Wednesday, October 21, 2015

A Debtor's Sales in Bankruptcy (Stephen Stapleton)

By Steve Stapleton

The Third Circuit Court of Appeals recently issued an opinion which condoned the use of asset sales in a bankruptcy context.  While not earth shattering in and of itself, two facts set this opinion apart.  

The first is that it was issued out of the Court of Appeals for the Third Circuit, a circuit which includes Delaware.  While Delaware is a small state, because it is the place of incorporation for many large companies, it is also the venue of choice for many large bankruptcy filings.  Thus, the bankruptcy opinions of the Third Circuit carry a punch significantly above its weight class.  

The second is that the opinion takes direct aim at what is and what is not property of the bankruptcy estate.  A rendition of some of the facts underlying the opinion is in order.

The debtor was “once a leading operator a long-term acute care hospitals.”(1)   It operated 27 of them in ten states and employed 4500 people.  Hurricane Katrina destroyed three of the facilities and management blamed federally-mandated regulations with hobbling its prospects.  Secured debt was $355 million and unsecured debt made up the rest of its $484 million debt load.  Management attempted to sell the businesses outright but could not find buyers willing to pay enough to satisfy the obligations due.  Management thus entered into an agreement to allow the lenders to credit bid $320 million of the $355 million owed.  After working up the asset purchase agreement which provided that the lenders would take everything - even the debtors’ remaining cash - the company and its 34 subsidiaries filed for bankruptcy protection the next day.

The bankruptcy court allowed an auction and the marketing materials went to 106 potential bidders.  The lenders’ credit bid, however, remained the most attractive offer.  Nevertheless, the unsecured creditors committee objected to the deal saying the debtors’ unsecured creditors would receive nothing and the US government objected as well, saying that the sale would result in a capital gains tax liability of $24 million which, as an administrative liability, needed to be paid as a part of the costs attendant to the administration of the bankruptcy case.

The committee resolved its objection in exchange for the lenders’ agreement to deposit $3.5 million in a trust for the benefit of general unsecured creditors and to escrow money to pay its attorneys fees and wind down expenses which ultimately amounted to an additional $1.8 million.  The government in contrast took its objection to the mat.

The bankruptcy court approved the sale as a sound exercise of the debtors’ business judgment, finding that the sale was the only alternative to liquidation.  As to the government’s objections, the government contended that the money reserved to the unsecured creditors was an end-run by the debtor which “attempts to distribute estate property to junior creditors over the objection of a senior creditor [the government] in violation of the absolute priority rule.”  That non-statutory rule essentially says that administrative claimants must get paid before unsecured creditors.  The bankruptcy court held that the settlement monies placed in trust for the unsecured creditors and the funds escrowed for the payment of fees were not property of the bankruptcy estate, however,  since it came directly from the lenders.  Thus, the government had no claim to the funds as an administrative claimant.

The government appealed to the district court which affirmed and appealed again to the Third Circuit, arguing that the both escrowed funds and the settlement money were proceeds paid to obtain the debtor’s assets and thus qualified as bankruptcy estate property subject to the absolute priority rule.  The Third Circuit however disagreed saying that the money in trust never made it to the bankruptcy estate.  It was “not proceeds from a secured creditor’s liens, do[es] not belong to the estate and will not become part of the estate” even if the court does not approve the settlement.  The trust money was in effect a fee “to … facilitate … a smooth … transition of the assets from the debtors’ estates to [the secured lenders]” by resolving objections to the transfer.

As to the escrow, the court noted that it was cash placed in escrow by the lender, not placed with the debtor.  Thus, the court reasoned, none if it became property of the bankruptcy estate.
So here is the practice note:   if you as the lender want to take everything through a credit bid, make sure you take everything -- leaving nothing behind.  And make sure, too, that the transaction does not implicate anything to which the debtor lays claim.  Use vehicles that tender the funds directly to the objecting parties instead of indirectly through the debtor.  At least in the Third Circuit, it might ultimately cost you less.

(1)  In re ICL Holding Co., Inc., et al., Case No. 14-2709 (3d Cir., Sept. 14, 2015)

Return to list.