Contributed by Doron P. Kenter.
“[T]hey would sell their possessions and goods and distribute the proceeds to all…” Acts 2:45
What does a debtor need to do when it wants to sell its assets to an insider? How can we compare apples to apples when one bidder seeks to act as liquidating agent, and another proposes to buy the assets outright? What needs to happen when a debtor proposes to sell causes of action in connection with a section 363 sale? These questions and others were considered and discussed in a decision from Judge Gregg in the United States Bankruptcy Court for the Western District of Michigan. Even though the decision is very much premised on the specific facts and circumstances before the court, it is interesting to consider the court’s concerns with certain aspects of the auction and proposed sale, many of which are part and parcel of asset sales that are approved without question in other contexts but, for some reason, were viewed by Judge Gregg in this case as sufficiently offensive to warrant a rejection of a proposed sale that otherwise enjoyed support from most parties in interest.
In In re Family Christian, L.L.C., the debtors operated as not-for-profit organizations, selling religious merchandise in more than 250 brick and mortar stores and donating their profits to Family Christian Resource Centers, Inc., their nondebtor parent. Family Christian Resource Centers distributed those profits in furtherance of charitable purposes such as disseminating bibles, supporting those in need, funding mission trips, and disaster relief efforts. When the debtors’ business was struggling in 2014, Richard Jackson – who controlled the nondebtor parent entity – paid $7 million to the bank lender to avoid (or perhaps cure) a default on Family Christian’s line of credit. Mr. Jackson then purchased the bank loan via FC Special Funding LLC, a subsidiary of a merchant bank, with Mr. Jackson acting as the sole source of funding. Immediately after filing for chapter 11 protection in February 2015, Family Christian moved to sell substantially all of its assets to FCS Acquisition, LLC, yet another entity controlled by Mr. Jackson and formed for the purpose of acquiring the debtors’ assets. After opposition from numerous creditors and other parties in interest, however, the debtors withdrew their initial sale motion. Thereafter, the debtors returned to court with a revised sale process and obtained approval of consensual bidding procedures with no stalking horse bidder.
After an auction that was “nothing short of chaotic,” two status conferences, a request from certain non-insider bidders that the court supervise the auction process, and a second day of bidding (ending in the early morning hours), the two bidders left standing were (i) FCS Acquisition, which proposed to buy the debtors’ assets for a bid valued at $46.8 million, of which $42 million would not be subject to adjustment and (ii) a joint venture of liquidating firms (referred to as “GBH”), which proposed to act as the debtors’ agent for purposes of liquidating the debtors’ assets. Even though the GBH bid was valued at approximately $49.8 million ($3 million more than the FCS Acquisition bid), FCS Acquisition was declared the winner, largely because the GBH bid would place greater risk on the debtors and did not guarantee adequate “minimum” proceeds.
After the smoke cleared on discovery disputes and several settlements on the courthouse steps, two objectors remained. First, GBH argued that the sale was the product of an unfair auction and that the debtors had improperly selected FCS Acquisition as the successful bidder over GBH (without explaining to GBH why its bid was inferior to the insider’s) and that the sale constituted an impermissible sub rosa plan. Second, a consignment creditor and litigation claimant opposed the releases to be granted to the debtors’ insiders and to the distribution of the sale proceeds as unfairly discriminatory—to the extent that the debtor proposed to pay $500,000 to certain consignment vendors, and not to others.
The debtors first attempted to dispose of GBH’s objections by arguing that GBH, as an aggrieved bidder, lacked standing to object to the selection of the winning bidder. However, pursuant to Sixth Circuit precedent (and elsewhere), aggrieved bidders do have standing to object to a sale where they have “a pecuniary interest” or where they allege that the sale process was itself flawed. Here, GBH had standing for both reasons. First, it had challenged the fairness of the auction. But perhaps even more clearly, GBH had purchased an administrative expense against the debtors, which brought with it the requisite pecuniary interest to object to the proposed sale.
The Auction Process
Having concluded that GBH had standing to object to the sale, the court turned to whether the auction was, in fact, fair. The court recited a long-form summary of the auction, describing the challenged activities and laying out where the auction process went wrong, and where it did not. Importantly, the court observed that the debtors were not obligated to “mechanically accept” GBH’s offer, even though its apparent face amount was greater than the winning bid. Because GBH’s bid was fraught with contingencies and risks that the debtors would have to bear, Judge Greeg concluded that the debtors had properly discounted the bid in assessing the highest and best offer, particularly where the competing bid guaranteed minimum proceeds, which GBH had declined to do. Moreover, the debtors were under no obligation to provide GBH with a line item analysis of those perceived risks in the GBH bid.
It is interesting to note that the court did not address the fact that the winning bid contemplated allowing the debtors’ business to continue to operate, as opposed to the liquidation contemplated by GBH. The benefit that would accrue to the debtors’ vendors, employees, and others, as well as furthering the not-for-profit’s charitable mission. Perhaps the court was not convinced that the company would actually remain in business. Or perhaps the court did not see a need to place a value on such indirect benefits, particularly because the debtors did not necessarily err in concluding that the FCS Acquisition offer was the better offer. In any event, the court was not willing to challenge the debtors’ conclusion that the winning bid was the higher and better offer.
Instead, the court concluded that the auction was flawed due to two “mistakes” by the debtors in the auction. First, the sale to FCS Acquisition included “releases” of potential claims of the debtors against insiders and a sale of avoidance actions, which had not been accounted for in valuing the bid and the assets being sold. Had those provisions been taken into account, the debtors may have had to adjust their valuation of the competing bids, insofar as the GBH bid proposed to leave those potentially valuable assets with the debtors’ estates. Indeed, the debtors had failed to articulate a rationale for granting releases in favor of insiders in the context of a 363 sale and certainly had not placed a value on them. Even though the debtors were not obligated to offer a line-by-line accounting of their bid, the court concluded that the debtors could not fairly compare a bid for all assets (including the avoidance actions and the released claims) against GBH’s bid for only a subset of the debtors’ assets (i.e., not including the claims against insiders and avoidance actions).
