Once a debtor files its Chapter 11 bankruptcy case, the debtor may choose to sell some or all of its assets pursuant to 11 U.S.C.§363 (f) of the Bankruptcy Code. This section gives the debtor-in-possession or trustee in a bankruptcy the power to sell its assets, “free and clear of liens” — even over the objection of junior creditors — after notice and an opportunity to be heard is afforded to the interested parties. The proposed purchaser (sometimes referred to as the “stalking-horse” bidder) agrees in advance of the auction sale held in bankruptcy court to pay for the debtor’s assets at a price that becomes, at the time of the auction, the opening bid. Such a sale (commonly referred to as a “363 sale”) has been considered permissible over the objection of junior lienors either before confirmation of a plan of reorganization or pursuant to a plan of reorganization, provided that the other requirements of the statute were met.

For debtors-in-possession in a Chapter 11 bankruptcy proceeding, this strategy is desirable because it allows them to be in control of a bulk disposition of assets under the protections of the bankruptcy court, thereby allowing the debtor to control its deal terms, product and reputation, as opposed to a trustee selling the assets in bulk as part of a liquidation plan or Chapter 7 liquidation bankruptcy. Moreover, debtors-in-possession can often obtain funding from the secured senior lienholder for the costs of sale, as a trade-off for the lender gaining the collateral through the expedited 363 sale process in lieu of obtaining relief from the automatic stay and conducting a state law foreclosure.

Debtors sometimes use the 363 sale of assets as a strategy to avoid filing a Chapter 11 plan of reorganization since the sale of all assets and the distribution of money from the 363 sale may eliminate the need for a plan of reorganization because the plan process can be time consuming and more expensive. In a Chapter 11 case, to confirm a plan a debtor must file and serve a disclosure statement, which gives the creditors “adequate information” as to the status of the debtor’s assets and liabilities, income and expenses, history of the debtor’s operations, and a description of the debtor’s plan of reorganization. The disclosure statement will set forth when and how much creditors will be paid by the debtor to furnish creditors enough information to vote for or against a plan of reorganization. The disclosure statement must be approved by the court and then, after the disclosure statement is approved, there will be notice to creditors as to the hearing on confirmation of the plan of reorganization and balloting to see whether the creditors accept or reject the plan (see 11 U.S.C. §1125, §1126, §1128 and §1129).

This process cannot take less than 50 days and more likely will take 60-90 days before a plan of reorganization will be confirmed even in cases where there are no objections to the disclosure statement and plan of reorganization. This consideration may be important for both the debtor and the creditors because the debtor may be under substantial stress to get its assets sold as soon as possible because it is out of operating funds, or it cannot get postpetition financing, or a creditor may be able to get relief from the stay to foreclose on the debtor’s assets.

Therefore, a debtor may choose to use the §363 sale as a substitute for the more laborious, time consuming and expensive plan process. Courts have held that a 363 sale cannot be a sub rosa plan, that is, a substitute for a plan of reorganization and its procedural safeguards which give creditors the information required in a disclosure statement, the opportunity to object to the debtor’s plan, and requires the debtor to put on evidence to show that the plan of reorganization meets the standards required under the Bankruptcy Code to confirm its plan of reorganization [see e.g. In re Braniff Airways, Inc. 700 F.2d. 935 (5th Circuit, 1983) and In re Continental Airlines, Inc. 780 F.2d. 1223 (5th Circuit 1986)]. Notwithstanding the foregoing, courts routinely approve 363 sales, selling all or a substantial portion of the debtor’s assets and distributing the money from the sale, even though the 363 sale violates the requirements of the Bankruptcy Code simply because the 363 sale process may be a practical way for the debtor to get more money to its creditors as quickly as possible.

As a result of the foregoing, the preplan 363 sale may be the best way for a debtor to proceed to liquidate its assets for the highest price possible when faced with the financial stress of time, the lack of money and/or junior lienholders that will not “play ball” with the debtor or senior-in-time lien creditors because they may not get any money from the sale of the debtor’s assets. A real-world instance where this is happening is the case of a defaulted construction project where there are junior lienholders and mechanics liens that will not receive anything from the sale of the “underwater” property but will also not release their liens unless they are paid some, or all, of the debt due to them.

Previously, the stalking-horse bidder was typically an entity that had no direct interest in the assets to be sold and has agreed to pay money for the asset, either in a lump sum payment at closing or structured over time. During the past year or so — as homebuilder insolvencies have reached unprecedented levels — a new model was beginning to emerge, with the senior secured lender acting as the stalking horse, offering to buy the property free and clear of all liens — 
including its own — by credit-bidding in some portion, or all, of its debt so that junior “out of the money” lienholders cannot stand in the way of a debtor selling its assets.

