the situation was ripe for collusion and interested dealing between ADC and Abbotts."21 Moreover, the "auction" could not be counted on to determine value; if the alleged collusion tainted the process, no real "auction" took place.22
While the interim agreement in Abbotts Dairies, in allowing operation of the business pending sale, may have exceeded the usual "control" provisions of a DIP-to-buy, the difference is not so great that the case is not instructive in the DIP-to-buy context. In a DIP-to-buy arrangement, the stalking horse/lender and the debtor often negotiate in an environment where the debtor is cash-starved and where the process of negotiation can leave the debtor with only one choice. The timing of the filing will usually leave the debtor with little time to obtain sale approval. If there is evidence that the stalking horse/lender "manipulated" the timing of the deal and the chapter 11 filing, or that the timing emergency is the product of strategic planning rather than an unavoidable exigency, and there are "chilling" provisions in the DIP financing (such as early payoff provisions if the debtor accepts another bid, drop-dead clauses or access to information beyond due diligence provided to all bidders), Abbotts Dairies provides authority to deny a stalking horse/lender the benefits of a good-faith finding and ammunition to attack the DIP-to-buy and the sale process.
Subsequent courts, while acknowledging the teachings of Abbotts Dairies, have been reluctant to conclude an absence of good faith in DIP-to-buy situations based on the facts before them. In Tempo Technology,23 the Delaware bankruptcy court was faced with a pure DIP-to-buy arrangement. The bankruptcy court granted the debtor's first-day motions, including an order authorizing the use of cash collateral and allowing DIP financing from the stalking horse/lender, with the stalking horse/lender (TAC) being granted first liens and superpriority claims. On the same day, in response to the debtor's first-day motion to sell, the court scheduled a hearing date for the approval of the sale of substantially all of the debtor's assets to the stalking horse/lender, and scheduled an auction to entertain higher or better offers.24 Over objections, including by a prospective bidder, the court approved the sale to the stalking horse (the only bidder) on short notice and prior to the formation of the creditors' committee, and found that TAC was a good-faith purchaser.25 No stay of the sale was obtained, but certain objectors appealed, questioning the good faith of the stalking horse/lender; the debtor sought to dismiss the appeal as moot under §363(m).
The objectors' challenge mirrored the allegations in Abbotts Dairies. They alleged that the debtor waited for all of the pieces of its negotiations with TAC to fall into place before filing the petition (and could have filed earlier), and that the first-day motions and orders had the effect of depreciating the value of the debtor's assets and chilling the bidding at the auction.
They claimed that the DIP financing enjoyed by the debtor locked up the debtor's assets and weighed it down with (presumably unnecessary) debt, insuring that TAC would be the only bidder, and that TAC and the debtor contrived such tactics to take unfair advantage of the bidding process. They further noted that the debtor's CEO later obtained a favorable employment package from the buyer.26
However, the district court noted that the bankruptcy court had found good faith, a finding with which it agreed, and dismissed the appeal under §363(m). Noting the only testimony (that of the debtor's CEO), the court concluded that the bankruptcy court could have found that the debtor had been extensively marketed pre-petition, that the debtor's cash situation was such that a quick sale had to occur, that the negotiations were arm's length, and that the CEO had received, at the time of the sale, no promise of future employment.27
The district court noted the absence of other bidders, despite three week's notice (including in the Wall Street Journal) and the fact that four other bidders had done due diligence.28 Indeed, the court seems to state that a problematic term of the DIP financing justified the sale to TAC on short notice because of the potential difficulty in replacing the working capital financing:
Nevertheless, it is undisputed that no person or entity other than TAC bid at the auction. In the event that a competing bid had been entered, the...DIP financing would have had to have been replaced by the competing bidder so that any loans advanced to the debtor by [the stalking horse/lender] could be paid back and the additional DIP funding would be available pending closing of the sale.29Thus, the term of the DIP financing apparently provided that repayment occurred on bid acceptance, thus requiring any other bidder to be also a lender and a buyer. Notwithstanding this term, good faith was found due to the buyer's lack of affiliation with the debtor and the allegedly arm's-length nature of the negotiations as established by the debtor's CEO's "unrebutted testimony." The district court noted an absence of evidence "that any prospective purchasers regarded the auction terms as chilling their interest in bidding."30 Thus, the bankruptcy court's good-faith finding was upheld and the appeal was held moot under §363(m).31 The Third Circuit affirmed without a reported opinion.32
