Ice Cube Bonds: Allocating the Price of Process in Chapter 11 Bankruptcy
abstract. In Chrysler’s Chapter 11 bankruptcy, a finding that the debtor was losing $100 million per day justified the hurry-up sale of the company to Fiat. The assertion that a firm is a melting ice cube is frequently offered, soon after a bankruptcy filing, to justify a quick sale of the firm under § 363(b) of the Bankruptcy Code. This raises a policy question: is this speed and the attendant streamlining of process a bug or feature? Do hurry-up going-concern sales maximize value for the bankruptcy estate, or do they facilitate collusive deals among incumbent managers, senior creditors, and potential purchasers? The answer is a little bit of both. It is crucial to distinguish between sales where the court and parties have good information about the value of the company and the costs of delay, from those in which melting ice cube leverage is used to exploit information asymmetries and to lock in a favored deal. To accomplish this sorting and reduce opportunistic use of transactional leverage, we seek to allocate the increased risks of forgone process to the beneficiaries of the sale rather than to the bankruptcy estate. We propose that a reserve—the Ice Cube Bond—be set aside at the time of sale to preserve any potential disputes about valuation and priority for resolution after the sale has closed. This approach retains expedited § 363 sales as a useful way to quiet title in complex assets and maximize value, while preserving the opportunities for negotiation and adjudication contemplated by the Bankruptcy Code.
authors. Melissa Jacoby is Graham Kenan Professor of Law, University of North Carolina at Chapel Hill. Edward Janger is David M. Barse Professor, Brooklyn Law School. The authors would like to thank Miriam Baer, Donald Bernstein, Susan Block-Lieb, Frederic Bloom, Matthew Bruckner, Jim Fanto, Adam Feibelman, Michael Gerber, Elizabeth Gibson, Michelle Harner, Gloria Jacoby, Randall Klein, Jonathan Landers, Richard Levin, Adam Levitin, Lynn LoPucki, Stephen Lubben, Ronald Mann, Harvey Miller, David Neff, James Park, Michael Simkovic, Nancy Rapoport, Chris Serkin, Charles Tabb, Michael Temin, Andrew Verstein, Spencer Weber Waller, and Mark Weidemaier, as well as participants in the Vanderbilt and Pace Law School faculty workshops, and the Brooklyn Law School Summer Faculty Workshop, for helpful comments on earlier drafts. Colleen Connelly, Graham Ford, Guangya Liu, Brett Neve, and Michelle Merck Walker provided able research assistance at various stages of this project. Mistakes are, of course, ours alone. The authors would also like to thank Deans Joan Wexler and Nick Allard, the Dean’s Research Funds at Brooklyn Law School, and the University of North Carolina School of Law, for generous support of this project. We are grateful to the UCLA-LoPucki Bankruptcy Research Database, and particularly to Lynn LoPucki and Doug Irion, for sharing updated data.
Financially distressed companies can melt like ice cubes: every day that a company burns through more cash than it earns, it loses value.1 In Chrysler’s Chapter 11 bankruptcy, the bankruptcy court’s finding that the car company was losing $100 million per day justified a hurry-up going-concern sale of all of its assets under § 363(b) of the Bankruptcy Code.2 The Second Circuit agreed that these exigent circumstances justified the procedural shortcuts taken to accomplish the sale, citing the “melting ice cube” theory.3
Though the Supreme Court vacated the Second Circuit decision in Chrysler,4 the Second Circuit’s use of the melting ice cube argument was well within the judicial mainstream.5 The government’s role as a source of debtor-in-possession and exit financing was novel, but the expedited sale of all the company’s assets outside a plan of reorganization was not. Hurry-up all-asset sales under § 363 of the Code (“363 sales”) are now a common feature in the bankruptcies of large public companies.6 A decade ago, Douglas Baird and Robert Rasmussen declared the classic business reorganization dead; the going-concern sale had replaced the traditional Chapter 11 reorganization.7 While the claim may have been overstated as an empirical matter, many high-profile Chapter 11 cases, including the bankruptcies of Enron, Adelphia, and Lehman Brothers, have disposed of major assets through sales outside of a Chapter 11 plan.8 Members of Congress were sufficiently concerned after the Gulf oil spill that BP would try to engineer a quick 363 sale to shed liabilities that they preemptively sought to change the Code.9 Pleas for quick 363 sales frequently feature the melting ice cube argument—a “strong assertion of non-viability” because of an alleged rapid wasting of assets—as a justification for short-circuiting the Chapter 11 plan process.10 The practical effect is to lock up the proposed sale package, and to raise the cost of investigating alternatives.
Although the largest cases attract public attention, small- and mid-market cases also feature proposals for quick all-asset sales.11 Smaller debtors may have fewer assets to burn, fewer financing options, a weaker corporate infrastructure to help keep the business together, less publicly available financial information, and a lower likelihood of an active creditors’ committee to counterbalance other forces. A going-concern sale may be the best, or only, option, but, as these cases often involve non-public companies, concerns about leverage resulting from timing-related information asymmetries may be even greater.12 In such cases, the disclosure regime associated with Chapter 11 plan confirmation may be of particular value.
Quick sales, therefore, raise a policy question in bankruptcies of all sizes: is Chapter 11’s speed and flexibility a bug or a feature? Do these sales maximize value for the bankruptcy estate? Or do they facilitate collusive deals between incumbent managers, senior creditors, and potential purchasers? The answer is a little bit of both. Some companies really are melting away—worth far more today than they will be tomorrow. Acting quickly will benefit all stakeholders. But calling something a melting ice cube does not make it one. And, even the fact of a melting ice cube does not justify exploitation of the resulting transactional leverage to disadvantage other claimants. It is, therefore, crucial to distinguish a case in which the court and claimants have good information about the company’s value and the costs of delay, from a case in which sale proponents13 are seeking to exploit information asymmetries and crisis-created leverage to strong-arm a deal that opportunistically appropriates value.14
Speed comes at a cost. Early in a bankruptcy case, information is limited on two separate axes: the value of claims against the firm and the cost of taking time to learn more. Characterizing the company as a melting ice cube ratchets up the perceived costs of learning more and enables a prospective purchaser to present its terms as “now or never,” or “my way or the highway.” The melting ice cube argument is, thus, a tool that can be used to lock-in or strong-arm a particular deal.15 In this regard, we join a number of corporate and bankruptcy scholars who have raised concerns about management-sponsored corporate sales, in which parties with leverage cement a favored deal through devices such as lock-up agreements, topping fees, bidder protections, or breakup fees.16
As currently applied, the Code and case law are inadequate to address the challenges posed by expedited all-asset sales. Section 363(b) of the Code provides, in relevant part, that the debtor may sell property of the estate “other than in the ordinary course of business” with court approval after “notice and hearing.”17 This language applies equally to sales of a single company car as it does to the sale of an entire car company. The Code provides no substantive guidance or remedial nuance to enable the court or creditors to sort between positive and negative value sales, or to determine when delaying the sale would be beneficial to the estate.18
The leading decision in the Second Circuit, Lionel, overturned a bankruptcy court order approving the sale of stock in a subsidiary because the debtor-in-possession proffered no “business justification” for short-circuiting the Chapter 11 plan process.19 Yet, the Lionel standard has evolved to provide a blueprint for hurry-up sale motions.20Under current practice, if the sale proponent offers a plausible business justification, the court can (and, we believe, usually does) approve it.21 Some courts have issued guidelines or local rules of procedure to put more flesh onto the sale review process.22 Sales sometimes do not go forward due to other challenges. But when a proposed sale is presented as a unique, time-limited opportunity, judges understandably are reluctant to stand in the way. If delay risks destroying millions of dollars in value, that is a high price to pay for process.23 Those pushing the quick sale can thus exploit this Hobson’s choice to their advantage.
Recent empirical work by Lynn LoPucki and Joseph Doherty suggests that this concern is not merely theoretical. After finding that 363 sales yielded a substantially lower percentage of book value than reorganizations in large public company bankruptcies, they concluded that quick all-asset sales were working to the benefit of purchasers (and senior creditors), but to the detriment of other claimants and the bankruptcy estate.24 Other commentators have interpreted LoPucki and Doherty’s results as showing that § 363 allows senior secured creditors to push for “inefficient fire sale[s].”25
Chrysler notwithstanding, in recent years, senior secured creditors have more typically played a significant, if not dominant, role in the decision to pursue a 363 sale.26 Frequently, the secured creditor asserts a first-priority lien on all of the company’s assets and further asserts that the company is worth less than the amount of its claims.27 If other claimants are deeply under water, why should they have anything to say about the sale’s timing and terms?
We see several reasons. First, a so-called blanket lien may not be comprehensive due to creditor error, gaps in the scope of statutory schemes, and value that is not lienable at all or not traceable to the lender’s collateral.28 Second, it is not obvious that the secured creditor is entitled to the firm’s reorganization premium or the speed premium allegedly created by a quick sale.29 Early all-asset sales also foreclose any hope for junior claim or interest holders that the assets will increase in value during the case, either by waiting to sell at a later date, or by reorganizing the business. This reorganization option has monetary value, and therefore should be considered when analyzing the costs of a quick sale.30 All-asset sales outside a Chapter 11 plan constitute a realization on the debtor’s assets, foreclosing the reorganization option, and transferring any upside to the purchaser.31 These points undercut the argument that a senior secured creditor should be treated functionally as a sole ownerof a bankrupt firm for governance purposes.32
The recent literature on 363 sales has been polarized, especially after Chrysler. Some critics have focused on speed and failure to expose the proposed deal to the market.33 Others have argued that the Chrysler sale was inconsistent with existing bankruptcy law.34 Stephen Lubben, by contrast, has contended that Chrysler’s bankruptcy was “no big deal”; hurry-up all-asset sales have gone on for years, after all.35 We take a different approach. We acknowledge that all-asset 363 sales are not new. In some cases, full-blown process must give way to the need for speed. Flexibility, however, creates opportunities for abuse. The difficulty is devising a mechanism to permit quick sales that are beneficial, while discouraging their opportunistic use.
Our proposal—the Ice Cube Bond—preserves not only the finality of sale, but also the possibility of ex post judicial factfinding and negotiation about valuation and entitlements. We propose a mandatory holdback of a portion of 363 sale proceeds to allow later resolution of disputes about value and priority. The holdback would not be required for sales conducted pursuant to a Chapter 11 plan. The reserved funds would be retained by the bankruptcy estate and distributed as unencumbered funds unless the claimant could show that (1) the estate had not been harmed by the procedural shortcut (e.g., that the ice cube was indeed melting), and (2) it was entitled to the reserved funds as proceeds of its collateral or under applicable priority rules. The Ice Cube Bond does notforeclose the possibility of quick sales, but reduces the ability to use the melting ice cube threat to strong-arm a sweetheart deal.
The Ice Cube Bond works by limiting the extent to which sale proponents can externalize the increased valuation risk associated with quick all-asset sales, as well as the extent to which they can use crisis leverage to reallocate value. The Bond does not disturb the finality of the sale, as the sale order would grant the purchaser clear title. However, the reservation of funds shifts at least some of the risk associated with such sales to those who seek to conduct the sale outside of the Chapter 11 plan process, and preserves for later determination, any disputes about perfection or priority. Our approach thus reinforces the separation between governance decisions about value maximization from those about value distribution, and should help courts sort between sales in which speed is essential, and those in which it is merely tactical.
Conceptually, at least, the Ice Cube Bond is neither unfamiliar nor complicated. Although there might be benefits to statutory implementation, courts could implement the Ice Cube Bond today, either on a case-by-case basis or through local rules or guidelines. Outside of bankruptcy, it is standard practice for federal courts to require that a bond be posted in association with preliminary injunctive relief.36 Courts already have the power to surcharge a secured creditor’s collateral under § 506(c), to compensate the bankruptcy estate for sale expense, as well as the power to preserve disputes about liens and priority, by creating disputed claims reserves.37
The Ice Cube Bond also reflects principles common in state foreclosure law. Procedural noncompliance with state foreclosure law can result in the loss of the secured creditor’s right to collect a deficiency judgment even if the sale stands.38 When the melting ice cube argument is used to forgo the protections associated with confirming a Chapter 11 plan, this should be considered a procedurally aberrational disposition of estate assets.39 With an Ice Cube Bond, the sale can go forward and be protected against reversal, but release and distribution of the holdback will be determined later.
