Faegre & Benson LLP and The Deals Turning the Emergency Escape Valve: The 363 Auction

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Turning the Emergency Escape Valve: The 363 Auction Sale

Moderator: Expert panelists: Jonathan B. Cleveland, Houlihan Lokey Bruce M. Engler, Faegre & Benson LLP Rafael Klotz, Gordon Brothers Group Michael R. Stewart, Faegre & Benson LLP Matt Miller, The Deal

Summary of Historical Section 363 Sales

(Transaction Values in $USD millions)

Focus on Section 363 Asset Purchases

Where the action is in distressed M&A
Chrysler and GM both sold through 363 sales in under 50 days

Description
The simplest and quickest distressed deal approach in which debtor sells assets, subsidiaries or entire entity via formal process under Bankruptcy Code Often driven by (i) secured lenders pushing for sale (e.g., negative cash flows, lender fatigue, etc.) or (ii) debtors selling assets to fund a reorganization 363 asset sales can run the gamut from (i) discrete assets (e.g., equipment, fixtures), to (ii) overburdened middle-market companies that cant finance or survive a restructuring, to (iii) the sale of entire large enterprises Sales processes and solicitation of offers can occur (i) wholly inside Chapter 11 or (ii) outside Chapter 11 with consummation of the deal shortly after a Chapter 11 filing

Focus on Section 363 Asset Purchases

Illustrative Timeline for Middle-Market 363 Process
Week 8 Weeks 1-5 Weeks 6-7 Week 11

Expedited Marketing Process (competitive, but fast)

Select Stalking Horse (typical)

Filing of Sale Motion

Competitive Bid Deadline Court Auction

Weeks 13-15

Closing Bid Procedure (describes breakup fee, deposit requirements and overbid amounts)

Comparison of 363 Sale and Plan of Reorganization

Plan of Reorganization
Permits complex financing techniques, issuance of new securities Requires a comprehensive plan and multiple-party agreement Two step approval: first the disclosure statement and then the plan itself Better successor liability protection

363 Sale
Much fasterapproved by motion with a relatively short, 20-day notice to creditors Prospective buyer can be more easily overbid Like traditional M&A transaction with an ordinary asset purchase agreement, except: Limited representations and warrantiesas is, where is Generally no indemnification (but may have holdback or escrow) Limited closing conditions Deposit or down payment typical

Other Alternatives to Bankruptcy Sales

Receivership Assignment for the Benefit of Creditors UCC Foreclosure Out-of-Court Negotiated Sale

Key Attributes
Stalking-Horse Issues

Considerations
Early access to management and more time to diligence Negotiate breakup fees and overbid protections
Breakup fee and expense reimbursement potential have jurisdictionally sensitive parameters an issue for local counsel

Stalking horse often dictates purchase agreement structure for competitive bidders Stalking horse wins 70% of the time (according to Houlihan Lokey study of 165 sample transactions)

Structural Advantages

Structure deal to get what you want (i.e., purchase only valuable assets) Can require debtor to assume and assign (or reject) contracts (special protections for real estate lessees and IP [excluding trademarks] licensees) Acquire assets free and clear of liabilities (including potentially leaving payables behind, but does not apply to certain successor liabilities) Speed and relative certainty for buyer No formal ability for a dissatisfied creditor class to block deal; objection is sole recourse Guarantees a public auction
Requires that you show all your cards publicly without knowing that the deal will be yours if you are the stalking horse

Disadvantages/Risks

Uncertainty with court process and securing stalking-horse protections Breakup fees and bid protections are not guaranteed; judge has discretion and parties may object Potential material disadvantage particularly for the stalking horse if buyer does not want to retain existing management (who may be significant decision makers)
Not all the most powerful tools available under the POR NOLS not transferable Inability to obtain financing from trapped creditors (no secured creditor cram-up, for example, outside a POR)

Secured lender credit bid

Section 363 Process Initial Solicitation

Initial process parallels traditional healthy auction process:
Confidential marketing effort undertaken to solicit interest from one or more potential buyers No fixed rules governing the manner in which the company markets its assets for sale

