Bankruptcy and appellate courts disagree over the standard that should apply to a request for payment of a break-up fee or expense reimbursement to the losing bidder in a sale of the debtor’s assets outside the ordinary course of the debtor’s business. Some apply a “business judgment” standard, while others require that the proposed payments satisfy the more rigorous standard applied to administrative expense claims. The U.S. District Court for the Southern District of Texas addressed this question in In re Bouchard Transp. Co., Inc., 639 B.R. 697 (S.D. Tex. 2022). The court affirmed a bankruptcy court order approving a $3.3 million break-up fee and more than $885,000 in expense reimbursement to a disappointed “stalking-horse” bidder in an auction of the debtors’ assets, finding that the payments satisfied both the business judgment test under section 363(b) of the Bankruptcy Code and the standard for approval of administrative expense claims under section 503(b).
Stalking Horses and Break-Up Fees
Section 363(b)(1) of the Bankruptcy Code authorizes a bankruptcy trustee or chapter 11 debtor-in-possession, “after notice and a hearing,” to use, sell, or lease property of the estate outside the ordinary course of business. Most courts apply a “business judgment” standard to a proposed use, sale, or lease of property under section 363(b)(1) whereby “the bankruptcy court reviews the trustee’s (or debtor-in-possession’s) business judgment to determine independently whether the judgment is a reasonable one.” Collier on Bankruptcy (“Collier”) ¶ 363.02 (16th ed. 2022) (citing and discussing cases).
A sale under section 363(b)(1) is most frequently undertaken by means of a public auction, in which assets are generally sold to the highest bidder, although the bankruptcy court may also approve a private sale entered into between the debtor and a purchaser. Generally speaking, the initial bidder in a public auction held under section 363—the “stalking-horse bidder”—sets the minimum price and other terms of the transaction. Because of the time and effort expended by the stalking-horse bidder in performing due diligence and engaging in the negotiations necessary to arrive at the initial bid, bankruptcy courts generally will allow reasonable bid protections for the stalking-horse bidder in the event the bidder does not prevail at the auction. Those bid protections, which are typically the subject of extensive negotiations, often include reimbursement of expenses incurred by the bidder in connection with the transaction, a break-up fee equal to a specified percentage of the bidder’s purchase price, auction procedures, and certain other rights related to the stalking-horse bid.
Outside of bankruptcy, a seller’s decision to give such protections are typically accorded deference under the “business judgment” rule. In the bankruptcy context, however, several different approaches have been applied by courts in assessing the propriety of bid protections. See generally Collier at ¶ 363.02. Some courts apply a business judgment standard to the issue, which involves the highest degree of deference to the debtor’s decision to commit to the bidding protections under scrutiny. See, e.g., In re Diocese of Buffalo, N.Y., 637 B.R. 701, 704 (Bankr. W.D.N.Y. 2022); In re JW Res., Inc., 536 B.R. 193, 197 (Bankr. E.D. Ky. 2015); In re Genco Shipping & Trading Ltd., 509 B.R. 455, 465 (Bankr. S.D.N.Y. 2014). Other courts apply stricter scrutiny, requiring evidence that proposed bid protections are in the “best interests of the estate.” Collier at ¶ 363.02 (citing cases).
Finally, some courts, and in particular the U.S. Court of Appeals for the Third Circuit, have generally allowed or disallowed bid protections, including break-up fees, according to the standard governing the allowance of administrative expenses under section 503(b). See In re Reliant Energy Channelview LP, 594 F.3d 200 (3d Cir. 2010); Calpine Corp. v. O’Brien Envtl. Energy, Inc. (In re O’Brien Envtl. Energy, Inc.), 181 F.3d 527, 535 (3d Cir. 1999); accord In re Acis Cap. Mgmt., L.P., 604 B.R. 484, 517 (N.D. Tex. 2019); In re President Casinos, Inc., 314 B.R. 786, 788 (Bankr. E.D. Mo. 2004).