This Article is divided into three Parts. In Part I, we lay out the doctrinal framework for expedited all-asset sales in bankruptcy under § 363 of the Code. We extend the insight of Baird and Morrison that Chapter 11 cases have an informational sweet spot at which point the parties and court have learned enough about the debtor to make an intelligent decision about the disposition of the assets.40 We illustrate how the bankruptcy estate currently bears the increased risk of erroneous undervaluation caused by hurry-up sales, thus distorting both governance incentives and normative distributional commitments in the Code. In Part II, we systematically identify benefits and harms of hurry-up all-asset sales, and discuss how they should be allocated. In Part III, we explore the Ice Cube Bond’s capacity, by setting aside a portion of the sale proceeds, to reallocate the risk associated with expedited sales and preserve the ability of the judge to resolve the legal issues raised by the case. The Ice Cube Bond proposal embraces and utilizes a court’s ability to serve as an ex post decisionmaker in a variety of contexts that purely market-based proposals cannot. This both simplifies the task of operationalizing the proposal, and allows a healthy agnosticism about which version of the Ice Cube Bond will work best in a particular case.
Firms are permitted to operate—to use and sell their assets—while in Chapter 11 bankruptcy.41 This power to use and sell property of the bankruptcy estate serves several distinct functions. On the one hand, it permits the debtor to stay in business. Thus, for example, a debtor retailer generally can continue to sell inventory in the ordinary course of business without seeking court permission.42 On the other hand, it also permits the debtor-in-possession to liquidate by selling assets outside the ordinary course of business, if that is the best way to realize on the value of the estate.43 But sales outside the ordinary course must either be conducted under a confirmed Chapter 11 plan or, with court approval, after notice and a hearing.44Since this court supervision arises ex ante, the debtor’s business decisions are subject to constraints beyond those of ordinary corporate law.45 The sales at issue might involve a single asset, such as a corporate car or jet, entire subsidiaries of the debtor, or substantially all of a debtor’s assets. A sale may be part of an overall liquidation, or incidental to reorganization. While the stakes of approval or rejection of a sale rise with the centrality of the asset to the debtor’s business, the Code provides no more specific guidance for a going-concern sale than it does for the sale of a spare pizza oven.46 Section 363 is a provision of general applicability to all kinds of bankruptcies, untailored to specific types of cases and circumstances.47
Out of this generality has emerged flexibility. Compared to state foreclosure law, bankruptcy is a congenial place to sell assets. In any kind of bankruptcy case, the court has the power to approve sales of assets free and clear of liens and encumbrances.48 The asserted liens and priority claims are simply shifted to the sale proceeds.49 Thus, the assets can be sold in bundles that are calculated to maximize value, even if multiple liens and lenders have claims against the property, while saving any bickering over distribution for later.50 The power to transfer clean title backed by a federal court sale or plan confirmation order is considerably more attractive than the quitclaim deed one generally gets following a state law foreclosure sale.51 Moreover, by design, challenging a bankruptcy court’s confirmed sale order is very difficult; absent a showing of bad faith, even a successful appeal of a sale order will not result in reversal of the sale.52 Due to the design of the statute as well as the overall direction of case law on sales free and clear, these benefits are available for sales under § 363, as well as sales under a liquidating Chapter 11 plan. Due to this ability to quiet and convey title in complex assets, bankruptcy courts have become favored locations for selling business units or whole companies.
Although the Code drafters contemplated that going-concern sales could be conducted through Chapter 11 plans,53 such sales now often occur under § 363 instead.54 The well-known Lionel case provides the standard typically applied to significant sales of assets through § 363 in Chapter 11 cases. Instead of the “business judgment” standard typical for less significant sales, the debtor must present a “business justification.” In Lionel, the debtor, with the support of the creditors’ committee, sought approval of a sale of its majority stock holding in a subsidiary.55 The debtor and the creditors’ committee wanted that sale to occur prior to completion of the plan confirmation process.56 The SEC filed an objection, and the shareholders, represented by an equity committee, appealed the court’s order.57
The Second Circuit reversed the lower court’s approval of the sale because the creditors’ committee’s insistence was the only reason given for accelerating the sale of the subsidiary—not a sufficient justification for a sale outside a Chapter 11 plan. The panel majority set forth a standard that future courts would invoke frequently: approval of sales of significant assets outside of a Chapter 11 plan did not require an emergency, but did require a good business justification.58 The court admonished that “a bankruptcy judge must not blindly follow the hue and cry of the most vocal special interest groups; rather, he should consider all salient factors pertaining to the proceeding and, accordingly, act to further the diverse interests of the debtor, creditors and equity holders, alike.”59 One hallmark of the Lionel majority opinion, which other courts note, is that courts need flexibility to do what is best under the circumstances.60
Lionel also illustrates the valuation risk associated with all-asset sales outside a plan, as well as the value of the reorganization option. In dissent, Judge Winter argued that the objection to the sale was a last-ditch effort by out-of-the-money equity holders to get some value out of this case, and that the majority’s ruling would be costly for Lionel’s creditors.61 In this case, though, the asset did not waste away: when the debtor later sold the subsidiary’s stock, albeit two years later, the sale generated a price fifty-four percent higher than the bid that resulted in the earlier appeal.62
One might expect modern citations to Lionel to support courts’ and creditors’ concerns about quick going-concern sales outside of a Chapter 11 plan. Recent cases tend to involve assets far more difficult to value than a profitable subsidiary, and tend to be requested earlier in the case. In Lionel, the debtor moved for the sale well over a year after the initiation of bankruptcy. But today, it is common for debtors to enter bankruptcy announcing an intended going-concern sale,63 and to file a sale motion within hours, days, or weeks of filing. Looking across the largest public company Chapter 11 cases involving 363 sales since the Code became effective in October 1979, the median time between filing and final sale approval is 110 days.64Roughly a quarter of all such cases have sales approved in sixty days or fewer, and approximately ten percent have sales confirmed within forty-two days.65 Focusing on cases since 2000, the median time from filing to substantial 363 sale drops by around two weeks.66 Although similar data are not available for smaller and non-public cases, we have no reason to believe those sales move at a more deliberate pace, and, indeed, suspect they are prone to move more quickly, especially if the firm has severe liquidity constraints. For example, in a sample of sixty asset sales, spanning a range of sizes, collected by the American Bankruptcy Institute, about forty-two percent of the sale transactions were approved within twenty-one to ninety-eight days after the filing.67 One can read these results as suggesting that the Lionel standard has evolved to provide a blueprint for the successful motion for a quick sale of assets of all kinds.
In this regard, the facts of Lionel and the fate of its legal holding encapsulate a central concern that motivates this Article. As an empirical matter, we fear the melting ice cube metaphor is overused, and suspect that, in a relevant number of these cases, allowing additional time to price the assets and to evaluate potential deals would not impair the value.68 In Lionel,the Second Circuit decision essentially called the creditors’ committee’s bluff, and the delay resulted in a larger distribution to stakeholders.69 Lionel’s legal standard, however, is usually cited, discussed, and applied in written decisions for precisely the opposite proposition: to justify the approval, not the denial, of a sale motion.70
The written opinions in Chrysler and scores of other cases cite Lionel for the proposition that quick sales of substantial assets are fine so long as the debtor articulates a good business justification. Many sources, including the Second Circuit opinion upholding the Chrysler sale, have cited Lionel while observing the commonplace nature of 363 sales of significant assets outside of a Chapter 11 plan.71 The Second Circuit’s Chrysler decision noted the benefits of quick all-asset sales under § 363, including efficiency and the quieting of title through the power to sell free and clear of liens and interests.72 As a practical matter, Judge Winter’s dissent in Lionel may have carried the day.
Rejections of sale motions can and do arise when a powerful creditor objects, arguing that the evidence of value, marketing, and business justification are lacking.73 Few decisions can be found, however, reporting a court’s denial of a request to sell all or substantially all assets.74 Sale orders and denials—like much activity in bankruptcy cases—do not necessarily result in searchable written decisions. Nonetheless, the brevity of this citation list is consistent with the conventional wisdom that denials of motions to sell assets are rare, particularly when no powerful creditor objects.75 To the contrary, many contemporary 363 sales are driven by a prepetition secured creditor who provides only enough postpetition financing to achieve a quick sale.76 Lawyer Michael Richman has been quoted as saying that lenders want to keep distressed debtors on a “short leash” and “requir[e] that a sale . . . happen [quickly].”77 Moreover, creditors who initially object to a sale might ultimately decide not to pursue such objections, leaving a concerned court without the optimal adversarial presentation of the issues.78 Even if the judge or creditors suspect the purchaser is underpaying, or that someone is taking advantage of a melting ice cube argument, they do not, under current practice, have a workable mechanism for preserving the economic status quo while developing the facts.
While post-Lionel practice has evolved over three decades, the Chrysler bankruptcy placed the Lionel court’s concern about valuation in high relief, and raised a new concern—distribution. With regard to valuation, critics complained that the sale happened too quickly to determine asset values with confidence. To these observers, the speed of the sale signified insufficient exposure to the market to determine whether other purchasers might be willing to pay more.79 Concerns about distribution in Chrysler were also closely related to the leverage created by the melting ice cube argument. That leverage, it was argued, allowed the U.S. government to dictate the manner in which the funds were distributed, short circuiting the protections of the Chapter 11 plan process, and allegedly violating the rights of secured bondholders.80 Secured bondholders were receiving a smaller percentage distribution on their claims than employees who held unsecured pension claims, an apparent violation of normal priority principles. If secured creditors with liens on all assets were not paid in full, it was asked, how could a class of unsecured creditors receive a distribution at all, let alone a greater percentage payout?81
Extraordinary government intervention explains a lot. The U.S. Treasury pumped vast amounts of money into the Chrysler case—with seemingly little regard to the value of the assets—and sought to dictate where the money went. One can conceptualize two distinct transactions: (1) a purchase of Chrysler’s assets, and (2) a (choose one:) payout, bailout, or buyoff to the (choose one:) employees, organized labor, or employee benefit plans to handle the company’s unfunded pension liability. Under §§ 1113 and 1114 of the Code, Chrysler could not unilaterally modify those plans without either consent, or compliance with an involved, statutorily mandated, bargaining process.82 In other words, part of the government financial contribution to facilitate a sale of Chrysler may not have been a payment for the assets at all, but a decision by the Treasury Department to use TARP funds to cover a portion of Chrysler’s unfunded pension liability with New Chrysler stock, and thereby secure the necessary union support.83
The bankruptcy court appears to have recognized this when it found the liquidation value of the secured lenders’ collateral was $800 million,84 making the $2.2 billion paid to the secured bondholders more than adequate compensation for the value of their claims. Indeed, the agent of the bondholders consented to this distribution after a majority of secured bondholders agreed.85 Thus, to the extent that the government offered payment to purchase labor peace and to ensure continued operation as a going concern, it is hard to characterize those funds as proceeds of the bondholders’ collateral. For better or worse, the government’s willingness to fund the purchase appears to have ensured that claimants received more than they would have in any conceivable alternative liquidation, and probably in any conceivable reorganization.
The critical attention to Chrysler was useful, however, for casting light on a practice that is widespread in cases that receive neither this kind of government subsidy, nor this kind of publicity.86 Although expedited all-asset sales usually do not raise Chrysler-type distributional issues so explicitly,87 postpetition lenders and purchasers often seek to affect the distribution of sale proceeds to some extent. More importantly, these sales raise valuation questions that have substantial distributional consequences. In other words, for all of its unique features, Chrysler raises broad and important questions about when the temporal exigencies of a particular purchase should override the Code’s protections against sweetheart deals and its distributional scheme.
