Asset sales often play an integral role in the bankruptcy process for both Chapter 7 and Chapter 11 debtors.

For instance, in Chapter 7 proceedings, bankruptcy trustees primarily discharge their duty to convert estate assets into cash through sales pursuant to Sec. 363 of the Bankruptcy Code. Chapter 11 debtors-in-possession and trustees also frequently employ asset sales as part of a strategy of liquidating assets while simultaneously seeking to reorganize the debtor's core business, or pursuant to a plan of orderly liquidation.

In the past year, courts in this jurisdiction have decided a number of cases dealing with issues directly and indirectly related to asset sales in bankruptcy. This article focuses on three decisions that will be extremely important to bankruptcy practitioners in the future.

These decisions will affect bankruptcy trustees' compensation awards and the "breakup" fees awarded to frustrated bidders at bankruptcy auctions. The rulings will also affect the extent to which a purchaser of a debtor's assets can be held liable for the debtor's pre-petition torts. Finally, these decisions will affect not only the debtors' ability to sell assets under the Bankruptcy Code, but also the structure of such sales in the future.

Trustee's Commission/Credit Bid Sales

Section 326(a) of the Bankruptcy Code sets forth a formula to calculate the maximum commission that can be awarded to a bankruptcy trustee on "all moneys disbursed or turned over ... to parties in interest." See 11 U.S.C. Sec. 326(a). In Staiano v. Cain (In re Lan Associates XI), the Third U.S. Circuit Court of Appeals addressed the issue of whether a bankruptcy trustee may receive a commission under Sec. 326(a) for assets sold to a secured creditor pursuant to a "credit-bid" against the creditor's secured claim. 192 F.3d 109 (3d Cir. 1999).

In this case, the debtor's main asset was an office complex with a market value of approximately $9.7 million and a liquidation value of approximately $7.8 million. The asset was encumbered by a mortgage in favor of First Union National Bank for approximately $12.8 million. After the debtor's case was converted to Chapter 7, the trustee was prepared to abandon the debtor's asset in view of First Union's mortgage, which exceeded the asset's value. 192 F.3d at 112.

However, First Union offered to purchase the asset through a private sale by "credit-bidding" up to the property's liquidation value, waiving its unsecured deficiency claim and allowing the Chapter 7 trustee to retain approximately $370,000 in cash collateral to satisfy administrative claims and fund a dividend to unsecured creditors. Id.

Upon the trustee's motion, in which he disclosed the terms of the credit-bid sale and his expected commission, the Bankruptcy Court approved the private sale. After being awarded interim compensation based on a commission from the credit-bid sale, the trustee filed his final fee application, which sought confirmation of two interim awards by the court.

One year later, after the trustee already had sought and obtained court authorization to make a distribution to unsecured creditors, the Office of the United States Trustee (UST) objected to the trustee's final fee application. The UST's objection contended that the Chapter 7 trustee was not entitled to a commission pursuant to Secs. 330 and 326(a) on the credit-bid sale to First Union. Id. at 113.

The Bankruptcy Court approved the trustee's fee application over the UST's objection, with an adjustment to the trustee's award to ensure a 25 percent dividend to unsecured creditors as initially presented by the trustee's motion. The UST appealed, and on August 12, 1996, the District Court reversed and remanded. The District Court held that the language of Sec. 326(a), which provides that the trustee may receive a commission "on moneys disbursed or turned over" to creditors, was unambiguous and required the trustee to disburse dollars, not property. Id. at 114.

The trustee appealed to the Third Circuit, which began its analysis by reviewing the statutory language of Sec. 326(a). As an initial matter, the court disagreed with the District Court's conclusion that the reference to "moneys" in Sec. 326(a) was unambiguous. Instead, after an exacting definitional analysis and in view of "changing cultural, social and economic practices," the Third Circuit held that the term "moneys" was ambiguous and required an analysis of the legislative history regarding Sec. 326(a) to determine whether a "credit-bid" should be included in the base on which a trustee's compensation is calculated. Id. at 116.

The Third Circuit determined that the section's reference to the term "moneys" does not encompass a situation where a trustee merely turns property over to a secured creditor, or where the secured creditor is permitted to foreclose on abandoned property. Rather, the court found that Congress intended to distinguish between the terms "property" and "money." The Third Circuit concluded that the term "moneys" was intended to mean dollars paid to a creditor after the trustee liquidates the property for the estates benefit. Id. at 116-17.

Because the credit-bid scenario was analogous to an abandonment and foreclosure, as opposed to a liquidation and subsequent creditor payment, the Third Circuit held that the trustee was not entitled to receive a commission based on the credit-bid sale to the secured creditor. Id. at 117.

In its decision, the court expressly rejected the "constructive disbursement" theory adopted in other jurisdictions, and advanced by authorities such as Collier on Bankruptcy, which allows trustees to receive commissions on disbursements of property which are deemed "moneys" for purposes of Sec. 326. According to the court, the "constructive disbursement" theory conflicts with its narrow interpretation of Sec. 326, and was inconsistent with the majority of bankruptcy courts in the country and the Fifth Circuit's recent holding in Pritchard v. United States Trustee (In re England). Id. at 118-19.

