Elizabeth B. Rose, Chocolate, Flowers, and Sec. 363(b): the Opportunity for Sweetheart Deals Without Chapter 11 Protections

• Publication year: 2011

CHOCOLATE, FLOWERS, AND Sec. 363(B): THE OPPORTUNITY FOR SWEETHEART DEALS WITHOUT CHAPTER 11

PROTECTIONS

INTRODUCTION

Testifying before the Subcommittee on Commercial and Administrative Law in 2004, Lynn M. LoPucki stated that Bankruptcy Code Sec. 363 sales are "fraught with potential for abuse."¹Others have described Sec. 363 preplan business sales as "hijacking chapter 11"²or "side-stepping creditor protections."³While some criticize the use of the provision to sell all or substantially all of the debtor's assets, troubled companies are increasingly using Sec. 363⁴as an alternative exit from bankruptcy to minimize the expense and duration of the process.⁵

Bankruptcy Code Sec. 363(b) allows for the debtor in possession ("DIP") to use, sell, or lease property of the estate outside the ordinary course of business after notice and a hearing.⁶The strategic use of this provision allows the debtor to not only "cherry pick" advantageous protections from chapter 11 but also to achieve a quick approval for the sale of all or substantially all of its assets without complying with chapter 11 requirements for plan confirmation.⁷

The stark contrast between chapter 11's numerous and intricate requirements for plan confirmation⁸and the nominal requirements for Sec. 363 sales naturally causes tension. The preplan business sale is attractive to debtors because of its ease,⁹speed,¹⁰and finality.¹¹The lack of transparency,¹²the pace of the process,¹³and the inconsistent treatment by the courts,¹⁴however, leave the bankruptcy courts and parties in interest vulnerable to unfair dealing, abuse, and sweetheart deals.

The susceptibility of abuse with Sec. 363 preplan business sales requires increased scrutiny. Recent memory of flagrant corporate corruption in Enron,¹⁵WorldCom,¹⁶and Adelphia¹⁷should arouse concern and encourage reform. The waning bias against preplan business sales,¹⁸vague good faith standards,¹⁹and the ability of the debtor or inside creditor to manufacture a sound business justification for preplan sale approval²⁰illustrate the need for reform. Courts requiring debtors to merely provide a business justification for

Sec. 363 sales²¹without any additional disclosure requirements is grossly insufficient to expose unfair dealing.

To address the need for increased scrutiny of Sec. 363 preplan business sales, this Comment will first identify the differences between chapter 11 confirmation requirements and procedural requirements for Sec. 363(b) sales. Part I will provide the mechanics, application, and policy for chapter 11 reorganizations and Sec. 363(b) sales. Part II will present a brief history of case law and the evolving restrictions on Sec. 363(b) sales. Part III of this Comment will analyze the application of case law from Part II and provide case examples where courts chose to increase scrutiny with preplan business sales. Part IV will survey recent bankruptcy decisions that demonstrate Sec. 363(b)'s vulnerabilities and highlight areas of abuse in preplan sales. Part V contains recommendations for intensified scrutiny and modifications to the current treatment of Sec. 363 preplan business sales.

I. COMPARING CHAPTER 11 AND Sec. 363(B)

A reorganization through chapter 11 bankruptcy allows the business to continue operations by relieving a portion of its unsecured debt and supporting its return to economic stability and prosperity.²²The Bankruptcy Code provisions balance creditor protections and debtor tools to facilitate continued business operations and negotiations during the confirmation process.

Traditionally, business reorganizations were seen as superior to liquidation because assets used in a particular industry for which they were designed were more valuable than the liquidation value of those same assets.²³Congress explained the underlying rationale of reorganization as:

The premise of a business reorganization is that assets that are used for production in the industry for which they were designed are more valuable than those same assets sold for scrap. . . . It is more economically efficient to reorganize than to liquidate, because it preserves jobs and assets. ²⁴

Today, the theory that assets are worth more within their existing industry does not have the same strength with twenty-first century, service-oriented industries,²⁵and debtors have increasingly altered their use of chapter 11 protections.²⁶A Sec. 363 preplan business sale is an alternative use of chapter 11 protections because all of the debtor's assets can be sold outside the ordinary course of business after a simple notice and a hearing.²⁷For some, Sec. 363 sales have become the preferred method of disposing of an entire business,²⁸but preplan business sales have been and continue to be controversial.

