Chapter 10 Keeping the Ship Afloat

• Jurisdiction: United States

Chapter 10 Keeping the Ship Afloat

§ 10.1 ~ no more unfettered judgment

The goal of the chapter 11 case is confirmation of a plan. In the meantime, there is a lot to be done just to keep the ship afloat. But the debtor does not get to do it just as it chooses. Rather, the debtor must operate within a framework of rules that limit its power to make and implement decisions.

Part of the price the debtor pays for the protection of the bankruptcy laws is this limitation on its previously unfettered discretion to run its business. As a general rule, the debtor may undertake "ordinary course" activities without court approval, but it must obtain court orders for activities that are not in the ordinary course of business. Not surprisingly, then, there is a lot of debate about what constitutes an "ordinary course" action. When in doubt, it may be best to seek confirmation of an action's ordinary course status or, alternatively, permission to act from the court.

In this chapter, we review three important topics that arise between filing and confirmation. First, we explain § 363, which allows the debtor to use, sell, or lease property and conduct its day-to-day operations. Then we look at § 364, which permits the debtor to borrow money. Finally, we look at the matter of "operating orders," particularly "first-day orders," where the debtor needs the assent of the court to continue with its business.

§ 10.2 ~ Use, sell, or lease: a path Through § 363

Section 363 authorizes the trustee (a term that includes the DIP) to "use, sell, or lease" property of the estate. Section 363 is forbidding at first blush, but if you follow the right path, the general meaning is tolerably plain. Start with § 363(c)(1):

If the business of the debtor is authorized to be operated ... and unless the court orders otherwise, the trustee may enter into transactions, including the sale or lease of property of the estate, in the ordinary course of business, without notice or a hearing, and may use property of the estate in the ordinary course of business without notice or a hearing.

Now, consider the classic chapter 11. Recall that the term "trustee" includes the DIP, and that § 1108 provides that the trustee may continue to operate the business of the debtor until the court tells her to stop. Taken together, these rules provide the basic framework in which the trustee/DIP will continue to operate.¹ The upshot is that in most cases the same people will continue to operate the business after filing as before, and so long as they operate "in the ordinary course of business," they may do so without court interference.

Contrast that with operation "other than in the ordinary course of business." Section 363(b)(1) provides that the trustee, including the DIP, may "use, sell, or lease" property of the estate in this case as well — but only "after notice and a hearing." "Notice and a hearing" means no more than notice plus opportunity to be heard, with the burden of persuasion falling on the objector.²

Section 363(c)(2) governs the use, sale, or lease of "cash collateral," and imposes much stricter requirements that favor the secured creditor. The phrase is a term of art, defined in § 363(a). It includes property "in which the estate and an entity other than the estate have an interest." The phrase is broad enough to include property held by the debtor subject to a security interest — including a right of setoff. The property covered includes "cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents."³

For debtors who have working capital financing, with a lien on receivables and inventory, most or all of the debtor's cash is likely to be cash collateral. The practical consequence is that in almost any case where the debtor has a secured working capital loan, and where it hopes to continue to operate in chapter 11, it will have to make a deal with the secured creditor at the beginning of the case — or find a new lender to take out the pre-petition lender.⁴

All of the trustee's powers to use, sell, or lease property are governed by an overriding condition that the court, upon a party-in-interest's request, "shall prohibit or condition such use, sale, or lease as is necessary to provide adequate protection of such interest."⁵

Finally, sales outside the ordinary course on occasion will be so extensive that they undermine the plan process itself — becoming a so-called "sub rosa plan." This historically has been an issue when a debtor seeks to sell all or most of the estate's assets and to dictate the distribution of sale proceeds as part of the sale, rather than plan, process. As time has gone on, the attitude of the courts to § 363 sales that dispose of substantially all the assets of the debtor has mellowed, and the "sub rosa plan" objection tends to ring rather hollow these days, at least where the sale transaction does not dictate distributions of the proceeds to creditors other than the secured creditors whose collateral is being sold.⁶

§ 10.3 ~ Procedure

The rules specify some of the procedure for sale of property of the estate outside the ordinary course of business. The rules provide that 21 days' notice shall be given to creditors and others.⁷ Any objection must be filed and served not less than seven days before the date set for the proposed action.⁸ The objection turns the proposed sale into a contested matter.⁹ Emergency sales may be permitted on shorter notice, but usually only under exigent circumstances, such as with wasting assets (e.g., if you wait 21 days to sell a truckload of bananas, you may lose your buyer).