Consider, for example, the first Polaroid bankruptcy sale.88 As Lynn LoPucki has recounted, Polaroid’s managers presented the company as a melting ice cube, and the confirmed sale, following a seventy-day sale process, was priced at a third of the company’s book value.89 The court declined to consider the creditors’ committee’s proposed evidence that would have illustrated the company was worth more.90 The dynamics of all-asset sales in today’s bankruptcy system put courts in an untenable position, especially when sale proponents make melting ice cube arguments.91
The perceived need for speed and the attendant power and danger of the melting ice cube argument is perhaps greater in cases with somewhat less debt and fewer assets, less information in the marketplace, and less public scrutiny. Cannondale, the bicycle manufacturer, filed for bankruptcy in 2003 and was on a fast track to a sale to a stalking horse bidder that left other creditors and potential investors with very little opportunity to evaluate the case.92 A motion to sell On-Site Sourcing, a digital management company, to its senior secured lender came just five hours after its Chapter 11 filing, and was coupled with an aggressive proposed debtor-in-possession financing order going well beyond what was necessary to keep the debtor alive until a sale.93 The court recognized that some of the most extreme portions of the sale order were rationally accepted by the debtor as the cost of moving things forward, but commented, “[p]ragmatism, though, does not convert a spoiler’s argument into a legitimate business reason.”94 Even so, the court ultimately approved the sale to the secured creditor, albeit conditioned on some significant amendments.95
Humboldt Creamery was in the business of processing, distributing, and marketing dairy-derived products and filed for bankruptcy in late April 2009.96 Less than ninety days into the Chapter 11 case, the debtor filed a motion to establish bid and sale procedures for substantially all of its assets and identified a stalking horse bidder (another dairy) that would pay $20.5 million or would receive a $300,000 breakup fee. The sale would leave little value for unsecured creditors.97 The stalking horse bidder was the only bidder.98 The creditors’ committee and unsecured note holders filed objections. But at the full hearing scheduled for August, the debtor informed the court that all objections had been withdrawn, leading the judge to conclude he had no choice but to accept the debtor’s representations about the propriety of the procedures used to market the assets and the detriment to the estate that might be caused by further delay.99 The judge approved the motion, but not before offering pointed commentary on going-concern 363 sales, characterizing them as “court-approved financial restructuring[s] stripped of all the procedural safeguards built into Chapter 11 of the Bankruptcy Code by Congress, including disclosure and voting. Legal rights are reduced to the sole discretion of a lone and often over-worked bankruptcy judge.”100
The judge went on to critique the melting ice cube argument, noting that the debtor could control the timing of filing to make any sale seem like more or less of an emergency: “it is easy enough,” he noted, “for the debtor to unplug the freezer prior to bankruptcy.”101 He then returned to the challenges for the court:
Unless the bankruptcy judge is willing to show exceptional judicial courage, he or she must approve the sale. While nominally “presiding” over the case, the judge is reduced to a figurehead without any meaningful discretion and might as well leave his or her signature stamp with the debtor’s counsel and go on vacation or shift attention to consumer cases where the law may still mean something.102
Humboldt Creamery is hardly the only case where a judge has expressed frustration with being backed into a corner by the parties. For example, asked to approve sale procedures thirty-six hours into the case because of an absolute unwillingness for lenders or counter-parties to consider even a slight extension, a Delaware bankruptcy judge lamented in the Digital Domain case:
I don’t offend easily and you’ve managed it. I have been through many, many sales. I’ve said before I’m sympathetic to the circumstances that you present before me . . . .
This is a faster transaction than anything I’ve seen. I’m concerned with respect to the process that’s been employed. Don’t tell me about Lehman; don’t tell me about General Motors; don’t tell me about Chrysler. They have no bearing on a case such as this.
. . . .
. . . I am satisfied that the options before me today are effectively to shut this company down. And I’ve [been] asked, I think, to call the bluff, and I’m not going to call that bluff.103
These comments highlight the problem.104Blame need not be entirely laid at the feet of the debtor: some courts and commentators see the secured lender as the one with the power to unplug the freezer when the timing is right.105 In any event, a judge presented with a fait accompli has two options as a practical matter, and neither is attractive. The judge can refuse to approve or delay the sale, but this produces the fear and risk that the buyer will decline to go forward, and that the estate will suffer either because of the wasting nature of the assets, or because this particular sale represents a unique (and time sensitive) business opportunity. Alternatively, the court can approve the sale. Here the court may be accused of being complicit in whatever deal the debtor’s management, buyer, and potentially a particular lender have cooked up, but at least this is a bird in the hand and there will be value to distribute.106 Although we know of no firm statistics on approval or denial of sale motions, the conventional wisdom is that judges tend to take the bird in hand.107
Until recently, law and economics scholars consistently expressed a preference for bankruptcy auctions over lengthier and allegedly more costly reorganizations (or sales) under a Chapter 11 plan.108 They emphasized three themes when speaking of the Chapter 11 process. First, corporate bankruptcy always involves a sale of some kind: either the estate is formally sold to outside purchasers (piecemeal or as a going concern), or functionally sold to its own stakeholders through a plan of reorganization.109 Hybrids are possible, and indeed contemplated. Even companies that reorganize in the traditional sense emerge smaller, having sold assets or even divisions. Either way, the goal is understood as realizing the highest value for the company’s investors rather than some broader conception of maximizing social welfare.110 Second, value should, where possible, be determined by exposure to the market rather than by judicial assessment.111 And, third, distributions of sale proceeds in bankruptcy should respect distributional priorities established by the Code and non-bankruptcy law.112
With regard to the third point, while economists tend to elevate allocative efficiency over distributional concerns, law and economics scholars in the bankruptcy context largely favor the concept of “absolute priority.”113 In some cases this is due to certain liberal commitments to property law—those with property rights in the debtor’s assets should come ahead of contractual and other unsecured claimants, who should in turn come ahead of equity owners. In many discussions, though, the justification for priority is rooted not in distribution, but in governance—in the suggestion that respect for non-bankruptcy entitlements will create appropriate ex ante incentives, and that, ex post, governance rights should be given to the class of stakeholders that has the greatest interest in maximizing value—the residual claimant.114
These commitments, coupled with the empirical sense that bankruptcy is sometimes used by out-of-the-money owners to extort value from creditors (as Judge Winter worried in his Lionel dissent), have led law and economics scholars to prefer sales, whether piecemeal or as a going concern, to the pursuit of a reorganization.115 These scholars also argue that their normatively preferred approach has empirically triumphed, with major public company bankruptcies frequently getting resolved through sales.116 To the extent a Chapter 11 plan process followed these sales, the process merely allocated proceeds from sales of assets or unrelated sources (such as avoidance actions relating to transactions that occurred months or even years earlier). This pattern was followed by Chrysler and GM, as well as Enron, Adelphia, and Lehman Brothers.117 The sales in Chrysler and GM each were approved in fewer than forty-five days,118 and generated significant opprobrium. Commentators had less to say about the quick sale by Lehman Brothers, which sold its brokerage division to Barclays just a few days after the (unplanned) bankruptcy filing. Although the timing was even more extreme, the sale by Lehman was, perhaps, perceived as necessary due to systemic risk implications.119
For the purposes of this discussion we accept the overall framework of the law and economics scholars, but challenge a number of their conclusions. We note that some of the same scholars who have historically favored bankruptcy auctions criticized the Chryslersale because the short timeframe limited the ability of other parties to bid. These scholars have also raised concerns about subversion of bankruptcy’s distributional scheme (particularly as it applies to secured creditors).120 In general, we share their concerns about process as well as priority. With regard to speed, we recognize that a short timeframe may be necessary in certain cases. We believe, however, that there are ways to improve the courts’ ability to sort between cases where speed is a necessity, and those where it is used tactically. With regard to distribution, careful attention to the scope of non-bankruptcy entitlements and equitable tracing rules leaves us giving rigorous, but somewhat narrower, protection to secured creditors than critics of Chrysler.121
Notwithstanding our concerns, we acknowledge that asset sales are an important source of Bankruptcy-Code-created value. It is widely accepted that the availability of a federal bankruptcy forum has efficiency advantages over state law creditor remedies. State law debt collection is based on first-in-time priority and can precipitate a chaotic race to the courthouse followed by piecemeal liquidation. Chapter 11 bankruptcy, by contrast, provides a collective forum that helps preserve going-concern value and prevents inefficient liquidations. As stated in the House Report for the 1978 Bankruptcy Code:
The purpose of a business reorganization case, unlike a liquidation case, is to restructure a business’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors, and produce a return for its stockholders. The premise of a business reorganization is that assets that are used for production in the industry for which they were designed are more valuable than those same assets sold for scrap. Often, the return on assets that a business can produce is inadequate to compensate those who have invested in the business. Cash flow problems may develop, and require creditors of the business, both trade creditors and long-term lenders, to wait for payment of their claims. If the business can extend or reduce its debts, it often can be returned to a viable state. It is more economically efficient to reorganize than to liquidate, because it preserves jobs and assets.122
While the House Report focuses on the capacity of a traditional Chapter 11 reorganization to preserve going-concern value, the same is true for going- concern bankruptcy sales, whether accomplished through a Chapter 11 plan or through a 363 sale. At least in theory, these sales can preserve going-concern value and transfer clear title to complex assets—from software licenses to whole companies, solving fragmentation and assemblage problems, and addressing issues of successor liability in relatively short order.
Some critiques of Chapter 11, and their attendant formulations of the baseline distribution to secured creditors, proceed from an unduly romanticized account of creditors’ rights under state law.123 Recoveries from forced sales under state law are not necessarily greater or faster than those obtained in bankruptcy; indeed, as Ronald Mann has recounted, lending officers are likely to see state law foreclosure as a true last resort, associated with significant loan losses.124 Historically, state courts have been hostile to security. Real property foreclosures are often seen as cumbersome by mortgage lenders and servicers, subject to the delays of judicial process and to mortgagor protections that postpone finality.125 Some jurisdictions (California, for example) impose complex election of remedy rules that can trap the unwary.126 To the extent that a lender’s security interest encumbers diverse types of collateral, foreclosure may require multiple proceedings under state real estate law, Article 9 of the Uniform Commercial Code (U.C.C.), and other more arcane schemes. Finally, foreclosure sales often transfer no more than a quitclaim deed, leaving title uncertain.
As it has developed in practice, the bankruptcy system improves the lot of the creditor hoping to benefit from a sale of the debtor’s assets. We illustrated in Section I.A that bankruptcy sales, whether under § 363 or in a Chapter 11 plan, provide the buyer with greater certainty and clearer title, increasing the sale price, and creating value for the estate.127 A federal court sale order can preempt state law, and can simultaneously quiet title to assets of an entity whose property and operations cross multiple state lines.128 And, all this can be accomplished very quickly—before inventory and customer lists become obsolete, relationships with key employees and suppliers sour, or the debtor simply runs out of money.
Bankruptcy sales offer two distinct options that improve on coercive state law remedies: preserving going-concern value through reorganization or through a going-concern sale, under a plan or under § 363. This going-concern premium is a product of the federal bankruptcy regime. Sometimes, the going-concern premium can only be obtained by acting quickly. Thus, a Bankruptcy Code created speed premium exists (as part of the going-concern premium) when a quick sale is necessary to preserve value. While both premia are worth preserving, we are concerned that parties not be able to exploit the perceived need for speed to distort the Code’s distributional scheme.
In the preceding Sections, we have observed both that 363 sales can preserve value that would be lost under state law, and that they lack procedural protections associated with sales (or reorganizations) under a Chapter 11 plan. In this Section, we seek to identify more precisely the costs and risks associated with hurry-up 363 sales. First, we explore concerns related to information scarcity and asymmetry that create uncertainty about valuation and give sale proponents considerable transactional leverage. Second, we discuss the distributional consequences of this leverage.
In our view, hurry-up sales outside of a Chapter 11 plan present three related problems regarding value: (1) information is likely to be scarce early in the case; (2) the available information is often asymmetrically distributed; and (3) the prior two points enhance the leverage and chances for opportunistic behavior of informationally advantaged parties. These problems are compounded by coordination problems. Most debtors have multiple types of creditors whose interests are not all aligned.129 The bankruptcy court has no more information than the informationally disadvantaged claimants. Consequently, the melting ice cube argument places the estate at the mercy of the sale’s advocates—usually, although not always, incumbent managers, the senior secured lender, and the purchaser. This leverage may facilitate a sweetheart deal, and, as we will discuss later, may lead the court and parties in interest to accede to sale terms that distort the Code’s distributional scheme. The estate (along with informationally disadvantaged creditors), therefore, bears the increased risk of erroneous undervaluation associated with the expedited sale, and absorbs the cost of the transactional leverage associated with the melting ice cube argument.
At the moment a debtor files for bankruptcy, it is axiomatic that valuations are uncertain. Insolvency itself interferes with the market for the debtor’s products, the market for the debtor as a going concern, and the market for the debtor’s discrete assets. Even if ownership of the debtor were in play or the debtor had negotiated over a restructuring before filing, the company is usually in crisis at the beginning of a bankruptcy case. It may be unclear how the company will function in bankruptcy, and whether it will be able to resolve its problems. The structure of Chapter 11 is specifically designed to address these concerns, providing breathing room for the debtor and its stakeholders to fix the business, gather information, and allocate value.130 Hurry-up sales, by contrast, demand an immediate decision in an information-poor environment, sometimes before it has become clear whether the debtor is a likely candidate for reorganization.
