Stalking Horse

Practical insights from powerhouse attorney, author and speaker Bradley Bailyn.

You weren’t immediately concerned. You have been receiving notices from your largest debtor ever since the company entered Chapter 11 bankruptcy last year, and they have always been fairly easy to wrap your mind around. After all, the company has enough valuable assets that you are confident that as a secured creditor you will ultimately get your money.

But this notice seems different.

Inside the envelope is a notice from your debtor’s attorney that they are requesting permission from the bankruptcy judge to sell that prized asset of theirs. But this doesn’t seem like a normal auction; the notice says they’ve found something called a “stalking horse bidder,” and they’ve already agreed to a purchase agreement. You can’t help but wonder if they just sold their only real asset out from under you. You have tons of questions running through your head.

Did they just sell this asset without any input from their largest creditor?

How hard did they work to find the best price?

If this sale leaves money on the table, will it end up costing you?

Can I stop this from happening? Is it even in my best interest to?

It’s time to talk to an attorney that can answer these questions and more. You have legal rights when it comes to a stalking horse bid, but if you aren’t careful you can lose those rights. The truth is, however, that having a stalking horse bidder can result in your debtor getting the best possible return for their asset. Developing a strong legal strategy with your attorney can help facilitate a favorable deal, and it can also prevent you from being taken advantage of.

What is a Stalking Horse Sale anyway?

The term “stalking horse” may sound sinister, but in reality a stalking horse bid is simply a tool used by bankrupt debtors to liquidate assets while avoiding low bids at the auction. In the simplest terms, a stalking horse bid operates as a minimum bid for an asset a debtor intends to sell at auction. By entering into an agreement with a stalking horse bidder, the creditor goes into an auction with a negotiated agreement for the opening bid. That way, the debtor begins the process with an agreement in principle for their worst-case scenario. Since bidding will still be open starting at the amount of the stalking horse bid, it is possible the asset could wind up selling for much more. For that reason, it is not uncommon for these agreements to offer incentives for stalking horse bidders in case their bid is ultimately unsuccessful. The deal isn’t done even when the auction is completed however as the bankruptcy court must still sign off on the sale.

One of the primary goals behind the stalking horse bid process is to simply get the ball rolling with a strong opening bid. Purchasing assets from a bankrupt entity often offers a chance at a great value, but there is risk involved for investors. What’s more, many investors prefer not to make the first bid as they don’t have perfect information about what the asset is worth to the debtor. How would you feel if you started the bidding for an asset at $1 million when the debtor would be thrilled to part with it for a fraction of that? The fear of overpaying leads to one of the biggest problems with traditional auctions: lowball starting bids.

The stalking horse bid is designed to avoid the trepidation surrounding the first bid at auction and remove low opening bids from the equation. By negotiating terms with a potential buyer up front and including some incentives in case the bidding outpaces the stalking horse bidder’s budget, a debtor is set up to get potentially get a fair price for their asset.

How do these sales work?

The process of a stalking horse sale is governed by Section 363 of the bankruptcy code. Like most sales, it begins with a debtor that is seeking to sell an asset to raise capital. And while the ultimate result of a stalking horse bid is a public auction, the debtor starts by identifying potential buyers and eventually negotiating a purchase agreement.

Finding a Buyer

There are no hard and fast rules directing the way a debtor sets up a stalking horse sale. The debtor may have identified an ideal candidate to purchase the asset and negotiated with them in earnest. In other cases, a debtor may cast a wide net, spreading the word that they are seeking to sell the asset in question. The debtor could then field a range of offers and select the best one as their stalking horse bid.

A critical step for potential buyers is performing due diligence on the asset before they ever enter into a purchase agreement. Prospective buyers will want to fully understand value of the asset. That is in part because a bankruptcy court will be less flexible regarding the sale of an asset that is increasing in value. It is standard that any prospective buyer will sign a confidentiality agreement in exchange for access to the debtor’s records regarding the asset.

