In mid-May, Vice Media Group — once an alternative media darling — filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. The filing came months after the company had been planning a buyout for a fraction of its 2017 valuation of $5.7 billion. Now, the company will be offloaded to investors for a fraction of that amount.
When faced with the inability to pay off its debts, a company has two main options for filing for bankruptcy: filing under Chapter 11 of the Bankruptcy Code or Chapter 7.
Under Chapter 11, there are a few avenues and options available to companies, including arranging a stalking horse bid and vying for debtor-in-possession financing.
Chapter 7 and Chapter 11
While Chapter 7 and Chapter 11 bankruptcies are common options for companies facing financial troubles, they differ in one major way: Chapter 11 bankruptcy allows a company to control its assets as it reorganizes and paves a way for continuing operation and repayment, while Chapter 7 brings in a trustee to liquidate that company’s assets.
“The best way to describe Chapter 11 and that choice is to understand what Chapter 7 is first, and then [that] Chapter 11 stands in contrast to it,” said Jordan Kroop, a longtime bankruptcy lawyer and adjunct professor at Arizona State University’s Sandra Day O’Connor College of Law.
Businesses that enter Chapter 7 bankruptcy protection follow a similar path to individuals who file for Chapter 7. Assets are sold off by a trustee managing the debtor’s estate in order to pay off debts, after which the remaining debt is typically forgiven.
“That’s what a Chapter 7 is, and it really isn’t a whole lot more complicated — especially for a business — than that,” Kroop said.
This differs from Chapter 11 bankruptcy, as the debtor must continue to repay the remaining debt after the sale of assets through future earnings. Additionally, Chapter 11 “stands in stark contrast” to Chapter 7 in two key ways, Kroop said: “The first is that, generally speaking, a business that is operating, that continues to operate and wants to continue to operate, can and will do so in Chapter 11.”
Secondly, a trustee is generally not appointed under Chapter 11, and the current management remains in control of the company during the bankruptcy process, Kroop said. “At that point, the company is referred to as a debtor-in-possession for the simple reason that it remains in possession of its assets while the company is using the tools and relief available to it in Chapter 11.”
Even if a company knows that there is no way it could continue to operate, it is common that a business would file for Chapter 11 rather than Chapter 7 so it can retain control, Kroop said.
Having current management in control during bankruptcy proceedings may bring a better price for the company’s assets, said Laura Coordes, a professor of bankruptcy law at Sandra Day O’Connor College. Not having that third-party trustee handling the company’s assets is one of the most pertinent differences between Chapter 7 and Chapter 11, she said.
Because of this, not only does the law encourage businesses to liquidate inside Chapter 11, but creditors may view this option as more advantageous because it is generally true that current management will be able to sell assets for a higher price than a trustee could, Kroop said.
While the debtor doesn’t participate in liquidation during Chapter 7 filings, the debtor in a Chapter 11 bankruptcy filing may participate in a sale of assets under Section 363 of the U.S. bankruptcy code. This kind of sale of assets allows the company filing for bankruptcy to market its assets to bidders before putting them up for auction.
“That’s the third thing you can do in a Chapter 11 case,” Kroop said. “Is that you can find a way to sell all of your assets in an operating posture — the company is operating, it continues to operate, therefore it is more valuable to a buyer.”
Chapter 11 allows a buyer to purchase assets from an operating business without also taking on its liabilities and debts, Kroop said. “And only bankruptcy can accomplish that. There is no other proceeding under federal or state law that permits such a thing to happen.”
Stalking horse bidders
The Vice filing noted that it was in the best interest of the company to “enter into a stalking horse agreement for the sale of substantially all assets.”
A stalking horse agreement is when an initial bidder sets a floor price for other bidders on the debtor’s assets. In exchange, the stalking horse bidder can receive incentives, like expense reimbursement, breakup fees and leverage over other potential bidders.
This stalking horse agreement will have to be approved by the court, and incentives offered to the stalking horse bidder are going to be scrutinized by the court out of fairness to other potential bidders, Coordes said.
More often than not, a company will file for bankruptcy having already negotiated the purchase with a prospective buyer, Kroop said. The stalking horse bidder is an entity that has done its due diligence about the company and usually has previously negotiated the terms of an asset purchase agreement, which is filed with other documents with the bankruptcy court, he said.
“Now everybody in the world — literally, it is very public — everybody in the world will know the identity of the buyer, the buyer’s purchase price, the buyer’s allocation of the purchase price among the various classes of assets that the buyer is proposing to purchase,” Kroop said. No reasonable bidder would do this without some protections from the bankruptcy court.
Unlike in a private transaction, there’s no exclusivity as the purpose of a sale in bankruptcy is to sell assets to the highest bidder. “But we’ve got a stalking horse bidder who was at least the first one in the door,” he said. That bidder has usually put a lot of time, money and resources into preparing for the purchase.
Here there’s a potential situation that economists might call a free rider problem, where outside bidders utilize the work the stalking horse bidder did for free and simply bid at a higher price. To discourage this, one of the main arrangements in a stalking horse bid comes in the form of a breakup fee.
A breakup fee allows the stalking horse bidder to get a payout from a higher bidder, typically a small percentage of the purchase price, Kroop said. Additionally, the stalking horse agreement may require outside bidders to bid a minimum increment above the stalking horse’s purchase price.
According to a press release, Vice has asked the proposed purchase to be pursuant to Section 363, allowing “outside parties to submit higher or better bids for the company.”
A 363 sale typically takes less time than a traditional reorganization under Chapter 11, Coordes said, while creditors generally have less say in the sale because they don’t vote on it like they would a reorganization plan.
According to the filing, it is in the best interest of Vice that its companies listed in the document receive the debtor-in-possession financing, or DIP financing, that was established in a previously negotiated agreement with its lenders.
While Chapter 11 bankruptcy on its own does provide some breathing room for the company, “it doesn’t necessarily provide a cash infusion,” Coordes said. If the company hopes to continue operating during its bankruptcy, it has to secure debtor-in-possession financing and will often look to existing creditors to secure a loan.
As part of the DIP financing agreement, it is possible that other creditors’ positions could be subordinated from lenders as an incentive. “Typically the debtor cannot do this without showing the court that this is necessary … because we don’t, as a general rule, want to go about randomly subordinating creditors’ claims and elevating others,” Coordes said.
The lender in a DIP financing arrangement often imposes financial benchmarks that the debtor has to meet to assure the lender that loan will be repaid. These arrangements are often hashed out in great detail and need to be approved by the court.
If the debtor can’t secure the financing to continue operating, they may need to rework their DIP financing deal to make it more palatable to a judge or, worst case, forfeit their Chapter 11 case entirely.
“I think, in a lot of cases, if the judge is signaling that they’re not comfortable with the agreement, the parties can negotiate and try and come up with something that’s workable,” Coordes said. “Because you really do want to get that DIP financing because it’s pretty much your key to continuing with your case.”