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A Promising Crack in Third Circuit Precedent for Section 363 Auctions

June 1, 2009

New Jersey Law Journal, Volume 196, No. 9

It may be a bit premature to herald a complete sea change for the local bankruptcy practice from a single bankruptcy court ruling in the District of New Jersey. But for those bankruptcy practitioners who feel constrained -- in developing new bankruptcy business in New Jersey because of the Third Circuit's 1999 O'Brien Environmental precedent, any break in that erstwhile impenetrable wall would appear welcome. Simply stated, the O'Brien Environmental decision is perceived by many as a barrier -- real or imagined -- to obtaining appropriate business-like relief in New Jersey bankruptcy courts, relief which is typically and routinely available in mergers and acquisitions that occur outside of bankruptcy. Specifically, the lower courts that follow O'Brien Environmental interpret the decision as precluding the initial bidder at an auction -- the "stalking horse" -- from obtaining prior court approval of break-up fees and reimbursement expenses, deferring that protection to an evidentiary hearing after a Section 363 auction concludes. This is contrary to the practice favored in the mergers and acquisitions market outside of bankruptcy and in other bankruptcy courts, most notably in the Second Circuit, where a stalking horse bidder knows at the outset of the process that reimbursement protection exists for having incurred costs in getting the auction process started.

On January 16, Bankruptcy Judge Donald H. Steckroth approved bidding procedures for a stalking horse bid for a Section 363 sale in the Chapter 11 bankruptcy of Tarragon Corporation. That ruling alone is unremarkable. In fact, it is routine these days in bankruptcy courts nationwide. What is remarkable, at least for a bankruptcy court in the Third Circuit, is the approval of a bidding procedure order that contained both a break-up fee and a reimbursement of expenses, including reasonable counsel fees, at the outset of the auction process. The Court in Tarragon recognized that nothing in the O'Brien Environmental decision expressly mandates that a bankruptcy court must conduct a post-auction hearing to determine the benefit to the estate from having granted stalking horse protections. Rather, Judge Steckroth in Tarragon focused on the establishment of benefit to the estate as a matter of evidentiary proof, regardless when the proffer of proof or evidentiary hearing occurs. The judge concluded that a proper evidentiary showing, under the factual circumstances of any given case, might warrant a pre-emptive finding of benefit for the estate, irrespective of the outcome of a subsequent auction. That the benefit may be established prior to an auction to warrant pre-approval of a break-up fee is the significance of this case in New Jersey. With this recent decision, at least one New Jersey bankruptcy judge appears willing to revisit the bidding procedures practice under O'Brien Environmental, and to be flexible in applying the requirements if the evidence warrants a departure from existing practice. If, as an added benefit, the recent decision alleviates unfounded concerns about the treatment afforded business bankruptcies being filed in New Jersey, all the better.

The Facts of Tarragon

Tarragon Corporation filed a Chapter 11 bankruptcy petition on January 12. The case was assigned to the Honorable Donald H. Steckroth. On January 13, Tarragon filed a Section 363 sale motion for its subsidiary to sell 71 condominium units in bulk from a 140-unit midrise condominium apartment development in Palisades Park. The motion essentially had two parts: (i) the first sought a preliminary hearing on shortened notice to approve certain bidding procedures, including naming MWHF Palisades Park, LLC, an affiliate of Phoenix Realty Group, a New York-based real estate investment firm, as a stalking horse bidder, and granting approval of a break-up fee and reimbursement of expenses; and (ii) the second part scheduled a final hearing to approve the highest and best offer at auction.

At the preliminary hearing to approve the bidding procedures, evidentiary proof in the form of a sworn affidavit established that the stalking horse, MWHF Palisades Park, LLC, had enabled Tarragon to negotiate with its lender prior to the filing of the bankruptcy a discounted payoff amount for the lender's secured loan, provided the sale closed by February 27. The discount was significant. This condition was expressly incorporated into MWHF Palisades Park, LLC's Asset Purchase Agreement, which was to be approved as the stalking horse bid and expressly required competing bidders also close by February 27, to preserve the negotiated discount.