This standard for allowed administrative expenses is set forth in section 503(b)(1)(A) of the Bankruptcy Code, which provides in pertinent part that, “[a]fter notice and a hearing, there shall be allowed, administrative expenses, … including—(1)(A) the actual, necessary costs and expenses of preserving the estate.” 11 U.S.C. § 503(b). According to the Third Circuit, for a claim to be entitled to administrative expense status under this provision, it must “arise from a [postpetition] transaction with the debtor-in-possession,” and “be beneficial to the debtor-in-possession in the operation of the business.” O’Brien, 181 F.3d at 532–33; accord In re Philadelphia Newspapers, LLC, 690 F.3d 161, 172–73 (3d Cir. 2012).
In O’Brien, the debtor sought court approval of a stalking-horse agreement prior to a planned auction of its assets. The bankruptcy court refused to approve the break-up fee and expense provisions, expressing concern that allowing such fees and expenses would chill or unnecessarily complicate the bidding process. After the auction, the losing stalking-horse bidder filed an application seeking allowance of more than $4 million in fees and expenses under section 503(b). The bankruptcy court denied the application, and the bidder appealed.
The Third Circuit ultimately affirmed. It concluded that there was no “compelling justification for treating an application for break-up fees under § 503(b) differently from other applications for administrative expenses under the same provision,” meaning that the requesting party must “show that the fees were actually necessary to preserve the value of the estate.” O’Brien, 181 F.3d at 535. The Third Circuit also determined that, although “the business judgment rule should not be applied as such in the bankruptcy context … , the considerations that underlie the debtor’s judgment may be relevant to the Bankruptcy Court’s determination on a request for break-up fees and expenses.” Id.
In Reliant, Kelson Channelview LLC (“Kelson”) submitted the highest bid in a private auction of the debtors’ Texas power plant. Under the agreement with Kelson, the debtors were required to seek an order of the court either authorizing the sale without a public auction or approving bid protections for Kelson, including a $5 million minimum overbid threshold, a $15 million break-up fee, and reimbursement of up to $2 million in expenses.
Before the bankruptcy court could rule on the motion, a competing bidder—Fortistar, LLC (“Fortistar”)—asserted that it was willing to enter a “higher and better” bid, but claimed that the $15 million break-up fee and the $2 million expense reimbursement would deter its competing bid. The court ruled that a public auction was necessary. It also refused to approve the $15 million break-up fee for Kelson, but approved both the $5 million overbid threshold and the expense reimbursement provision.
Fortistar’s winning bid at the auction topped Kelson’s previous bid by $32 million. The bankruptcy court approved the sale and authorized the debtors to pay Kelson approximately $1.2 million in expenses, but no break-up fee. After the district court affirmed on appeal, Kelson appealed to the Third Circuit.
The Third Circuit affirmed. Applying the O’Brien standard, the Third Circuit explained that there are two ways that a break-up fee can preserve the value of an estate: (i) by inducing the stalking-horse bidder to make an initial bid; and (ii) by inducing the bidder to adhere to its bid after the court orders an auction. According to the Third Circuit, the bankruptcy court correctly found that neither element was satisfied in this case. The Third Circuit also concluded that any benefit to the estates was outweighed by the potential harm to the estates that a break-up fee would cause by deterring other bidders.
Finally, the Third Circuit rejected Kelson’s argument that, because no one objected to the break-up fee, the business judgment test was the proper standard to apply. According to the court, in accordance with O’Brien, the section 503(b) standard applies and is not satisfied merely because no objections are interposed.
The U.S. Court of Appeals for the Fifth Circuit adopted a more nuanced approach to the issue in In re ASARCO, L.L.C., 650 F.3d 593 (5th Cir. 2011). In ASARCO, the bankruptcy court granted the debtor’s request to reimburse all qualified bidders for their expenses prior to an auction. The Fifth Circuit was “not persuaded that Reliant and O’Brien [were] apt [when] … a debtor requests the authority to reimburse expense fees ‘for second-round “qualified bidders” in a multiple stage auction for a very unique and very valuable but possibly worthless asset.'” Bouchard, 639 B.R. 697, 710 (quoting ASARCO, 650 F.3d at 602). Instead, because the bankruptcy court in ASARCO approved the expense reimbursement before any potential qualified bidders had incurred any due diligence and work fees, the Fifth Circuit “conclude[d] that the business judgment standard is the better fit for assessing ASARCO’s reimbursement motion.” Id.