What are the practical implications of Staiano v. Cain? First, it's possible that the Third Circuit's decision will remove the incentive for creative bankruptcy trustees who otherwise would be willing to work diligently with undersecured creditors to ensure a dividend to these types of creditors.

Second, trustees may seek to circumvent the Third Circuit's holding by creating a disbursement. In other words, cause the secured creditor to actually pay the trustee the purchase price, then return the purchase price to the secured creditor as the proceeds of the sale of its collateral. While such "form over substance" transactions obviously were not intended by the Third Circuit, these options appear sustainable under the court's analysis of Sec. 326(a).

Breakup Fees to Unsuccessful Bidders

Before the Third Circuit decided Calpine Corporation v. O'Brien Environmental Energy Inc. (In re Environmental Energy Inc.), no other federal appeals court had addressed the issue of the standard to apply to an unsuccessful bidder's request for a breakup fee in the context of bankruptcy sales. 181 F.3d 527 (3d Cir. 1999).

In Calpine, the debtor determined to proceed with the sale of substantially all its assets rather than attempting to continue in business as a debtor-in-possession. Of 19 buyers that initially expressed interest in purchasing the debtor's assets, ultimately three offers were chosen as the highest and best, including the offer of Calpine Corp.

The debtor ultimately entered into a purchase agreement with Calpine under which the corporation's obligation to perform was expressly conditioned on the parties' ability to secure Bankruptcy Court approval of a $2 million breakup fee, and expenses up to an additional $2 million, in the event Calpine's bid was not accepted by the debtor or approved by the court. 181 F.3d at 529.

The Bankruptcy Court refused to approve the breakup fee in advance of the proposed sale. Rather, the court expressed concern that such a fee would negatively affect the proposed sale by chilling bidding and/or overly complicating the process. The court, however, indicated that it would entertain an application by Calpine for payment of the proposed fee at the conclusion of the sale process. Id. Notwithstanding the Bankruptcy Court's ruling, Calpine agreed to proceed with the sale process and, indeed, re-entered the bidding for the debtor's assets.

Calpine was unsuccessful at the auction, and later filed an application seeking payment of its breakup fee and expenses. Id. at 530. The Bankruptcy Court, and the District Court on appeal, denied Calpine's application. On appeal to the Third Circuit, Calpine challenged both the Bankruptcy Court's decision not to approve the corporation's breakup fee on its initial application, and the subsequent order denying its application for breakup fees and expenses after the sale was completed.

The Third Circuit held that Calpine was without standing to appeal the Bankruptcy Court's initial order denying the motion to approve the breakup fee in advance of the sale because:

1. Calpine was not a creditor;
2. Calpine did not have a binding contract with the debtor, as its contract was contingent upon Bankruptcy Court approval;
3. Calpine's appeal did not challenge the "intrinsic fairness" or the process of the sale; and
4. The sale did not diminish or otherwise affect Calpine's property rights. Id. at 531.

Because the parties conceded Calpine's standing to appeal from the Bankruptcy Court's order ultimately denying its application for a breakup fee and expenses, the Third Circuit then addressed the merits of Calpine's appeal.

The court denied Calpine's application for a breakup fee and expenses under Sec. 503(b) of the Bankruptcy Code, which provides for the allowance of administrative expenses in bankruptcy proceedings for "the actual, necessary costs and expenses of preserving the estate." Id. at 537-38. After reviewing various decisions regarding breakup fees in bankruptcy sales, the court expressly rejected the business judgment rule in evaluating the allowability of breakup fees, and held that applications for breakup fees and expenses must be evaluated in the same manner as all other requests for administrative claims under Sec. 503(b). Id. at 535.

The Bankruptcy Court listed nine factors it considered in determining whether the breakup fee was warranted. Rather than adopting those factors, the Third Circuit merely reviewed the record below and determined that there was ample support for the Bankruptcy Court's conclusion that the proposed breakup fee and expenses were unwarranted because Calpine did not enhance or preserve the estate's value. Id. at 537-38.

The Third Circuit's decision in Calpine sounded an alarm in the minds of all potential purchasers of debtors' assets. As the court's analysis makes clear, to be awarded a breakup fee, the debtor and prospective purchaser need to demonstrate - in advance of a bankruptcy sale - that the requested fee will preserve or enhance the estate's value. Unlike Calpine, many would-be purchasers are unwilling to enter into a sale agreement unless it receives advance assurance that it will be compensated, through payment of a breakup fee, for actual expenses and/or lost opportunities in the event its bid as a "stalking-horse" is not accepted or approved. Purchasers may now have to enter into the sale process with less assurance of their ability to recapture expenses and related costs.

Successor Liability

In Lefever v. K.P. Hovrranian Enterprises Inc., 160 N.J. 307 (1999), the New Jersey Supreme Court addressed the issue of whether successor liability can attach to a purchaser of assets "free and clear of all interests" pursuant to Sec. 363(b) and (f) of the Bankruptcy Code.