Junior lienholders can even be brought around to support such a sale, because, properly negotiated, a 363 sale raises at least the possibility that proceeds in excess of the lender’s highest permissible bid might be generated by the sale and, then, distributed to the junior creditors. A 363 sale is usually structured under an agreement that contemplates that an auction will be conducted in open court, before the bankruptcy judge. The parties may agree that the sale should be advertised or marketed in a fashion designed to maximize the exposure of the project to the market, so that the project’s value can be tested at auction. The net result of the bidding rules and marketing procedures agreed upon (and often approved in advance by the bankruptcy court in a “bid procedures order”) is a multibidder, competitive auction. It is not at all uncommon for the final price to be significantly higher than the stalking-horse bid amount.

Depending upon the economics of the situation and the current value of the loan reflected on the lender’s balance sheet, a lender might be willing to limit its bid to an amount less than the full amount of its claim in order to get the assets sold. If there is a lien priority problem, the lender can agree that a portion of the sale proceeds can be reserved to pay the lien claimant if the claimant later wins the lien priority fight, or paid to the lender if the lender later wins that fight, or even carve out something for the junior lienholder to get the sale done without objection. Even if distasteful, both sides should recognize the value in getting the asset sold, with a reservation of only the sums necessary to cover the mechanics of lien claims, if they turn out to be senior.

The interplay between the lender’s desire to get access to its collateral and the junior lienholders’ desire to have a chance at something, instead of the stark possibility of getting nothing at all from the sale of the assets, can also lead to constructive negotiations. The risk of the sale being approved “free and clear of liens” over the objection of the junior lienholder because the true value of the property is less than the senior lien means that the ability of the junior lienholder to exert hold-out leverage is potentially short lived.

As with all 363 sales, a “lender-stalking-horse” sale can only go forward if the debtor first files a motion and gives notice to all interested parties that they have an opportunity to file an objection, which may or may not be sustained. This process imposes time deadlines that force the stakeholders to either negotiate a compromised resolution or run the risk of an adverse ruling from the bankruptcy court. Because both the proponents and opponents of the sale run the risk of the judge ruling against them, all are given an incentive to try to work out a deal.

The emerging strategy of a lender in the first lien position being allowed to be the stalking-horse bidder, however, has run into a significant obstacle. In Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC) 391 B.R. 25 (9th Cir. BAP 2008), the United States Bankruptcy Appellate Panel for the Ninth Circuit Court of Appeals (BAP) held that §363 does not permit a secured creditor to credit bid its debt and purchase estate property free and clear of valid, nonconsenting junior liens outside of a plan of reorganization, based upon a highly technical reading of the statute. The Clear Channel sale was predicated on the assumption that the full credit bid of the senior lender equaled the fair market value of the project and, as such, one of the technical requirements of §363 was violated. A lender that is willing to argue and submit evidence that its debt substantially exceeds the value of the collateral, probably can structure the sale to avoid the problems of the Clear Channel decision, so long as it is willing to credit bid more than the proven fair market value. It also appears that the litigants in the Clear Channel decision didn’t make other technical arguments that might also have saved the day for them. (For a more technical discussion of the technical arguments that can be made to potentially avoid the holding in Clear Channel see the article written by Kenneth Russak in the Los Angeles Lawyer, March 2009 on page 10.)

Although the Clear Channel decision creates a hurdle for a lender credit bidding its debt and becoming a stalking-horse bidder a §363 sale, it is not an impossible hurdle. In an appropriate case, it may well be that a preplan 363 sale can still be structured to meet the requirements of the Bankruptcy Code, be used to limit the leverage of out-of-the-money junior lienholder hold-outs, and serve as an expedient way to get assets sold and money distributed to creditors. Therefore, the 363 sale can be a lender’s best friend or its worst enemy depending upon the value of the assets, the liens on the assets, and the willingness of the debtor and all lienholders to be flexible to a business solution when the debtor is insolvent, is faced with pressure to get its assets sold quickly, and the assets have insufficient equity to pay all creditors.

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Andrew K. Alper is a partner with the law firm of Frandzel Robins Bloom & Csato, LC in Los Angeles. Alper has been representing equipment lessors, funding sources and other financial institutions since 1978. Alper obtained his Bachelor of Arts degree in Political Science, magna cum laude, from the University of California at Santa Barbara, and received his Juris Doctor from Loyola Marymount University School of Law making the Dean’s List. Alper’s practice emphasizes the representation of equipment lessors and funding sources in all aspects of equipment leasing including litigation, documentation, bankruptcy and transactional matters. Besides representing equipment lessors and funding sources, Alper represents banks and other financial institutions in the area of commercial litigation, insolvency, secured transactions, banking law, real estate and business litigation.