In the early days of a case, some creditors, the as-yet unformed creditors’ committee, and certainly the court, have relatively little information about the debtor, its value, and the prospect of successful reorganization.131 Until the point of bankruptcy, trade creditors and other nonfinancial creditors probably viewed themselves as fixed claimants, rather than as parties with reason to evaluate competing business plans. Involuntary creditors, such as tort claimants or the taxing authority, are at an even greater informational disadvantage. Official committees that might represent the various claims or interests are barely getting started.132 The court may have first learned of the debtor on the petition date.
Adding to the information-gathering problems, larger corporate debtors routinely request significant extensions of time to file their bankruptcy schedules, which provide information to the court and third parties on assets, liabilities, claims, transactions, and other factors.133 This delay further limits availability of relevant information about the debtor early in the case, especially with respect to debtors that are not publicly traded companies.
Baird and Morrison have posited the existence of an informational sweet spot in Chapter 11 cases. As the case proceeds, the judge and creditors gather more information by observing how the debtor operates in bankruptcy, and take advantage of the investigative powers of creditors’ committees, the U.S. Trustee, and other stakeholders.134 After a while, though, the amount of new information will hit a plateau, and the costs of waiting will exceed the benefit of learning more. This is the sweet spot—a presumptively optimal point at which an entity’s stakeholders can make the decision whether and how to reorganize or liquidate.135 Such an informational sweet spot means that there is little benefit to allowing a debtor to linger too long in bankruptcy, but it also means there are informational costs to culling cases too early. The exact timing of the informational sweet spot may vary depending on the size or the nature of the business, whether it is publicly or privately held, and other factors. For present purposes, however, the crucial point is that an informational sweet spot exists.136
Baird and Morrison’s discussion of the optimal decision point focused on the reorganize-or-liquidate decision of a firm. But the sweet spot will also affect judgments about the price and timing of any significant asset sale and whether such a sale should occur pursuant to § 363 or under a Chapter 11 plan. In a rushed preplan going-concern sale, those with an interest in the bankruptcy estate have less-than-optimal information about price and whether the asset is wasting. To the extent that the sale request precedes the informational sweet spot, interested parties may not be able to evaluate price, the possibility of other bidders, or the very assertion that the debtor is a melting ice cube. Under current practice, however, the melting ice cube argument makes it risky and expensive for claimants to seek additional information or additional time.137
There is, therefore, a pernicious interaction between the lack of information at the beginning of a case and the melting ice cube argument. While bankruptcy may come as a surprise to many creditors, and the aggregate amount of information held by creditors on the petition date is low, the filing is not a surprise to everybody. Incumbent management, a key secured lender, or a favored purchaser may have (relatively) good information about a debtor at the inception of a bankruptcy case. The debtor’s management may have been preparing for bankruptcy for a while, or have spent considerable time in discussions with the proposed purchaser and evaluating the risks and rewards associated with a sale. Whether management will use this knowledge in a manner consistent with its fiduciary duties to the company, or instead to feather its own nest, is a significant concern.138
Consider the Derby Cycle bankruptcy sale. An earlier owner of Derby, Alan Finden-Crofts, had sold the company in 1999, and came back as a CEO/turnaround manager in 2001.139 Later in 2001, Finden-Crofts and other members of management sought to buy the company. Derby filed for bankruptcy in August with an amended offer from Finden-Crofts and associates in hand and the allegation that the company was a melting ice cube.140 The sale ultimately was approved, over objection, albeit a month later than the debtor had insisted was necessary to preserve its value. About this set of facts, LoPucki asks: “If it took Finden-Crofts—the former owner of Derby—five months to evaluate the company from the inside and prepare a bid, how were competing bidders supposed to do it from the outside in five weeks?”141 Why, after months of due diligence by a management-led group, had the company suddenly become a melting ice cube?
The information gap is asymmetric with regard to both price and urgency. As a result, it is difficult and risky to assess or challenge the melting ice cube argument. The hurry-up sale may also chill bidding. Investing the time and resources to challenge the sale (or submit a bid) might therefore be doubly self-defeating. While so-called “stalking horse” bidders are sometimes thought to prime the pump for subsequent bids by signaling that somebody is willing to bid, bidder protections and other lock-up devices may combine with the short timeframe to limit the abilities of other bidders to take advantage of that signal.142 In addition to potentially depressing the price, the absence of additional bidders limits the generation of information about value beyond the offer already on the table.143 To the extent expedited all-asset sales have become routine in the current bankruptcy system, they may lead to a “lemons problem” or a persistent bad information equilibrium.144
Informational scarcity and asymmetry lead directly to a leverage problem. The debtor formally controls the moment of filing a voluntary bankruptcy petition. Therefore, the debtor can join with a potential purchaser to opportunistically exploit the fear associated with a crisis to capitalize on the informational disadvantage and strong-arm a favored deal. A determined purchaser might time its offer to coincide with an apparently deep (but in reality transitory) crisis for the company and set a short take-it-or-leave-it deadline. An oversecured creditor that would like to exit the case quickly may be indifferent to maximizing value beyond its own payment.145 Such a creditor may extend debtor-in-possession financing just long enough for a quick sale.146 Debtor-in-possession financing (and its control features) became considerably more common in the 1990s,147 increasing the avenues through which to lock up quick sales. Indeed, debtor-in-possession financing by an existing incumbent lender has a common nickname among practitioners—the “defensive DIP”—a debtor-in-possession financing order used to defend the secured creditor’s favored liquidation strategy from interference by others.148
The short timeframe works as a defensive strategy by limiting the ability of other bidders to gather information or participate in the process. If the debtor really is a melting ice cube, these problems may have to be tolerated. We are concerned, however, with opportunistic use of the melting ice cube argument (by unplugging the freezer) to strong-arm a particular sale.149
The leverage created by the melting ice cube argument is thus a tool. Who uses this tool, and how, can vary from case to case. The debtor-in-possession (or the trustee) is the party authorized to formally propose a sale under § 363.150 The debtor-in-possession has a fiduciary duty of loyalty to the estate, but generally gets the protection of the business judgment rule and the wide discretion it entails absent a conflict of interest.151 The evidence is fairly strong that senior creditors often impose considerable pressure on debtors in ways that directly affect corporate governance,152 often through a debtor-in-possession financing order.153 Melting ice cube leverage might be used, however, by others—incumbent management,154 the buyer, or someone else. From the outside, it may not be transparent who is setting the terms.
Embedded within every business bankruptcy case are numerous conflicting interests. An oversecured creditor may prefer a quick sale to a more time-consuming traditional reorganization because it will get paid in full in any event.155 An undersecured creditor also may prefer a quick sale for a host of reasons. The creditor might be concerned that some of its asserted security interests are unperfected (rendering them vulnerable to avoidance in bankruptcy), or may seek to skirt questions about the amount of bankruptcy estate value properly attributable to its collateral. Alternatively, a potential buyer may have already purchased controlling positions across the capital structure. The speed associated with the quick sale may reduce the likelihood that such objections can be identified, raised, and considered.156 Unsecured creditors might wish to squeeze out equity interests in the debtor, and could do so by cutting off the potential upside that lingers as a case heads toward a plan.157 They might even capture some of that upside for themselves by agreeing to take some of their own distribution in the form of stock in the new (purchased) debtor.
We could conjure many other hypotheticals. For example, incumbent management might prefer a buyer likely to continue their employment, even if it is not offering the best price.158 Or the purchaser might wish to favor certain unsecured creditors over others (as the government did in Chrysler). Shareholders of the debtor might team up with the buyer and use the terms and covenants of proposed debtor-in-possession financing to squeeze out unsecured creditors. Whatever the scenario, the leverage and informational asymmetry associated with a hurry-up sale make it more difficult for the court or other stakeholders to smoke out and neutralize unsavory arrangements, and may cause claimants to be more accepting of priority deviations, assuming they become aware of them.
The combined effect of information and incentive problems limits a court’s capacity to protect the estate regardless of a particular judge’s experience or sophistication. Poor information plus the (possibly manufactured) crisis create an untenable situation for courts. Judges are faced with the Hobson’s choice of permitting a potentially opportunistic sale or possibly overseeing the destruction of value by insisting on the diagnostic process that would reveal the truth.159 Although the purchaser might be bluffing about time being of the essence, the risk associated with calling that bluff is considerable.160 In the GM case, for example, the bankruptcy court explained the discomfort:
GM’s counsel noted in summation that the F & D Bondholders Committee was expecting this Court to play Russian Roulette, and the comparison was apt. So that the F & D Bondholders Committee could throw GM into a plan negotiation process, the Court would have to gamble on the notion that the U.S. Government didn’t mean it when it said that it would not keep funding GM. There is no reason why any fiduciary, or any court, would take that gamble.161
To the extent that expedited going-concern sales under § 363 precede the informational sweet spot, they force the court (not to mention potential objecting creditors and potential alternative bidders) to make a key “reorganize/liquidate/hurry-up sale” decision prior to the optimal moment. Engineers of a sale increase their leverage by using the melting ice cube argument to make it seem dangerous to collect more information and explore other options. And, as the judges in Humboldt Creamery, GM and Digital Domain observed, judges and judicial process have little choice but to give way to this practical fait accompli.162
The cases that raise the most explicit distributional issues involve sale orders that contain explicit instructions about how to allocate value. These sales are often attacked as “sub rosa” plans—plans of reorganization disguised as sales in order to evade the requirements of plan confirmation.163 The procedures that govern the Chapter 11 plan process do not apply to the debtor-in-possession’s powers to administer the estate, such as the power to sell and use property of the estate under § 363, or the power to incur debt under § 364. But when the power to sell includes selling everything, and the power to borrow includes terms that predetermine the distribution of proceeds, the plan process can be rendered irrelevant. Thus, early sales, coupled with restrictive financing, facilitate the use of transactional leverage for individualized benefit, particularly by creditors holding prepetition undersecured claims. But even sales that lack obvious sub rosa features can have significant distributional consequences and are procedurally noncompliant, in that they short-circuit the safeguards of Chapter 11.
As we describe below, the Code contains well-developed procedures, with a long historical provenance, that allows parties to negotiate an allocation of enterprise value in the shadow of an established disclosure regime (applicable to Chapter 11 plans), a mandatory set of legal findings, and a distributional scheme established by state law and the priority rules for Chapter 7 liquidations. The Chapter 11 plan confirmation process imposes important limits on the use of transactional leverage to divert value.
Section 1125 of the Code requires a disclosure statement that provides claimants with “adequate information” to make an informed decision whether to support or oppose a plan of reorganization.164 Section 1129(a)(7) requires a finding that each claimant will receive at least as much under the plan as they would if the debtor were liquidated under Chapter 7.165 This means that the distributions under the proposed plan must respect the distributional priorities contained in Chapter 7.
Code-authorized priorities among unsecured claims are rooted both in the exigencies of bankruptcy, and in other public policy considerations. For example, unpaid employee wage claims get special priority,166 and Chapter 11 entitles such claimants to payment in full in cash on the effective date of a confirmed plan.167 The Code also requires the debtor-in-possession to cure defaults in executory contracts that will be assumed and performed. The estate’s counterparty goes from being entitled to only a pro rata share of the debtor’s unencumbered assets, to being entitled to one hundred percent payment of its prepetition claim.168 Debtors-in-possession can seek court permission to give super-priority or secured status to lenders offering to extend credit to the bankruptcy estate.169 These Code-authorized liens and priorities subordinate prepetition creditors in the interest of a successful reorganization.
Yet, a common theme of these Code-authorized priorities is that they do not exacerbate, and are often designed specifically to limit, the leverage of prepetition creditors on the eve of, and early in, a bankruptcy case. The employee wage priority protects people who often have little leverage.170 The executory contract provisions allow the debtor to hold a non-debtor to its contract notwithstanding bankruptcy, and sometimes require the non-debtor to accept a contractual assignment, even if the non-debtor would prefer to do business with someone else. The financing provisions are meant to prevent prepetition creditors from placing a credit stranglehold on the debtor.
Other mechanisms for redistributing value have developed (sometimes on shaky statutory grounds) through bankruptcy practice or been placed into the statute as a result of interest group lobbying.171 Rather than reducing stakeholder leverage, many reflect the power of certain participants in the bankruptcy process. Texlon-type cross-collateralization and critical vendor motions, discussed below, are two prominent examples.