The Stalking Horse Bid

Regardless of whether a debtor considers one potential buyer or many as their stalking horse, they will ultimately have to select an offer as their favorite. Once a stalking horse bid has been selected, it is up to the debtor and the bidder to negotiate the terms of a purchase agreement.

There is no required form for a purchase agreement under Section 363 of the bankruptcy code, and for a good reason. After all, every asset is different. Would you expect the sale of a dolphin tank to have the same sticking points as the sale of a tractor? Of course not. That’s why the parties are given latitude to negotiate in fairly broad terms. In addition to negotiating the sale price and other issues specific to the asset, the parties will also typically iron out some incentives that favor the bidder. The process of putting together a bid and doing the necessary due diligence can be expensive. It’s not fair to the bidder to leave empty-handed after helping the debtor by starting out with a strong bid, only to be outbid at the auction. To address this possibility, there are a few common benefits that are frequently written into these purchase agreements:

  • Expense Reimbursement – Likely the most common incentive enjoyed by stalking horse bidders is expense reimbursement. For large-scale purchases, the expenses a bidder will incur to facilitate the purchase and perform due diligence can be staggering. That’s why many purchase agreements require the debtor to repay the expenses of a stalking horse bidder if they are ultimately outbid.
  • Break-up Fees – Expense reimbursement helps make a stalking horse bidder whole if they are ultimately outbid, but that leaves them back where they started after going through the enormous undertaking of putting the bid together. A break-up fee is an amount negotiated above and beyond any expenses designed to induce an investor to make a bid. Break-up fees are controversial, and not every jurisdiction allows them.
  • Bidding Guidelines – Another controversial incentive involves the stalking horse having a say in drafting the bidding procedure for the public auction. The stalking horse bidder will, of course, seek any advantage they can get. That’s problematic, as anything that discourages other bidders drags down the sale price. Creditors in particular are hostile to these incentives, and some jurisdictions require the debtor to draft the bidding guidelines in conjunction with the creditors’ committee before a stalking horse is selected.

Public Auction

There are no set guidelines on how the auction must take place. Even the date of the sale can vary; creditors typically want more time to allow more bidders while the stalking horse bidder often wants a shorter timeframe for the opposite reason.

Once the date for the auction is set, the court will often set a deadline for potential buyers to announce that they are participating in the auction. If no other party gives notice of a competing bid, the auction will be canceled and the original parties will move forward with the purchase agreement that was previously negotiated.

The final step is approval by the bankruptcy court. This is not guaranteed, especially if there are creditors that object to the sale. The judge will decide what the asset is worth and if the asset’s value is increasing or decreasing. Ultimately, the judge is required to make a ruling that is in the best interest of all parties.

Are Stalking Horse Sales Fair to Creditors?

Generally speaking, a stalking horse sale can be good news for everyone involved. By entering into the public sale with an acceptable starting bid, you will at least have the peace of mind that the asset will receive more than just lowball offers. But there is room for you to be treated unfairly. Any purchase agreement that discourages other bidders will likely lead to a lower sale price. There are a few things you will need to be careful of:

Ensure Auction Procedures Stimulate Bidding

While it is common for creditors to get a say in the drafting of the auction parameters, it is possible for the debtor and the stalking horse bidder to attempt to limit the pool of bidders by restricting the time in which a bidder can give notice of their bid.

Avoid Unreasonable Break-Up Fees

If the sale is taking place in a jurisdiction where break-up fees are allowed, it is important for a creditor’s attorney to keep any break-up fees within reason. It is one thing to offer an incentive that will only be paid when the final bid will more than pay for it. But exorbitant fees can eat the return on the asset, costing the creditors dearly in the end.

Object to the Final Sale if Necessary

Thankfully, if you believe the sale price is unreasonable or the sale itself was unfair, you are within your rights to object to the purchase agreement being finalized. You will need to file a timely objection to the sale before the bankruptcy judge makes a final determination on allowing the sale or not. As long as the you are diligent, the final result in a stalking horse sale will likely be beneficial to everyone involved.