Under the ASARCO approach, a request for approval of bid protections prior to an asset sale under section 363(b) should be examined under the business judgment standard, whereas a post-sale request for such protections not previously authorized by the bankruptcy court must be scrutinized under section 503(b).
In September 2020, ocean-going petroleum barge company Bouchard Transportation Company, Inc. and its affiliates (collectively, “BTC”) filed for chapter 11 protection in the Southern District of Texas. BTC decided to sell substantially all of its assets (principally vessels) under section 363(b) of the Bankruptcy Code and sought court approval for a public auction and proposed bidding procedures. The bankruptcy court approved bidding procedures that allowed BTC to offer bid protections to an as-yet unnamed stalking-horse bidder, including a break-up fee not to exceed 3% of the cash purchase price and expense reimbursement in an amount to be agreed upon by BTC and the stalking-horse bidder. The order approving the procedures established deadlines for designation and court approval of a stalking-horse bidder and for the filing of any objections to either the stalking-horse bidder, the bid protections, or the auction process.
Because BTC failed to generate significant interest in its fleet, either as a whole or in part, those deadlines were extended several times with the consent of the unsecured creditors’ committee (the “committee”). Ultimately, BTC’s board considered bids from only two prospective purchasers—Hartree Partners, LP (“Hartree”) and Centerline Logistics Corp. (“Centerline”). Centerline submitted a bid to purchase 31 vessels pledged as collateral to postpetition lender JMB Capital Partners Lending (“JMB”) and 19 additional vessels securing BTC’s prepetition revolving-credit facility. Hartree bid only for the vessels securing the JMB loan.
The board decided not to proceed with the Centerline bid because it was unclear whether Centerline could obtain the necessary financing. Instead, on July 18, 2021, it agreed to sign a stalking-horse sale agreement with Hartree in anticipation of the auction. The agreement provided for a $3.3 million break-up fee equal to 3% of Hartree’s $110 million bid and expense reimbursement up to $1.5 million. The agreement also included a $500,000 overbid threshold. Thus, taking into account the overbid, the break-up fee and reimbursable expenses, the agreement established a floor overbid price of more than $115 million for the covered vessels.
BTC filed a notice of the selection of Hartree as the stalking-horse bidder and the terms of the stalking-horse agreement on July 18, 2021. BTC never obtained court approval of the agreement, and the auction took place the following day. No party objected prior to the auction.
At the auction, the 19 vessels pledged to secure BTC’s prepetition credit facility sold for $130 million. JMB outbid Hartree for the remaining 31 vessels by submitting a bid in the amount of $115.3 million. During the auction, the committee stated that it did not support the bid protections in the stalking-horse agreement. Two days later, the committee filed an objection to Hartree’s designation as the stalking horse and to the bid protections. The committee argued that the bid protection request should be evaluated and denied under section 503(b).
Chief U.S. Bankruptcy Judge David R. Jones approved the asset sale on August 5, 2021, but deferred any ruling on the bid protections. Acknowledging that it was unclear which standard should apply (i.e., section 503(b) or the business judgment rule), the bankruptcy court later ruled that the stalking-horse agreement, including the bid protections, satisfied either standard because the agreement “certainly” conferred a benefit on the estate and BTC’s decision to offer the bid protections to Hartree was “a knowing, intelligent, and thoughtful decision.” The court allowed the break-up fee in full, but reduced the expense reimbursement cap to $1 million.
The committee appealed to the district court.
The District Court’s Ruling
The district court affirmed the ruling below and dismissed the appeal.
Chief U.S. District Court Judge Lee H. Rosenthal noted that courts disagree over the standard applicable to the approval of bid protections in a bankruptcy sale.
