Bottom Fishing: the Art of Acquiring Distressed Assets Out of Bankruptcy

• Publication year: 2004
• Pages: 51

33 Colo.Law. 51 Colorado Lawyer 2004.

2004, January, Pg. 51. Bottom Fishing: The Art of Acquiring Distressed Assets Out of Bankruptcy

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51

Vol. 33, No. 1, Pg.51

The Colorado Lawyer
January 2004
Vol. 33, No. 1 [Page 51]

Specialty Law Columns
Business Law Newsletter
Bottom Fishing: The Art of Acquiring Distressed Assets Out of Bankruptcy
by Glenn W. Merrick

This column is sponsored by the CBA Business Law Section to apprise members of current information concerning substantive law. It focuses on business law topics for the Colorado practitioner, including, but not limited to, issues surrounding anti-trust, bankruptcy, business entities commercial law, corporate counsel, financial institutions franchising, nonprofit entities, securities law, and small business entities

Column Editors:

David P. Steigerwald of Sparks Willson Borges Brandt & Johnson, P.C., Colorado Springs - (719) 475-0097, dpsteig@sparkswillson.com; Troy Keller, senior attorney at Qwest, (303) 992-6167, troy.keller@qwest.com. Column Ed. for Bankruptcy Law: Curt Todd of Lottner, Rubin, Fishman, Brown & Saul, P.C., Denver - (303) 292-1200, ctodd@rflegal.com

About The Author:

This month's article was written by Glenn W. Merrick, a shareholder of Senn Visciano & Kirschenbaum, P.C. and a Fellow of the American College of Bankruptcy - (303) 298-1122, gmerrick@sennlaw.com.

Entrepreneurs searching for business and asset acquisition prospects that can return handsome profits often seek purchase opportunities arising out of bankruptcy proceedings. This article highlights applicable legislation, rules, and case law governing such purchases, and explores principal issues involving bankruptcy acquisitions.

The aphorism "buy low, sell high" is a venerable slice of the entrepreneurial constitution. Profit-seekers tirelessly comb the economic seascape in pursuit of businesses and property that can be converted into modern-day gold doubloons. Faced with formidable competition in the conventional markets, shrewd purchasers seek acquisition opportunities in the bankruptcy courts, where investors may discover prospective purchases at handsome discounts. However, exploiting opportunities requires an appreciation of the legal principles governing these sales.

This article reviews the fundamentals governing acquisitions out of bankruptcy proceedings from the perspective of deal-seekers. It covers the applicable Bankruptcy Code ("Code") and rules provisions, and discusses problems and accepted solutions encountered by those who purchase assets and businesses out of cases pending before the U.S. Bankruptcy Court. The article is targeted at business lawyers and clients who wish to have a working appreciation of how to constructively exploit purchase opportunities from this valuable forum.

Bankruptcy Fundamentals

The overwhelming majority of bankruptcy dispositions occur in cases administered under Chapter 7 (liquidation) or Chapter 11 (business reorganization) of the Code. In Chapter 7 cases, the trustee is the sole representative of the bankruptcy estate and holds the exclusive right to sell assets belonging to the estate.1

In Chapter 11 cases, sales may be executed only by a debtor-in-possession or the Chapter 11 trustee, if one has been appointed. Efforts by creditors' committees and individual creditors to force sales by the Chapter 11 estate usually have been spurned by the bench.2 Thus, the astute purchaser will strive to maintain a good working relationship with the debtor-in-possession or the trustee throughout the negotiation and sale process.

Sales Within and Outside
The "Ordinary Course"

In bankruptcy cases where continued operation of the debtor's business is authorized, sales in the "ordinary course of business" may be effected without notice and without approval of the bankruptcy court.3 This rule is designed to facilitate the normal flow of the debtor's business. All too often, however, the determination of whether a proposed sale is within the ordinary course is difficult.

To make this determination, two tests are commonly employed (individually and sometimes collectively): the "horizontal" and "vertical" tests.4 The "horizontal" inquiry focuses on whether, from a trade perspective, a proposed sale is of the sort routinely effected by members of the debtor's industry. The "vertical" inquiry examines whether the sale subjects creditors to risks different from those they would have anticipated at the time the credit, for which creditors have claims in bankruptcy, was extended.5 Although the bankruptcy fiduciary (the debtor-in-possession or the trustee in cases where a trustee has been appointed) must articulate some business rationale for a proposed sale outside the ordinary course of business,6 the justification may be as simple as promoting a continuation of the business by transferring assets to a new owner "free of the stigma and uncertainty of bankruptcy."7 Subject to appropriate notice, these sales can be accomplished either by private sale or public auction.8

Contractual Restrictions
On Purchases

The right to sell assets of a bankruptcy estate cannot be frustrated by contractual provisions, or otherwise applicable law, that purport to work a forfeiture of the estate's interest in property based on the: (1) financial condition of the debtor; (2) commencement of a bankruptcy case; or (3) appointment of a trustee.9 In addition, sales cannot be stymied by a right of first refusal, because such rights usually are subject to rejection as executory contracts.10 However, transfer restrictions that are not conditioned on financial or bankruptcy factors are enforceable against the estate.11 For example, a restriction that limits the sale of shares in a professional corporation of licensed professionals to one or more licensed professionals should be enforceable.

Secured Claimants

Secured parties are protected in bankruptcy sales by a statutory right of credit bid.12 In particular, unless the bankruptcy court orders otherwise for cause, a lienholder is entitled to bid at any proposed sale. If the lienholder is the successful bidder, it then is permitted to offset the lien balance against the purchase price, instead of having to produce cash.13 For instance, the holder of a perfected lien on an estate asset securing indebtedness of $100,000 may bid all or any portion of that indebtedness at the bankruptcy sale and may fund the bid with a cancellation of a corresponding portion of the secured debt rather than fresh cash.

Bid Incentives

Prospective purchasers of significant assets routinely pursue bid protection in connection with an initial offer to buy. They seek to shield a potential and material expenditure of time and resources to investigate the acquisition opportunity and extend an opening bid. Familiar techniques for safeguarding initial offerors include the following:

Break-up or topping fees entail direct payments to a frustrated initial offeror. They provide pecuniary recompense (usually out of the sales proceeds) for an unsuccessful bidder's expended resources and lost opportunities.14

Matching bid rights guarantee the initial bidder success provided that this...