Price Allocations in Section 363 Sale Asset Purchase Agreements

Are Implied Recoveries Carved in Stone or Sand?

This article examines a latent issue that arises in a sale of a business as a going concern under Section 363 of the U.S. Bankruptcy Code when multiple secured creditors have liens on different assets or bundles of assets and the net proceeds from the sale do not exceed the total lien amounts attached to those assets.

In such a situation, one or more secured creditors can destabilize or threaten to hold a proposed sale hostage to leverage a disproportionate allocation of the sale proceeds. From the standpoint of the parties involved in the transaction—the debtor/seller on one hand and the buyer on the other—the art of the deal involves keeping what is usually a time sensitive transaction on track. Obtaining required approval may require deferring for later determination allocation of proceeds issues that cannot be resolved in the relatively short time between the filing of a sale motion and an approval hearing.

From the standpoint of the secured creditors, the issue is to leverage the most favorable allocation of proceeds before the entry of a sale order or, if that is not possible, preserving to the greatest extent possible rights and negotiating leverage for later determination. With this framework as the focus, several other issues surface. One typical issue is the effect of a purchase price allocation provision in the asset purchase agreement (APA) between the debtor/seller and buyer. Should the allocation in the APA control or influence the recoveries of the secured creditors? This issue arose and was resolved in the case of In Re: Kiel Bros. Oil Company, Inc. and KP Oil, Inc ., in the Southern District of Indiana, jointly administered as Case No. 04-11121-BHL-11.

This article summarizes the facts leading up to the bankruptcy filing and the outcome. It also addresses some of the policy considerations to be weighed in resolving this issue. In certain instances, the author may have made some simplifying assumptions either to preserve confidentiality when facts were not of public record or when simplification made the presentation more straightforward. In some instances, numbers have been rounded. Neither the author, as the debtor company's principal restructuring financial advisor, nor its legal counsel had a professional bias in the outcome of the allocation of recoveries among the affected creditors.

Typical Path to Bankruptcy

Kiel Bros. Oil Company, Inc., and its affiliate KP Oil, Inc., operated more than 200 convenience stores and distributed gasoline and other petroleum products to about 95 dealer outlets in Indiana , Kentucky , and Illinois . The convenience stores sold the usual array of grocery products, gasoline, and various other items. In addition, Kiel supplied all of the company-operated stores and 95 third-party operated stores with gasoline supplies from its own fleet of trucks. Kiel owned the real estate on about 50 of its company-operated stores and about 16 of its dealer-operated stores. The remaining stores were either leased or dealer-owned. The debtor also owned or leased more than 100 other properties, including bulk plants, unimproved real estate, office facilities, and vacant, non-operating convenience stores. For the full year prior to filing, Kiel had revenue of about $400 million.

Kiel followed a fairly typical path into bankruptcy. The slide began a few years before the filing when compressing margins for both gasoline sales and in-store merchandise sales combined with the financial strain of above-market rents it paid for numerous leased store locations. This caused the company's cash flow at the store level to dwindle to levels that were insufficient to cover overhead and service outstanding debt. For more than a year before the filing, the company financed its negative cash flow by borrowing from its principal owners and by maximizing its bank credit facility until those sources had been exhausted.

The convenience food store business tends to be seasonal. Profitability and cash flow generally are strongest in the summer, when outdoor activity and car travel are greatest, and weakest during the winter when outdoor activity and car travel are at their lowest levels. By the winter of 2004, the company was tapped out on its bank line of credit.

At that time, the company attempted a creative restructuring. An investment bank was retained to market and sell at auction the management/operating rights to the convenience stores that were owned or leased by the company. Buyers of the operating/ management rights also would be compelled to enter into a petroleum product distribution agreement with the company. The company would continue to control the real estate holdings through ownership or lease after the auction and retain its petroleum product distribution business.

The auction failed to raise enough money to pay down bank and trade debt sufficiently to make viable the real estate/ petroleum product distribution company that would have existed after the sales. However, the auction did establish what the company eventually termed its "blue sky value" for its various locations—that is, the general intangible value of the cash flow generated by the location, independent of the real estate fee or leasehold interest. With seasonal cash flow losses projected for the winter months and no other sources of cash, the company borrowed $3 million of fresh cash from its shareholders to tide it over until the seasonally stronger summer months arrived.

However, the company's cash flow needs during the winter and spring of 2004 were greater than anticipated. By June 2004, the company had insufficient cash to fund its day-to-day operations, and its bank lender refused to advance any more funds under the revolver except as debtor-in-possession (DIP) financing. Faced with financial crisis, on June 15, 2004, Kiel filed for protection from its creditors under Chapter 11 of the Bankruptcy Code.

