The Increasing Deployment of §363 Sales at the Inception of Chapter 11 and Issues of Collusion Related Thereto
By: Mark Lichtenstein
Buchanan Ingersoll PC; New York
The sale of a debtor's assets outside of a confirmed plan of reorganization is accomplished pursuant to §363(b) of the Bankruptcy Code. There has traditionally been tension within the courts when a proposed §363 sale involves the selling of all or substantially all of a debtor's assets, or a sale is proposed outside such debtor's ordinary course of business. Courts have historically viewed §363 sales of this nature as sub rosa plans or defacto plans (i.e., transactions that seek to avoid the safeguards of the plan confirmation process and/or significantly impact the terms of any future reorganization plan). The selling or leasing of business assets not in the ordinary course of business and prior to confirmation of a reorganization plan is a red flag to courts that such transactions may constitute a sub rosa plan.
However, in recent years there has been a trend within bankruptcy courts in chapter 11 proceedings of going from reorganization to liquidation of debtor assets through §363(b) sales. Many of these sales are done through aggressive first-day motions with pre-approved bidding procedures leading to the liquidation of substantially all of the debtors assets. Although §363(b) sales are a growing trend in bankruptcies, courts utilize strict standards to approve such sales.
Standards for §363 Sales
In determining whether to authorize the use, sale or lease of property of the estate under §363(b), the courts require the debtor to show that a sound business purpose justifies such actions. Courts look at a number of factors to determine whether a sound business purpose justifies the use, sale or lease of property under §363(b). Factors include the proportionate value of the asset to the estate as a whole, the amount of elapsed time since the filing, the likelihood that a reorganization plan will be proposed and confirmed in the near future, and whether the asset is increasing or decreasing in value. See In re Montgomery Ward, 242 B.R. 147 (D. Del. 1999).
In Montgomery Ward, the debtor filed a §363 motion to authorize the implementation of an employee severance program, key employee retention plan, retirement security plans and various other employee-incentive programs that would result in the payment of millions of dollars out of the estate. A creditor objected to the motion, stating that such motion (1) provided no factual support that the debtor could reorganize, (2) contained no information that the creditors would benefit from reorganization, (3) contained no factual support for the debtor's assertion that the various employee-discount programs represented necessary and reasonable amounts to pay employees and to protect them from further loses of its key employees, and (4) failed to estimate the cost of the severance programs if the debtor were to liquidate. The court, using factors prescribed In re Lionel Corp., 722 F.2d 1063 (2nd Cir. 1983), held that the debtor does not have to show that it possessed a reasonable prospect of successfully reorganizing to justify the sale, but rather that the sale will "aid in the debtor's reorganization." Although decided in factually distinguishable circumstances, Montgomery Ward seems to suggest that if the objectant can show that the proposed sale and its terms will have a direct effect on a reorganization plan, the court may find that such a transaction constitutes a sub rosa plan. The court held that the proposed transactions of the debtor did not have any effect on a future reorganization plan and that the objectant failed to disprove any of the reasons and factors given by the debtor to justify the proposed transactions. Any proposed sale outside the ordinary course of business must have a sound business purpose and must not dictate the terms of any future reorganization plan. In re Lionel, 722 F.2d at 1071.
A case that demonstrates the growing acceptance of bankruptcy courts approving §363(b) sales at the inception of cases is In re Medical Software Solutions, 286 B.R. 431 (D. Utah 2002). In In re Medical Software Solutions, the debtor made a §363(b) motion for authority to sell substantially all of its business assets within 40 days of filing chapter 11. The proposed §363(b) sale also had another wrinkle to it, as the proposed sale was to an insider of the debtor. Shareholders of the debtor objected to the sale, claiming among other things, that the sale lacked good faith and was not for fair and reasonable value. The court listed four elements that must be met in order for a sale of substantially all of the business assets outside the normal course of business. The elements are: ([b]1) a sound business reason exists for the sale; (2) there has been adequate and reasonable notice to interested parties, including full disclosure of the sale terms and the debtor's relationship to the buyer; (3) the sale price is fair and reasonable; and (4) the proposed buyer is proceeding in good faith. Since the action involved an insider, the court closely scrutinized the element of good faith and determined that the purchaser had a heightened responsibility to show that the proposed sale was in good faith. Nevertheless, the court held that the purchaser met the four elements and that it was not bad faith per se for an insider to purchase property from the estate even when the insider has a fiduciary duty to the estate.