However distressed context quickly introduces a number of procedural departures from a traditional auction process:
Speed process is typically conducted on an expedited basis: Frequently driven by, among other issues, business liquidity constraints, threat of customer flight, supplier disruption, employee instability and competitive threats Ability to close quickly becomes a paramount objective and a differentiating attribute of buyers Constituencies lenders and other creditor constituencies may be (usually are) heavily scrutinizing process Disclosure in general there is comparatively greater and more immediate disclosure but auction participants are required to submit to several unique confidentiality requirements: Nonsolicitation provisions of CA typically more stringent "Standstill" provision precludes credit bids to ensure process integrity Ultimate objective in the interests of speed the typical 363 auction process is designed to secure the interest of a stalking horse: Value maximization not necessarily paramount in the initial auction Section 363 procedural requirements compel further open auction designed to ensure value maximization

Section 363 Process Initial Solicitation

A successful initial solicitation culminates in an interested buyer outlining the parameters of an acceptable deal subject to higher and better offers, court approval and a host of other conditions:
Initial solicitation may be conducted on a pre- or postpetition basis: Value maximizing strategy is often to conduct prepetition solicitation/negotiation process and then file for Chapter 11 In order to gain court acceptance of a 363 sale, the buyer must submit to a second official "court auction" process In negotiating the initial purchase agreement, the initial bidder or stalking horse will seek to impose substantial restrictions on subsequent bidding while the company and creditors committee will negotiate for as much competition as possible Combining offer with DIP financing can give stalking horse extra measure of control and create extra hurdle for competitors
May include significant prepayment penalties and be credited against final purchase price Accelerate timing (with milestone covenants in DIP financing to minimize competition) Influence pessimistic financial disclosures to chill bidding

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Section 363 Process Court Auction Process

Key procedural requirements and distinguishing aspects of the court process include:
(1) Notice: Notice must be to all creditors and interested parties under Bankruptcy Rule 2002 Notice is often published to attract bidder and other interested parties (2) Due Diligence: Courts generally require equal access to due diligence materials to create a level playing field Burden is on buyer to conduct extensive due diligence or suffer consequences because sales are as is often without any meaningful representation or warranties If auction being conducted postpetition, buyer should look at title reports, UCC filings, court dockets, etc. for mechanics, creditors and tax liens, terms of leases, environmental problems, etc.
Stalking-horse purchase agreement is typically posted to the court docket so buyer looking to unseat stalking-horse buyer should examine carefully If APA is not posted, buyer should request from company financial adviser

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Section 363 Process Court Auction Process

(3) Bidding Procedures:
In noticing an auction for the proposed sale of a debtor entity, a bankruptcy court will typically impose procedures that must be complied with by all bidders before a bid can be considered a qualifying bid Typically such procedures include: Overbid protection also known as an upset price which any competing bid must meet or exceed; and A requirement that all competing bids conform to the terms and conditions of the original purchase contract No modifications or late bids permitted

Other stalking-horse protections approved by bankruptcy courts

Termination provisions if specific and narrow Significant deposit requirements (10%-15%) Breakup fees and expense reimbursements Exclusivity period or no-shop/limited-window-shop periods (all highly unusual)

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Section 363 Process Court Auction Process

(4) Higher and Better Offers:
Section 1129 of the Bankruptcy Code sets out the so-called best-interests test, which stipulates: All holders of impaired claims receive property with a value no less than what they would receive if the company were liquidated This requirement is true in connection with both a 363 sale and plan of reorganization The court recognizes that the higher offer is not always better. In evaluating competing bids, courts look at whether financing (or other terms) are contingent, whether regulatory approvals have been obtained and likelihood the bidder will close Courts also consider whether the various creditor constituencies support the sale: Treatment of trade is often an issue Frequently strategic buyers desire to assume trade puts them at an economic disadvantage, but provides a basis for a better offer

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Section 363 Process Court Auction Process

