As we enter year two of the COVID-19 pandemic, the number of new Chapter 11 cases being commenced has slowed to a trickle. But the cycle will turn again. There are always companies that lose a major customer, fail to adapt to new technology, or suffer from poor management. Debt burden is another major issue. And when interest rates go up, which they will, excess leverage will be exposed.
There are always opportunities for bargains in real estate, especially where distressed businesses on the brink of bankruptcy and companies already in Chapter 11 proceedings seek to unload assets. This is because the psychology of a transaction in bankruptcy or in a distressed situation is much different than that in a transaction where the seller is not under major pressure to monetize an asset.
The key to acquiring bargains in these situations is to understand the process and dynamics of a bankruptcy sale. It is true that buyers can purchase real estate assets at bargain prices from bankrupt companies, but they must be prepared to act quickly when opportunity knocks. And to do that, buyers must understand how assets are sold in bankruptcy. The ready buyer also must have (or have immediate access to) a nimble team of environmental consultants, appraisers, engineers, property managers, and funding sources who are able to assist on an expedited basis.
Where can opportunities be found? To begin, buyers should monitor newsletters that report on distressed companies that are in a workout mode, have executed forbearance agreements with their lenders or bondholders, face approaching debt maturities, or have commenced bankruptcy proceedings. These newsletters also report on the professional advisors retained by key constituencies. One particularly valuable advisor to look for is the debtor’s chief restructuring officer in charge of the reorganization and restructuring–who determines what assets should be liquidated. Industry periodicals also track overleveraged companies with excess and underutilized real estate.
In Chapter 11 cases, the debtor’s Schedules of Assets publicly disclose all of the debtor’s assets. A review of a debtor’s Schedules of Assets will help identify available real property. Buyers should not hesitate to repeatedly express–to everyone with a financial stake in the debtor–that they are interested in acquiring real properties that may not be part of the debtor’s go-forward strategic plan. The smart buyer brands itself as a solutions provider- i.e., someone who is there as a purchaser when a debtor desperately needs to unload real estate to raise cash–albeit at very distressed prices.
The psychology of a distressed situation is that the company is often willing to sacrifice price if by doing so it gains enough runway (working capital and also cash) to buy time with creditors to turn its business around and avoid bankruptcy. Whatever discount a company may give in sale price will be less than the devaluation of its business in bankruptcy. In addition, secured creditors that are concerned about a failing borrower want to exit or to have their loan paid down promptly before a possible bankruptcy, even if it means seeing collateral sold at heavily discounted prices that may be costly to shareholders or other parties below them in the capital stack. They care less about sale price than they do about being paid down. A buyer that can move expeditiously will be very attractive to the distressed company and its lenders.
In an out-of-court situation, typically only the distressed company and the buyer are at the bargaining table. A distressed company typically needs liquidity (a) for working capital in order to gain time to turn around its fortunes, or (b) to forestall its institutional lenders from taking aggressive action. The secured lenders or bondholders may be pressuring the company to pay down debt or for an interest payment. If the company is subject to a forbearance agreement, the company is under immense pressure to raise cash before the expiration date.
Conversely, the psychology of a business bankruptcy is that the debtor is willing to sacrifice price on nonessential assets (assets not necessary to an effective reorganization) if by doing so it promptly obtains enough cash to propose and to confirm a plan of reorganization. In bankruptcy situations, a potential purchaser may be engaged in multilateral, rather than bilateral, negotiations. Several parties may seek to participate in the sale process–the debtor, the secured creditor, and a creditors’ committee. Each has a different goal. The secured creditor may be most interested in a loan payment and care less about sale price. The creditors’ committee may be seeking to carve out a portion of the sale proceeds for unsecured creditors, and sale price may be less important to it than the amount carved out for its constituents. The key to success is understanding the needs of each party in interest, what their leverage is, and how they can help you as buyer.
You are a buyer with cash (or can sign a contract without a financing contingency or for whom the consensus is that a financing will not be an issue) to purchase real estate from a bankrupt debtor and can close quickly with few contingencies. Speed and the absence of contingencies justifies a deep discount off fair market value. The devaluation of the debtor’s business in bankruptcy–or the delay in emerging from bankruptcy–is far worse than the sale discount on the property to be sold. If the debtor does not see things that way, walk away. If the property to be acquired requires post-closing approvals, you must build this into the price and be further compensated by way of additional discount for the risk assumed.
In Chapter 11 cases, assets are generally sold at auction in a two-step process, often called a Section 363 sale (referring to the Bankruptcy Code section that governs such sales). A Section 363 sale is typically a fast, cost-effective way for a buyer to acquire, and a debtor to complete a sale of, assets. From start to finish, the whole process can take as little as 30 days.
In a Section 363 sale, the proponent of the sale (usually the debtor) must establish that the proposed sale is in the best interest of the debtor’s bankruptcy estate and that it has taken reasonable steps to maximize the sale price by exposing the property to the marketplace. The goal of this marketing process is to find a buyer willing to enter into a “stalking horse” asset purchase agreement for the sale of the real property. Such an agreement will be subject to higher and better offers as well as bankruptcy court approval.
The stalking horse agreement establishes a floor for both the purchase price and the terms of subsequent bidding. At the commencement of negotiations, the stalking horse bidder should negotiate a limited period of exclusive dealing as it attempts to arrive at a purchase agreement with the debtor. The stalking horse bidder can then leverage its position as first bidder to negotiate favorable terms for the overbid procedures.