The sale may be private or by public auction, although where significant assets are being sold, courts tend to favor public sales, with an opportunity for prospective purchasers to overbid the originally proposed transaction, in order to ensure that the estate is receiving maximum value for the assets.¹⁰ The rule requires the filing of "an itemized statement of the property, the name of each purchaser, and the price received."¹¹ It does not specify who must file the report, but it is surely in the interest of the buyer to see that it is filed, so as to confirm the validity of the sale. Although the rules do not require a court order in all circumstances, a prudent buyer will ordinarily insist on one.

There is no universal procedure for bankruptcy asset sales other than the very broad framework established by the statute and the rules. But a certain procedure has developed as a matter of practice, and in one form or another this procedure is generally adopted in major asset sales, the objective being to maximize the sale price through an auction-like mechanism.

It typically works like this: The debtor, often with the assistance of an investment banker, shops its assets to potential buyers. Eventually, it reaches an agreement with a buyer to purchase the assets for a certain price and signs a purchase contract that is subject to higher and better offers by other bidders (it may also be subject to due diligence, financing and other contingencies, although the debtor of course tries to eliminate as many of these contingencies as possible). The debtor will then file a motion asking the court to establish bidding procedures.

This bidding-procedures motion has two purposes: first, to establish a procedure for other bidders to make competing offers, and second, to protect the initial bidder (sometimes referred to as the "stalking horse") and to compensate the stalking horse for the risk that, after having spent a lot of time and effort to make the initial bid — and to create interest in the assets that leads to a robust auction — it will be outbid. The theory is that if you do not offer such protection and compensation, nobody will be willing to be the stalking horse. Whether this is true is the subject of considerable debate among judges and academic commentators.¹²

The particulars of the bidding procedures order will vary depending on what the DIP negotiates with its stalking-horse bidder and what the creditors' committee and the court will tolerate. But some common provisions in the procedures order might include:

- the time for submission of competing bids;
- the form of competing bids (for example, they must be all cash, they may or may not be contingent, they must use the same form of proposed contract as the stalking horse, etc.);
- the amount by which competing bids must exceed the initial bid (the "bidding increment");
- requirements for a bidder to qualify (deposit, demonstration of net worth, etc.);
- a breakup fee and expense reimbursement payable to the stalking horse if it is outbid;¹³
- restrictions on the ability of the debtor to shop the deal to other interested bidders (note that when these restrictions become too onerous, they may cause the court concern and may raise questions about the debtor's fiduciary duty to maximize value); and
- data room¹⁴ procedures, to make information available to bidders.

There are many other provisions in sale procedure orders; these are just some of the most common ones. After the bidding deadline, there will typically be an auction if there are competing bidders. Sometimes, this will take place in open court. Other times, it will take place at the office of debtor's counsel. When the highest bid is received, the DIP will seek court approval for the sale to the prevailing bidder.

§ 10.4 ~ Local Rules and Forms

Sales out of the ordinary course of business is a topic that seems to excite the interest of individual courts. Many have promulgated local rules, with or without forms, governing the sale process.

§ 10.5 ~ asset sale order

Below is a typical form of asset sale approval order.

IN THE UNITED STATES BANKRUPTCY COURT FOR THE EASTERN DISTRICT OF UTOPIA

In Re: INSOLVENT SUPPLY CORPORATION, Debtor-in-Possession

Case No. 14-1416-BBL

(Chapter 11)

ORDER AUTHORIZING THE SALE OF CERTAIN ASSETS FREE AND CLEAR OF LIENS PURSUANT TO THE TERMS OF A...