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The ‘Stalking Horse’ in a US Chapter 11 363 Sale

From Financier Worldwide’s May 2006 Edition

The terms ’363 sale’ and ‘stalking horse’ bidder are woven into the standard vernacular of US reorganisation and insolvency professionals. In recent years, 363 sales have become routine in many Chapter 11 cases. It’s now nearly standard operating procedure for professionals involved in the disposition of a debtor’s assets under Section 363 of the United States Bankruptcy Code (the Code) to plan for a stalking horse bidder as a means of establishing a valuation floor.

The Code states nothing about the role of the stalking horse bidder or of the procedures under which this role is administered. Nonetheless, a substantial number of Chapter 11 cases in recent years have been essentially concluded with a sale of the entire business or a major portion of discrete operating assets under Section 363 of the Code, with most such cases involving a stalking horse bidder.

Outside of the Code, stalking horse compensation and bidding procedure protocols have been developed by reorganisation and insolvency professionals, recognising its leading position. These protocols give the stalking horse bidder several advantages above other potential buyers of the debtor’s business. In most cases, the stalking horse enjoys considerably more time for due diligence than other potential bidders and negotiates an asset purchase agreement which other potential bidders must either accept prima facie or make a higher and better offer than that proposed and negotiated by the debtor and stalking horse.

Other stalking horse benefits incorporated in orders approving 363 bidding procedures include expense reimbursement, bidding procedure influence leading to a favorable advantage and stipulations in the bidding procedures that call for: (i) the stalking horse to receive a breakup fee if another bidder offers more, (ii) competing overbids higher by at least a specified minimum amount, and (iii) short time periods for other bidders to conduct due diligence and value the business. With these tactical advantages, it’s not surprising that, in most 363 sales, the stalking horse bidder is ultimately the successful bidder.

Stalking horse bidders can play a valuable role in certain 363 sales, but such a preeminent status is not always necessary. In many cases, having a stalking horse actually diminishes the received value. The debate on whether the stalking horse adds value or, as many insolvency professionals suggest, the stalking horse process will most likely chill the bidding, making the established floor the ceiling.

A stalking horse is not always needed

The debtor’s management combined with retained insolvency professionals should examine the particular circumstances of each situation and determine if a stalking horse bidder is necessary. For example, if the debtor has assets, customers or other valuable business attributes which will likely attract potential buyers, a stalking horse bidder is most likely not necessary to assure that the 363 auction process reaps the assets’ market value.

In a recent case (Desa Holdings Corporation, Case No, 02-11672 (WS)), the decision was made, after much debate with the secured lenders, to ‘go naked’ into the 363 sales process after the potential stalking horse bidder, backed by management, would not negotiate its demands for the amount of the breakup fee, expense reimbursement, minimum overbid and bidding procedures. The debtor’s business was expected to be valuable to several parties, and, hence, the auction was expected to attract strong interest and a competitive bidding process. After three days of bidding and negotiation with several parties, the business was sold for 25 percent more than the offer from the potential stalking horse. Additionally, the parties saved several million in breakup fees and expense reimbursement by not having a stalking horse.

In another recent case {The Glass Group, Inc, Case No. 05-10532 (RJW)} in which the author was involved as the debtor’s Restructuring Advisor, two different offshore strategic buyers purchased approximately half of the debtor’s business each in a competitive auction process. In one instance, the successful bidder arrived in court on the confirmation hearing date and outbid the front runner by 30 percent.

Both cases give credence to the economic reality that if there’s recognisable value in the debtor’s business, that value will be recognized in a competitive auction process whether there is a stalking horse involved or not.

Advantages and disadvantages of a stalking horse

The principal advantage to having a stalking horse bidder is the comfort provided, particularly to a secured lender, of a price floor. This assumes that the stalking horse will close the transaction. To guard against the stalking horse bidder not closing the transaction, a sizable deposit should be received which is only refundable if: (i) the stalking horse is outbid, and (ii) the stalking horse does not bid after its stalking horse bid is exceeded by another bidder.

On the other hand, it appears that the tactical leverage, provided the stalking horse has, in many cases, dissuades other qualified bidders who might have bid more from even entering the fray. There have been cases where other potential bidders choose not to participate rather than spend more time and effort trying to overcome the bidding advantages offered to the stalking horse.

For example, in a recent case {PSA Quality Systems, Case No. 04-13030(MFW)}, the bidding procedure and tight timeframe favouring the stalking horse dissuaded several potential buyers expressing an interest in the debtor’s assets from even attending the auction.

Stalking horse considerations

It’s important to consider whether: (i) the 363 sale is intended to merely confirm a sale to the logical buyer of the company’s assets or the potential successful bidder per a pre-filing auction process, or (ii) the 363 process is intended to result in a spirited auction of the debtor’s business.

In some cases, stalking horse identification and selection is the end result of a disciplined auction process seeking the highest value for a debtor’s assets. In such cases, the pre-filing process usually determines the debtor’s business unviable on a stand-alone basis. In this circumstance, the company must be sold to a strategic competitor with the strength to maximize the value of the debtor’s assets; the debtor’s business, which requires significant equity capital and perhaps new management to reorganise, can only be provided by a deep-pocket strategic or financial buyer. After the auction process, the 363 sale gives the buyer the legal protections provided by the Code and allows for an orderly distribution of funds to secured and unsecured creditors in accordance with the priorities set forth in the Code. In essence, the stalking horse is the successful bidder as a result of a fair and efficient auction process, and the 363 sale confirms that fact while still leaving the door open for a higher and better offer.

In other cases, the timeframe for marketing the business in the usual manner is not sufficient and the 363 auction process is expected to result in the highest and best offer.

Summary

The debtor’s management and the reorganisation and insolvency professional must determine whether or not a stalking horse is necessary. Sometimes the 363 sale is largely initiated to confirm the sale to a stalking horse, identified after a rational and comprehensive auction process. But if the debtor’s assets have value to several potential buyers, a stalking horse process will likely chill the bidding, making the established floor become the ceiling.

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