The stalking horse bidder typically will demand compensation for its time, effort, and expense in analyzing the property, conducting due diligence, and negotiating an asset purchase agreement if it ultimately does not purchase the property. The most common form of fee paid to a stalking horse bidder is a breakup fee, which is paid to the stalking horse if it is not the winning bidder. Break-up fees typically are no more than 3 percent of the purchase price. Most bankruptcy courts will allow reasonable breakup fees and expense reimbursement because failing to do so could lead to no bid at all, thus harming the debtor’s estate.
A strategic consideration for the stalking horse bidder is whether to proceed with the transaction if all the requested protections are not approved by the bankruptcy court. If you have reason to believe that it would be difficult for the debtor to obtain an initial bid from another party, the stalking horse should consider walking away–at least as a test to see what further concessions will be made as an inducement to return.
The stalking horse should negotiate with the debtor on as much as possible of the following:
- Requiring competing bidders to match the stalking horse bid’s non-price terms.
- Agreement upon the criteria for determining whether a competing bid is qualified to participate in the auction
- The overbid deadline
- The terms under which the secured creditor may be allowed to credit bid
- Whether bidding will be open or silent
- Whether competing bids are shared with the stalking horse bidder and when
- A “no-shop” provision during which the debtor agrees not to solicit, initiate, or encourage other offers from potential bidders, which should be the time period between execution of the stalking horse agreement and the bankruptcy court’s approval of the sale procedures
- Limiting the amount of time prospective bidders have to negotiate with the debtor and to conduct due diligence
- Provisions dealing with the treatment of late bids
- A right of first refusal for the stalking horse bidder (i.e., the right to match any overbid and be deemed the highest bid)
- Requiring that any breakup fee and expense reimbursement be paid to the stalking horse bidder at the closing and directly out of the sales proceeds, if the stalking horse bidder is ultimately not the winning bidder
- The amount of bid deposit and proof of financial wherewithal by competing bidders
- A deadline by which there must be a closing after which there is a daily reduction of the purchase price
- A target closing date and an increase in the purchase price for each day that the closing occurs earlier than the target closing date
The stalking horse bidder also should consider acquiring secured debt on the property at less than par given that it could then credit bid (bid the amount of its secured debt rather than cash), which will give it a distinct advantage over other bidders that bid with 100-cent dollars. A secured party has the right to credit bid in a Section 363 sale, and cases denying secured creditors the right to credit bid in a Section 363 sale are rare.
Another consideration occurs where the proposed purchase price of the property is less than the secured debt encumbering the property. In that instance, an agreement by the secured lender not to credit bid in excess of the purchase price is essential. Otherwise, the secured creditor may strategically use its right to credit bid to ratchet up the purchase price the stalking horse bidder will need to meet or exceed at the auction. If the secured creditor will not agree to limit or cap its credit bid rights, then the potential stalking horse buyer should terminate the transaction.
Once the stalking horse bidder and the debtor reach an agreement on sale terms, breakup fee, and bidding procedures, the debtor will enter into the conditional asset purchase agreement with the stalking horse bidder and seek bankruptcy court approval of the sale. Approval is usually sought in a two-step process, which is laid out in detail in a motion requesting approval of the bidding procedures and any breakup fee for the stalking horse, and approval of the sale to the winning bidder. It is at this point that the bidding procedures and the auction date are finalized.
Competing bidders typically perform their due diligence review after the bidding procedures motion is granted and before the auction or deadline for overbids. To bid, a prospective bidder typically submits a marked-up version of the asset purchase agreement signed by the stalking horse bidder.
At the auction, it is tempting to bid starting with the first round. However, if there are more than two bidders in attendance, silence may be the best initial strategy. There is little to gain by raising the energy in the room or by increasing the speed at which the highest price is reached. Be patient; see when other bidders drop out before entering the action.
When bidding at an auction, the amount of competition matters. If there is unexpected competition at an auction, it may be appropriate to come in with a really aggressive bid to show confidence, catch other bidders off guard, cause them to scramble for authority to increase their bids, and send an immediate shockwave. On the other hand, if you can see there is only one other registered bidder, then play your cards a little bit closer to the vest.
Ultimately, a winning bid will be selected and the bankruptcy court will be required to review and approve the sale. Thereafter, Section 363(m) of the Bankruptcy Code protects the purchaser of property sold at a Section 363 sale from the effects of a reversal on appeal of the bankruptcy court’s order approving the sale, as long as the purchaser acted in good faith. Practically speaking, if the bankruptcy court approves the sale, a buyer can rest comfortably knowing that it is the proud new owner of prime real estate.
In closing, distressed companies and bankrupt debtors present excellent opportunities for real estate bargains. A prudent buyer just needs to know where to look and be prepared when opportunity knocks.
Kenneth A. Rosen is a partner in the bankruptcy and restructuring group at Lowenstein Sandler. He has more than 35 years of experience advising on the full spectrum of restructuring solutions, including Chapter 11 reorganizations, out-of-court workouts, and financial restructurings. Mary E. Seymour has a broad range of experience representing corporate debtors, official and unofficial creditors' committees, significant stakeholders, and third-party purchasers. John P. Schneider is experienced in securities class actions and complex commercial litigation and has served as counsel to bankruptcy trustees, debtors, and creditors’ committees.