On the filing date, Kiel had five classes of pre-petition secured debt totaling about $48 million, including:

·                    $21 million of senior bank debt owed to its commercial lender under a revolving working capital line of credit secured by first liens on all of the company's assets except for the real estate mortgages and seller financing.

·                    $16 million of mortgages on 56 parcels of fee owned real estate owed to a smaller bank.

·                    $4 million of contract purchase financing owed to the sellers of several parcels and related equipment sold to Kiel prior to the filing date.

·                    $3 million of junior secured debt owed to Kiel 's principal shareholders, which was collateralized by a second lien on all of the bank's collateral.

·                    $4 million of other secured debt that either was subordinated to the secured debt or collateralized by various real estate leases that had little, if any, economic value.

When the bankruptcy petition was filed, the bank made an additional $2.5 million in DIP financing available to Kiel by rolling up the pre-petition senior bank debt with this additional availability into a $23.5 million DIP credit facility.

Agreement to Sell

When it filed, Kiel and its advisors knew—and after it was formed, the committee and its advisors also adopted the view—that the company would not have sufficient liquidity to fund its operations after the onset of the seasonally slow winter months beginning in December. The company's cash flow forecasts indicated that it would deplete its availability under the DIP loan facility and would run out of cash by Thanksgiving, if not before. Absent further cash injections from the bank—which it steadfastly refused to consider—the company would be forced to cease operations as a going concern and liquidate its assets.

This result would decimate the enterprise value of the business and inflict huge financial losses on all of the creditors, including the bank. Thus, the stakeholders all agreed that a sale of substantially all of the company's assets as a going concern under Section 363 was in their collective best interests. They also believed that the process needed to be implemented by finding a stalking horse bidder as rapidly as possible. In addition to these efforts, a parallel process was implemented to sell any remaining assets that were not covered by the strategic buyer's agreement. This process was designed to sell remaining assets individually in a so-called break-up auction that would run simultaneously with the strategic auction.

As a result of the marketing efforts by the company's investment bankers, a stalking horse APA was entered into with a major integrated oil company, one of Kiel's largest gasoline suppliers and unsecured creditors. The stalking horse APA identified the purchased assets as 66 fee owned stores, 16 of which had been operated by dealers; 71 leasehold locations, 12 of which pertained to stores that had been closed and whose leases already had been rejected; contracts to supply gasoline to 95 dealers; two miscellaneous fee owned parcels; and all of the gasoline and in-store inventory. The all-cash price, while clearly within the range of fair values for the bundled assets, was several million dollars less than the total stated face value of the aggregate secured claims attached to those assets. The stalking horse APA contained a purchase allocation to each of the bundled assets acquired and provided for a quick closing.

Shortly after the form of the stalking horse APA and the bidding procedures were approved by the court, Kiel held two simultaneous auctions: the bundled sale, a strategic auction for the bulk of the properties covered by the stalking horse APA, and a break-up auction for each individual property not covered by the stalking horse APA. At the strategic auction, the stalking horse buyer was outbid by another buyer that conformed its offer (the final APA) to the form of the stalking horse APA, purchase price allocation and all. The only difference between the two was the higher purchase price provided in the final APA and a provision that grossed up the price allocation to the individual bundled assets on a pro rata basis to reflect the higher overall purchase price offered. Bids for most of the remaining assets were accepted at the break-up auction.

The stakeholders unanimously supported the final APA and the sales under the break-up auction, and the court approved these sales without any material objections. The closings took place on schedule, and the agreed-upon cash proceeds were wired into the debtor's account in accordance with the final APA and the other agreements.

Figure 1 summarizes the net proceeds received from the strategic auction under the final APA and the break-up auction. The total gross sale price for the store locations was $35.7 million, about $31.9 million from the bundled sale strategic auction and about $3.9 million from the break-up auction. Net proceeds from the sale of all store locations were $27.3 million after paying seller financing and transaction-related expenses; $23.7 million from the single buyer bundled sale strategic auction; and $3.6 million from the multibuyer break-up auction. Inclusive of inventory, the aggregate net sale proceeds totaled $33.2 million, $29.2 million from the single buyer bundled sale strategic auction, and $4 million from the multibuyer break-up auction.

Figure 2 summarizes for each tranche of secured debt outstanding as of this closing date the outstanding balance and the allocation of sale proceeds implied by the price allocation contained in the final APA. The seller financing amounts have been omitted from Figure 2 because the payoff amounts were settled and paid from the closing proceeds as set forth in Figure 1. As Figure 2 indicates, there was $42.2 million of outstanding secured debt at closing, exclusive of seller financing, but only $33.2 million of net sales proceeds (after provision for seller financing), leaving an overall haircut of almost $9 million to be absorbed by the four tranches of secured claimants. But how should the $9 million haircut be apportioned over the secured claims?