Second, the court questioned ex parte discussions between the debtors’ CEO and Richard Jackson. The court observed that the CEO’s mid-auction telephone call to Mr. Jackson, during which he asked Mr. Jackson to increase FCS Acquisition’s bid, was “at the very least, reckless.” Instead, the court stated that any requests that a bidder increase its bid should have been made on the record and should have been relayed to all active bidders. Interestingly, such ex parte discussions are not at all uncommon in auctions. Bu the court was nonetheless uncomfortable with the discussion, perhaps in light of the fact that Mr. Jackson had hired the CEO and promised him future employment if FCS Acquisition were to win the auction.
Perhaps the court was also skeptical of the CEO’s good faith in selecting Mr. Jackson’s company as the winning bidder, given his personal interest (as opposed to the company’s or the estate’s best interests). The court noted that the apparent impropriety of the ex parte discussion was that much more pronounced in light of FCS Acquisition’s immediate departure from the auction after making its bid following that phone call. The court was “le[ft] with the impression” that the CEO “may have represented” to FCS Acquisition that “it would be declared as the winning bidder, which it eventually was after a recess and an abrupt closing of the auction” (perhaps without giving competing bidders a meaningful opportunity to outbid FCS Acquisition, a point that is not addressed in the opinion). The court was somewhat circumspect in concluding that the discussion was improper, so we can only assume that the court had reason to be particularly dubious of the content of the discussions, particular in light of the “heightened scrutiny” applied to the proposed transaction with an insider.
No Sound Business Justification for the Sale
Even though the court found that the auction process had been flawed, the court noted that most creditor constituencies had supported the proposed sale and that it could still approve the sale if rejection of the pending offer would be “devastating to creditors.” Nonetheless, the court concluded that the debtors had failed to articulate a “sound business justification” for the sale and that the sale, therefore, could not be approved.
Once again, the court explained where the debtors had succeeded before explaining their shortcomings. First, the court recognized that the debtors plainly had to do something – the value of their assets was declining, and they would run out of cash soon. Second, they did not have to choose the highest offer (on its face), but could choose a lower offer with fewer contingencies. Third, the debtors were not “blindly following the desires of a vocal group of special interest creditors.” And fourth, the debtors had wisely negotiated an exit strategy whereby they would be able to wind down their business and confirm a plan of liquidation.
All that being said, the court could not confirm the sale because certain other considerations weighed heavily against the proposed sale. First, no party in interest had shown any relationship between the proposed sale price and the value of the assets being sold (for example, the releases and avoidance actions). Although this point appears to be at odds with the court’s conclusion that the debtors need not itemize their valuation, perhaps the court was troubled with the complete failure to account for the potentially valuable claims that were being given away without any analysis whatsoever, or with the debtors’ ability to truly assess the competing bids when one bid proposed to buy these claims, and the other bid would have left them with the estate. Perhaps this concern would not have been at issue if the bidders had been bidding on the same bundle of assets.
Second, the court determined that the debtors had failed to show the good faith of FCS Acquisition, which was an insider of the debtors. Is that issue relevant, though, outside the context of section 363(m) of the Bankruptcy Code? Even though sale proponents generally need not prove winning bidder’s good faith, the proceedings before the court may have put the court on high alert regarding the insider deal, leaving the court disappointed that no one could demonstrate that the proposed transaction was truly arms’ length. Third, the court found that the proposed sale would essentially circumvent the requirements inherent in confirming a chapter 11 plan, including by providing broad releases of claims against insiders by both the debtors and by third parties, which should be more properly included in a chapter 11 plan.
These conclusions, coupled with the creditors’ committee’s [perhaps conspicuous] absence from the sale hearing and the evidence being put on in support thereof, necessitated a denial of the debtors’ motion to sell their assets to FCS Acquisition.
In its final note, the court recognized that it could not simply approve a sale to GBH or any other bidder, particularly in light of the fact that no notice had been given to parties in interest of any “backup” bids. The court, however, was not without practical guidance. It was “cognizant of the consensus” that had developed in the cases, and “place[d] great significance” on the support from the major stakeholders. The court noted that the debtors “may wish to reopen the auction” to consider bids from FCS Acquisition GBH, and any other bidders, and encouraged the parties to take the court’s conclusions into account and to bear in mind that any settlements must comply with Bankruptcy Rule 9019. The court also expanded the United States Trustee’s role in the auction, directing it to monitor “all aspects of the auction” (emphasis in original) and to file a report regarding the fairness of the auction.
Finally, as an alternative strategy, the court suggested that the debtors may consider filing a plan of reorganization, which could avoid any concerns that certain elements of their proposed sale are inconsistent with the Bankruptcy Code and improper in the context of a sale motion.
Many of the facts that troubled the court in Family Christian are quite common in the context of 363 sales. For example, ex parte discussions are often integral to fruitful auctions, and assessing the value of competing bids is often a matter of comparing apples to oranges. All of the facts of the case, however, compelled the court to reject the winning bid, particularly in the context of the court’s high alert regarding the insider nature of the proposed sale and the debtors’ failure to take certain important facts into account (such as the value of the debtors’ claims against the insiders). But in setting forth the complete narrative, and explaining what the debtors did right, in addition to what they did wrong, the court provided some guidance on a bankruptcy exit strategy that would inure to the benefit of all parties interest, without dictating a particular result and without driving the debtors into deeper financial distress.