Bidding for the Collateral by Cancelling What You Are Owed

Selling Assets Instead of Reorganising

A Chapter 11 company can be restructured through a reorganization plan which takes time requires creditor votes and produces a reorganized entity

The alternative is to sell the business. A sale under section 363 The bankruptcy code transfers assets with court approval outside of a plan and can be completed in months rather than years

The provision was designed to dispose of individual assets and has become the mechanism through which entire companies change hands in the event of bankruptcy representing a substantial evolution in practice from what the drafters envisioned

Why Buyers Prefer It

The feature that makes a sale valuable is that the assets can be sold. free and clear of liens claims liens and interest which are instead attributed to the proceeds of the sale

Thus a buyer acquires the business without inheriting the obligations that come with it. Liens are removed and succession liability that is claims that would otherwise follow the assets to a new owner is generally removed by the sale order although the extent of that protection has been litigated particularly for environmental and damage claims

The Stalking Horse

Sales are conducted through a court-supervised auction and almost always begin with a stalking horse bidder: An initial buyer who negotiates a purchase agreement setting the minimum price and terms

The hunting horse assumes a real cost carrying out procedures and negotiating documentation with the risk of being outbid. In exchange it receives offer protections usually a break fee payable if you lose and a reimbursement of expenses plus the ability to set terms that other bidders must match or beat

These protections are closely scrutinized by courts because excessive interruption fees or restrictive bidding procedures can suppress competition rather than encourage it defeating the purpose of the auction

Credit Bidding

The most important feature for the results is that a secured creditor can offer its debt instead of cash

under a credit offer a lender who is owed two hundred million for collateral sold can bid up to that amount offsetting his credit without financing anything. If he wins he owns the assets and his debt is extinguished up to the amount of the offer

The reasoning is simple. The lender is entitled to the value of your collateral. Requiring you to pay cash and then receiving that repayment as a secured creditor would be a pointless round trip

The competitive consequence is substantial. A cash bidder must outbid you for credit with real money and the lender can bid your entire claim regardless of what you paid for the debt. A distressed debt investor who purchased a loan for fifty cents can offer credit for the full amount which is a big advantage over anyone offering cash

This is a primary route by which distressed credit funds come to own operating companies and explains why acquiring fulcrum debt is often a strategy for acquiring the business

A Worked Example: Why a Cash Bidder Cannot Win

That last section describes the advantage. Putting numbers on it shows that the word advantage is too soft

Set up the auction. A company has a secured loan for a nominal amount of $200 million. The assets securing it are actually worth about $150 million in today's market. A distressed credit fund bought the loan on the secondary market for 50 cents so it paid $100 million for a $200 million loan

Now run the auction. The fund can credit the offer up to the full face amount of 200 million. It does not matter that it paid 100 million. The offer is denominated in the claim not what the claim cost

Look at the two rows at the same bid level. Both sides have bid $151 million. The cash bidder writes a check for $151 million and receives assets worth $150 million making a loss that day. The credit pool does not write a check maintains a cost basis of $100 million from the secondary purchase and receives the same $150 million of assets representing a fifty percent profit

If the offers are increased things will get worse for the outsider. The fund can continue to bid up to 200 million without spending another dollar because everything up to the face amount of its claim is free currency. A cash bidder who wants to win with 180 million must find 180 million of real money to buy 150 million of assets which no rational person does

Therefore the auction is not a competition between two parties with different views on value. It is a contest between one party bidding with money and another bidding with paper purchased at half price. The credit bidder's effective cost of any bid up to 200 million is zero at the margin and no cash bidder can compete with a marginal cost of zero

That's why buying fulcrum debt is the strategy and not a step toward it. By the time a fund controls the secured claim it has effectively purchased an option to acquire the business at a price that no one else can beat and the price it paid for that option was set in a bond market and not in an auction. These are illustrative figures and the actual capital structures are much more confusing but the mechanism is exactly this

The Limits and the Objections

Credit offers are not unlimited. A court can deny it for cause and cases have been found where a lender's conduct was inequitable where the scope or validity of its lien was genuinely questioned or where allowing bidding would paralyze the auction so severely that no meaningful process could take place

The broader objection to quick asset sales is procedural. A sale conducted quickly financed by lenders who also control the process can effectively determine the outcome of the case before creditors have had a chance to organize or investigate. Unsecured creditors frequently object that the sale process is reduced to a timeline that suits the lender and not the estate

Courts have responded by examining the timelines milestone requirements built into debtor-in-possession financing and bidding procedures. The tension between speed which preserves value in a deteriorating business and process which protects stakeholders is inherent and unresolved

