Breakup Fees Revisited: Burlington Industries Inc. and SHC Inc.

Two recent Delaware cases illustrate how courts continue to scrutinize so-called “breakup fees” payable to “stalking horse” bidders in bankruptcy sales. In both the Burlington Industries, Inc.¹ and SHC, Inc.² (“Top-Flite”) cases, the debtors’ proposals to pay multimillion-dollar breakup fees to reputable bidders faced intense scrutiny. Although breakup fees often pass muster under prevailing criteria and thus continue to feature prominently in bankruptcy sale negotiations, debtors and potential bidders should not assume that a perfunctory showing of “added value” will carry the day. Indeed, the court denied breakup fees altogether in Top-Flite, and the court in Burlington slashed the proposed fee by more than fifty percent.

I. Brief History of Breakup Fees; General Commentary

Commentators have long debated the arguments for and against breakup fees.³ Proponents invariably argue that the availability of breakup fees provokes an opening bid. Indeed, the debtors’ motions for approval of bidding procedures in both the Burlington Industries and SHC cases disclose that the proposed purchases were expressly contingent on court approval of breakup fee arrangements. The “white knight” or stalking horse bidder’s reputation alone can add value. For example, Burlington Industries lauded its stalking horse, Berkshire Hathaway, noting that, “Many investors follow closely the buyer’s investment interests, and the buyer’s general reputation as a sound judge of business value will help to ensure that the auction process yields the maximum value for the debtors’ estates.” ⁴

Early breakup fee decisions, relying on non-bankruptcy concepts, developed a modified “business judgment rule” to be used in determining whether fees should be allowed. For example, the court in Official Committee of Subordinated Bondholders v. Integrated Resources, Inc.⁵surveyed breakup fee cases to date and devised a list of three questions to be used when evaluating the validity of proposed fees, namely: “(1) is the relationship of the parties who negotiated the breakup fee tainted by self-dealing or manipulation; (2) does the fee hamper, rather than encourage, bidding; (3) is the amount of the fee unreasonable relative to the proposed purchase price?”

Courts and commentators have disputed whether breakup fees actually induce bidding and add value. In a seminal 1992 article, Prof. Bruce Markell rejected the adoption of the non-bankruptcy “business judgment rule” concept and argued instead that the “maximum breakup fee that a court should approve is one that offers to repay a bidder’s direct costs of preparing and making its bid.” ⁶ The court in In re America West Airlines, Inc. adopted Prof. Markell’s reasoning when it held that the proper analysis must “include a determination that all aspects of the transaction are in the best interests of all concerned.” ⁷ Rejecting the business judgment approach, the court asked whether the “transaction will ‘further the diverse interests of the debtor, the creditors and equity holders, alike.” ⁸

A recent Third Circuit decision refined the “best interests” approach by borrowing “general administrative expense jurisprudence.” In Calpine Corp. v. O’Brien Environmental Energy, Inc. (In re O’Brien Environmental Energy, Inc.),⁹ the court compared breakup fees with other administrative expenses, requiring the requesting party to “show that the fees were actually necessary to preserve the value of the estate.¹⁰ All the interested parties in Burlington and Top-Flite invoked this new standard in their breakup fees briefing.

II. Current Developments: Burlington and Top-Flite Case Studies

The committee in Burlington attacked the proposed sale to Berkshire Hathaway on several fronts. In summary, Berkshire Hathaway proposed to pay roughly $579 million in total consideration to acquire all the reissued stock of the corporation. A $14 million breakup fee figured prominently in the deal. The committee argued that (a) the purchase price would return a dividend of only 35 percent to unsecured creditors; (b) this unprecedented procedure (selling stock pursuant to §363) would coerce plan acceptance and bypass the plan confirmation process.¹¹ The Committee noted that, given Berkshire’s $14 million breakup fee and the proposed $5 million overbid requirement, subsequent bidders would need to top Berkshire’s offer by $19 million.¹² Joining in the committee’s objections, the U.S. Trustee’s office also objected to the debtors’ attempt to set the matter for hearing on shortened time.¹³ In defense of their proposal, the debtors replied that the proposal “create[d] the shortest and surest path to the successful conclusion of these chapter 11 cases” ¹⁴ and that they had “negotiated vigorously with Berkshire” regarding the bidding procedures. ¹⁵