Texlon-type cross-collateralization, named for the first case to criticize it,172 involves the granting of postpetition liens to secure unsecured prepetition debt. The postpetition priorities and liens authorized in § 364 speak only of security for new postpetition loans and do not disturb the relative priority of prepetition obligations.173 The Code does not expressly authorize debtor-in-possession financing orders that use new liens to secure, and effectively pay, prepetition debt. But the case law of some jurisdictions permits cross-collateralization or arrangements such as roll-ups, if deemed to be in the best interest of the estate after considering multiple factors.174 Just like the melting ice cube sale, the call for financing deals with these terms typically depends on an assertion that the situation is dire, that there is no other possible financing, and no other prospect of preserving value for stakeholders.175
Similarly, some courts permit debtors to invoke the equitable “doctrine of necessity” to give special treatment to so-called critical vendors, with whom business relationships must be preserved, by paying their prepetition debts in full and early in a case.176 Supporters of these payments assert, sometimes without much evidence, that the deviation from priority makes creditors better off as a whole—a small price to pay, they say, if the absence of critical vendor cooperation will undermine the entire reorganization. But if too many parties exploit their leverage, and courts do not enforce the “critical” standard rigorously, those demands for cash and special treatment early in the bankruptcy case will have the opposite effect: smaller payouts for other creditors and a lower likelihood of reorganization.177
Quick all-asset sales raise the same kinds of questions as these suspect types of priority.178 Indeed, the push for a quick sale can be tightly intertwined with proposed debtor-in-possession financing by a prepetition secured creditor, with the financing order (rather than the sale order) realigning statutory priorities. It is possible that the transaction is still in the best interest of creditors notwithstanding the distortion of bankruptcy priorities. Highly charged sale environments, in which parties proclaim the need for speed, make it difficult to determine whether the buyer is walking away with more than its share, leaving others with less.179
While we do not inherently prefer reorganizations over going-concern sales, we do favor sales with more information and opportunity for bargaining in the shadow of the Code over sales concluded with less. We therefore favor going-concern sales accompanied by the procedural protections of a Chapter 11 plan to those conducted under § 363 without disclosure, solicitation, voting, and judicial confirmation. If a going-concern sale is proposed as part of a Chapter 11 plan, the plan proponent must provide “adequate information” in a disclosure statement, usually including an explicit comparison to a Chapter 7 liquidation, as well as adequate time to evaluate the proposal.180 Expedited 363 sales, by contrast, run the risk of cutting short the opportunity to compare the value of the assets to the proposed price, to compare the proposed price to what might be offered were the debtor to be exposed to the market over a longer period of time, or to consider the benefits of a true reorganization. In other words, expedited all-asset sales of alleged melting ice cubes shift the risk of undervaluation to the estate and allow distributional distortions—even if the sale does not expressly dictate allocation as the Chrysler sale did. Our Ice Cube Bond proposal in Part III seeks to reduce this reallocation of risk and seeks to limit the leverage associated with a melting ice cube crisis.
The discussion so far, reduced to its essentials, suggests that the bankruptcy estate benefits from a quick 363 sale under some but not all conditions, and that parties with conflicts of interest may use the melting ice cube argument to distort the choice between a quick sale outside a plan, a sale under a plan, and a reorganization under a plan. In this next Section, we explore how to sort between value-maximizing and opportunistic quick sales.
Chapter 11 can help maximize the value of a debtor in a number of ways. As explored in Part I, Chapter 11 captures value that would have been lost in a piecemeal sale under ordinary state law mechanisms or in a Chapter 7 liquidation. This value can be preserved through a traditional plan of reorganization, or through a Chapter 11 plan with a going-concern sale as its centerpiece. This sale-created value derives in part from the flexibility of Chapter 11, which in practice allows pragmatic structuring of sales, a short timeframe (even under a plan), and, most importantly, the transfer of clear title.181
Sometimes, however, preservation of this Chapter-11-created value may require a quick 363 sale prior to plan confirmation; this increment of preserved value is what we call the “Speed Premium.” The Speed Premium is the difference between the proposed “Expedited Sale Price,”182 and the present value of the price if one delays the sale until approval of a Chapter 11 plan or substitutes a traditional reorganization (the “Hypothetical Plan Price”):
Speed Premium = Expedited Sale Price - Hypothetical Plan Price
The asserted benefit of a quick sale does not exist unless, at the very least, the quick sale price exceeds the anticipated price under a Chapter 11 plan.183 In other words, the value of the assets are declining. The ice cube is melting.
This is not the end of the inquiry, however. It is important to distinguish melting ice cube risk from the risk of erroneous valuation. Melting ice cube risk is based on the concerns about perishability reviewed in Part I. For example, fresh produce, customer lists, and other types of assets may quickly decline in value. Some firms run the risk that firm-specific value will dissipate quickly. Key employees may leave, for example. There are many reasons a Speed Premium may exist. However, a quick sale reduces the level of information available to interested parties to value the company, and therefore increases the risk of erroneous valuation. In particular, because of the information asymmetries discussed above, we assume that the sale proponents and debtor’s incumbent management have better information than the creditors and the court. We are therefore particularly concerned with the increased risk of undervaluation imposed on the estate by the quick sale. We will refer to this cost, along with the other reasons for increased likelihood of erroneous valuation, as the “Increased Probability of Undervaluation.”
The governance question raised by a quick sale is to determine whether the Speed Premium’s value exceeds the costs imposed by the Increased Probability of Undervaluation. Information scarcity increases the probability that the quick sale will harm rather than benefit the bankruptcy estate. A quick 363 sale is not desirable if the Speed Premium is less than the cost imposed by the procedural shortcut.184 This is a more rigorous assertion of the governance holding in Lionel—that a good business justification is needed.185
The costs imposed by a quick sale could be calculated by multiplying the increased probability that the Expedited Sale Price is too low times the anticipated undervaluation (“Undervaluation Amount”). Thus the Quick Sale Cost would be:
Increased Probability of Undervaluation × Undervaluation Amount = Quick Sale Cost
In sum, the increment of value created by a going-concern sale under § 363 (“363 Sale Value”) can be quantified as the difference between the Speed Premium and the Quick Sale Cost:
Speed Premium - Quick Sale Cost = 363 Sale Value
If the 363 Sale Value is positive, then a quick sale is preferable to a sale under a Chapter 11 plan. If it is negative—that is, the Quick Sale Cost exceeds the Speed Premium—then there is no valid reason to shortcut the ordinary plan confirmation process to conduct a hurry-up sale under § 363.186 Unfortunately, under current practice, the court must decide on the fly, without sufficient information and sometimes without an adversarial presentation, whether to declare the melting ice cube argument a bluff. As previously explained, this is too much to expect. As a result, there is a considerable risk that the court’s ad hoc estimate of a positive 363 Sale Value at the time of sale will turn out to be wrong. Under current law, this risk lies entirely with the bankruptcy estate.
In our view, if the advocates of the quick sale are seeking a procedural shortcut, they should, at some level, insure the estate against the possibility that the value of the sale is negative. In other words, as we argue in Part III, those pushing for a sale outside the Chapter 11 plan process should be required to put their money where their mouths are and demonstrate, after the fact, that the estate has not been harmed by forgone process.
Early sales can produce two types of harm. Valuation harm is absolute. Distributional harm is relative. Or, to put it another way, when one asks if the benefit of the Speed Premium outweighs the cost to the estate, one is asking if the early sale is Kaldor-Hicks efficient. By contrast, when the melting ice cube leverage is used to alter the relative distribution, the sale is not Pareto optimal. Efficiency is being achieved at the expense of one or more holders of claims or interests.
Parties can, and frequently do, use the value preservation argument (e.g., “We must buy/sell before the ice cube melts”) to capitalize on their informational advantages. This use of transactional leverage has both efficiency and fairness consequences. As we discuss below, baseline entitlements cannot be modified without individual claimholders’ consent. By contrast, bankruptcy-created value is properly the subject of bargaining, subject to the protections of the Chapter 11 plan process.
To be confirmed, a Chapter 11 plan of reorganization must satisfy a condition colloquially known as the “best interests of creditors” test: each holder of a claim (or interest) must receive in the Chapter 11 plan at least as much as it would have received in a liquidation of the assets in Chapter 7.187 Section 363 does not have its own “best interest of creditors” test. Under current law, the proponent must simply demonstrate that it has a good business justification for the sale, or to put it another way, that it appears the sale will be in the best interest of the estate as a whole. Thus, if courts permit the distribution of 363-sale proceeds outside of a Chapter 11 plan, claimants do not get the same protection they would have received in a sale within a plan.188 Yet, where a sale of all assets is effectively determining the distributions in the case, it makes sense to impose a similar condition of Pareto Optimality.
To establish whether the sale meets the Pareto condition, we need both a baseline valuation and a baseline distribution. To compare a quick 363 sale to a sale under a Chapter 11 plan, one ought to ask the same question: what would creditors receive if the debtor were liquidated or sold pursuant to a plan? Crudely stated, the secured creditors are entitled to receive the value of their collateral, and the unsecured creditors share pro rata in the remainder.189 In Chrysler, secured creditors argued that unsecured creditors were receiving value that should have gone to them.190 The bankruptcy court concluded, however, that the secured creditors were receiving considerably more than piecemeal liquidation would have yielded.191 So, in that case, the Pareto condition was satisfied. More typically, a secured creditor will claim it holds a first priority lien on all of a debtor’s assets, rendering everything sold in the quick sale its collateral. If this naked assertion were dispositive, most quick sales would satisfy the Pareto condition. As we will further explain, however, alleged blanket liens may be less complete than secured creditors frequently contend.192
Thus, while Pareto Optimality requires protecting the secured creditors’ entitlements as of the petition date, it similarly requires protecting the unsecured creditors, by preserving any distribution they might have received. Spurious claims of priority or security reallocate assets that would (and sometimes should) have been available for distribution to others. The speed demanded in an alleged melting ice cube sale can preclude adequate investigation of the perfection and scope of the secured creditor’s lien, either as a term of the sale, as a term of an associated debtor-in-possession financing order, or as a practical matter.193 Such an improvement of the secured creditor’s position reallocates unencumbered value from the bankruptcy estate to the secured creditor without any clear basis for the entitlement.
Property rights in the bankruptcy estate’s assets and entitlement to the Speed Premium may vary from case to case. We cannot definitively allocate the cost and distribute the Speed Premium in a one-size-fits-all way.194 Ideally, the Chapter 11 plan process protects the ability of stakeholders to negotiate over the allocation of the various elements of value that are up for grabs. Quick sales short circuit the balancing of interests and opportunity for deliberation inherent in the plan process. So, in considering the distributive consequences of quick sales, it is essential to identify the possible beneficiaries and cost bearers.
Consider the senior secured lender who asserts a blanket lien on all of a debtor’s assets. When such a creditor advocates for an early going-concern sale it will likely argue that it has the right to determine what to do with the estate’s assets, all of which the creditor believes are collateral for its loan.195 Here, however, we question the assumption that the senior secured creditor owns the Speed Premium.
This assertion is first cast into doubt by the concept of optionality. As we have noted, in the absence of a bankruptcy filing, the secured creditor would have the right to foreclose under state law.196 Bankruptcy law cuts off this right. As such, the distributional baseline starts with the value a creditor would receive if it conducted a foreclosure sale of the liened assets under state law. A secured lender does not necessarily own an increase in value above this baseline, created by the efficiencies of the bankruptcy system.197 Anthony Casey, who has described option value in great detail, agrees that bankruptcy-created value is not necessarily proceeds of the secured creditor’s collateral, and thus might not be owned by the secured creditor.198 He suggests that a secured creditor asserting a blanket lien should have to purchase the option value of the unsecured creditor’s claim if it is pursuing a sale, rather than a reorganization, through a Chapter 11 plan.199 Casey is concerned with post-confirmation option value in sales conducted pursuant to a plan. We are concerned with “optionality” during a different time period—between the quick sale and reorganization or sale under a plan. The logic is the same, however. The quick sale cuts off any option value that might be held by other claimants. And unlike Casey, the option value we seek to protect is already allocated to the estate by the Code. The key point is that the option value is not “owned” by the senior secured creditor. For this and other reasons, the asserted blanket lien may not encumber the full value of the enterprise, leaving value for others.
The terms “realization” and “option value” denote two components of firm value: the value of the firm if sold today, and the value of an option that would allow the sale to be delayed to a future date—the price of a bet that the value of the firm will go up. The price of equity shares of a solvent firm contains both values. The officers and directors retain the ability and obligation to maximize firm value by choosing when to liquidate assets.