Collusion as Addressed by the Code
When a §363(b) sale gets past the hurdles of the sound business test and survives scrutiny as a potential sub rosa plan, the court may examine the possibility of collusion among the parties. Collusion is covered under §363(n) of the Code, which states as follows:
The trustee may avoid a sale under this section if the sale price was controlled by an agreement among potential bidders at such sale, or may recover from a party to such agreement any amount by which the value of the property sold exceeds the price at which the sale was consummated, and may recover any costs, attorneys' fees or expenses incurred in avoiding such sale or recovering such amount. In addition to any recovery under the preceding sentence, the court may grant judgment for punitive damages in favor of the estate and against any party that entered into such agreement in willful disregard of this subsection.
There are many interesting nuances under §363(n), such as when such a claim can be brought, whether §363(n) applies to both private and public sales, who can bring such a claim and what exactly qualifies as collusion.
One interesting case that discusses when a §363(n) claim can be brought is In re Intl. Nutronics Inc., 28 F.3d 965 (9th Cir. 1994). The main issue in this case is whether the res judicata effect of a bankruptcy court's sale order may bar the trustee from bringing an action to avoid a sale under §363(n). In Nutronics, the trustee brought a §363(n) action, alleging that bid-rigging was present in the sale of the assets of the debtor and that, accordingly, the sale should be voided. The defendants in the action claimed that the trustee's claims were barred under the doctrine of res judicata as sale order was final. The district court granted the defendant's motion, and the court of appeals for the 9th Circuit reversed. The appeals court held that §363(n) was a statutory exception to the finality of bankruptcy sale orders for res judicata purposes. To hold that the res judicata effect of a sale order bars a trustee from bringing a §363(n) claim would render a trustee's ability to assert a §363(n) claim essentially moot. Bankruptcy courts have traditionally been allowed to set aside sale orders when such sales may contain fraud, error or other defects that may affect the validity and integrity of the sale under Rule 9024. Therefore, other claims that may result from the sale will not be barred by res judicata, including the collusive antitrust claims that were asserted in Nutronics.
Under §363(n), the term "bidders" implicates a public sale, as bidders are usually associated with a public sale or gathering. However, In re Vogel, 970 F.2d 471 (8th Cir. 1992), clarifies that a §363(n) action applies to both private and public sales. In Vogel, the district court held that the word "bidders" did not encompass a private sale under §363(n) and only applied to public auctions. Despite evidence that collusion was present, the district court held that the trustee could not bring a §363(n) action alleging that certain individuals agreed to control the real estate price sold at a private sale. The appeals court held that the words "potential bidders" contained in §363(n) were not limited to public sales and covered all persons who are contemplating making an offer to purchase property of a bankruptcy estate that the trustee seeks to sell. Under Bankruptcy Rule 6004(f)(1), a sale can be made through a public or private auction, and thus §363(n) cannot be restricted to public sales. In addition, claims asserted under §363(n) are not restricted to trustees, but may be brought by other parties. See In re Michael Hat, 310 B.R. 752 (E.D. Cal. 2004).