A subsequent action by the now-formed creditors' committee seeking to set aside the sale to TAC was equally unavailing.33 The committee alleged that certain lock-up and "no-shop" agreements existed between the debtor and the stalking horse/lender that prevented the CEO from shopping for financing or other bidders. The court, noting the CEO's testimony that the other directors were not bound by the agreements and had shopped the deal, found these allegations insufficient.34 The committee also noted that it had not been formed at the time of the sale and therefore could not object. The court, while finding the late formation of the committee "unfortunate," found this an insufficient ground to overcome the effects of §363(m) and the prior proceedings.35 The committee's complaint was dismissed for failure to state a claim upon which relief might be granted.36
In the Medical Software Solutions case,37 the Utah bankruptcy court found "good-faith purchaser" status where an insider was the stalking horse/lender. In Medical Software, the stalking horse/lender was a pre-petition investor in, and later a pre-petition lender to, the debtor. As the debtor slid into financial distress and a management dispute, the debtor hired an investment banker to sell the business, which attempted for about a year to market the company, without success.38 With no "white knight" in sight, the debtor filed a chapter 11 case and sought leave to sell the business to the pre-petition investor/lenders (who also had had representatives on the debtor's board). The debtor took the somewhat unusual step of seeking the appointment of an examiner to investigate the appropriateness of the DIP financing to be provided by the pre-petition investor, as well as the proposed sale to the same group (DF lenders), specifically to preempt any issues of conflict of interest.39 The DIP financing required a sale within 60 days of the filing, or a default would occur.40
Relying heavily on the examiner's report, the court approved the DIP financing.41 The debtor's motion to sell was also approved, over the objection of a minority shareholder, even though the consideration was primarily forgiveness of pre-petition secured debt and assumption of debt, and the sale was premised upon a release being granted to the pre-petition lenders, as well as a finding of no successor liability. The stalking horse/lender was also found to be a good-faith purchaser. Again, heavy reliance was placed on the favorable examiner's report.42 The court specifically found that there was nothing wrong with the stalking horse/lender being an insider, because here the insider had complied with its fiduciary duty of full disclosure.43
Similarly, in the Delaware & Hudson Railway case,44 a stalking horse/lender was found to have acted in good faith under both §§363(m) and 364(e). Again, the key was that the deal was negotiated at arm's length, following attempts to solicit other financing and interested buyers, and there was full disclosure.45
Insider-buyer cases may be instructive on the standard to be applied in the DIP-to-buy context. In a case of an insider-buyer-lender, one court (relying on Medical Software) stated:
When an insider is used as a stalking horse in a bankruptcy sale, the debtor must show that a sound business reason exists for the sale, that there has been adequate and reasonable notice to interested parties including full disclosure of the sale terms, that the sale price is fair and reasonable, and that the proposed buyer is proceeding in good faith.46
Finding inadequate disclosure as to the availability and value of certain key assets, the court refused to allow a sale to the insider without corrective disclosure.47 However, where an insider-creditor was the bidder—and a major component of the bid was a credit bid—the bidder was extended §363(m) protection as a good-faith purchaser because the court found "no evidence of collusion between the [debtor] and [the insider-bidder] to deny [the alternate bidder] information."48
Indeed, credit bid cases are similarly instructive. The courts have not hesitated to extend §363(m) protection to creditor bidders, even where the bidder was credit bidding a pre-or post-petition secured debt.49 Thus in the absence of other factors—such as manipulation of timing, disclosure or access to information—stalking horse/ lenders should get §363(m) protection.
Section 364(e) and the DIP-to-buy
Section 364(e) provides that:
The reversal or modification on appeal of an authorization under this section to obtain credit or to incur debt, or of a grant under this section of a priority or a lien, does not affect the validity of any debt so incurred, or any priority or lien so granted, to an entity that extended such credit in good faith, whether or not such entity knew of the pendency of the appeal, unless such authorization and the incurring of such debt, or the granting of such priority or lien, were stayed pending appeal.50Courts have generally defined "good-faith lender" under this section in the same way as "good-faith purchaser" under §363(m). The conduct that will destroy "good-faith lender" status is fraud, collusion between the lender and the debtor for an improper purpose, or an attempt to take or acquire grossly unfair advantage.51
The only reported decision other than Delaware & Hudson Railway to consider the application of §364(e) in a DIP-to-buy transaction was the opinion of the district court in In re Pan Am Corp.52 In Pan Am, the debtor was seeking to sell its trans-Atlantic routes and entered into negotiations with Delta whereby Delta would acquire them. In order to acquire the routes, Delta agreed to "sponsor" a reorganization of the debtors and to supply DIP financing to continue the funding of operating losses. Delta and the debtors agreed to an asset-purchase agreement, and when other bidders emerged, Delta increased its purchase price for the routes and agreed to fund a plan, provide post-petition financing and to hire certain Delta employees. The bankruptcy court approved the financing and the sale, finding Delta to have acted in good faith, over the objection of a creditor. The creditor sought to appeal the approval of the financing, but did not obtain a stay. At the district court, the creditor sought to preserve its right to appeal in the face of dismissal motions by challenging Delta's status as a "good-faith lender" under §364(e).53
