January 27, 2010
On January 15, 2010, the Third Circuit Court of Appeals issued a decision affecting the approval of break-up fees in connection with Section 363 bankruptcy sales. In In re Reliant Energy Channelview LP, the Court affirmed the decision of the United States Bankruptcy Court for the District of Delaware not to authorize payment of a break-up fee to the initial buyer in a sale of the debtor’s largest asset because, according to the Court, it did not deem the fee necessary to preserve the value of the estate. In re Reliant Energy Channelview LP, No. 09-2074 (3d Cir. Jan. 15, 2010).
Section 363 of the Bankruptcy Code governs asset sales by debtors in bankruptcy outside of a plan of reorganization. Such sales are generally public, in which case assets are awarded to the highest bidder at auction. In certain, limited, circumstances, bankruptcy courts have also approved private sales in which the debtor enters into an agreement to sell assets to a particular buyer, which is then approved by the bankruptcy court.
Break-up fees play a crucial role in facilitating public auctions of significant assets. Debtors often enter into an agreement with an initial bidder prior to commencement of a Chapter 11 bankruptcy case, which then becomes effective upon filing. The initial bidder is a "stalking horse" whose bid generally serves as a catalyst for the auction process. Other potential bidders may rely on the due diligence of the initial bidder in deciding whether to submit an overbid. In addition, the initial bid establishes a floor price for the assets to be sold and, in most cases, a complete agreement that may serve as a template for other bidders.
In Reliant Energy, Reliant Energy Channelview LP and Reliant Energy Services Channelview LLC (the "Debtors") filed for bankruptcy and decided to sell their largest asset, a power plant in Channelview, Texas. The Debtors then implemented an aggressive marketing effort seeking bids for the asset. More than one hundred potential buyers were contacted, thirty-eight potential bidders executed confidentiality agreements, twenty-four conducted due diligence, and twelve submitted bids.
Kelson Channelview LLC ("Kelson") submitted the winning bid of $468 million, not contingent on financing. The Debtors and Kelson then entered into an Asset Purchase Agreement (the "APA"). Since the Debtors were in bankruptcy, the transaction required the approval of the Bankruptcy Court under Section 363 of the Bankruptcy Code. As a result, the APA provided that if the Court determined there should be an auction for the plant prior to its sale, then the Debtors would seek an order approving certain "bid protections" contained in the APA. These bid protections provided that the Debtors could not accept a competing bid unless it was at least $5 million higher than Kelson’s bid. In addition, Kelson would be entitled to a $15 million "break-up fee," plus reimbursement of expenses up to $2 million in the event the Debtors entered into another transaction.
The Bankruptcy Court did in fact order an auction for the plant before the sale. In doing so it approved the $5 million "overbid" requirement and the reimbursement for expenses up to $2 million, but declined to approve the break-up fee. Kelson did not participate in the subsequent auction and the bid that eventually won topped Kelson’s by $32 million (for a total of $500 million). Kelson was awarded about $1.2 million for its first-bid expenses. Kelson nonetheless appealed to the District Court from the order denying the payment of the $15 million break-up fee, and the District Court affirmed, holding the denial was not an abuse of discretion.
On appeal from the District Court, the Third Circuit again declined to order payment of the break-up fee. In doing so, the Court relied on the Third Circuit’s prior decision in Calpine Corp. v. O’Brien Environmental Energy, Inc., which established what is now the most widely used standard for the approval of break-up fees in the bankruptcy context. Under O’Brien, a court may only approve a break-up fee if it is "necessary to preserve the value of the debtors’ estate." The Reliant Energy opinion stated that there were two ways a break-up fee could preserve the value of an estate: (1) by inducing the first bidder to make an initial bid; or (2) by inducing the first bidder to adhere to its bid after the court orders an auction.
The Court found that Kelson’s break-up fee was not necessary to preserve the value of the Debtors’ estate because, first, the fee did not "induce" Kelson’s bid. This was clear, it stated, because Kelson did not expressly condition its bid on approval or receipt of the break-up fee, only on the Debtors’ promise to seek approval to pay the fee. According to the Court, this undermined Kelson’s argument that the fee was needed to induce its bid. Second, it held that the break-up fee was not needed to preserve Kelson’s bid once an auction was ordered because there was no reason to believe it would abandon a fully negotiated agreement, and, in any event, there was another ready bidder.
The decision in Reliant Energy highlights the importance the Delaware bankruptcy courts place on public auctions in conducting 363 sales and also suggests that bankruptcy courts will continue to closely scrutinize the necessity of break-up fees in Section 363 sales before approving them. Despite the aggressive marketing of the asset, the court refused to approve the sale without requiring the Debtors to conduct an auction. In addition, the Third Circuit held that the break-up fee must preserve the value of the debtor’s estate either by inducing or preserving the initial bid. The provisions at issue in the APA in Reliant Energy merely required the Debtors to "seek the entry of an order approving" the break-up fee, out-of-pocket reimbursement and minimum overbid requirement. The Third Circuit interpreted this language as not requiring the actual approval and receipt of the break-up fee as a condition of consummating the agreement. As a result, it found that the break-up fee did not induce Kelson’s bid (since it was, on the face of its agreement, willing to enter into the agreement without assurance of the fee), and the benefit of preserving Kelson’s bid was outweighed by the possibility of deterring other bidders that had already expressed interest.
In light of the Third Circuit’s reasoning in Reliant Energy, buyers in Section 363 sales should anticipate that courts will require public auction in connection with bankruptcy sales and, if the buyers are relying on a break-up fee, they should make sure appropriate break-up fee conditions are in the agreements governing any proposed 363 transactions. Such provisions should be carefully drafted to make clear that failure of the debtor to actually obtain approval of the fee is an event of termination releasing the buyer from all obligations. Recitals in an APA should also reflect that the break-up fee induced the initial bidder to make its bid and is necessary to preserve that bid in the event of an auction.
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