Standing to Challenge Collusion
Section 363(n) specifically states that a "trustee" has the power to void a §363(b) sale; however, courts have held that other parties, including unsuccessful bidders, may bring actions pursuant to §363(n). Generally, unsuccessful bidders lack standing to challenge a bankruptcy court's approval of a sale transaction. However, the case of Michael Hat presents an interesting example of when an unsuccessful bidder can assert a §363(n) action. In Hat, a potential purchaser, Phoenix Bio Industries, met with the former spouse of the debtor, Diamante, who held a §363(i) right of first refusal. (Section 363(i) provides a joint tenant with an interest in property that is being sold by the state a right of first refusal and an option to match any price offered for the property in order to retain the property.) Diamante and Phoenix entered into an agreement in which she would exercise her rights under §363(i) and purchase the property, then assign her rights to the property to Phoenix in exchange for a 3 percent commission on the sale. Due to this agreement, a potential bidder, The Wine Group (TWG), was unable to bid on the property and filed a §363(n) motion alleging collusion between Diamante and Phoenix. Diamante asserted that TWG lacked standing to bring a §363(n) claim as an unsuccessful bidder. The court held that TWG did have standing and that TWG was attacking the sale not because it lost a bidding contest, but instead alleging that the sale was tainted because the two potential bidders colluded with a third party who held a statutory right of first refusal. As a result of the collusion, the price at which the property was sold was controlled. The court further elaborated that the use of §363(i) rights to remove potential bidders from the sale and assert control over the price of the sale was improper. Since Diamante, Phoenix and the debtor were affecting the integrity of the sale, TWG properly successfully asserted the §363(n) claim. It is an interesting question whether an entity other than the debtor or trustee may have standing to assert a §363(n) claim in this circuit in light of In re Cybergenics Corp., 330 F.3d 548 (3d Cir. 2003), which permitted a creditors' committee derivative standing to prosecute avoidance actions.
Agreements between potential bidders that control the price of property sold in a §363 sale generally give rise to a §363(n) collusion claim; however, agreements that merely affect the sales price do not. The seminal case on the difference between "control" versus mere "affect" is In re New York Trap Rock, 42 F.2d 747 (2nd Cir. 1994). The debtor in New York Trap Rock indirectly owned a 50 percent joint venture interest in CSM, an Argentinian cement-producing company, through one of its wholly owned subsidiaries, Lonestar. The other 50percent interest of CSM was owned by another Argentinian cement-producing company, Perez-Patagonia (Perez). The debtor sought to sell its 50% interest in CSM and had at least three potential bidders. The three bidders were Perez (seeking to control the remaining 50 percent of the company), Loma Negra and Petroquimica. Loma Negra submitted a bid of $38 million dollars for the purchase of the debtor's interest in CSM; while the bid was pending, Loma Negra, without disclosure to the bankruptcy court, purchased Perez's 50 percent interest in CSM for $55 million. The bankruptcy court approved the sale of the debtor's 50percent interest in CSM to Loma Negra for $38 million. The sale of Perez's interest to Loma Negra was not disclosed until after the bankruptcy court approved the sale.
Subsequently, the debtor brought a §363(n) action against Loma Negra asserting collusion, stating that Loma Negra conspired to have Perez drop out of the bidding process and failed to disclose its purchase of Perez's interest. The debtor wanted $17 million in damages, the difference between the price paid to Perez for its 50 percent share and the $38 million price submitted for the debtors' share. The court held that §363(n) prohibits agreements that "control" the sales price, not agreements that merely "affect" the price. The court further held that influence on the sales price must be the intended objective of the agreement and not merely an unintended consequence of an agreement of potential bidders. However, though the court held that agreements that affect the sales price do not translate into collusion, if the agreement was made on the condition that Perez would drop out of the bidding for the debtor's interest in CSM, a viable claim of collusion existed. Agreements to remove potential bidders from the sale fall under the protections of §363(n). The case was remanded to the lower court for discovery on the issue of possible collusion to remove Perez from the bidding process, causing the debtor to not fully achieve full value in the sale.
Conclusion
In conclusion, §363(b) sales are now a widely accepted practice in bankruptcy cases. Factors such as the increasing or decreasing value of an asset, viability of an effective reorganization and the percentage of a debtor's estate being sold will determine if a court approves a §363(b) sale. Collusion under §363(n) can be alleged by the trustee or the debtor and perhaps by other parties in exceptional circumstances that can show that the sale was tainted due to agreements by potential bidders. Collusion must show that the sale price was controlled by the collusion and not merely affected by an agreement.
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