Figure 2 also shows how the net proceeds from these assets would be allocated under the final APA. If the methodology described in the final APA were to govern, the junior debt would have taken a $4.1 million haircut, the mortgage debt would have taken a $4.4 million haircut, the DIP loan would have been paid in full, and the excess proceeds of $2.4 million applied to the DIP loan would have been allocated to the shareholder notes because they were second in priority behind the DIP lender on all of its collateral. Obviously, the DIP lender was quite happy with this result, as were the holders of the shareholder notes. The Unsecured Creditors Committee was also happy with the result because all proceeds allocated to the DIP loan and the shareholder notes in excess of their collective claims would have gone to pay general unsecured creditors after administrative and other priority claims.

The purchase price allocation in the final APA was not a hotly negotiated item per se for a couple of reasons. First, the debtors' primary responsibility was to maximize the overall recovery for all of its creditors generally without favoring any particular class of creditors. Thus, as a practical matter, the debtor did not have an interest in how the purchase price was allocated over the acquired assets and therefore to any particular creditor.

Second, the stalking horse buyer for the most part dictated this allocation with almost no input from the debtor or any of its stakeholders. In fact, when the stalking horse buyer was asked how the price allocation was determined, in effect, the buyer informed the debtor that the buyer applied various "black box" valuation parameters which, when applied to many locations, assigned valuations on the purchase price allocation schedule that bore little or no relation to the underlying cash flow generated by the particular location. From the debtor's perspective, this really was a "voodoo allocation."

Finally, in the overbid process at the bundled sale strategic auction, the price allocation embedded in the stalking horse APA was merely carried forward in the final APA. That said, the price allocation in the final APA was of some economic importance to the debtor because the allocated amounts would govern any purchase price offset that may have come into play if the buyer had duly rejected any assets originally scheduled to be purchased.

Objection Surfaces

The only real objection to the allocation of sale proceeds in accordance with the price allocation in the final APA came from the mortgage lender. The holders of the junior debt, after putting up a valiant fight for months, eventually succumbed to the reality that their liens were deeply subordinated and therefore had little value as secured claims. The junior debt eventually settled by accepting a negotiated allowed unsecured claim without waiving rights to bring actions against certain parties.

The mortgage lender's principal argument was that the price allocation in the final APA was intended primarily for tax purposes to benefit the buyer. Because the debtor had no vested stake in this issue, the allocation was not negotiated at arm's length and therefore should not be binding on third parties with respect to the wholly separate issue of allocating net sale proceeds among secured creditors.

While this argument was at least partially true, the allocation did serve another economic purpose in which the debtor had a bona fide stake. The values assigned to the bundled assets in the final APA served as the basis for a purchase price offset if any of the purchased locations were rejected prior to the closing due to title defects or other unresolved warranty issues. Thus, if a bundled asset were properly eliminated from the schedule of purchased assets prior to closing, the purchase price would have been reduced by the value assigned to that asset in the price allocation schedule to the final APA.

Nonetheless, the mortgage lender pressed its central argument that, because it was never intended to govern the allocation of sale proceeds among the seller's creditors, the allocation in the final APA should not be binding on its recovery on its mortgage debt. Instead, the mortgage lender argued, the net sales proceeds should be allocated to the secured creditors pro rata in accordance with the relative appraised values of their collateral.

Several weeks before the closing, the DIP lender had each of the properties appraised and shared the results with the mortgage lender. The aggregate appraised value of the bundled assets sold to the strategic buyer under the final APA was $42.1 million. Of this total, the appraised value of those locations secured by mortgage debt amounted to $21.6 million (Figure 3). Applying these appraised values, the mortgage lender constructed two alternative frameworks for computing its recovery.

First, the mortgage lender postulated that the purchase price under the final APA, net of the break-up fee, was $31.1 million, and the total appraised value of the bundled assets sold was $42.1 million, indicating in its view that there was almost a 73.9 percent recovery on the assets sold. The lender then applied that recovery factor to the $21.6 million appraised value of the mortgage debt locations in the final APA to derive an alternative proposed recovery amount of almost $16 million for the bundled assets. When added to the recovery from the break-up auction properties, this would make the mortgage lender whole by a comfortable margin.