The Cases That Defined It

The large auto bankruptcies of 2009 used this mechanism at scale transferring viable operations to new entities in a matter of weeks and leaving behind unwanted liabilities. The transactions were approved and heavily criticized primarily because a sale of substantially all assets on an accelerated schedule accomplished what a reorganization plan would have required creditor votes to achieve

Chrysler is the case worth learning about in detail. It filed for Chapter 11 on April 30 2009 and proposed selling substantially all of its operating assets to a newly formed entity owned by Fiat a retiree health care trust established for the union and the U.S. and Canadian governments. The bankruptcy court approved the sale about a month later. Secured lenders including a group of Indiana state pension funds who objected took the fight to courtof appeal and the Supreme Court which refused to block the transaction in June 2009. The sale closed approximately six weeks after filing

The objection was not that the price was too low in isolation. It was that the senior secured lenders recovered about twenty-nine cents on the dollar while junior shareholders particularly the union retiree trust received shares in the new company. Under the ordinary priority rules of a reorganization plan that result would have required either the senior class to vote in favor or a court to find the priority scheme satisfied. Conducting the transfer as an asset sale meant that no vote was taken.collective

That criticism that a quick sale can function as a plan without the electoral protections a plan requires remains the central structural objection to the practice

Where the Criticism Overstates It

Having stated the objections I think the standard criticism of these sales is overconfident in three respects

The counterfactual situation is usually liquidation not a better plan. A manufacturer in Chapter 11 is burning cash losing suppliers who don't extend credit and losing customers who doubt warranties are honored. Value evaporates as the process plays out. A reorganization plan that lasts eighteen months is not a slower path to the same result;It is often a path to a much smaller estate and the unsecured creditors who demand the process would be dividing up a smaller fund at the end of it

Credit offers are in principle economically neutral. A secured lender is entitled to your collateral. If the assets are worth 150 million and the claim is 200 million the lender will terminate the assets in almost any outcome whether through a credit offer a plan distribution or a foreclosure. The credit offer is a faster route to an outcome that the priority rules already dictate and the apparent unfairness in the table above is primarily that the lender makes a profit on a discount purchase which is the ordinary return on a distressed investment and not aabuse of process

The advantage is available to anyone. Nothing prevents a potential acquirer from purchasing the secured debt on the market instead of bidding cash at the auction. Funds that specialize in this do exactly that and complaining about the credit offer after refusing to buy the credit is complaining about having chosen the weakest instrument

My own opinion is that credit offers are defensible and schedule pressure is not and that the strongest reform is not to restrict credit offers but to examine milestone agreements in debtor-in-possession financing since that is what really compresses the process before anyone can get organized

How I Would Read a 363 Process

If you were following one of these cases instead of reading it afterwards the documents that matter are not the ones reported

I would start with the debtor-in-possession financing order specifically the milestones. Those agreements generally require the debtor to submit bidding procedures on one date hold the auction on another and close on a third under penalty of default. Milestones not bidding procedures are what determine whether a competitive process is possible and are agreed upon with the lender before anyone else enters the room

Second I would examine bidding protections and specifically whether the break fee and expense reimbursement are proportional. A protection package large enough that no rival can profitably outbid has turned an auction into a paperwork-heavy coronation

Third you would check who owns the underlying debt and when they purchased it. The example above shows why a claim purchased at fifty cents behaves completely differently than one held at par with the identity of the holder often indicating the outcome before the auction is scheduled

Fourth I would read the unsecured creditors committee's objections carefully. They are often dismissed as noise and are also the only case record written by someone with an incentive to point out what is being skipped in the process

Fifth I would look to see if anyone actually showed up. An auction with a single qualified bidder is not a test of the market regardless of what the sales order says about having been

The Bottom Line

A Section 363 sale provides clear title quickly which is why buyers pay more inside bankruptcy than outside of it and why so many distressed companies now change hands this way rather than through reorganization

Credit bids are what decide who ends up owning it and the arithmetic is crude. A fund that bought a $200 million claim for fifty cents has a basis of $100 million and can bid the full amount without spending another dollar. Against $150 million worth of assets it buys them at a fifty percent profit while a cash bidder bidding the same $151 million pays real money for less than it receives. Nonecash bidder can compete with a marginal cost of zero

Chrysler is the case that defined the objection. Filed on April 30 2009 sold in about six weeks the senior secured lenders recovered about twenty-nine cents while a junior shareholder received equity and no collective vote was taken because it was structured as a sale rather than a plan. The recurring objection is that the speed and control of the lenders together can decide a case before anyone else has had a chance to participate