Asset Sales: ABI Commission’s Recommendations Could Make Value Realization by Secured Creditors a Waiting Game of Diminishing Returns

The American Bankruptcy Institute Commission to Study the Reform of Chapter 11 (the “Commission”) recently issued a report (the “Report”) containing numerous recommendations to reform Chapter 11 of the Bankruptcy Code 26 BBLR 1688, 12/11/14. Many of the recommendations appear innocuous, yet if they are adopted by Congress their effect could be far-reaching. Some of the most dramatic changes relate to the Commission’s proposed changes regarding asset sales. ¹The Report differentiates between discrete sales of assets outside the ordinary course of business and sales of all or substantially all of a debtor’s assets, which the Commission refers to as “section 363x sales.” The Commission recommended very few meaningful changes to the current manner in which the Bankruptcy Code addresses discrete asset sales, but it recommended a number of significant procedural and substantive changes to the provisions governing section 363x sales. Our focus in this article is on the latter, and thus our discussion of the Commission’s proposed changes to provisions of the Bankruptcy Code affecting all asset sales is not intended to be exhaustive. In this article, we focus on the effect these proposed changes would have on secured creditors and the distribution of sale proceeds.

While many Chapter 11 debtors seek to reorganize pursuant to a plan of reorganization, a debtor also may seek to sell all or substantially all of its assets in what the Commission refers to as a section 363 sale, outside of a plan of reorganization. ²Section 363 of the Bankruptcy Code addresses a debtor’s use, sale or lease of its property. Generally, a debtor is permitted to use or sell its property in the ordinary course of its business without court approval. If a debtor wants to use or sell its property outside the ordinary course of its business, it must first obtain court approval on notice to parties in interest. Critically, the Bankruptcy Code permits a debtor to sell its property free and clear of interests in that property (such as liens) under certain conditions. 11 U.S.C. § 363(f). This ability to sell property free and clear of interests is intended to enhance the property’s value, maximize creditor recoveries and provide comfort and certainty for buyers. On a macro level, the Commission found few differences between the net effect of a section 363x sale and confirmation of a plan of reorganization. Both result in the fixing of the “maximum recovery any particular creditor will receive in [a debtor’s] case.” Report at 204. While the Commission found little difference between the consequences to creditors’ rights and claims under a section 363x sale order or plan confirmation order, it observed significant differences in the creditor protections available in each of these processes. Report at 206. Thus, the Commission proposed several key revisions to section 363 of the Bankruptcy Code intended to more closely align the standards for approval of section 363x sales with the standards for plan confirmation.

1. Adoption of the Commission’s Recommendations Would Impose Additional Requirements for Approval of a Section 363x Sale

Under the current Bankruptcy Code, section 363x sales can be accomplished relatively quickly with few of the procedural or substantive requirements required for plan confirmation. For instance, to confirm a plan, all impaired creditors entitled to receive a distribution may vote on the plan. Further, the plan proponent must show, among other things, that: (a) all administrative claims and certain priority claims will be paid in full in cash on the effective date of the plan; ³The Bankruptcy Code defines administrative expenses as “the actual, necessary costs and expenses of preserving the estate … .” To qualify for priority treatment, the administrative expense must arise from a postpetition transaction with the debtor that was beneficial to the debtor’s business operation in order to qualify for administrative status. 11 U.S.C. § 503. (b) creditors will receive at least as much under the plan as they would in a chapter 7 liquidation (the “best interests test”); and (c) the plan is “fair and equitable” (i.e., the plan does not provide: (i) a greater recovery to one class of claims or interests with equal priority to another; or (ii) any recovery to a junior class if all more senior classes are not paid in full). ⁴In the plan process, debtors must send to creditors a disclosure statement that includes “adequate information” about the case and the plan to allow creditors to make an informed decision on how to vote on the proposed plan. The Commission did not address whether to require similar disclosure in the section 363x sale process. 11 U.S.C. § 1129.

