Restructuring

Contributed by Andrea Saavedra
Sales of substantially all of a debtor’s assets outside the strictures of the Bankruptcy Code’s plan confirmation requirements have become so commonplace in the past decade that when the sale efforts of Chrysler and General Motors in 2009 were met with resistance by public bondholders, many bankruptcy buffs were taken by surprise.  After all, if a debtor in possession, in the exercise of its sound business judgment, chooses to pursue a non-ordinary course pre-plan sale of its business, why shouldn’t a bankruptcy court approve such chosen course?
In today’s edition of Throwback Thursday, we look at the paramount importance of the Second Circuit Court of Appeal’s nearly three-decade old decision, In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), in developing the business judgment standard in the context of section 363 asset sales, which provides debtors, and the courts that oversee their actions, with one of the most effective tools to maximize value in the context of a distressed restructuring.
The factual background of Lionel feels as staged as the toy train sets for which the debtor-manufacturer had gained its reputation.  In the winter of early 1982, Lionel and two of its subsidiaries filed for chapter 11 protection after two years of unprofitable performance. As of its petition date, Lionel’s most valuable asset was not its toy trains, but its majority equity interest (82%) in Dale, a solvent, profitable, non-debtor electronic components manufacturer.  The remainder of Dale’s stock was held by public shareholders and traded freely on the American Stock Exchange.
Shortly after filing for bankruptcy relief, Lionel, at the behest of the creditors’ committee, sought authority, pursuant to section 363 of the-then newly amended Bankruptcy Act, to sell its equity interest in Dale to the bidder with the highest and best offer.  After a competitive bidding process, the highest and best offer received was $50 million.  In support of its sale application, Lionel submitted the testimony of its investment bank and its CEO, who both testified that the sale price was “fair” under the market circumstances.  The CEO also testified that the sale also could be accomplished via the plan process, however, the “sole reason” for Lionel’s application to sell its equity interest in Dale prior to confirmation, stated the CEO, was that the creditors’ committee wanted an assured “pot of cash” for the bulk of distributions required to repay creditors under the then-proposed plan of reorganization.  In approving the sale, the bankruptcy court made no formal findings of fact, but noted that sufficient cause to sell was evidenced by the creditors’ committee’s insistence upon it.
The equity committee (which represented the interests of Lionel’s public shareholders in the chapter 11 cases) appealed the decision to the district court, which affirmed the bankruptcy court’s order.  On appeal to the Second Circuit, the equity committee argued that the sale should not have been authorized given that Lionel had failed to demonstrate any immediate need to sell its equity interest in Dale prior to approval of a plan where Dale was not a “perishable” or otherwise “wasting” asset, nor that the offer to purchase was a soon-to-close window of business opportunity.  The SEC joined in the appeal to support the efforts of the equity committee, arguing that the disclosure and voting requirements on a plan of reorganization that had been embedded into the amended Bankruptcy Act had been instituted to protect public investors from actions by a debtor and its creditors that would effectively wipe out any value that could potentially accrue to equity in a restructuring.  A pre-plan sale, the SEC argued, would eviscerate those protections.  The creditors’ committee countered by arguing that the plain language of section 363 did not impose any restraints on a debtor in possession’s sale powers, and, if anything, elimination of prior language in the Bankruptcy Act requiring that a debtor show “cause” to effectuate a pre-plan sale demonstrated Congress’s intent to give a debtor in possession such unfettered powers and also empower the bankruptcy courts overseeing their actions with substantial discretion.
In reversing and remanding the decision of the lower courts, the Second Circuit declared that it had to “avoid the extremes” posited by either side and look to the legislative history underlying the Bankruptcy Reform Act of 1978 to determine a “middle ground.”  After a painstaking review of the legislative history behind section 363, the “middle ground” established by the Second Circuit is now the well-known “business judgment” standard:

The rule we adopt requires that a judge determining a § 363(b) application expressly find from the evidence presented before him at the hearing a good business reason to grant such an application. . . .

In fashioning its findings, a bankruptcy judge must not blindly follow the hue and cry of the most vocal special interest groups; rather, he should consider all salient factors pertaining to the proceeding and, accordingly, act to further the diverse interests of the debtor, creditors and equity holders, alike.  He might, for example, look to such relevant factors as the proportionate value of the asset to the estate as a whole, the amount of elapsed time since the filing, the likelihood that a plan of reorganization will be proposed and confirmed in the near future, the effect of the proposed disposition on future plans of reorganization, the proceeds to be obtained from the disposition vis-à-vis any appraisals of the property, which of the alternatives of use, sale or lease the proposal envisions and, most importantly perhaps, whether the asset is increasing or decreasing in value.  This list is not intended to be exclusive, but merely to provide guidance to the bankruptcy judge.

Lionel, 722 F.2d at 1071.  Applying this standard to the facts of the case before it, the Second Circuit found that the sale had been improperly approved where the “only reason advanced” for granting the sale was the insistence of the creditors’ committee, which was insufficient, as a matter of fact, because it could not provide the basis for the exercise of the debtor’s business judgment and, as a matter of law, because it permitted the bankruptcy court to ignore the concerns of equity.  While the need for speed was established, that alone, the Second Circuit opined, could not justify abandonment of the business judgment standard.  While the dissent disagreed and sided with the creditors’ committee’s plain meaning argument, finding that the majority’s decision resulted in an improper hold-up of the reorganization by equity, the business judgment rule was clearly articulated and has since been firmly established.
Revisiting Lionel provides those in the restructuring field with an opportunity to consider best practices as to establishing a debtor’s “business judgment” when pursuing a 363 sale effort, and reminds us all of the importance that such judgment be impartial, based in evidence, and truly in the best interests of the debtor’s business.