Invoking Abbotts Dairies, the creditor, Evergreen, argued that Delta was complicit in contriving the emergencies under which the borrowing and sale orders were obtained. Evergreen further argued that there was no evidentiary basis for the good-faith finding. Delta was also alleged to have made the loans for an "ulterior purpose," to gain an advantage in buying the trans-Atlantic routes.54
The district court rejected these arguments and found that the appeal was moot under §364(e). The district court emphasized that the bankruptcy court's good-faith finding "must be viewed in the context of facts known to the bankruptcy court—and presumably Evergreen and Delta—at the time the orders appealed from were entered."55 Those facts included the debtor's heavy, daily operating losses, and the fact that cessation of operations—a real possibility without financing—would have resulted in loss of the trans-Atlantic routes, as well as traveler confidence, thus dooming the reorganization. Thus, the debtor and Delta had not colluded to create a contrived emergency; the court considered Abbotts Dairies as the standard and found no similar evidence of collusion in the case at bar.56 The court also found nothing in Delta's conduct suggesting bad faith. "That Delta imposed conditions on its loans, and advanced money in segments, rather than putting the entire amount ultimately advanced at the debtor's disposal all at once, simply reflects rational business judgment, not bad faith."57 Delta and the debtors had not concealed any information about the loans or their conditions. The court noted that "[t]he loan documents were, in the case of the three loans, a part of the record."58
The district court also found unpersuasive Evergreen's arguments that Delta was not a good-faith lender because it had advanced money for an "ulterior purpose." In so finding, the district court endorsed the very concept of the DIP to buy, properly conducted:
In the present case, Delta did, of course, have its own purposes: It wanted the debtor's trans-Atlantic routes. It was willing to risk advancing funds to the debtors in the effort to get those routes. But that is not an improper purpose, but one contemplated by the bankruptcy laws....59Evergreen's appeals were, accordingly, dismissed as moot under §364(e).60
DIPs-to-buy, while not new, are increasingly common and may provide a legitimate way—and sometimes the only way—to preserve value and continue operations pending a going-concern sale. However, the temptation exists to use the terms of the DIP financing to tip the bidding in favor of the stalking horse/lender. Courts will carefully scrutinize these arrangements, and the proponents of DIPs-to-buy should be prepared with evidence to support a finding of good faith in order to achieve approval and preserve the benefits of §§363(m) and 364(e). At the same time, if a proper record is built, the courts will generally find good faith in this context in the absence of strong contrary evidence that the stalking horse/lender has sought and obtained an unfair advantage over other bidders through the DIP-to-buy or a manipulation of the approval process.
3 See, e.g., Mark Bell Furniture Warehouse Inc. v. D. M. Reid Associates Ltd. (In re Mark Bell Furniture Warehouse Inc.), 992 F. 2d 7, 8 (1st Cir. 1993); Dick's Clothing & Sporting Goods Inc. v. Phar-Mor Inc., 212 B.R. 283, 289 (N.D. Ohio 1997). Return to article
7 Abbotts Dairies, 788 F.2d at 147; See, also, Gucci, 126 F. 3d at 390-393 (intended use of assets after the sale not relevant to good faith). Thus, conduct in negotiating the DIP-to-buy, and its terms, are relevant to "good-faith purchaser" status. Return to article
10 See, e.g., Abbotts Dairies, supra; In re National Health & Safety Corp., 1999 WL 703208 (Bankr. E.D. Pa.) (court expresses concern about "managed emergencies" and " managed information."). But, see Phar-Mor, 212 B.R. at 294 (undisclosed agreement between purchaser and third party, former bidder to sell certain assets if purchaser prevailed at auction did not suggest lack of good faith); In re Cable One CATV, 169 B.R. 488 (Bankr. D. N.H. 1994) (buyer does not lack good faith just because it is aware that sale may be procedurally defective); In re Sasson Jeans Inc., 90 B.R. 608 (S.D.N.Y. 1988) (that purchaser is also a creditor does not affect good-faith status); In re Cost Control Marketing & Management Inc., 1992 W.L. 398402 (M.D. Pa. 1992) (that purchaser sought and obtained release as part of sale did not indicate lack of good faith). Return to article
43 Id. at 445-446. The court also validated the stalking horse/lenders' use of credit bids of the pre-petition secured debt as well as the DIP loan for the majority of the sale consideration, rejecting the objectors' attempts to recharacterize the pre-petition loans as capital contributions, or to equitably subordinate the lender's claims. Id. at 442-444. Return to article
49 In re Trism Inc., 328 F 3d 1003 (8th Cir. 2003); In re Miami General Hospital Inc., 81 B.R. 682 (S.D. Fla. 1988) (creditor bidder supplied financing to debtor so that sale would realize going-concern value; creditor bidder also offered to finance other bids; good-faith was found). Return to article