Asset Sales Committee

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Collusion in Bankruptcy Sales Part III – Collusion Versus Collaboration

Part I of this four-part series discussed, in general terms, the prohibition of collusion in bankruptcy sales under section 363(n) of the Bankruptcy Code. Part II discussed the fine line separating permissible collaboration from impermissible collusion. In this third part another fine line will be explored: the line between agreements that control the sales price at an auction, and agreements that only affect the sales price. As in Parts I and II, the discussion generally is from the point of view of a prospective bidder and addresses the knowledge such a bidder should have to avoid liability under § 363(n). Part IV will discuss the finality of sale orders, i.e., the time period within which a party must bring a § 363(n) action. That discussion will generally be from the point of view of a § 363(n) plaintiff. Therefore, while the information provided in Parts I through III is helpful to both § 363(n) plaintiffs and defendants, stay tuned for Part IV if you are looking for a roadmap of how to hold a suspected colluder accountable under the Bankruptcy Code.

As discussed in Part I, the elements for liability under section 363(n) are: (1) the existence of an agreement; (2) among potential bidders; (3) that controlled the price at bidding. As to the first element, an agreement among potential bidders need not be in writing. Circumstantial evidence of a collusive agreement is sufficient for a court to hold parties liable under § 363(n).

It should be noted, however, that § 363(n) is not a blanket prohibition on agreements between potential bidders. For example, bidders that cannot afford a competitive bid may enter into an agreement to submit a joint bid. Moreover, as discussed in Part II, potential bidders may enter into collaborative (but not collusive) agreements. The case discussed in Part II (In re Edwards, 228 B.R. 552 (Bankr. E.D. Pa. 1998)) touched on the issue of agreements that control the sale price versus agreements that are motivated by other innocent reasons. The innocent motivation of the potential bidders in the Edwards case was a desire to obtain a favorable settlement agreement that resolved all the on-going disputes between the parties.

The Edwards case provides a helpful example in the context of collaborating parties, but the issue of “controlling” the sales price bears further discussion. What does it mean to control a sales price? And, what if an otherwise innocent agreement “affects” the sales price? Does that mean that § 363(n) has been violated?

These questions were considered by the Second Circuit Court of Appeals in In re New York Trap Rock Corp., 42 F.3d 747 (2d Cir. 1994). New York Trap Rock is likely the most significant case discussing the application of § 363(n). The case is significant because it addressed the “control” versus “affect” issue. But, it is also significant because it is one of the very few circuit level decisions that discuss § 363(n) at all. In other words, no § 363(n) education is complete without a discussion of New York Trap Rock.

New York Trap Rock case involved Chapter 11 debtor Lone Star Industries, Inc. (“Lone Star”). In an effort to liquidate its interest in the South American cement market, Lone Star sought to sell its wholly-owned Argentine subsidiary, Compania Argentina de Cemento Portland, S.A. (“CACP”). CACP, in turn, owned a 50% interest in Cemento San Martin (“CSM”), an Argentine cement producer. The other 50% was owned by Patagonica. Patagonica was the wholly-owned subsidiary of Perez (see the decision at 42 F.3d 750 for a helpful diagram illustrating the relationship between Lone Star, CACP, Perez, Patagonia, and CSM).

CSM’s by-laws provided that each joint-venturer (CACP and Patagonica) had a right of first refusal in the event that the other joint-venturer sold its 50% interest to a third party. Lone Star marketed its interest, and the only party to submit an initial bid was Perez for $36 million. After more marketing, a company called Loma Negra submitted a bid for $38 million. While Loma Negra’s bid was on the table, and without disclosure to Lone Star or to the bankruptcy court, Loma Negra signed an agreement to purchase Patagonica’s 50% interest in CSM for $55 million. The bankruptcy court later approved the sale of Lone Star’s interest in CSM to Loma Negra.