Conversely, under the current Bankruptcy Code, creditors are not entitled to vote on a section 363 sale; a debtor need not satisfy the best interests test in connection with the sale; nor must a debtor provide for the payment in full in cash of all administrative claims on the closing date. ⁵Currently, bankruptcy courts often permit secured creditors to be paid from the sale proceeds at the closing of a section 363x sale with no assurance that the debtor’s estate is administratively solvent (i.e., that funds are available to satisfy all administrative claims). Finally, the Bankruptcy Code does not require the debtor to disclose how the sale proceeds ultimately will be distributed.

To address the potential for inconsistent outcomes in the section 363x sale and plan processes, the Commission has recommended that approval of a section 363x sale should be based on many of the same factors that apply to confirmation of a so-called “cram-down plan.” ⁶Section 1129(b)(2) of the Bankruptcy Code provides the standard by which a court evaluates whether a Chapter 11 plan is “fair and equitable” and can be confirmed over the objection of a class of claims — colloquially referred to as “cramming down” the objecting class. The Commission thus suggests that for a court to approve a section 363x sale, among other things:

• All administrative expense claims incurred through the sale closing date must be paid in full in cash, or reserved for, unless the holder of an affected claim agrees to a different treatment for its claim;

• A debtor should not be permitted to conduct an auction of, or to receive final approval of a sale of, all or substantially all of its assets within the first 60 days after the petition date or the date an order for relief is entered;

• The sale should meet the “best interests test”;

• Any “redemption option value” payable to unsecured creditors must be paid from sale proceeds (another recommendation of the Commission); ⁷In addition to the recommended changes to the conduct and approval of asset sales, the Commission also recommended significant changes to how proceeds from asset sales would be distributed. The Commission’s proposal would compel senior creditors to pay a mandatory “tax” — the so-called “redemption option value” — to junior stakeholders in certain circumstances. Simply put, this proposal, if enacted, would force senior creditors to give a portion of the value of their collateral to out-of-the-money stakeholders even if the senior creditors are not being paid in full. The proposal is a significant departure from fundamental bankruptcy principles, including the “absolute priority rule,” and would in many cases impair the expected recoveries of secured creditors.

• Payments made in connection with the sale (e.g., purchaser’s costs and expenses) must be approved by the bankruptcy court; and

• The section 363x sale should be followed by a plan or a conversion to chapter 7 — “structured dismissals” would no longer be permitted. ⁸A so-called “structured dismissal” is a dismissal order that provides a mechanism for the bankruptcy court to retain jurisdiction over certain post-dismissal matters. Structured dismissal orders also often contain provisions typically found in a plan or sale order, such as releases and protocols for reconciling and paying claims.

2. What Do the Proposed Changes Mean for Secured Creditors?

The Commission’s recommendations, if implemented, would provide debtors and statutory committees with additional leverage in negotiating carve-outs from secured creditors’ cash collateral to fund administrative expenses. ⁹Current practice in many bankruptcy cases is for debtors, committees and secured creditors with liens in all or substantially all of a debtor’s assets, including cash, to negotiate a carve-out from the secured creditor’s cash collateral to fund administrative expenses, including professional fees, incurred during the bankruptcy case. This carve-out, which is documented in a cash collateral or financing order, permits a debtor to use the secured creditor’s cash collateral pursuant to a budget agreed upon by the parties and subject to bankruptcy court approval. In exchange for the use of its collateral, the secured creditor typically receives “adequate protection” in the form of a replacement lien in cash the debtor receives after the petition date and a release of any potential claims against the secured creditor in its capacity as such. Debtors and committees likely would demand larger carve-outs to, among other things, fund cases that will last longer (and cost more) and finance the wind-down of debtor’s’ estates post-sale.