Permitting the use or sale of the debtor's assets outside of a reorganization plan has been debated since 1938 when chapter X was enacted.²⁹One of the principle purposes of chapter X was to offer businesses a means to reorganize and continue operations³⁰as a distinct option from straight liquidation.³¹

However, section 116(3) permitted the debtor to sell estate property outside a plan of reorganization.³²

Courts struggled with the inherent contradiction of the provision. The intricate requirements of reorganization plans created a structured, fair bargaining process and plan. Yet a plain reading of the statute³³permitted a sale of all or substantially all of a debtor's assets outside the plan.³⁴Collier described the use of section 116(3) as follows:

[U]nder Sec. 116(3) . . . if the facts impel a decision that the debtor's property be sold prior to the working out of a reorganization plan, the court may authorize the sale to be made. And even if such disposition involves all the income-producing property of the debtor, the order may be justified. Section 116(3) says 'any property of the debtor, whether real or personal' and even though the sale may practically prevent the adoption of a reorganization plan and thus defeat the purpose of the case, it may be permitted where conditions warrant. There is no inconsistency in this result. True, as we have said, the goal of Chapter X is rehabilitation not liquidation. But some play must be allowed for the joints of the machine. A rigid denial of the right to sell or lease to the fullest extent necessary would prove ruinous to creditors and stockholders where the situation called for that action.³⁵

Despite the provision's plain language, courts did not freely allow outside-of- plan sales. Over time, courts have used a variety of standards and doctrines to limit the use of preplan sales.³⁶

Courts are accommodating the debtors' demands for alternative exits from bankruptcy, and the historical bias against preplan business sales is dwindling.³⁷Chapter 11 no longer serves as a "substitute for a market sale, chapter 11 now serves as the forum where such sales are conducted."³⁸The surge in chapter 11 mega-cases in the late 1990s revealed that debtors adapted their use of chapter 11 protections beyond mere reorganization plans.³⁹With

Sec. 363 preplan business sales, debtors sped up the process and essentially cemented their nonbankruptcy deals with bankruptcy provisions.⁴⁰Section

363 sales circumvent the time-consuming and expensive process of plan confirmation and offer an attractive streamlined process for business sales. However, diminished court oversight also increases vulnerability to unfair dealing and sweetheart deals.

A. Chapter 11 Provisions

Despite these well-known and increasingly popular nontraditional practices, the goals and purposes for chapter 11 were stated by the 1997

National Bankruptcy Reporting Commission in its Final Report as follows:

ƒ Maximize enterprise value;

ƒ Preserve jobs;

ƒ Rehabilitate viable businesses;

ƒ Encourage out of court restructuring;

ƒ Resolve distributive decisions;

ƒ Promote efficiency; and

ƒ Benefit other parties affected by business failure.⁴¹

Traditionally, the above reorganization goals were achieved in chapter 11 by providing a balanced set of tools for both the debtor and the creditor that compelled negotiations and provided the necessary transparency for true multiparty bargaining. The Bankruptcy Code provides each party with tools via its provisions.

1. The Debtor's Tools

The Bankruptcy Code generally defers to the debtor's expertise and control of its own business within a reorganization plan. There are four key chapter 11 provisions, for purposes of a Sec. 363 comparison, that facilitate debtor control in plan formulation and confirmation. The role of the DIP, the exclusivity period for the debtor,⁴²claims classification,⁴³and cramdown⁴⁴provide the debtor leveraging power in reorganization.

First, chapter 11 generally allows the DIP, typically the original management,⁴⁵to continue running the business. The retention of management is believed to increase the value of the estate while preserving industry expertise for plan confirmation negotiations and successful emergence from bankruptcy.⁴⁶Although management typically remains in place,⁴⁷their roles and duties dramatically shift with entry into bankruptcy. Prebankruptcy directors and officers owe fiduciary duties to shareholders and the corporate entity, but upon entry into bankruptcy the DIP's charge is to maximize the value of the estate with additional fiduciary duties attaching to its creditors.⁴⁸

Second, the DIP benefits from the 120-day exclusivity period⁴⁹where only it can propose a reorganization plan.⁵⁰The automatic stay⁵¹provides breathing room and time for regrouping, so that the DIP can negotiate and work towards a viable confirmation plan. Although the DIP has exclusive rights to propose a plan, the plan is a product of multiparty bargaining where leveraging tactics and negotiations create a product that has a chance for confirmation.⁵²Without an approved confirmation plan, there is no reorganization.

Third, the debtor may strategically classify claims. ⁵³Debtors can use claim...