Bankruptcy auctions can be extremely frustrating for bidders. This fact was reinforced by a recent decision of the Third Circuit Court of Appeals which demonstrated the importance for a stalking horse bidder of obtaining approval of bid protection provisions before proceeding in a bankruptcy auction. In re O'Brien Environmental Energy, Inc., 181 F.3d 527 (3rd Cir. 1999).
In O'Brien, the Bankruptcy Court had initially refused to approve the break-up fee and expense reimbursement provisions in the potential buyer's agreement on the ground that allowing such fees and expenses would perhaps chill or, at best, complicate the competitive bidding. It was apparent from the start that another qualified bidder was interested in bidding and the court was apparently prepared to take the risk that the stalking horse would continue to participate. The court did, however, indicate that it would permit the potential buyer to seek the break-up fee and expense reimbursement at the end of the sales process.
Thereafter, the stalking horse remained in the auction, despite the Bankruptcy Court's refusal to approve the requested protections, and engaged in a "bidding war" with the other bidder. The stalking horse ultimately was outbid, with the final purchase price exceeding the initial offer by more than $50 million. After the sale, the Bankruptcy Court denied the stalking horse's renewed application for payment of the break-up fee and expense reimbursement. The District Court upheld the Bankruptcy Court's decision. On appeal, the Third Circuit also upheld the Bankruptcy Court's decision, ruling that the stalking horse would have only been entitled to the requested fee and expense reimbursement if it could establish both (i) that it had provided an actual benefit to the estate and (ii) that the fee and expense reimbursement was necessary to preserve the value of the estates' assets. It was apparent that the stalking horse had provided a valuable service. Without its participation there would have been no auction. Nevertheless, the Third Circuit concluded that the break-up fee and expense reimbursement were not necessary because the stalking horse had pursued the assets without any assurance of receiving such payments. The Third Circuit observed that the stalking horse pursued the debtor's assets in the hope of buying them cheaply rather than in the expectation of receiving a break-up fee.
Even when break-up fees have been approved, there is risk that they will not be paid if the stalking horse does not, in fact, contribute to an auction. In In re Marrose Corp., 1991 Bankr. Lexis 2177 (Bankr. S.D.N.Y. February 15, 1991), the stalking horse, who had a break-up fee and expense reimbursement provision contained in a letter of intent approved by the Bankruptcy Court (prior to the negotiation of a definitive agreement), was later denied the previously approved break-up fee and expense reimbursement. Although, the stalking horse did not default, it was unable to close the transaction due to lack of financing and the assets were ultimately sold to another buyer. In denying the break-up fee and expense reimbursement, the Bankruptcy Court, finding the relevant provision of the letter of intent ambiguous, wrote:
"However, [stalking horse] was never in a position to consummate the original proposed transaction as their required financing was not in place."
These cases underscore many of the problems that bidders in bankruptcy auctions can face. Although cash is king, a cash bid can lose out to a paper bid that purports to be higher. This is exactly what occurred in the O'Brien auction, where cash lost to cash and stock. Some judges may place little or no value on the existence of potentially problematic closing conditions and simply focus on the amount bid, as the Bankruptcy Court also did in O'Brien. Other judges may be concerned with closing conditions, and a higher cash bid may lose to a lower bid with fewer closing conditions. This is what happened in the case of In re Bakalis, Case No. 194-12310-353 (Bankr. E.D.N.Y.), where a lower "insider" bid with no conditions prevailed over a higher bid from a third-party with customary closing conditions.
There are a number of reasons why the parties in control of a bankruptcy auction may embrace a "lower" bid. The people controlling the auction may have ulterior motives, such as future jobs, resolving potential personal environmental liability or retaining an economic interest where it is not justified, that can skew the process in favor of a particular bidder or type of bid. A management bid may have the inside track and an owner bid may have tax advantages that place a third-party bidder at a disadvantage. On top of this, auction procedures are often unclear, may permit or require a discretionary comparison of "apples" to "oranges" and may be subject to change during the auction, if such a change would result in additional value to the debtor. In view of these pitfalls and the time and money required to pursue a bid in a bankruptcy auction, a potential bidder should carefully weigh whether the possibility of obtaining a bargain will be offset by the risk that its valid, bona fide offer will be used simply to attract other potential buyers or to get the preferred potential buyer to increase its bid to a reasonable level. Where that risk exists, iron-clad breakup fee and expense reimbursement arrangements are critical.
Outside of bankruptcy, parties protect themselves from these risks in various ways. Potential buyers invariably require payment of their due diligence costs. Potential buyers obtain "no shop" agreements and prohibitions on the disclosure of their identity to third-parties. Break-up fees are also routinely obtained. The prevailing wisdom is that these protections do not chill bidding but merely reduce the value of higher bids by requiring that the incremental value received be shared with the stalking horse who made the auction possible. However, as demonstrated by O'Brien and Marrose, in a bankruptcy case careful lawyering may be needed to obtain the required protection.
Moses & Singer, LLP played a central role in each of these cases. In O'Brien and Marrose, Moses & Singer represented the Official Committee of Unsecured Creditors. The reported decisions in O'Brien and Marrose are among the more important cases written in the area of buyer protections in the bankruptcy context.