Debtors and committees would have even greater leverage if the secured creditor intends to credit bid for its collateral. ¹⁰A “credit bid” allows a secured creditor to offset the purchase price by the amount of its secured claim, a right expressly provided for in section 363(k) of the Bankruptcy Code. The Commission’s recommendations thus would have the practical effect of codifying a common, but undocumented, feature of many credit bid sales, i.e., the “tax and tip” that secured creditors often pay to ensure a consensual sale order. ¹¹Even if a secured creditor has filed a UCC-1 asserting an “all asset” lien in the debtor’s property, bankruptcy may expose deficiencies in its collateral package. For example, to perfect a lien in motor vehicles that do not constitute inventory, a secured creditor is required in many states to note its lien on the vehicle’s certificate of title. Many secured lenders do not bother to do so. Thus, if its borrower becomes a debtor, the lender’s liens on the motor vehicles are not perfected vis-à-vis the debtor’s other creditors. Further, as a general rule, section 552(a) of the Bankruptcy Code invalidates after-acquired property clauses in prepetition security agreements, cutting off a secured creditor’s lien in after-acquired property on and after the petition date. Thus, debtors often have some assets that are unencumbered. The secured creditor cannot use credit bid currency to purchase these assets and, typically, must instead pay cash. When a secured creditor credit bids for its collateral, it may also agree to fund post-sale wind-down expenses with cash pursuant to a budget, provided that the creditor wins the auction. In exchange for funding these wind-down expenses, the secured creditor typically receives an additional release in the sale order of any potential claims against the secured creditor in its capacity as credit bid purchaser.

In many cases, the bulk of these wind-down expenses are not technically the responsibility of the secured creditor. In fact, section 506(c) of the Bankruptcy Code only permits a debtor to surcharge a secured creditor’s prepetition collateral for “the reasonable, necessary costs and expenses of preserving, or disposing of, such property” to the extent those costs provide a benefit to the secured creditor. ¹²11 U.S.C. § 506(c). While debtors sometimes agree to waive their rights under section 506(c) in cash collateral or DIP financing orders, the Report recommends that debtors no longer be permitted to do so. Many line items contained in a wind-down budget, however, are for payments that do not directly benefit the secured creditor (hence, the term “tax and tip”). Yet secured creditors often agree to pay these additional expenses in exchange for the additional release in the sale order and to avoid the risk and expense of litigating with a creditors’ committee or other out-of-the-money constituency. Further, many bankruptcy courts are disinclined to approve sales when all known administrative expenses incurred through the closing date are not paid, or otherwise provided for, in connection with the sale closing. This arrangement benefits the estate in at least two ways: first, it provides for the payment of costs that otherwise might not be paid in a Chapter 7 liquidation; and second, it enhances the potential for some distribution to unsecured creditors. If the estate’s administrative expenses ultimately exceed the agreed-upon wind-down budget, however, the creditor has no responsibility to finance the excess expenses because of the release it receives under the sale order. As noted, while paying some “tax and tip” is common practice, there is no requirement that a secured creditor fund the payment of administrative expenses unrelated to its collateral in order for a court to approve a sale. Thus, under the current Bankruptcy Code, it is possible that some administrative expenses incurred through the sale closing date will go unpaid.

If the Commission’s recommendations are enacted though, all administrative expenses incurred through the sale closing date must be paid in full or reserved for as a prerequisite to sale approval. This requirement would be in addition to section 506(c) of the Bankruptcy Code, which, as discussed, provides that a debtor may surcharge a secured creditor’s prepetition collateral for costs associated with preserving or disposing of its collateral. In other words, requiring that all administrative expense claims be paid at the closing of a section 363x sale effectively expands the scope of section 506(c) to permit a debtor to surcharge both: (a) a creditor’s prepetition collateral for the costs associated with preserving and selling that collateral; and (b) the proceeds of the sale of the creditor’s collateral (including any postpetition collateral the creditor obtains during the case) to fund any administrative expense — even expenses unrelated to preserving and selling its collateral. ¹³This result is in direct contrast to the Commission’s stated intention in the Report to not expand the scope of Section 506(c). Report at 229 (“The Commission determined that the current scope of section 506(c) was appropriate, and that the required nexus between the estate’s expenditures and the secured creditor’s collateral was an appropriate gating feature of this provision.”). If there is no unencumbered cash in the estate, a creditor would be required to fund all administrative expenses incurred through the sale date in order to obtain bankruptcy court approval for the sale.