The Legal Analysis Under O'Brien Environmental

Approval of expense reimbursements and other forms of bidding protections in connection with the sale of estate assets pursuant to Section 363 of the Bankruptcy Code is frequently granted. Bankruptcy courts regularly authorize bidding incentives under the "business judgment rule" which, essentially, prohibits judicial second-guessing of the actions of a corporation's board of directors taken in good faith and in the exercise of sound business judgment. See, e.g.,In re 995 Fifth Avenue Associates, L.P., 96 B.R. 24, 28 (Bankr. S.D.N.Y. 1989) (bidding incentives may be "legitimately necessary to convince a white knight to enter the bidding by providing some form of compensation for the risk it is undertaking") (citations omitted); In re Integrated Resources, Inc., 135 B.R. 746 (Bankr. S.D.N.Y.), aff'd, 147 B.R. 650 (S.D.N.Y. 1992).

The United States Court of Appeals for the Third Circuit established standards for determining the appropriateness of bidding incentives in the bankruptcy context in Calpine Corporation v. O'Brien Environmental Energy, Inc., 181 F.3d 527 (3d Cir. 1999). In O'Brien Environmental, the Third Circuit held that although bidding incentives are measured against a business judgment standard in nonbankruptcy transactions, the administrative expense provisions in Sections 503(b) of the Bankruptcy Code govern in the bankruptcy context. Therefore, to be approved, a debtor must demonstrate that the bidding incentives provide a benefit to its estate. O'Brien Environmental identified at least two scenarios where bidding incentives may provide a benefit to the estate and thus should be authorized.

First, a benefit may be established if "assurance of a break-up fee promoted more competitive bidding, such as by inducing a bid that otherwise would not have been made and without which bidding would have been limited." Second, where the availability of bidding incentives attract a bidder to analyze the value of the assets and to submit a bid that provides a minimum or floor bid on which other bidders can rely, the "bidder may have provided a benefit to the estate by increasing the likelihood that the price at which the debtor is sold will reflect its true worth."

Two points in the O'Brien Environmental decision were emphasized during the preliminary hearing in Tarragon to approve the bidding procedures order. First, the two benefits identified above -- both connected to the bidding process itself -- are not exhaustive of the examples of potential "benefit" to the estate. Thus, a bankruptcy court in analyzing potential benefit can look outside the auction process, if the evidentiary proofs support a finding of benefit elsewhere. Judge Steckroth recognized limited benefit, irrespective of the auction process, and gave the stalking horse bidder two options: (i) pre-approval by the Court of a portion of the breakup fee, based upon the limited evidentiary showing of benefit; or (ii) be given the opportunity for the full break-up fee, depending upon the evidentiary proof after the auction process concluded. MWHF Palisades Park, LLC, opted for the pre-approval of a limited break-up fee, but both options are perfectly consistent with the O'Brien Environmental decision.

Second, the Third Circuit in O'Brien Environmental expressly considered "... whether the record evidence supports the Bankruptcy Court's implicit conclusion that awarding [Calpine] break-up fees was not necessary to preserve the value of O'Brien's estate." Again, nothing in that decision requires an evidentiary hearing "after the fact." It was argued in Tarragon that bankruptcy courts routinely grant administrative status to certain creditors, without knowing in fact a benefit will follow. Examples of that kind of pre-approved protection include authorization for debtor-in-possession financing under Section 364 of the code and the assumption of an executory contract or unexpired lease, under Section 365, a default in which later creates an administrative claim usually with a detriment to the estate.

Tarragon likely will be best known for a creative approach by competent bankruptcy counsel and an open-minded jurist to fit the particular facts of a given case squarely within the parameters of a 10-year-old Third Circuit precedent. But seasoned bankruptcy practitioners really know, it's the beginning of a sea change.

Robert E. Nies is a member of the Bankruptcy Law Group at Wolff & Samson in West Orange. The author represented the stalking horse bidder, MWHF Palisades Park LLC, an affiliate of Phoenix Realty Group, a New York-based real estate investment firm, in the Tarragon Corporation bankruptcy which successfully acquired the subject-matter assets on February 27. For more information, please contact: Robert E. Nies at 973-530-2012 or via email at rnies@wolffsamson.com.

Reprinted with permission from the June 1, 2009 edition of the New Jersey Law Journal.@2009 Incisive Media US Properties, LLC. All rights reserved. Further duplication without permission is prohibited.