IS JPM BUYING WMI OUT THIS WEEK? EXPLANATION OF BANKRUPTCY CODE 363
BELOW IS AN EXPLANATION OF BK CODE 363
In a recent case, the U.S. Bankruptcy Court for the District of Delaware held that a Section 363 sale of the stock of a non-debtor subsidiary corporation by a parent company in Chapter 11 did not extinguish claims against the subsidiary arising from events that occurred prior to the sale - even by the parent company's estate and its creditors. This result serves as a good reminder that any purchaser in a bankruptcy sale must pay close attention to the mechanics of Section 363, the structure of any such proposed acquisition, and negotiation of specific provisions in the Court's sale order as a condition of sale to protect the buyer.
One of the most valuable advantages of using Section 363 of the Bankruptcy Code to implement asset sales is the ability of a debtor to sell its assets "free and clear" of liens or other third party interests in the assets, thus giving a purchaser considerable comfort and presumably enhancing the purchase price. The comfort that a purchaser derives and the resulting purchase price enhancement can, however, be excessive if the purchaser fails to pay close attention to the language of Section 363 as it relates to the structure of the transaction. This is particularly the case where a buyer seeks to acquire a business or assets owned by a subsidiary of a debtor.
Let’s start with the language of the statute. Section 363(b)(1) is the touchstone - it authorizes a "trustee" (which, in a Chapter 11 case, usually means the debtor) to sell "property of the estate" other than in the ordinary course of business after notice and a hearing. Section 363(f) goes on to provide that, subject to satisfying certain conditions, the trustee (again, read "debtor") may sell property under Section 363(b) "free and clear of any interest in such property" that a third party may claim. Thus, reading the two sections together carefully, it is clear that the ability of a debtor to sell property "free and clear" of third party claims is limited to property that belongs to "the estate" - a concept that is developed in much detail in Section 541, but in essence means property that belongs to a person as to which a case under the Bankruptcy Code has been commenced.
With this framework in mind, suppose that ABC, Inc., a diversified electronics manufacturer, files a voluntary Chapter 11 proceeding and seeks to sell its wireless telephone equipment division to a buyout fund under Section 363(b). In such a case, Section 363(f) permits ABC, Inc. to sell the assets of that division free and clear of third party claims. Suppose, however, that ABC, Inc.’s wireless telephone equipment business is held by XYZ, Inc., a wholly-owned subsidiary of ABC, Inc. and that no bankruptcy case has been commenced by or against XYZ, Inc. Clearly nothing in Section 363 authorizes XYZ, Inc. to sell its assets free and clear of third party claims, and no reasonable buyer would be under any contrary illusions.
Change the facts slightly, however, and suppose that ABC, Inc., a Chapter 11 debtor proposes to sell the shares of its wholly-owned, non-debtor subsidiary, XYZ, Inc. pursuant to Section 363(b). What comfort would a buyer of the shares of XYZ, Inc. have with respect to possible third party claims?
This is a simplified version of the facts presented in a recent case, Amphenol Corp. v. Shandler (In re Insilco Technologies, Inc.), 351 B.R. 313 (Bankr. D. Del. 2006), decided by the U.S. Bankruptcy Court for the District of Delaware. In that case, Insilco Technologies, Inc. and several of its subsidiaries entered into a "stalking horse" Stock and Asset Purchase Agreement to sell certain of their assets to Amphenol Corporation in a sale that was to be conducted under Section 363 of the Bankruptcy Code. Among the assets to be sold were the shares of Insilco’s wholly-owned subsidiary, Precision Cable Mfg. Corp. de Mexico, S.A. de C.V. ("PCM"). Following Chapter 11 filings by Insilco Technologies, Inc. and those of its subsidiaries that were sellers in the proposed transaction, the sale to Amphenol was consummated under Section 363(b). PCM, which was a Mexican corporation, did not file a Chapter 11 petition with the other members of the Insilco group that were sellers under the Stock and Asset Purchase Agreement. Amphenol paid approximately $10,000,000 for the assets and PCM shares.