Likewise, the committee in Top-Flite challenged several items in the proposed Sale Procedures that related to Callaway’s stalking horse compensation. First, the committee questioned why the debtor had expedited the auction process despite giving Callaway (the proposed buyer) two months to close the deal.¹⁶ Second, the committee questioned why Callaway should receive a combined breakup fee and expense reimbursement of as much as $5.625 million ($4.375 million breakup fee plus $1.25 million expense reimbursement). ¹⁷ The committee noted that this combined fee represented as much as 5percent of the net consideration the debtors would receive from the sale. Third, the committee argued that Callaway’s right to “credit bid” its breakup fee, coupled with the $2 million overbid requirement, would seriously inhibit bidding. ¹⁸

In both Top-Flite and Burlington, the debtors cited recent Delaware cases in which courts approved breakup fees in the 2.7 percent to to 3.6 percent range (as a percentage of the sale price).¹⁹ Berkshire’s breakup fee represented 2.4 percent of total consideration ($14 million (fee)/$579 million consideration). The parties disputed what percentage the breakup fee represented in Top-Flite—the committee used the “adjusted” sale price (resulting in a 5 percent fee) and the debtors used the “unadjusted” price (resulting in a 3.5 percent fee).

Because the courts in these cases approved modified bidding procedures, neither Judge Walrath in Top-Flite nor Judge Newsome in Burlington issued written opinions denying the breakup fee proposals. Nevertheless, the resulting orders approving sale procedures in these cases reveal that the objecting parties largely prevailed. In Top-Flite, the court-approved bidding procedures eliminated the breakup fee entirely and reduced the bid increment from $2 million to $1 million.²⁰ In Burlington, the “Modified Bidding Procedures” reduced the breakup fee from $14 million to a “reasonable breakup fee in an amount not to exceed one percent of the aggregate purchase price” offered by the highest bidder.²¹ In addition, the bid increment dropped from $5 million to $3 million.²²

III. Learning from Top-Flite and Burlington

The results in these recent cases demonstrate how courts remain reluctant to grant breakup fees without a showing that they actually stimulate bidding and thereby preserve value for the estate. The informal surveys disclosed in the parties’ briefs reveal that breakup fees as high as 3.6 percent in recent cases.

For example, despite the debtors’ assertions that Callaway’s purchase offer represented the best opportunity to realize the most value for the estates, Judge Walrath in Top-Flite denied breakup fees altogether. Other bidders waited in the wings, ready to make purchase offers, even without the promise of breakup fees.²³ One cannot predict whether other bidders would have emerged had Callaway not committed to its deal. In any event, Judge Walrath refused to reward Callaway for whatever economic benefit it generated. The credit bid feature in Callaway’s proposed breakup fee and the above-normal fee percentage (5 percent) may have also contributed to the court’s decision to deny the fee.

In Burlington, the modified sale procedures reflect a compromise that preserved a reward for Berkshire Hathaway as the stalking horse while lowering the barrier for competing bidders. Judge Newsome slashed Berkshire Hathaway’s proposed breakup fee from 2.5 percent to 1 percent. A competing bidder (and principal member of the committee), W.L. Ross, ultimately prevailed in the bid to acquire the company, offering just over $620 million at the bankruptcy auction. Given that the acquisition by W.L. Ross ran on a parallel track throughout Burlington’s negotiations with Berkshire Hathaway,²⁴ one cannot predict how much Berkshire’s involvement actually boosted the final sale price. If the sale closes, Berkshire will receive its 1 percent fee nonetheless.

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