In addition to the core allocation issue, a fundamental problem with this argument was that the $31.1 million net price used in the numerator of the proposed recovery fraction conveniently ignored more than $7 million of amounts paid at closing, as shown in Figure 1, reducing the actual net sale proceeds available for distribution to $23.7 million. Had $23.7 million been used for the numerator instead of $31.1 million, and otherwise applying the same methodology, the recovery percentage would have been 56.3 percent, and the proposed recovery would have been $12.2 million instead of $16 million.

As a fallback to its central argument, the mortgage lender applied that same logic, except that it did not subtract $1.7 million in seller financing payouts from the net closing proceeds. So, instead of $23.7 million of net closing proceeds, it used $25.4 million. By applying this figure, a 60.4 percent recovery percentage was derived. Applying that percentage to the appraised value of $21.6 million yielded a proposed recovery amount from the bundled assets of about $13.1 million. Then, adding the break-up auction proceeds of about $2 million would have yielded roughly a $15.1 million recovery for the mortgage lender, resulting in the far more modest write off of $1.6 million, rather than the $4.4 million haircut implied by the final APA allocation shown on Figure 2.

After hotly contested negotiations, the mortgage debt was settled by granting the mortgage lender an allowed secured claim of $12.5 million (plus the debtor's headquarters facility in Columbus, Ohio, secured by a separate mortgage of almost $1.2 million, which the mortgage lender had credit bid at the break-up auction), plus an allowed unsecured claim of about $2.2 million. The $13.7 million recovery of its secured claim was about $1.4 million more than the amount implied by the purchase price allocation in the final APA but about $3 million less than the mortgage lender originally had demanded.

Policy Considerations

In the context of Section 363 sales, while tax and other considerations of the buyer typically drive purchase price allocations contained in an APA and a bankrupt seller generally does not have a material economic stake in the price allocation among assets, it is difficult to make a forceful argument for upsetting such an allocation, given the level of scrutiny applied to these APAs. In most cases, including Kiel , drafts of APAs are distributed to each major stakeholder for review and input. Another opportunity for stakeholders to object to material provisions that may be problematical arises at the hearing in which court approval is sought to enter into the agreement. After the auction, yet another hearing is held to approve the sale and closing.

At each of these stages, a secured creditor may note its objections to the agreement or the sale. Absent such an objection, a strong argument may be made that creditors have waived their right to upset the application of a provision in an agreement entered into by a debtor with the court's approval, notwithstanding that a provision such as a price allocation may have had as its primary purpose something other than a mechanism for apportioning sale proceeds among creditors.

This conclusion is further supported when the price allocation serves an economic purpose important to the debtor, as it did in this case. In Kiel the price allocation provided purchase price offset amounts in the event that assets were duly rejected by the buyer prior to closing. This was negotiated between the debtor and the buyer. If a price allocation is negotiated and not merely accepted by a debtor because it has no economic stake whatsoever in the outcome, then it would seem that the right result on policy grounds would be to respect a negotiated allocation contained in a court-approved agreement.

To reach a contrary result would give interested parties the right "to have their cake and eat it too" at the expense of the overall estate. If an interested stakeholder could lie in the weeds and not object to an agreement or a material provision in it because it likes the price, only to object to the application of an offending provision later, every interested party conceivably could object to the allocation of proceeds implied by an agreement that supposedly was wholly acceptable to govern the disposition of assets. This would add thousands of dollars of administrative expenses and open-ended delay to case administration, all to the detriment of the overall body of creditors.

Little Case Law

Surprisingly, case law is fairly sparse on this issue. No reported decision has directly considered whether a purchase price allocation in a sale agreement determines the allocation of proceeds among creditors. However, unless a secured party can show that it had no notice of how the sale agreement allocated proceeds among different assets, such a contractual allocation likely would be binding on the secured creditor or at least taken as strong evidence of actual market values.

A secured creditor that did not accept the allocations as set forth in the agreement would be advised, before the sale is approved, to object to using the agreement as the basis to allocate proceeds among creditors. In the context of that objection, the creditor should be allowed to offer evidence showing different asset values. Once the sale has been approved, however, provided the agreement approved by the court included an allocation, the time for an objection has passed, and the creditor should be bound by the allocation in the agreement.

While a price allocation in an APA in a Section 363 sale of substantially all of a debtor's assets sometimes may "unfairly" allocate net sale proceeds with respect to a particular secured creditor, the time to address such perceived unfairness would be at the agreement negotiation stage. If the perceived unfairness may not be remedied at that stage, then the aggrieved party may take it up at the court approval stage, either when the agreement is entered into or when approval for the final sale is sought. If the contested allocation cannot be resolved at either of these stages, then the allocation contained in the agreement most probably is not materially unfair and thus should be respected, absent other extremely compelling considerations. To reach a contrary conclusion would add substantially to the cost of case administration and open the confirmation process to undue delay.




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