Approximately 21 months after the closing of the Section 363 sale, the trustee for the Insilco Liquidating Trust brought an action against PCM, seeking to recover approximately $1.8 million which the trustee alleged had been paid by Insilco to PCM as a preference in violation of Section 547 of the Bankruptcy Code. Surprised and dismayed, Amphenol asked the Bankruptcy Court to enjoin the trustee’s claim on the basis that the claim was precluded by Section 363.
In a carefully reasoned opinion, the Bankruptcy Court held that Section 363 did not insulate PCM from the trustee’s claim. The court based its decision on both the language of Section 363 and basic hornbook corporation law.
According to the court, "t is an axiom of corporate law that … a corporation is an entity, distinct from its stockholders even if the subsidiary’s stock is wholly owned by one person or corporation." Simply put, PCM was not Insilco - the two were separate legal entities. Moreover, although Insilco and several of its other subsidiaries were subject to Chapter 11 proceedings, PCM was not. While Section 363(f) authorized Insilco to sell its property free and clear of third party claims, PCM’s assets were not Insilco’s assets. Therefore, while Amphenol took the PCM shares free and clear of any claims that might have attached to the shares, PCM itself was not immunized from third party claims by virtue of Section 363(f).
The court expressed sympathy for the harsh result of the decision for the buyer. The effect of the decision was to expose Amphenol to the risk that the value of its investment would be reduced by approximately one-fifth of the purchase price. As Amphenol argued, had this result been foreseen it may well have affected the price that Amphenol would have been willing to pay for this acquisition. Indeed.
There are practical lessons to be learned for buyers when a potential acquisition under Section 363 includes a business or assets owned by a wholly-owned subsidiary of a debtor in bankruptcy:
1. If it is important to the buyer that it acquire the assets of the subsidiary free and clear of third party claims against the subsidiary (and it almost always will be), then the buyer should insist that the subsidiary both become a party to the asset purchase agreement as a "seller" and also become a "debtor" i.e. file a bankruptcy petition. Further, the sale agreement should make clear that the subsidiary is selling its assets to the buyer, and that the buyer is not merely acquiring shares of the subsidiary from its parent.
2. If the subsidiary cannot or should not become a debtor (either because it is ineligible to do so under Section 109 of the Bankruptcy Code or for other good reasons), then a potential buyer should be aware that there is more pressure on the already important task of getting the due diligence right to ferret out all possible third party claims that may be raised post-closing against the subsidiary. As a practical matter, holdbacks and indemnification will be very difficult to negotiate if the effect is to make uncertain or materially to delay the debtor’s enjoyment of the proceeds of a Section 363 sale.
3. In addition, if the subsidiary cannot or should not become a debtor it would be reasonable for a buyer to take into account the potential of post-closing claims against the subsidiary in deciding upon the price that the buyer is willing to pay for the acquisition.
4. Under certain special circumstances, it may be possible to obtain from the Bankruptcy Court a so called "channeling injunction" requiring that claims that may have been brought against the subsidiary instead be brought solely against the proceeds of the sale.
5. The buyer should also consider requiring the seller to release any claims that it may have against the subsidiary that is being sold. While such a release will obviously not protect the buyer against all potential future third party claims, it will at least avoid the risk that the seller may attempt effectively to increase the purchase price after closing by bringing such a claim (as in fact occurred in the Insilco case).
6. In other situations, the subsidiary may be eligible to be a debtor, but if its most valuable assets are executory contracts (such as intellectual property licenses) that cannot be assigned despite the liberal provisions of Section 365 of the Bankruptcy Code, a Section 363 asset sale will not be the appropriate structure. The solution in such a case is for the subsidiary to file a bankruptcy petition along with its parent and for the subsidiary to be sold pursuant to a Chapter 11 plan. The plan would protect the buyer by including a discharge of claims against the subsidiary, and creditors would be limited to recourse against the proceeds of the sale.
While the purchase of the business of a subsidiary of a debtor under Section 363 requires special attention and care, a buyer that is well advised with respect to the operation of the relevant Bankruptcy Code provisions should be able to identify and manage the risks.
WMI INC MAY SELL ALL IT'S STOCK TO JPM AND LEAVE THE LIABILITIES IN BK (Lawsuits, claims by pre seizure stockholders etc.)
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