The situation changes when a firm becomes insolvent but is not yet in bankruptcy. Outside of bankruptcy, creditors have the power to force realization by liquidating assets to satisfy their debts. Unsecured creditors can obtain judgments and, to the extent state law permits, pursue unencumbered assets of the debtor to satisfy those judgments.200 Secured creditors that have contracted for collateral can repossess and foreclose on the assets securing the debt.201 These are the state law entitlements of the secured and unsecured creditor on the bankruptcy petition date.202
Conceptualized this way, the secured creditor is entitled to the value of its collateral on the bankruptcy petition date.203 As a practical matter, this dating rule is a legal fiction. Liquidation outside of bankruptcy (or even in Chapter 7) would take considerable time. Foreclosures outside of bankruptcy are subject to time delays by design or circumstances, and uncertainty about the title purchased.204 Because different systems govern the lender’s remedies upon a debtor’s default, cobbling together a nonconsensual, going-concern sale may be difficult, if not impossible.
Chapter 11 offers a number of tools designed to enhance the value of the firm beyond what it would be worth if liquidated on the petition date. Some examples:
· It gives the debtor-in-possession enhanced powers to sell the debtor as a going concern and to transfer those assets with clear title.205
· It provides significant incentives to third parties to provide financing to the Chapter 11 debtor.206
· It establishes mechanisms to allocate value.207
· It overcomes coordination problems by limiting the power of individual holdouts through the class approval process and binding dissenting classes of claims or interests through the “cram down.”208
· It delays realization (at least for junior claimants in cases where the debtor reorganizes) until completion of the Chapter 11 plan negotiation and confirmation process.209
These tools can preserve value through a reorganization or sale under a Chapter 11 plan.
Chapter 11 creates two possible routes for increasing the value of the estate beyond this baseline: a going-concern sale or a reorganization. Each, in its own way, preserves firm-specific investment and going-concern value and can be accomplished under a Chapter 11 plan of reorganization. The Chapter 11 plan may provide for the recapitalization of the firm, or for the sale of the firm and distribution of the proceeds. In some cases, an increment of the going-concern premium may arise because Chapter 11 provides a breathing spell and a chance to fix the business. Cases like Chrysler illustrate that just the opposite may be true in other cases: an increment of the going-concern premium may be attributable to the ability to accomplish a sale quickly and with finality. The Speed Premium arises postpetition, as a product of federal bankruptcy law. It is Chapter 11 that creates the ability to conduct a going-concern sale, and to do so before the firm loses value.210 As previously discussed, the Speed Premium sometimes can be obtained in a sale under a plan, either by moving quickly, or if the plan is prepackaged. In such cases, the Speed Premium is merged into the going-concern premium, and can be distributed through the plan process as the parties have negotiated. However, when it is claimed that a sale must be completed before plan confirmation, the Speed Premium must be weighed against the attendant increased error cost.211 The key point here is that both a traditional reorganization and a going-concern sale create value that would be lost using state law remedies.
So, to what extent is Chapter 11-created value the collateral of a secured creditor, as opposed to an unencumbered asset of the bankruptcy estate? State law provides the foundation for what a secured creditor can demand in bankruptcy.212 To the extent a debtor is worth more as a going concern than in a piecemeal liquidation—because of its talented workforce, unique assemblage of contractual and non-contractual relationships, or other factors—it is not clear that this extra value is tethered to, or subsumed in, the secured creditor’s collateral. Section 1129(b)(2)(A) allocates any increase in value in the collateral between the petition date and the effective date of the Chapter 11 plan to the secured creditor. However, § 552, and the concept of equitable tracing, ensure that this entitlement applies only to the value of the collateral itself, not to the value of the enterprise as a whole.213 Oversimplifying slightly, the filing of a bankruptcy petition cuts off the effectiveness of floating liens, which otherwise would attach to a debtor’s interest in property when the debtor acquires it.214 The prepetition secured creditor’s collateral extends to traceable proceeds of the lender’s prepetition collateral. For example, if a piece of inventory is sold, then the security interest continues in the identifiable cash proceeds. By contrast, if flour, sugar, and eggs, collateral of the secured creditor, are used to make an elaborate wedding cake, the value of the cake that is the product of postpetition labor of at-will employees is not proceeds of the secured creditor’s collateral. Allocation may be difficult, but is not a new or unique challenge in bankruptcy law. The Code authorizes the court to use equitable tracing principles to allocate the value of work-in-progress, for example, between the creditor’s collateral and other sources, such as human capital.215 Proceeds have a tendency to expand, as collateral is converted to cash proceeds and cash proceeds are used to buy inventory and pay employees or otherwise run the business. The effect of equitable tracing called for in § 552 is to limit the extent to which assets will be reallocated to a prepetition secured creditor as the case moves forward.
In sum, the Speed Premium and the going-concern premium both constitute Chapter-11-created value.216 In either event, the secured creditor’s right to this value is limited to the market increase in the value of its collateral and any traceable proceeds.217 As such, even a secured creditor with a purported blanket lien on the debtor’s assets is not likely to be entitled to all of the debtor firm’s enterprise value.
The suggestion that a secured creditor is entitled to the entire Speed Premium may be inaccurate for a second reason. Prior to the debtor’s bankruptcy a lender may have sought to obtain, and the debtor may have agreed to convey, a first priority lien on all of a debtor’s assets.218 Yet, the mechanics of making such consensual liens binding on third parties is rooted in state property law generally, and real and personal property mortgages more specifically. Article 9 of the U.C.C. governs security interests in personal property.219 The scope of Article 9 is broad, but it may or may not encompass such things as franchise licenses, government-issued licenses, or certain causes of action.220 Security interests in collateral automatically extend to the identifiable proceeds of that collateral.221 Yet, not all property can be encumbered by a security interest as a legal or practical matter. Whatever the intentions of the parties, the so-called blanket lien is likely to have gaps. As just noted, one should be wary of, for example, characterizing value created by the work of at-will employees postpetition, a claim for failure to obtain business interruption insurance, or the value of a state issued liquor license, as proceeds of prepetition collateral.222
Even if the debtor intended to grant the lender a security interest on all property interests that the law permits to be encumbered, the scope of the security interest is not ironclad. The security interest may not have attached to the collateral,223 or may not have been perfected under applicable non-bankruptcy law, either due to defects in the original transaction or due to changes over time.224 Methods of perfection vary by the type of collateral; the filing of a U.C.C.-1 financing statement in the correct government office perfects some, but by no means all, security interests in personal property.225 It may be particularly difficult to maintain perfection and priority with respect to collateral requiring a non-filing method of perfection and collateral for which possession of the collateral can trump filing. The rules are technical, and lenders can and do make mistakes, rendering the security interests unperfected.226 If a security interest is unperfected, it is vulnerable to an avoidance action in bankruptcy that frees the value of property that otherwise would have been collateral for distribution to other creditors.227
Thus, again, it is important to question the assumption that a creditor asserting a blanket lien actually has one. Where there are gaps in perfection, or unencumbered assets at the time of a Chapter 11 filing, an increase in value of the debtor during the bankruptcy case cannot necessarily be traced back to pre-bankruptcy collateral. This offers another reason to doubt that the senior secured lender is automatically entitled to all of either the going-concern premium or the Speed Premium.It is another reason that unsecured creditors should presumptively have a voice in the manner of asset disposition, and, if the plan process is displaced, that steps should be taken to ensure their rights are protected.
In our view, the state law liquidation value of collateral establishes the distributional baseline for the purposes of fairness, and also perhaps constitutional purposes. The Code entitles the secured creditor to the value of its collateral plus the identifiable proceeds of its collateral, subject to equitable tracing as of the effective date of the plan of reorganization.228 The remainder of the value of the debtor, consisting of the value allocated to unencumbered assets, postpetition effort of at-will employees and other unalienable value, and any appreciation that is not tied to encumbered assets, is up for grabs.
Declaring some portion of bankruptcy-created value as unencumbered does not determine who will receive it in the end. The drafters of the Code contemplated that Chapter 11-created surplus would be the subject of negotiation and compromise through the Chapter 11 plan process.
To the extent that transactional leverage is used to lock up a portion of that surplus early in a case, without going through the Chapter 11 plan process and its attendant negotiation, hurry-up sales facilitate an end-run around the Code’s procedural protections. Chapter 11 seeks to give the debtor and its stakeholders time to stabilize the business, to resolve coordination problems among stakeholders, to consider different business options, and to negotiate over allocation of value.229 In some contexts, the intended breathing spell of bankruptcy is simply unaffordable, and value will be preserved only with exceptional speed. But, based on our analysis in Part I, it is not hard to see why and how the temptation to exploit the leverage associated with a quick sale itself could arise. And based on Part II, we see those harms producing several kinds of risks to the bankruptcy estate: (1) that the bankruptcy estate currently bears the burden of error in assessments of 363 Sale Value; (2) that the sale may go forward when the increased error costs exceed the speed premium; and (3) that parties may use transactional leverage, and exploit information asymmetries, for redistributive ends.
Our proposal in Part III—the Ice Cube Bond—seeks to encourage quick 363 sales motivated by value creation or preservation and discourage those that are being used to strong-arm a particular distribution contrary to ordinary bankruptcy principles. It seeks to return the bargaining over bankruptcy surplus to the plan process, even if it is necessary to sell assets before the plan can be confirmed.
For the reasons discussed above, when a sale of substantially all assets takes place under § 363 and outside the purview of the Chapter 11 plan process, the bankruptcy court should require the sale proponent(s) to post a bond or reserve a portion of the sale price to cover any damages suffered by the estate.230 We call this reserved fund the “Ice Cube Bond.” An Ice Cube Bond requirement, if used consistently, will help courts and claimants sort between sales for which there is a need for speed and opportunistic use of the melting ice cube argument.
At the outset, we should note that the Ice Cube Bond is consistent with broader commercial law principles. Outside of bankruptcy, a creditor who conducts a procedurally noncompliant foreclosure sale under the U.C.C. can lose her right to a deficiency judgment (the remaining debt left unsatisfied by the sale of collateral) unless she can show that the debtor has not been harmed by a low sale price.231 Some jurisdictions are harsher in the face of procedural noncompliance in consumer transactions, requiring that the lender forfeit its entitlement to a deficiency judgment altogether.232 Under the Restatement of Mortgages, for real property, even if a sale complies with state procedures, the deficiency may be adjusted to reflect the actual value of the property.233 An improperly conducted real property foreclosure might even lead to an unwinding of the sale transaction.234 In bankruptcy, the analogous procedural baseline is resolution pursuant to a Chapter 11 plan, whether the plan contemplates a sale or reorganization. The hurry-up sale under § 363 departs from that procedural baseline, and should be viewed as non-compliant. As we will explain below, the burden should therefore shift to the sale proponent to show that the quick sale did not cause harm, and the Ice Cube Bond should be released only upon a showing that no harm was caused by the procedural non-conformity.235
A bonding requirement is neither unusual, nor should it be particularly controversial. However, it raises important legal and operational questions. First, can courts impose the Ice Cube Bond under current law? If yes, then how should the amount of the reserve be set? What is the baseline for measuring harm? Who should have the burden of establishing entitlement to the funds? We address these issues in order.
While no provision of the Code specifically calls for an Ice Cube Bond, a variety of provisions could be used to authorize a court to impose one. Some of these provisions have general applicability. Others would apply to particular contexts.
When parties seek expedited affirmative relief in othercontexts, judges must order the posting of a bond to insure against the harm caused by an erroneous order. Although courts sometimes have waived this requirement or imposed a nominal bond,236 Federal Rule of Civil Procedure 65(c) generally requires the posting of a bond before a court can order affirmative preliminary relief.237 Federal Rule of Bankruptcy Procedure 7065 incorporates Rule 65, with one difference: it eliminates the bonding requirement for debtors, debtors-in-possession, and trustees. It does not, however, prohibit a judge from requiring a bond. It simply leaves the issue to the bankruptcy judge’s discretion because of the limited cash available to Chapter 11 debtors.238 This cash concern does not apply when sale proceeds are being allocated. Furthermore, Rule 7065 applies only to adversary proceedings (akin to civil lawsuits within bankruptcy cases). Section 363 sales are pursued as contested matters, not through adversary proceedings.239 Our proposal is inspired by the philosophy of Rule 65—preserve issues for final adjudication by requiring the party seeking immediate relief to bear the risk of an erroneous preliminary order. The Ice Cube Bond is then available to compensate the bankruptcy estate for valuation error or proceeds misallocation that occurs as a result of the quick sale.
