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Chapter 11 Alternative: Using Section 363 to Maximize "Going Concern" Value By Selling all the Debtor's Assets Outside a Plan of Reorganization

By Ida L. Walters and Robert W. Kamphuis, Jr.


International Research and Development Corporation (IRDC) of Mattawan, Michigan (near Kalamazoo), is one of the world's leading contract research laboratories performing animal safety evaluation studies for drug, chemical and agricultural clients. Established in 1962 by Dr. Francis X. Wazeter, a pharmacologist, IRDC grew quickly and prospered, earning between $3 and $5 million a year. In 1989 it had a market capitalization of $93 million.

    Then its troubles began. Though a publicly held company for two decades, the Wazeter family owned about 25 percent of the 5.6 million shares outstanding, placing it in firm control. The founder's son became chief operating officer in 1990 and president in 1994. The founder remained chairman and CEO. There was, as there often is in these cases, the corporate jet, the Florida condo, the leased German luxury cars, and the generous expense accounts. There was also, in 1990, the skin care products company in California, acquired for $20 million and financed mostly with bank debt. This acquisition was a disaster and the major reason for the company filing for bankruptcy in the fall of 1995.

    There were other problems, of course. Serious accounting fraud at the skin care products unit, discovered in early January 1995, affected the results of the previous two years, but how badly wasn't known until spring 199 [sic]. The SEC and FBI began investigations. A turnaround manager was put in charge of operations in early February, but the company was deeply insolvent and being kept afloat by the secured lender whom was owed more than $20 million and fast losing patience. The founder's son was dismissed in late January, the founder in mid-May, and IRDC stock was delisted from NASDAQ on May 31. These events kept the glare of negative publicity focused on the company for months, making reassuring customers and finding a buyer much more difficult.

    What makes this case instructive, however, is not the extravagance nor the mistakes and missteps that pushed the company into bankruptcy. Rather, it is the combination of critical elements and strategies that ultimately produced an outcome that was superior to anything that would have been predicted by those close to the situation during the months that IRDC teetered on the brink of collapse. In fact, as more fully described below, the bankruptcy of IRDC was resolved in a way that maximized the "going concern" value of the assets--assets that would have otherwise been virtually worthless, and preserved 300 jobs. As such, the IRDC case provides a model for how an efficient bankruptcy process should work.

    What were the three critical elements and strategies that made a huge, positive difference in the outcome of the IRDC bankruptcy?

    1. A set of comprehensive financial projections and analysis that credibly estimated the capital needed to take the company forward and explained why IRDC's balance sheet had deteriorated so rapidly over the previous 18 months. These projections and analysis provided persuasive evidence that IRDC's research business had the potential to make a dramatic recovery.

    2. A strategy that involved filing in Delaware under Section 363(b)(1) of the Bankruptcy Code, which maximized the "going concern" value of the assets by allowing the debtor-in-possession to greatly expedite the bankruptcy process. The assets of IRDC's skin care products subsidiary, for example, were sold 21 days after filing; the contract research assets were sold five and half weeks after filing.

    3. The fortuitous passing on June 5, 1995 of a new environmental law in Michigan that, among other things, imposed liability for environmental clean up only on those "responsible for an activity" causing the contamination. Prior to this, anyone in the chain of title after contamination occurred was potentially liable. Under the new laws, IRDC's assets could be sold largely free of preexisting environmental liabilities.

The Situation

In 1985 IRDC established a subsidiary, IRAD, in Ft. Myers, Florida, to perform clinical safety evaluation studies of drugs and other compounds on humans. The founder ran IRAD, leaving his son in charge of most of the company's other activities. In 1989 the company acquired Medical Surgical Specialties, a small supplier of medical devices located in Kalamazoo. Carme, the California skin care products company was acquired, as noted above, in 1990 for $20 million.

    Shortly thereafter, Carme's sales fell sharply and the unit continued to perform poorly. In the first place, it was less than brilliant for a company that performs animal safety studies for cosmetic companies, among others, to acquire a company that touts its products as not having been tested on animals. As word of this got around, sales collapsed. Cooking the Carme books by recording non-existent sales began in early 1993 and continued through most of 1994.

    In addition, because of the attention lavished on Carme, the contract research business and other subsidiaries were neglected. In the first quarter of 1994 the company began experiencing significant cash flow problems and delayed paying bills to suppliers and others. Some bills weren't paid, triggering lawsuits. Its operating losses in 1994 amounted to more than a quarter of operating revenues. In 1992, the most recent year in which the financial statements of the company are not affected by the accounting fraud, it had operating revenues of $40.2 million.

    When turnaround manager Michael Feder, a principal of Stratford Partners in Chicago, took over as acting president in early February, the company was insolvent and customers were deeply concerned. They had made large upfront payments for studies that in many cases had years to run before being completed. Some even threatened to withhold money still owed to offset potential losses if IRDC shut down. The secured lender recognized that IRDC's assets had value only as a going concern, and so bit the bullet and funded the company's cash flow shortfalls.

    The turnaround manager immediately took measures to stabilize the situation and calm customers. IRAD, the subsidiary in Florida, was closed, saving the company $75,000 a month. The corporate jet was sold and the fancy company cars sent back. He called on creditors and customers, attended scientific meetings to assure groups of customers and potential customers that the situation was being stabilized, and sought a buyer for Carme, which the IRDC board, in early February, had agreed to sell. All this contributed to a sharp fall in employee turnover at the contract research business.

    It wasn't until early April, however, when financial information for 1994 became available, that Carme could be more aggressively shopped. An investment banking firm was retained to find a buyer. By late April, at the behest of the secured lender, buyers were also being sought for the contract research business and the small medical devices subsidiary. By early summer, the company was in negotiations with a buyer for Carme (which eventually sold for $3.7 million) and prospects for selling the medical devices unit, which had positive cash flow, were considered good.