In this case, a manufacturing concern (Lull I) sold its manufacturing business to the debtor (Lull 11) in 1973. The plaintiff was injured in 1989 in an accident involving a forklift manufactured by Lull I. Lull II filed a Chapter 11 proceeding in 1992 and its manufacturing business ultimately was sold to the defendant (Lull III) "free and clear of all interests" pursuant to Sec. 363(b) and (f).

Lull III moved to dismiss the plaintiff's complaint based on the purchase of the assets "free and clear" from Lull II's bankruptcy estate. The trial court granted Lull III's motion and the plaintiff appealed. 160 N.J. at 311-12. The Appellate Division reversed, holding that the plaintiff did not claim an "interest" in the debtor's property and, thus, the Bankruptcy Court's order did not affect the plaintiff"s products liability claim. Id. at 312. The New Jersey Supreme Court granted Lull III's petition for certification.

The Supreme Court began its analysis by stating the general rule against successor liability and tracing the origins of the so-called "product-line" exception to that general rule. The Court defined the product-line exception as allowing for strict liability in tort to purchasers of a substantial part of a manufacturer's assets who continue to market goods in the same product-line. Id. at 310.

The first issue the Court addressed was whether the product-line exception can be applied to create liability on the part of an entity that purchased the predecessor's assets in a bankruptcy sale. In the context of Sec. 363 sales, the Court noted that Sec. 363(f) speaks only in terms of "interests," not claims, and that "claims" represent rights to payments pursuant to Sec. 101(5); not property interests in the debtor's assets. Id. at 316-17.

According to the Court, "[t]here is nothing in the Code ... to suggest that the term interest was intended to embrace rights to payment which are the substantive nuclei of bankruptcy "claims'." Id. at 317 (quoting Reed, "Successor Liability in Bankruptcy Sales," 51 Bus. Law 653 (1996)).

The Court clearly distinguished and had more difficulty addressing the sale of a debtor's assets pursuant to a plan of reorganization under Chapter 11 of the Bankruptcy Code. The decision noted that Sec. 1123(a)(5)(D) authorizes the sale of any part of the estate, either subject to or free and clear of liens, pursuant to a plan of reorganization. See II U.S.C. Sec. 1123(a)(5)(D). Section 1141(c), the "discharge" section of Chapter 11, provides that property "dealt with" by a plan of reorganization shall be free and clear of all claims and interests. See 11 U.S.C. Sec. 1141(c). Thus, unlike a Sec. 363 sale, property sold pursuant to a plan of reorganization arguably has been "dealt with" under the plan, allowing the purchaser to take free and clear of claims.

The Court found this interpretation of Sec. 1141 was "unclear," however, especially in view of the fact that Congress recognized the limited scope of the Sec. 1141 discharge by expressly authorizing bankruptcy courts in Sec. 524(g) to insulate a successor from liability for personal injury claims due to asbestos-containing products. Id. at 319-20 (citing ll U.S.C. Sec. 524(g)(3)(A)(ii)). Nevertheless, the Court held the products liability claim of the plaintiff - who had not filed a proof of claim against Lull II's bankruptcy estate - was not "dealt with" in the Lull II bankruptcy. Id. at 320-21.

Accordingly, the Court held Lull III did not receive the subject assets free and clear of the plaintiff's claim. The decision then held that there were no public policy concerns precluding successor liability on the part of a purchaser of a Title 11 debtor's assets. According to the Court, such purchasers, like all other purchasers of an entity's manufacturing business, are best suited to "spread the risk" of subsequent tort suits. Id. at 326-27.

Although the argument was rejected by the New Jersey Supreme Court in Lefever, the high court's decision - like the Third Circuit's holding in Calpine - could negatively affect the purchase price or increase the difficulty a debtor faces in marketing its assets to potential purchasers. A purchaser's ability to obtain a Bankruptcy Court order authorizing a debtor's sale of assets "free and clear" of claims and encumbrances is one of the most attractive characteristics of bankruptcy sales. Without the ability to ensure that it will receive the debtor's asset free from the potential of expensive tort suits, the consideration offered and the amount of potential purchasers of a debtor's assets may diminish.

Conclusion

The Staiano v. Coin, Calpine and Lefever decisions undoubtedly will affect the nature and future of asset sales in bankruptcy proceedings. Bankruptcy trustees may become creative in structuring sales to secured creditors willing to purchase assets through a credit-bid to avoid the expense and delay of a foreclosure proceeding.

Potential purchasers of a debtor's assets may be less willing to "enter the fray" of the bankruptcy sale process without the assurance of a reasonable breakup fee or an order guaranteeing its freedom of potential exposure to pre-petition products liability claims. Given the importance of asset sales in the bankruptcy process, it will be extremely interesting to observe the effect of these decisions in coming years.

This article is reprinted with permission from the February 7, 2000 issue of the New Jersey Law Journal.  ©2000 NLP IP Company.