Several months after the sale, Lone Star filed an adversary proceeding alleging that Loma Negra violated § 363(n) when it failed to reveal its dealings with Patagonica. The bankruptcy court denied summary judgment to Lone Star and granted summary judgment to the defendant on the ground that § 363(n) does not apply when the agreement affects, rather than controls, the sale price. The district court affirmed the bankruptcy court’s decision.

On appeal, the Second Circuit first summarized Lone Star’s position as an argument that Loma Negra violated § 363(n) because its agreement with Patagonica affected the sales price of Lone Star’s interest. More specifically, the effect of Loma Negra’s agreement to Purchase Patagonica was that it took Patagonica out of the bidding. The agreement therefore prevented a competitive bidding process between Loma Negra and Patagonica for the purchase of Lone Star’s interest in CSM.

The court went on to cite the text of § 363(n) which prohibits agreements that “control” the sale price. The court then noted that the common definition of “control” “implies more than acts causing an incidental or unintended impact on the price; it implies an intention or objective to influence the price. The court further provided:

It is most unlikely Congress would have intended to prohibit all agreements that affect a sale price. Such a prohibition would cover a vast range of innocent agreements among potential bidders; it would furthermore be very difficult for the parties to an agreement to recognize that their agreement was unlawful. They would need to make an imaginative exploration of the potential consequence of their agreement to determine whether it had a potential to affect the price of the auction sale.

Id. at 752.

The court rejected Lone Star’s argument and held that to be liable under § 363(n), “[t]he influence on the sale price must be an intended objective of the agreement, and not an unintended consequence . . . .” Id. The court therefore affirmed the district court’s denial of summary judgment in Lone Star’s favor because Lone Star was arguing that an agreement affecting the sale price was a violation of § 363(n).

The New York Trap Rock case sets a high bar that a § 363(n) plaintiff must clear to demonstrate liability. The specific, intended objective of an agreement must be to cause the property to sell for a lower price than it might have sold for had the agreement not been entered into.

Subsequent court decisions analyzing this specific issue have unanimously adopted the “affect versus control” framework. In addition, the Edwards court took this analysis another step by noting that even if the court finds that the parties entered into an agreement to control the price, such a finding is not sufficient by itself to require disapproval of the sale. Rather, a § 363(n) plaintiff must show that the agreement actually did deprive the estate of fair value for the assets.

From the perspective of potential bidders, the New York Trap Rock framework is good news. As per this framework, bidders are free to enter into a broad range of agreements that affect the sales price, as long as the parties are not entering into the agreement with the intention to influence (or “control”) the sale price. Therefore, any agreement between potential bidders should document the non-collusive reason that the parties have chosen to enter into the agreement. Disclosure of the agreement to the court and to other parties is also a good idea. It should also be noted that Loma Negra did not disclose the existence of its agreement with Patagonica in the New York Trap Rock case. This should not be seen as an endorsement of non-disclosure. Other § 363(n) case law has made it clear that disclosure of an agreement weighs heavily in favor of the defendant’s argument that the agreement did not run afoul of § 363(n).

From the perspective of § 363(n) plaintiffs, New York Trap Rock demonstrates the difficulty of successfully bringing a § 363(n) action. Such a plaintiff must delve into the motivations of the potential bidders to demonstrate that, while the agreement may provide boiler-plate non-collusive motivations, the “real” reason for the agreement was to stifle bidding and to keep the sales price low. This generally will require the collection of circumstantial evidence to demonstrate the intent of the defendants. In addition, the plaintiff may also be required to demonstrate that, but for the intentionally collusive agreement, the assets would have sold for a higher price. This may prove difficult where, for example, the assets are highly specialized and the universe of potential bidders is relatively small. The high bar set by these decisions likely explains why there are very few reported decisions holding parties liable under § 363(n). ________________________________________________________________________________________________

[1] Jason Binford is an associate in the bankruptcy section of Haynes and Boone, LLP. This article is adapted from a law review article to be published in vol. 21, issue 1 of the Emory Bankruptcy Developments Journal.