(5) Breakup Fees:
Breakup fee is a fixed fee payable to an unsuccessful initial bidder if the sale is made to a subsequent bidder An acquirer seeking the protection of a breakup fee or expense reimbursement must obtain court approval of the arrangement In considering breakup fees, the court looks at three factors: Is there self-dealing between the parties; Will the fee discourage bidding; and Is the amount of the fee reasonable given the circumstances fees usually range between 2% to 3% Losing bidders have sometimes sought reimbursement of their expenses under Section 503(b) arguing that the estate was benefited from their efforts in that a higher price was obtained (highly unusual to get this approved)

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Section 363 Process Court Auction Process

(6) Credit Bidding:
Unless the court orders otherwise, the holder of a claim secured by the property to be sold may bid at the sale and may offset such claim against the purchase price (Section 363(k)) Distressed debt investors sometimes buy secured claims at a discount to bid them at face value at the 363 sale Courts have permitted the agent for a bank group, if directed by the requisite majority of lenders, to credit-bid on behalf of all lenders over the objection of minority lenders However, if the sale is proposed under a plan of reorganization, instead of a Section 363 sale, a secured creditor may not have an absolute right to credit bid (In re Philadelphia Newspapers, LLC, 599 F. 3d 298 (3d Cir. 2010))

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Case Study: Foamex

Company Overview and Background Information
Foamex International Inc. is a leading producer of polyurethane foam-based solutions and specialty comfort products in North America. The company serves the bedding, furniture, carpet and automotive markets via its four strategic business units (foam products, automotive products, technical products and carpet cushion) Unprecedented earnings levels in 2006 allowed the company to repay in full all creditors from the companys bankruptcy in 2005, which created a heavily leveraged balance sheet Foamex was on the verge of a liquidation from the collapse of its main customer segments in the automotive and furniture industries
The lack of financing alternatives due to the global financial crisis of 2008 left the company in a vulnerable position

Situation Overview
Continued weakness in the macro-economic environment and a contraction of the companys borrowing base resulted in it electing not to pay its January interest payments and filing for Chapter 11 on Feb. 18, 2009
Although Foamex successfully completed a number of debt reduction and cost-saving initiatives prior to filing for bankruptcy, it was left with total prepetition debt in the amount of approximately $398.6 million

The debtor conducted an accelerated 363 sale in order to salvage value since a Chapter 11 plan process could not be implemented due to operational distress and limited resources of the company Foamex obtained a $95 million DIP loan from MatlinPatterson to fund operations during the sale process, which was approved by the bankruptcy court on March 16, 2009
Foamex was able to obtain a junior lien DIP against accounts receivable
The nonpriming nature of the DIP was an important element of the financing, due to the fact that accounts receivable was the only collateral available to lend against (the first-lien lenders had a first lien on the inventory and PP&E)

The financing was tied to a sale of the companys assets under 363 of the Bankruptcy Code Due to Foamex's tight liquidity position, the DIP featured PIK interest to conserve cash

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Case Study: Foamex

Outcome
The auction concluded on May 21, 2009, and the bankruptcy court approved the sale to MatlinPatterson and Black Diamond on May 26, 2009
The total consideration for the assets was a $155.0 million credit bid, with First Lien lenders given the choice of either taking equity in the new company or the Cashout option, which was equivalent to a $146.5 million cash bid First lien lenders were given the choice of either taking equity in the new company or the Cashout option, which was equivalent to a $146.5 million cash bid Actual proceeds to first lien lenders were impacted by a number of items, including the working capital adjustment and cash balance at closing, administrative and priority items, the DIP loan and associated fees, and professional fee and wind-down amounts placed in escrow

The accelerated sale process resulted in a greater than 50 percent increase in purchase price from stalking horse bid The sale transaction to MatlinPatterson and Black Diamond Capital Management LLC closed on June 12, 2009 This 363 sale transaction affirms that a credit bid is equivalent to a cash bid of the same amount
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Focus on the Retail/Consumer Sector

Using the 363 sale to relaunch a brand Linens n Things/Polaroid
Exit store model Purchase valuable brand through 363 sale Relaunch as online brand or licensing business

Financial buyers with expertise in 363 sales

Different risk profile than strategic buyers Familiarity with process Ability to move quickly

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Q&A.

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