To put a finer point on this, the requirement that all administrative expenses be paid negates the utility of a budget in a cash collateral order. For example, if professionals for a statutory committee exceed the amount budgeted for their fees, but their fees are allowed by the bankruptcy court, the entirety of those fees would constitute administrative expenses required to be paid (or reserved) before the bankruptcy court could approve the sale. This single change alone thus could create significant moral hazard as committees will be incentivized to pursue long-shot litigation against secured creditors knowing that the expense for the litigation must be paid (if allowed), and ultimately may be borne by the secured creditor itself.

3. Additional Concerns for Secured Creditors Regarding the Payment of Administrative Expenses

The requirement that all administrative expense claims incurred through the sale closing date be reserved for or paid in full raises two additional concerns for secured creditors. First, how is the debtor or the court to determine the amount of administrative expenses that have been “incurred” by the estate through the closing date that must be paid or reserved from the sale proceeds? Indeed, it is doubtful that all administrative expense claims will be known — or even calculable — by a debtor or its creditors on the section 363x sale closing date. Examples of “hidden” administrative expenses that may not be ascertainable until long after closing include:

• Any payment obligation that is only paid periodically (such as annually or quarterly) and that might not be reflected on a 13-week cash flow statement (but that are effectively accruing daily);

• Payments that become due postpetition for a period that straddles the petition date; ¹⁴For example, the Third Circuit has held that the postpetition portion of the liability incurred by a debtor for withdrawing from a multi-employer benefit plan (i.e., withdrawal liability) is entitled to payment as an administrative expense claim. In re Marcal Paper Mills, Inc., 650 F.3d 311, 3d Cir..

• Taxes (e.g., those resulting from a gain on the sale of assets);

• Claims for pre-closing breaches of assumed contracts;

• Insurance (particularly retroactive premium adjustments payable for prior periods under insurance programs that have been “assumed” in the bankruptcy case);

• Liability arising from failure to comply with the Worker Adjustment and Retraining Notification Act; and

• Any other claim resulting from the postpetition/pre-sale closing conduct of the debtor.

Second, the Report does not address how to allocate payment of these administrative expenses when there are unencumbered assets in the bankruptcy estate. Will secured and unsecured creditors be required to fund administrative expense claims incurred through the sale closing date pro rata, on a 50/50 basis, or will they be forced to litigate to determine which constituency is responsible for payment of which administrative expense claims? The Report is silent on this issue.

The potential for a court to require debtors to reserve sale proceeds pending the calculation of pre-closing administrative expenses and the attendant litigation risk that secured creditors would face regarding the allocation of the obligation to satisfy those expenses are troubling. In some instances, this requirement may even doom a sale at the outset or result in a case converting to a liquidation under Chapter 7.

4. The 60-Day Auction Moratorium Likely Will Increase the Cost of Cases — Perhaps Needlessly

The Report recommends that a debtor should not be permitted to conduct an auction of, or to receive final approval of a sale of, all or substantially all of its assets within the first 60 days after commencing its Chapter 11 case. ¹⁵The Commission recommends that a court may shorten the 60-day moratorium on a section 363x sale — whether or not the secured creditor has requested or received adequate protection of its interest — if the risk of decline in value of the debtor’s assets is sufficient to warrant a sale before the expiration of the 60-day period. This would be a dramatic departure from the current statute, which requires a court to prohibit or condition sales under Section 363 as is necessary to provide adequate protection on request of an entity that has an interest in the property being sold. See 11 U.S.C. § 363(e). The Report provides that a court may shorten the time for an auction or sale to less than 60 days, but only if a party in interest demonstrates by clear and convincing evidence that there is a high likelihood that the value of the debtor’s assets will decrease significantly during such 60-day period and the court finds that the proposed sale satisfies the standards (as proposed) for a section 363x sale.