As discussed below, the power to use a bond to preserve issues for later adjudication rests comfortably within the bankruptcy court’s ability to condition a sale order under § 363, to tax the secured creditor for the costs of liquidating its collateral under § 506(c), and, more generally, to exercise its authority under § 105 to preserve the estate.
First, § 363 does not explicitly authorize an Ice Cube Bond, but it does permit the court to impose conditions on the sale of property of the estate—such as through a lien or a holdback of a portion of proceeds—at the request of a party in interest to protect lienholders, including junior lienholders.240 This provision contemplates the exercise of judicial discretion to protect against the decline in value of a secured creditor’s collateral.241 Thus, to the extent the Ice Cube Bond is construed as protecting junior secured parties, this subsection of 363 provides a partial source of statutory support. If the estate needs to be protected more broadly, courts can preserve disputes about lien priority by providing that a lien would attach to the proceeds of sale.242 When a debtor negotiates debtor-in-possession financing, it is also not unusual for carveouts to be created to preserve disputes about the amount to be surcharged under § 506(c) or other matters.243 We are concerned that hurry-up sales under § 363 may be closed, and, at least in some non-trivial subset of cases, the funds disbursed, before any such disputes about perfection or priority could be uncovered. The Ice Cube Bond anticipates the possibility of undiscovered legal disputes, rather than providing only for those already identified. It ensures that funds will be available should any such disputes arise.
In many, if not most, hurry-up 363 sales today, the collateral is liquidated principally for the benefit of a senior secured lender. Section 506(c) of the Code provides: “The trustee may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim.”244 To the extent that the estate is forced to absorb expenses, even in the form of increased valuation risk, one could argue that the additional risk faced by the estate benefits the secured creditor. As such, the estate should be compensated. In these instances, the Ice Cube Bond is consistent with, and in furtherance of, the existing mandate in § 506(c).
More broadly, the statutory requirement that sales outside the ordinary course of business require notice, hearing, and court approval carries with it the implicit mandate that the sale should be approved only if it is in the best interest of the bankruptcy estate as a whole.245 Again, this leaves to case law and judicial innovation how to operationalize this mandate. The Ice Cube Bond provides the court with a useful tool for ensuring that the sale benefits the estate.
Finally, § 105 empowers the bankruptcy court to issue any order “necessary or appropriate to carry out the provisions” of the Code.246 Congress explicitly authorized courts to exercise this power sua sponte.247 A classic use of this kind of power by courts in other contexts is to issue a “status quo” injunction—an order that prevents irreparable harm, while preserving issues for litigation.248 The use of § 105 is controversial when employed to authorize actions that contravene the statutory priority rules,249 but our proposal does just the opposite. The Ice Cube Bond serves as a disputed claims reserve that can be used to give effect to the Code’s priority and timing principles in the face of the temporal exigency associated with the quick sale.
Under this analysis, courts currently have the authority to impose an Ice Cube Bond, whether as a literal bond or as a reserve or holdback of proceeds. No further statutory authorization is necessary.
The Ice Cube Bond allows a quick sale to go forward but preserves the legal status quo by providing for compensation in the event that the sale causes harm or distorts distributional entitlements. As our analysis in Part II illustrated, there are two types of harm to consider: (1) Quick Sale Cost that exceeds the Speed Premium, and (2) distortions to the bankruptcy priority scheme. To address both harms, the funds would be considered unencumbered property of the bankruptcy estate to be distributed pursuant to a confirmed Chapter 11 plan, unless a sale proponent met its burden of establishing that (a) the purchase price was not reduced by the expedited nature of the sale; and (b) the claimant is entitled to the funds as proceeds of its collateral, or pursuant to a specified priority entitlement.250 The Ice Cube Bond thus preserves the legal and economic status quo, without undercutting the finality of the sale. The sale proponent gets the expedited all-asset sale. The purchaser gets clear title to the assets. This approach makes it possible to approve a sale while postponing the discussion of proceeds allocation and possible valuation error.
Just as Federal Rule of Civil Procedure 65 provides a blueprint for the Ice Cube Bond, it also articulates a principle that can be used to establish its size: “an amount that the court considers proper to pay the costs and damages sustained by any party found to have been wrongfully enjoined or restrained.”251 In Part II, we detailed the possible harms: (1) erroneous approval of the sale because it was not in the best interest of the estate (Kaldor-Hicks efficiency); and (2) opportunistic use of leverage to alter the distribution of sale proceeds (Pareto Optimality).
The portion of the Ice Cube Bond attributable to valuation error likely would depend on the type of property. Where the principal assets are tangible and easily priced—restaurant fixtures, for example—the bond might be quite small. By contrast, a promising startup company with significant upside might be quite difficult to value. In between, a business with a predictable cost structure and cash flow might be capable of valuation but only with well-presented data. The Ice Cube Bond serves an information-forcing role: the better the information provided by the sale proponent, the smaller the reserve. The Ice Cube Bond thus encourages sale proponents to reduce the information asymmetry associated with the sale—one of the problems that precipitated our proposal in the first place.
The same information-forcing effect operates with regard to allocation of sale proceeds. Allocation error can arise in a number of situations. It can arise when incumbent management seeks a sweetheart deal to ensure itself a place in the company going forward. This form of allocation error merges with valuation error. More often, though, allocation error may arise due to overcompensation of a secured creditor arising from (1) a gap in perfection of prepetition liens, and the presence of unencumbered assets; or (2) an increment of going-concern value or the Speed Premium that cannot properly be classified as proceeds of the secured creditor’s collateral. In this context, to the extent that the sale proponent can provide information that establishes the secured creditor’s entitlement to sale proceeds, the necessary reserve may be smaller.
The informational limits that make it difficult to evaluate expedited sales also make it costly to craft the optimal bond on a case-by-case basis. Precision is not essential here, however, as the funds will not disappear and the amount can be adjusted later. Indeed, implementation of the Ice Cube Bond might benefit from a presumptive amount, such as ten percent of the purchase price.252 It need not, and probably should not, be set by statute, but rather by case law, local rule of procedure, or standing order.253 A presumptive amount would alleviate concerns that disputes over the amount of the bond would bog down the sale process. As we envision it, the court could deviate even from a presumptive amount if the existing evidence showed the range of valuation errors or allocation errors was particularly large or small.
Whereas the melting ice cube argument may be a valid reason for accelerating the sale, any attempt by management or others to use melting ice cube leverage to seek a total waiver of the Ice Cube Bond should raise a red flag. Even with respect to Rule 65(c), which by its terms requires a preliminary injunction bond, courts have split over whether the district judge has the discretion to set the bond at $0 or a nominal amount.254 We think the court and creditors should be able to resist in this context. First, melting ice cube leverage is greatest in cases where the valuation is most uncertain. Such situations counsel in favor of a greater bond, not a smaller one. Second, the Ice Cube Bond should not affect the value of the assets received by the buyer and thus should not affect the purchase price. As such, buyer interference in the reserve-setting process should backfire, signifying potential collusion with another party in interest. The only permissible basis for reducing the amount of the Ice Cube Bond should be certainty as to value, and this reduction should only be done by the court. It should not be the subject of pre-sale bargaining.
The Ice Cube Bond will make some claimants less certain of their ultimate distribution. However, this uncertainty is likely to improve rather than hinder governance. The Ice Cube Bond would place some, or all, claimants behind a veil of partial ignorance as to their distribution. This encourages such claimants to seek the highest value. More importantly, though, the Ice Cube Bond could be avoided by conducting the sale through a Chapter 11 plan. This would refocus questions about timing on the existence or non-existence of a Speed Premium. After all, when making the decision whether to hold an expedited sale, the question should not be whether the outcome is optimal for a particular claimant but whether holding the sale outside a plan is good for the bankruptcy estate.
Up until this point we have stated that the Ice Cube Bond, whether a true bond or a reserve from proceeds, would protect against valuation and allocation errors. We have not specified who will pay. Sometimes the proponent of the sale may be obvious. In some cases, an undersecured creditor (or syndicate of investors in a credit facility) asserting a blanket lien will push for a sale and try to claim all of the proceeds.255 In principle, that undersecured creditor should bear the entire cost. It is also axiomatic that claimants would not be required to post a bond if they are not going to receive a distribution in any event. However, cases are not always this straightforward.256 There may be a fully secured first lien claimant and an undersecured second lien claimant. Or there may be enough to pay all senior claimants, and a significant pro rata distribution to unsecured creditors, but no distribution to equity. There may be an indisputably undersecured senior creditor as well as unencumbered assets of the debtor. The principal beneficiary of the sale may not be obvious.
We do not want the costs of administering the Ice Cube Bond to eat substantially into its potential benefits. If a case-by-case approach is seen as unworkable, another approach would be to deduct pro rata from each claimant that stands to receive a portion of the sale proceeds, possibly adjusted based on any more specific information about the sale proponents. Everybody receiving a distribution would be involved proportionally. This would have the virtue of encouraging objections to the sale from claimants that doubt the existence of a Speed Premium.
The Ice Cube Bond should not harm the bankruptcy estate by reducing the sale price. The requirement affects the distribution of the sale proceeds, at least temporarily, but it does not directly affect the value received by the purchaser and should not affect the price they are willing to pay.257
In other judicial contexts, an injunction bond is released if the party that sought the injunction succeeds at trial. In other words, the bond remains in place until the proponent establishes that the injunction was properly issued. Bankruptcy sales are usually not reversible even if later found to be improvident.258 Indeed, the finality and clean title associated with bankruptcy sales contribute to bankruptcy-created value, as discussed in Parts I and II. The Ice Cube Bond is meant to preserve the finality of court-approved 363 sales. The legal questions relevant to releasing the Ice Cube Bond are whether expediting the sale reduced the value of the estate, and who is entitled to the sale proceeds.
With regard to sale price, Article 9 of the U.C.C., like bankruptcy, values transactional finality. Article 9 sales generally cannot be unwound even if the sale was noncompliant.259 The buyer can take its newly purchased property and go home, leaving any disputes about noncompliance to others.260 As stated at the outset of Part III, all-asset 363 sales in bankruptcy cases can similarly be characterized as noncompliant because the Chapter 11 plan process was designed to accommodate sales, not just traditional reorganizations.261 Consistent with this analogy, the reserve should be distributed as unencumbered assets on the effective date of the Chapter 11 plan, unless the sale proponent can establish that the 363 Sale Value was positive.262
With regard to distribution, as we discussed above, there are considerable reasons to doubt that even a secured lender with a blanket lien is entitled to all of the sale proceeds.263 As a result, a party seeking to recover withheld funds must do more than show lack of harm, but also that it is entitled to those sale proceeds—that, in the instance of a secured lender, they are proceeds of its collateral. Here we would place the burden of establishing entitlement on the claimant seeking preferred treatment.
Some may argue that withholding sale proceeds from a secured creditor while making a distribution to unsecured creditors subverts priority. To the contrary, our proposed bonding procedure takes legal priorities seriously—perhaps more seriously than current practice. A security interest is not a straight distributional priority. It is an interest in particular property of the debtor.264 As previously discussed, we neither assume the enforceability of blanket liens, nor expand the concept of proceeds to include reorganization (or other enterprise) value.265 We seek to carefully define what constitutes the collateral of the senior lenders. Under our interpretation, a senior lien claimant is entitled to the value of its collateral. Its collateral consists of the assets encumbered on the bankruptcy petition date, plus traceable proceeds subject to the limitations of § 552(b). Thus, for example, the senior creditor’s entitlement would exclude sale proceeds traceable to postpetition work by the debtor’s at-will employees as well as proceeds attributable to value that would not be realized had the assets been sold piecemeal, unless the senior creditor can show they are traceable proceeds of its collateral. Our approach does not deprive secured creditors of their property rights.266 It merely requires them to establish their entitlement. Preventing senior creditors from receiving more than they bargained for ex ante reflects the fact that priority has limits.267 An important point here is that, while our approach may increase the likelihood that junior interests will participate in a distribution, and gives them a voice, it does not allow the junior creditors to play for time by blocking a sale pending resolution of a priority dispute. The bond allows the sale to go forward and preserves the dispute for later.
Our proposal relies on a court to adjust the size and source of the bond or reserve on the front end (either setting it outright or establishing deviations from a presumptive amount), and preserves the ability of the court to determine release on the back end if necessary. Given that the role of the judge in Chapter 11 has been a perennial (albeit undertheorized) concern in the academic literature, the Ice Cube Bond will likely provoke questions about the judicial role in matters of valuation and distribution. When speaking of a market for distressed businesses and assets, advantages of a (generally thin) marketplace can be overstated. But whatever one’s views on this debate, the Ice Cube Bond should improve the quality of decisionmaking with less time pressure.
