Fifth Circuit: Bid Protections for Stalking Horse in Bankruptcy Asset Sale Satisfied Both Business Judgment and Administrative Expense Standards | Jones Day

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 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. Court of Appeals for the Fifth Circuit addressed this question in Matter of Bouchard Transportation Co., Inc., 74 F.4th 743 (5th Cir. 2023). The Fifth Circuit court affirmed lower court orders approving a $3.3 million breakup 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[4] (16th ed. 2023) (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. 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 bidder in the event the stalking-horse 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 is typically accorded deference under the “business judgment” rule if the protections are challenged in court. 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[7]. Some courts apply a business judgment standard, which involves the highest degree of deference to the debtor’s decision to commit to the bid 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[7] (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 standards 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). 

Section 503(b) of the Bankruptcy Code 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 reimbursement 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 winning 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 condition 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 breakup fee would cause by deterring other bidders.

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 should apply 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.” Id. 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). 

Bouchard 

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 minimum overbid threshold. Thus, taking into account the minimum overbid, the break-up fee, and reimbursable expenses, the agreement established a floor price of approximately $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). 

The bankruptcy court 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 363(b) or section 503(b)), 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, which affirmed the ruling below and dismissed the appeal. 

Like the bankruptcy court, the district court declined to decide whether section 363(b) or section 503(b) applied, but that the payments passed muster under either standard. 

The district court distinguished the case before it 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, it noted, this case was more similar to ASARCO, the leading Fifth Circuit precedent on the issue. 

The district court wrote that ASARCO, O’Brien, and Reliant were relevant, “but materially different from the facts of this case.” In re Bouchard Transp. Co., Inc., 639 B.R. 697, 710 (S.D. Tex. 2022), aff’d, 74 F.4th 743 (5th Cir. 2023). It 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, the district court 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. 

The district court 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, the stalking-horse agreement, although never approved by the bankruptcy court, “was a valid postpetition transaction,” and 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.” Id. at 714-15. 

In addition, the district court 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,” and evidence demonstrating that the bid protections were reasonable and necessary to induce Hartree to bid. Id. at 716–17. Finally, it 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).  

The district court also 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 the district court, 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 court wrote, “that the board acted in good faith, that it acted in the best interests of the estates, and that it reasonably believed that a stalking-horse bid was necessary for a successful auction, given the demonstrated low interest in bidding.” Id. at 721. 

The committee appealed the district court’s ruling to the Fifth Circuit, which took the opportunity to revisit the standard for approving bid protections in connection with bankruptcy assets sales.

The Fifth Circuit’s Ruling 

A three-judge panel of the Fifth Circuit affirmed. 

Writing for the panel, U.S. Circuit Judge Jerry E. Smith acknowledged the disagreement among courts concerning the standard for approving bid protections. Like the district court, Judge Smith concluded that “ASARCO—our leading precedent on the issue—gives mixed signals about which provision applies to these facts” because the case “is somewhere between the two situations that ASARCO described.” Bouchard, 74 F.4th at 751. For this reason, the Fifth Circuit, like the lower courts, declined to decide which standard should apply because “[u]nder either standard, the stalking horse payment was legal.” Id. 

Addressing section 503(b)—”the more stringent provision”—Judge Smith explained that the provision requires merely that the expenses were incurred “‘as a result of actions taken by the debtor,’ and that those actions occurred after bankruptcy,” which was clearly the case here. Id. (quoting Nabors Offshore Corp. v. Whistler Energy II, L.L.C. (In re Whistler Energy II), 931 F.3d 432, 441 (5th Cir. 2019)). The Fifth Circuit rejected the committee’s argument that the Hartree asset purchase agreement was not a valid postpetition transaction because it was not enforceable until approved by the bankruptcy court. According to Judge Smith, by focusing on the agreement rather than its postpetition nature, “the Committee reads the ‘post-petition agreement’ requirement too strictly.” He explained that “an agreement for services in bankruptcy is enforceable even if the ‘post-petition business relationship [is] not … clearly defined.'” Id. (quoting Whistler, 931 F.2d at 442). 

Judge Smith further noted that “although the associated fees [promised to Hartree] were dependent on court approval, that does not affect the postpetition nature of the transaction.” “Indeed,” he wrote, “§ 503(b) implicitly contemplates that debtors will incur postpetition administrative expenses before they seek court authorization.” Id. at 752 (citing sections 503(a)–(b), which provide that “[a]n entity may timely file a request for payment of an administrative expense, … [and] [a]fter notice and a hearing, there shall be allowed, administrative expenses” (emphasis added)). 

The Fifth Circuit found no error in the lower courts’ findings that the break-up fee and expense reimbursement provided numerous benefits to the estate by, among other things: (i) securing Hartree’s participation as a stalking horse and thereby avoiding a “naked auction”; and (ii) forcing JMB to pay more for BTC’s vessels than it otherwise would have, which was essential to pay BTC’s nearly $100 million in postpetition debts and to obtain confirmation of its chapter 11 plan. Judge Smith rejected the committee’s argument that the bid protections did not benefit the entirety of the estate, but merely “JMB and certain senior creditors while providing no recovery to other creditors.” Id. at 753. According to the Fifth Circuit, “a benefit is still a benefit even if it helps only secured creditors” and because “[u]nsecured creditors are in the back of the line, … sometimes that comes with downsides.” Id.  

In addition, the Fifth Circuit panel agreed with the lower courts that the bid protections were “necessary” to obtain those benefits because, among other things, Hartree would not have served as the stalking-horse bidder without them. Judge Smith wrote that: 

Considering the totality of the evidence, it is “plausible” both that Hartree’s stalking horse bid created a benefit for the estate and that Hartree would not have served as the stalking horse bidder without the prospect of fees. It is also plausible that JMB only bid $115.3 million because it was forced to beat out Hartree. Therefore, the break-up fee and the expense reimbursement were “necessary” administrative expenses under § 503(b). 

Id. at 755. 

Finally, the Fifth Circuit did not fault the lower courts’ determination that the bid protections passed muster under the business judgment standard applied under section 363(b). Given the facts of the case, Judge Smith wrote, “the stalking horse arrangement was the lesser of multiple evils” and, in signing the Hartree purchase agreement, BTC “acted well within the bounds of reasonable judgment,” which is all that is required under section 363(b). Id. at 756.  

Outlook 

Bouchard is an unusual case. It does not fit neatly into the framework established by the Fifth Circuit’s binding 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 appellate 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 arguably understandable. As a result of approval of the auction results and the payment of a break-up fee and expenses to Hartree, unsecured creditors received little or nothing from BTC’s estate. Even so, the committee was clearly aware that the court had already authorized bid protections for an as-yet-unnamed stalking horse.

In the end, the Fifth Circuit agreed with the lower courts’ conclusion 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 section 363(b).

Read the full Business Restructuring Review.

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