Bankruptcy cases are as different as the types of businesses that fail, but all share an element of crisis. The weeks and days that precede a bankruptcy filing are often chaotic. The first days after filing may be even worse, regardless of the size of the case. Any potential rescuer, be it a lender, a supplier, or a buyer, has tremendous leverage. The potential salvor has the power to, and often does, exact concessions in many forms: preferential treatment of prepetition debt, retroactive perfection of liens, onerous loan terms, control of the debtor after bankruptcy, or ownership of any upside in the debtor’s business.
A key intuition embedded within the Bankruptcy Code is that this moment of crisis is a bad time to make reasoned decisions about a company’s future. For this reason, the Bankruptcy Code seeks to give a debtor breathing space to arrange its affairs. It envisions a process premised on negotiation and deliberation among claimants about how to maximize and allocate the debtor’s value.
This tension between situational leverage and the Bankruptcy Code’s governance scheme is nothing new. In traditional reorganizations, incumbent lenders have exercised leverage by dictating the terms upon which they will continue to finance the debtor in bankruptcy. In return for a cash infusion (referred to as “Debtor-in-possession financing,” or a “DIP Loan”), an incumbent lender might seek to solidify its control over the debtor by locking up all of the debtor’s cash and assets. Practitioners call these loans “defensive DIPs.” The terms of such loans are often extraordinary in the extent to which they allocate all of the debtor’s value to the post-petition lender.
More recently, the lenders have teamed up with buyers of companies, and the “hurry-up sale” under section 363 of the Bankruptcy Code has emerged as a preferred way to exercise crisis-induced leverage. Enter the “melting ice cube” argument.
As the Second Circuit noted in the Chrysler bankruptcy case, the value of financially-distressed companies can melt away quickly. According to the court, the finding that Chrysler was losing $100,000,000 per day justified a hurry-up going-concern sale without the procedural protections anticipated by the drafters of the Bankruptcy Code. Although sales premised on melting ice cube arguments can preserve value, they may also serve to lock-in a proposed sale package, and to raise the cost of investigating alternatives. The concern about quick sales in cases like Chrysler thus raises a policy question relevant to Chapter 11 generally: is the speed and flexibility now afforded major sales a “bug” or a “feature?” Do these 363 sales maximize value for the bankruptcy estate? Or do they facilitate collusive deals between incumbent managers, senior creditors and potential purchasers?
The answer is, “a little bit of both.” Sometimes a hurry-up sale is necessary. But other times crisis-created leverage merely locks in a favored deal that exploits information asymmetries and opportunistically appropriates value. A rush to sale without process increases the risk of erroneous undervaluation. Crisis-driven leverage may be used as a tool to distort the Bankruptcy Code’s distributional scheme.
In Ice Cube Bonds: Allocating the Price of Process in Chapter 11 Bankruptcy, 123 Yale L.J. ___ (forthcoming, 2014), we propose that, in a “going concern” sale under section 363, the court should routinely withhold a portion of sale proceeds from claimants who would otherwise receive a distribution. To recover those funds, a beneficiary would need to establish that the quick sale did not harm the bankruptcy estate, and that the claimant would be entitled to the reserved funds under the otherwise applicable bankruptcy priority rules or post-sale negotiations. Our goal is to retain quick section 363 sales as a useful way to preserve value in moments of true crisis, while preserving opportunities for judicial and stakeholder deliberation to (1) ensure that value is maximized, and (2) properly allocated.
Outside of bankruptcy, it is standard practice for courts to require an injunction bond to help preserve issues for later litigation. Indeed, Federal Rule of Civil Procedure 65(c) requires such a bond for any preliminary relief. Injunction bonds are neither required nor prohibited by Federal Rule of Bankruptcy Procedure 7065, which extends Federal Rule 65 to adversary proceedings in bankruptcy. Although that rule does not apply to 363 sales, such a bond would be authorized, in our view, under a number of provisions of the Bankruptcy Code. This would be a relatively uncontroversial use of section 105, which gives courts presiding over bankruptcy cases the power to take actions necessary or appropriate to carry out the provisions of title 11 of the United States Code. Section 506(c) gives the court the power to require a secured creditor to pay the expenses of liquidating its collateral. Section 363 authorizes the court to impose conditions on sales. Indeed, where disputes have arisen about priority or entitlement, courts have created disputed claims reserves or holdbacks to preserve the disputes for later resolution.
If courts have the power to require Ice Cube Bonds today, why don’t they? In our view, courts generally do not raise concerns about harm to the estate sua sponte, and assertions of crisis deter parties from asking them to do so. We would therefore reverse the burden on the theory that a quick all-asset sale under section 363 should be understood as a procedurally irregular disposition of the estate. Chapter 11 contemplates going-concern sales, but pursuant to a confirmed plan with its associated procedural protections, or pursuant to a prepackaged plan with votes already solicited in a manner that complies with applicable securities laws, not in the first days of the case without disclosure or voting.
Under state foreclosure law, the “rebuttable presumption” rule applies to procedurally irregular sales of personal property. When a lender disposes of collateral in a manner that does not comply with Article 9 of the Uniform Commercial Code, the lender loses its claim to a deficiency judgment unless it can show that the irregularity did not depress the sale price. The Ice Cube Bond essentially mirrors this approach for all-asset sales under section 363. A portion of the quick-sale price could be reserved as presumptively unencumbered funds, to preserve issues of valuation and allocation for later determination.
The Ice Cube Bond limits the extent to which sale beneficiaries can externalize the increased risk associated with quick all-asset sales. It also limits the extent to which negotiations about distribution must be completed before the sale can occur. Our approach reinforces the separation between governance decisions about value maximization from those about value distribution. It also preserves the finality of the sale, as the purchaser gets clear title to the assets.
In sum, the Ice Cube Bond gives courts a procedural tool to sort between hurry-up sales that are necessary, and those that are opportunistic. While some details about the Ice Cube Bond, such as the percentage holdback, might be established by local rules of procedure, some may worry about onerous ex post judicial fact finding to determine when and how to release the funds. In practice, we predict that post-sale negotiations will dispense with many of these issues. Moreover, it should be noted, the cost of the Ice Cube Bond can be avoided entirely: the debtor (and its lenders behind the scenes) simply must conduct the sale pursuant to a plan, prepackaged or otherwise. In a world where Ice Cube Bonds are routine, hurry up sales would, therefore, be used only in cases in which the value of speed exceeds the anticipated harm to the estate or other claimants.
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