As justification for the 60-day moratorium, the Commission cites research showing that bankruptcy sale processes have become more abbreviated since the early 2000s. Report at 84-86. ¹⁶According to the research contained in the Report, which is based only on large public company filings, the average number of days between the petition date and the sale date declined from approximately 352 days (from 1990 through 2006) to approximately 100 days (from 2007 through 2013). While the Commission noted that there were several benefits to quick sales (e.g., shorter cases are cheaper and typically preferred by creditors and stalking horse bidders), it ultimately “found that in many cases the potential harm to the estate from a sale that is pushed through more quickly than necessary under the circumstances significantly outweighs any potential benefits of such sale.” Report at 87 (emphasis added). The Commission, however, provided no evidence that expedited sales actually harm the estate, noting that there is little empirical data on section 363x sales. Report at 203. Further, the Commission appears to have ignored the reality that many debtors market themselves for weeks, if not months, before seeking bankruptcy relief. Thus, even abbreviated sales in bankruptcy may be the result of a comprehensive sale process.

There is no guarantee that imposing a mandatory 60-day moratorium will result in increased sale proceeds. In fact, when a prepetition sale process has already occurred, running that process a second time likely would only increase the administrative burden — and expenses — to the estate, with no discernable benefit. Further, administrative expense claims may also increase if the recommended moratorium is implemented because the sale process will take longer and debtors will incur more professional fees. This problem would be compounded by the additional professional fees of other parties in interest payable by the estate (e.g., committees, indenture trustees, DIP lenders, etc.). Thus, the financial burden that may ultimately be borne by creditors in connection with these new sale requirements could become significant.

The 60-day moratorium may provide some benefit to debtors who “free fall” into bankruptcy, but for those debtors whose property already was adequately marketed pre-bankruptcy, it may be a needless and costly additional hurdle.

5. Clarifying the Scope of “Free and Clear” in Section 363x Sales is a Mixed Bag for Secured Creditors.

Under Section 363(f) of the Bankruptcy Code, a debtor may sell its property free and clear of any “interest” in the debtor’s property if the sale meets certain requirements. ¹⁷A court may approve a sale of a debtor’s assets free and clear of interests in those assets if: (1) applicable nonbankruptcy law permits sale of such property free and clear of such interest;(2) such entity consents; (3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property;(4) such interest is in bona fide dispute; or (5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest. 11 U.S.C. § 363(f). The Bankruptcy Code, however, does not define the word “interest.” Further complicating matters, the Bankruptcy Code describes a different treatment for assets sold under a plan. Specifically, “property dealt with” (e.g., sold) under a plan of reorganization is transferred free and clear of “claims and interests.” 11 U.S.C. § 1141(c) (emphasis added). Thus, some courts have questioned whether assets sold under a plan of reorganization actually are entitled to a broader release than assets sold in a section 363 sale. Report at 143. Courts also have differed on, among other things, whether the proceeds from the sale of the debtor’s property must exceed the face value of the secured claims asserted against the property in order to sell the property free and clear of all liens, claims and encumbrances. Report at 143-44.

In an effort to provide clarity on these points, the Commission has recommended that a debtor’s assets receive the same type of release regardless of whether they are sold under a plan or in a section 363x sale. According to the Commission, permitting a debtor to transfer clear title to a purchaser is value-enhancing and will permit debtors to achieve higher sale prices, thus benefiting the estate. Specifically, the Commission has recommended the following:

• A debtor should be able to transfer property free and clear of “all liens, interests, and claims, including, without limitation, civil rights liabilities, and any successor liability claims (including tort claims) other than those specifically excluded from free and clear sales”;

• Interests expressly excluded from free and clear sales include: (i) successorship liability for purposes of federal labor law, ¹⁸The Report does not specify the meaning of successor liability under federal labor law, but this term would seem to include, for example, claims for wage and hour violations under the Fair Labor Standards Act. and (ii) certain obligations that are deemed to “run with the land” under applicable nonbankruptcy law; ¹⁹The complete list of interests listed in the Report that a debtor cannot sell free and clear in a section 363x sale are: (i) easements, covenants, use restrictions, usufructs, or equitable servitudes that are deemed to “run with the land” under applicable nonbankruptcy law; (ii) environmental obligations that are deemed to “run with the land” under applicable nonbankruptcy law; (iii) successorship liability for purposes of federal labor law; and (iv) partial, competing or disputed ownership interests, except to the extent specified in Section 363(h) or (i). (Section 363(h) provides that a debtor may sell both the estate’s interest and the interest of any co-owner in property in which the debtor had, at the time of the commencement of the case, an undivided interest (e.g., marital property) under certain circumstances. Section 363(i) provides that such co-owner has a right of first refusal at any asset sale.)