Scholars have long declared that judicial valuations are inferior to market measures.268 To say that a litigation process will better determine a company’s worth than would a price paid by a willing buyer will strike some readers as extremely problematic; this concern has prevented some judges from permitting other kinds of evidence to be entered about asset value in the context of a sale.269 For many observers, therefore, it is hard to imagine a situation in which an ex postpresentation by experts could or should be undercut or be substituted for an actual market price.
On the other hand, the assumption that judicial valuations are inherently inferior deserves more critical examination. For example, in their study comparing 363 sales to traditional reorganizations, LoPucki and Doherty found that the all-asset 363-sale market underperformed the judicial valuations in traditional Chapter 11 plan confirmations. “The judicially-based valuations in reorganization cases were surprisingly accurate predictions of post-reorganization trading values. The market valuations in sale cases appeared to average less than half of what the companies were actually worth.”270 As one would expect, LoPucki and Doherty’s explanations have attracted some criticism,271 but their findings reinforce the basic concerns about markets for distressed assets. They examine the segment of Chapter 11 cases in which one would expect the most transparency and information: large, publicly held firms. Research on smaller firm outcomes in Chapter 11 has suggested reason for optimism about judicial decisionmaking—even among scholars who were once skeptical.272
In addition, the basic courts-versus-markets dichotomy as a matter of theory has long been over-emphasized. First, as Susan Block-Lieb has discussed, most proponents of contract corporate bankruptcy have not adequately explained how or whether those market alternatives would avoid the problems of decision costs and market imperfection when applied to real world settings.273 Second, market proponents have regularly characterized the role of courts in Chapter 11 as far more exceptional than is accurate in the federal court system.274
We accept that the potential for an ex post hearing is a second-best solution when compared to a thick and liquid market. But, as previously noted, this is not the situation in bankruptcy.275When compared to the markets that actually exist for distressed assets, the comparative disadvantage of courts may not be as great as generally assumed. Another asserted disadvantage of judicial determination of value is cost. However, this too is likely a red herring because parties are likely to bargain post-sale rather than litigate over allocation of the holdback. The Ice Cube Bond ensures that questions about the existence of a Speed Premium and related matters of distribution will be scrutinized and negotiated after the sale has closed, in a circumstance of reduced time pressure free of melting ice cube leverage. The reduced time pressure should increase the quality of decisionmaking.
The Ice Cube Bond comes into play with respect to 363 sales that are best understood as procedurally noncompliant,276 and that produce specific valuation and allocation risks.277 Procedurally compliant foreclosure sales are entitled to deference, while procedurally noncompliant foreclosure sales are not.278 It is precisely because the valuations in hurry-up sales are suspect that we want to preserve the opportunity to reexamine them afterwards. Similarly, the sale price may be viewed with more confidence where there is no evidence of attempts to use leverage to distort the distributional scheme. In such cases it may be quite straightforward for the court to release the bond, essentially ratifying the sale price, but only after the sale has been completed.
When considering entitlement to the sale proceeds (to be distinguished from valuation), the market does not have the same degree of comparative advantage over courts. The market is good at valuing enterprises, not determining who has properly perfected a lien or is entitled to a particular priority. Nor is there as much need to resolve distributional questions before the sale. While questions of legal status, such as perfection, entitlement to priority, or preference liability, can be settled through negotiation, these negotiations are not time sensitive. The existence of a preferential transfer,279 or lack of perfection of a lien on the petition date,280 should not affect the viability of the business, and the legal arguments are not likely to change over time. As noted earlier, secured lenders do sometimes try to resolve such issues quickly through waivers in association with a sale or with financing.281 But these efforts may themselves be evidence of melting ice cube opportunism.
The complexities and variations in Chapter 11 cases also give us a greater appreciation for the role of the judge overseeing these sales and cases. Although the largest public bankruptcies receive the most attention in the press, and have been the most systematically studied in the academic literature, the dynamics we have explored affect business bankruptcy cases of many sizes and structures. Many commentators assume the existence of a senior undersecured creditor (or syndicate) with a blanket lien on all assets, and that has been common in recent years. But that was not always the case historically and is not universally the case today. We anticipate a wider constellation of arrangements, including cases in which lenders intend a blanket lien but do not achieve it. A court can adjust to the variation, ensuring that the Quick Sale Costs and Speed Premium benefits are properly allocated.
Law and economics scholars also worry that the possibility of ex postrevision of transactions can distort ex ante incentives. In our view, this distortion is likely to be salutary rather than problematic. Ex post review should reduce the likelihood of proposed sales that substantially overreach. This dynamic exists whether or not a judge ultimately is called upon to make a determination (or, as might happen more regularly, the allocation of the reserve is worked out through post-sale bargaining). By deterring overreaching, the availability of ex postreview may improve market behavior ex ante,where, as here, there is considerable concern about opportunistic behavior. We are not concerned about hurry-up sales, per se. We are concerned about the impact of the opportunistic use of the melting ice cube argument on valuation and distribution.
Given that it does not actually prevent a quick sale from going forward, the Ice Cube Bond can be distinguished from proposals that would affirmatively limit the use of 363 sales.282 But, if properly administered, the Ice Cube Bond should deter quick sales for which the Speed Premium, if any, is outweighed by the Quick Sale Costs, and channel them towards a sale under a plan. It should also reduce the routine use of the melting ice cube argument when it is not warranted. Sale proponents have options. They can propose a quick 363 sale and either accept the fact of the bonding requirement, or be prepared to establish entitlement to the funds. This will be worthwhile only if the debtor really is a melting ice cube. Or they can conduct the sale as part of the full Chapter 11 plan process.283 This may occasion some delay, but no Ice Cube Bond would be necessary. If the debtor is not a melting ice cube, the proponent will be encouraged to comply with the normal plan process rather than take a shortcut.284
As previously noted, some readers may worry that the buyer will use its leverage to specify that, as a condition of sale, the estate will forgo the Ice Cube Bond. The concern here is that the same pre-sale leverage that is used to bargain for other favorable conditions also will be used by the buyer to obtain a waiver of the Ice Cube Bond. As we said before, this should be a red flag. A key benefit of the Ice Cube Bond is that it allows the buyer to take clear title to the assets without being embroiled in disputes about the distribution of the proceeds. We see no legitimate reason for the buyer to care how the proceeds are distributed, unless it has struck a side deal with a party in the case. In short, such a stipulation is not about the purchase, but about distribution, and a sign that a particular creditor constituency has agreed to support the sale in return for an enhanced distribution. The court, the creditors’ committee, or individual parties should call this bluff.
It is important to recognize that if the sale proceeds holdback is to be distributed pursuant to a Chapter 11 plan, it will be subject to negotiation and potentially allocated pursuant to a consensual arrangement. A full judicial hearing need not happen. This raises another question: if the proceeds are going to be the subject of bargaining ex post, why is this preferable to allowing them to be the subject of bargaining prior to the sale? The difference lies in the absence of transactional leverage. The type of bargaining that happens ex postover distribution of the Bond is likely to be quite different from the hothouse bargaining that occurs ex anteprior to the sale.
Pre-sale bargaining would likely be based on transactional leverage—“my way or the highway” arguments.285 The potential buyer is in the driver’s seat, and it can exact concessions for its allies, in the form of deviations from the bankruptcy distributional scheme or price concessions. This form of brute-force bargaining does violence to legal entitlements that, outside of bankruptcy, might give rise to an economic duress defense against contract enforcement.286 The Humboldt Creamery case discussed earlier shows that transactional leverage risks strong-arming the court as well, and insulates deals that might otherwise be unenforceable under contract law.287
By contrast, bargaining after the sale is positional. Instead of arguing about leverage, the conversation is about entitlement. Bargaining about the distribution of the Ice Cube Bond proceeds can and should be part of the Chapter 11 plan process. At that point, the conversation unfolds in the shadow of a judicial determination of value and entitlement rather than a game of transactional chicken. The fact that positional bargaining or judicial decision will occur ex post alters the nature of the bargaining ex ante.The bonding requirement thereby limits the extent to which transactional leverage can be used to distort legal entitlements.
The melting ice cube argument is a member of the family of tools that business purchasers utilize to lock up a favored deal in various transactional contexts. In the corporate law literature on lock-ups, a number of alternative proposals reflect the concern that a sale deprives dissenting stakeholders of option value. Daines and Hanson propose that the dissenters be given bonds that would pay off if the original sale price for the company turned out to be inadequate.288 Adler and Ayres, along with Lucian Bebchuk, propose various mechanisms through which junior interests could purchase the option value from the senior interest to protect their positions.289 Flipping this idea on its head, Anthony Casey suggests that the senior creditor be required to purchase the option value from the junior creditors.290
When thinking about the melting ice cube problem in 363 sales, we have concerns about each of these approaches. The topping off bond eliminates the finality and clean title that is the hallmark of bankruptcy sales, as we explored earlier. Given the choice, purchasers prefer to have all price risk resolved at closing, and may seek to make it a condition of the sale. Unlike the topping off bond, our Ice Cube Bond proposal does not alter the finality of the outcome.291 The Daines and Hanson proposal, by contrast, would leave the purchase price open for the duration of the proposed bond, which would undercut finality and reduce the asset’s value to the buyer. Our Ice Cube Bond proposal does not erode this finality; it merely reserves the questions of value and allocation errors for another, later day. These questions of allocation do not concern the buyer and should not affect the sale price.
The other proposals noted above would require the junior creditors to set the value of their interests at the very time when their information is at its weakest. Bebchuk would require the junior interests to buy out the senior interest. Adler and Ayres would auction off the equity.Casey would have the senior interest buy out the junior interest’s optionality. While these proposals, to varying degrees, have information-forcing attributes that might reduce the information asymmetry, none addresses the underlying problem of information shortage and time constraint associated with an early sale. They seek a market-based solution at a time when markets are thin, and, as Baird and Morrison point out in the Chapter 11 context, information is in short supply.292 This makes us wary of a solution that seeks to definitively allocate option value at the time of sale.293
In addition, each of these proposals assumes a senior undersecured creditor with a valid blanket lien. But what happens if priority becomes non-hierarchical or uncertain, as often can be the case? The bargaining games become too complex under real-world conditions, particularly in a time-sensitive negotiation, for these proposals to operate. Where there are issues of entitlement, priority, and leverage, held by multiple parties, coordination problems may make consensual solutions impossible to achieve. Authoritative determinations based on legal entitlements may be unavoidable.
Moreover, the Adler and Ayres type auction might be difficult to accomplish within the time constraints associated with a true melting ice cube sale. Casey’s priority may be even more problematic. By giving the junior creditors a veto, Casey takes a contractual right to repayment (protected with a liability rule) and enforces it with a property rule.294 The sale could not go forward unless junior creditors agreed to a price at which they might sell their option. He does not attempt to value the priority and does not suggest a judicial mechanism for doing so. As such, there is no set strike price that would allow the sale to go forward. This right to block a quick sale, like any functional property right, creates a unilateral veto and a bilateral monopoly.295 Moreover, Casey assumes that junior creditors will be able to bargain as a group. But unsecured creditors are often diffuse and, at least in larger cases, numerous, and may find it difficult to coordinate.296 Individually, they will have insufficient incentive (and limited capacity) to gather the necessary information.
While negotiation about the price of the option value may force out information and thus limit the information asymmetry, Casey’s proposal does not remedy the problem that the melting ice cube argument forces negotiation to occur at a time when information is generally in short supply. As a result, Casey’s proposal could overdeter quick sales.
Although the particular confluence of events that led to the Chrysler bankruptcy and sale may be a rarity, the case put the melting ice cube problem before the public in a concrete way. When a debtor and purchaser pursue a sale prior to a Chapter 11 plan and assert that the debtor is a quickly wasting asset, they initiate a game of chicken with other parties and a court that are at serious informational disadvantages.
If delay will destroy the value of the debtor, then bankruptcy law should facilitate a quick sale. Here, we have dissected the problem in a way that has led to a tailored solution: the Ice Cube Bond, reserved at the time of sale to insure against valuation errors and distortion of the bankruptcy priority scheme. The proposal should limit the leverage created using a melting ice cube bluff. We neither glorify nor vilify sales as a general matter, but seek to limit the use of transactional leverage by sale proponents, and facilitate the re-internalization of risks associated with expedited all-asset sales.