Judge Rosenthal distinguished the case before him from O’Brien and Reliant, where, after an auction, the losing stalking-horse bidders sought payment of fees and expenses that the bankruptcy court refused to approve prior to the auction. Instead, he noted, this case was more similar to ASARCO, the leading Fifth Circuit precedent on the issue.
However, Judge Rosenthal wrote, ASARCO, O’Brien, and Reliant all were relevant, “but materially different from the facts of this case.” He explained that, because the bankruptcy court in this case never approved the final stalking-horse agreement before the auction, the court’s rationale in ASARCO suggests that the section 503(b) standard should apply. However, Judge Rosenthal noted, the bankruptcy court did generally authorize BTC to provide bid protections within certain parameters prior to the auction, suggesting that the stalking-horse agreement should be reviewed under the business judgment test applied under section 363(b).
Given the “unusual facts of this case,” the district court, like the bankruptcy court, ultimately declined to decide which standard should apply because it agreed with the bankruptcy court’s determination that both standards were satisfied.
First, Judge Rosenthal explained that, although the bankruptcy court did not make detailed findings regarding the benefit the estate derived from the break-up fee and expense reimbursement, the record supported its conclusion that these bid protections satisfied the test for administrative expense status under section 503(b). Among other things, Judge Rosenthal determined that the stalking-horse agreement, although never approved by the bankruptcy court, “was a valid postpetition transaction” and that Hartree “provided [BTC] with a service—acting as the stalking-horse bidder—and then sought payment for providing that service in the form of the bid protections offered in the stalking-horse agreement.” Bouchard, 639 B.R. at 715. In addition, Judge Rosenthal found that the bid protections were “actual and necessary expenses” given the difficulties encountered by BTC in finding prospective purchasers, the risks associated with a “naked auction” without a stalking-horse bidder, and evidence demonstrating that the bid protections were reasonable and necessary to induce Hartree to bid. Id. at 716-17. Finally, he noted, had there been no bidders at the auction, JMB would have foreclosed on its collateral, which would have led to “a host of other undesirable consequences,” including the estate’s administrative insolvency, conversion of the chapter 11 cases to chapter 7 liquidations, and “costly and uncertain litigation” among the parties. Id. at 718 n.3 (internal quotation marks omitted).
Second, Judge Rosenthal found no error in the bankruptcy court’s conclusion that BTC’s agreement to offer the bid protections satisfied the business judgment test under section 363(b). According to Judge Rosenthal, BTC’s board reasonably concluded that an auction was in the best interests of the estate, attempted to market BTC’s assets, and once those marketing efforts generated little interest, made thoughtful and knowing decisions regarding the auction and the stalking-horse agreement, including the bid protections, after engaging in substantial negotiations. “The record is clear,” the judge wrote, “that the board acted in good faith, that it acted in the best interests of the estates, and that it reasonable believed that a stalking-horse bid was necessary for a successful auction, given the demonstrated low interest in bidding.” Id. at 721.
Bouchard is an unusual case. It does not fit neatly into the framework established by the Fifth Circuit’s precedent in ASARCO that pre-sale proposed bid protections be judged under the business judgement standard, whereas post-sale requests for such protections must be subjected to more exacting scrutiny under the estate-benefit analysis demanded by section 503(b). As a consequence, the bankruptcy and district courts examined the bid protections under both standards, and concluded that both were satisfied.
Given BTC’s failure to seek court approval of the stalking-horse agreement prior to the auction (as it was obligated to do by court order) and the single day between the committee’s receipt of notification that the agreement had been signed and the auction, the committee’s objections were understandable. Because BTC’s secured creditors were undersecured, after the payment of a break-up fee and expenses to Hartree, unsecured creditors would receive little or nothing from BTC’s estate. Even so, the committee was clearly aware that the court had already authorized bidding protection parameters for an as-yet unnamed stalking horse, and the protections granted to Hartree were generally consistent with those parameters.
In the end, the bankruptcy and district courts in Bouchard concluded that BTC and its board of directors made the best of a bad situation in a way that passed muster under either section 503(b) or the business judgment standard.