• A debtor should not be permitted to sell or transfer assets under section 363(f) in a manner that violates or impedes “the police or regulatory power of the federal or a state government to the extent that such government could enforce those rights against the debtor or estate property during the case, notwithstanding section 362(a) of the Bankruptcy Code”; and

• A debtor should be able to sell its assets free and clear of interests, without the consent of any lienholder, regardless of whether the sale proceeds exceed the aggregate value of the liens in the assets, provided that the liens attach to such sale proceeds or the lienholder receives adequate protection of the lien. This requirement appears to be applicable whether or not the secured creditor will (or will not) credit bid for its collateral.

Acquirers of assets in section 363x sales will probably welcome these changes because they provide clarity on the types of liabilities that remain with the estate and the likelihood of closing. Debtors and unsecured creditors also would benefit from these changes, for they may result in higher bids and additional sale proceeds. Secured creditors, on the other hand, should be concerned. In particular, creditors today typically oppose efforts to sell their collateral for less than the face amount of their claims, and the Commission’s recommendation would eliminate this protection. This may be less of a concern, however, for creditors willing to credit bid for their assets.

6. The Chilling Effect of Credit Bidding Would Be Eliminated as “Cause” to Limit a Creditor’s Credit Bid Right

Section 363(k) of the Bankruptcy Code permits a secured creditor to credit bid the allowed amount of its claim in any sale of its collateral, unless the bankruptcy court “for cause” orders otherwise. “Cause” is not defined in the Bankruptcy Code and is left to the discretion of the court. Recent court decisions have limited a secured creditor’s right to credit bid “for cause” when the court found that permitting credit bidding (in whole or in part) might “chill” a competitive auction process. ²⁰E.g., In re Fisker Auto. Holdings, Inc., 510 B.R. 55, Bankr. D. Del., appeal denied, 2014 BL 37766 (D. Del. Feb. 12, 2014); In re Free Lance Star Publ’g Co. of Fredericksburg, Va., 512 B.R. 798, Bankr. E.D. Va., appeal denied, 512 B.R. 808 (E.D. Va. 2014). The Commission’s recommendations appear to be aimed at curbing the effect of these cases. The Report notes that all credit bidding chills an auction process to some extent. However, the Commission concluded that the mere existence of a chilling effect should not preclude a creditor from exercising its statutory right to credit bid. Report at 147. The Commission thus recommends that courts should attempt to mitigate any chilling effect by managing the entirety of the auction process (e.g., restricting efforts by secured creditors to discourage a competitive bidding process). If enacted, this would be a victory for secured creditors because it should end the recent attempts to limit credit bid rights “for cause” on the ground that a creditor’s credit bid might chill bidding. ²¹The Commission’s recommendation, if approved, would bring section 363x sales in line with plan sales, which have most recently been addressed in the U.S. Supreme Court’s decision RadLAX Gateway Hotels, LLC v. Amalgamated Bank (In re River Road Hotel Partners, LLC), 132 S. Ct. 2065, U.S. (plan providing for the sale of collateral free and clear of a secured creditor’s lien must permit the creditor to credit bid at the sale).

Conclusion

The Commission’s proposals regarding section 363x sales will result in the sale process — and perhaps cases themselves — taking longer and costing more, without any certainty that the additional time or expense will result in greater recoveries for creditors. More troubling, the Commission’s recommendations may mean significantly lower recoveries for secured creditors, and higher borrowing costs for debtors as a result.

That said, acquirers should welcome the Commission’s recommendations, which would expand the scope of free and clear sales. Secured creditors should also be pleased with the clarification that the potential “chilling effect” of credit bidding at an auction does not constitute “cause” to deny a secured creditor a right to credit bid the allowed amount of its claim.