    The real challenge was the contract research business. The company's scientific reputation had remained stellar, despite its financial problems. Given this and the company's earlier history, it was reasonable to assume that, freed of the excessive debt burden and managed properly, it could again be a profitable business. But in the late spring and summer of 1995, IRDC's affairs were such a tangled mess that potential buyers couldn't see their way clear, given the lack of hard information and the uncertainties this caused, to spend money on due diligence. Not even strategic buyers, who presumably knew the business, and several expressed strong interest, could cut through the fog. (One of them subsequently purchased a smaller, less capable contract research laboratory for a price that was more than five times greater than the price ultimately paid for IRDC's contract research assets.)

    The fact is, few things compromise the going concern value of a company, or put off potential buyers, more than serious accounting fraud and the pathetic financial systems and controls usually associated with it. Potential buyers were rightly concerned that little reliable information was available for developing credible pro formas and that the recent historical information was tainted. Moreover, millions of dollars had disappeared rapidly--far more than could be ac counted for by IRDC's known financial problems and executive extravagance. What was going on?

    Another big uncertainty was potential environmental liabilities. IRDC was on Michigan's list of contaminated sites and the permit for operating its substantial sewage treatment plant, which showed severe maintenance problems, had expired in 1990. No useful information about the extent of environmental contamination was available. As a result, the costs associated with remediation could only be guessed at.

    Yet another big uncertainty: whether or when the secured lender (which at the time was in the process of being acquired by a foreign bank) would simply run out of patience and cut its losses. With a host of unsecured creditors and with lawsuits of all sorts mounting, no buyer was likely to consider purchasing the company's assets except out of bankruptcy, normally a lengthy process.

    As if all this weren't enough, passing the PETA (People for the Ethical Treatment of Animals) protesters at IRDC's front gate was a forceful reminder that animal testing is a type of business that is politically incorrect. This tended to discourage all but the hardiest potential investors. (It didn't, however, discourage William U. Parfet, former president of Kalamazoo-based The Upjohn Company and great-grandson of Upjohn's founder, nor Gerald Mitchell, former executive vice president and head of research at Upjohn. Parfet and Mitchell are principals of MPI Research LLC, which ultimately acquired IRDC's research assets. Upjohn had long been a customer of IRDC.)

Understanding the Financials

In a first cut at getting a grip on the research business's financial situation, Caledonia Group principal Harry Watson and his team of financial analysts found that IRDC had two additional problems that were compounding the typical problems of an insolvent company. These related strictly to the nature of the contract research business. First, it is the kind of business that depends more than most on the confidence of customers. Animal safety evaluation testing of drugs and other compounds is simply without value unless the studies are completed and strict protocols are followed. Also, it is a business in which customers pay largely up front, rather than on completion of the contract. This results in a very unusual relationship between cash flow and revenue, as the major expenses related to research contracts are largely concentrated at the end of the study.

    This led to the second problem. Cash flow in the contract research business is radically divorced from revenue earnings, the exact opposite of what one finds in virtually all other businesses. This is a business that sucks cash when it shrinks and gushes cash when it grows. There was a further complication. Research studies can last anywhere from a few days to a decade, and the relationship between cash flow and revenue is vastly different for studies of different lengths.

    Watson was able to model the various relationships, validate the models by replicating the historical record, and thus demonstrate cash needs going forward. The unaccounted for millions? Actually, it turns out they were expended in liquidating large unbooked liabilities at a time when contracts for new studies (because of IRDC's well publicized and mounting financial problems) were either falling or were too short-term to generate net cash. Not understanding this would play havoc with the traditional turnaround approach because that approach normally takes as a given that shrinking a troubled company generates cash. Yet shrinking IRDC's research business would have greatly worsened the problem rather than improved it. Feder's difficult achievement in growing the company's sales, which were 30 percent higher in the second quarter of 1995 than in fourth quarter of 1994, provided much needed breathing room and helped keep the secured lender from bolting.

    Based on his analysis, Watson later develop pro formas that would enable the buyer to fully understand the capital requirements needed to return the company to stability or breakeven, and also to grow it under various scenarios regarding the mix of contract types and lengths.

Expediting the Bankruptcy Process

One option considered for effecting the transfer of the research unit's assets was for IRDC to surrender them to the secured lender who in turn would sell them to the buyer. This had the clear advantage of curtailing the deterioration of the assets that would likely occur during a lengthy bankruptcy process. The main disadvantage, of course, was that the sale would lack the extra legal protection that bankruptcy confers. But neither IRDC's directors, nor the buyer, wanted to expose themselves to greater legal risks.

    For these reasons, Section 363(b)(1 of the Bankruptcy Code (here abbreviated S363) was explored. S363 provides that the trustee or debtor-in-possession "after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate." This makes possible a quick, convenient, and economical disposition of assets outside of a reorganization plan.

    Bankruptcy judges in Delaware are amenable to expedited S363 sales because such sales tend to maximize the going concern value of insolvent businesses. When a company is collapsing, as IRDC was, every day in limbo worsens the situation, whereas a quick sale maximizes the return to creditors. In an expedited S363 sale, two things get separated: (1) disputes among various creditors' claims, and (2) maximum recovery by creditors as a class. A traditional plan of reorganization, on the other hand, forces these issues to be jointly addressed. In the IRDC case there was little for creditors to dispute, as the lone secured lender, whose claim took precedence, would not recover its entire claim. But even if there had been disputes among creditors, the sale could have gone ahead rapidly, and the courts could have dealt with any disputes in due course and under full judicial review, with all parties having an opportunity to fully pursue their remedies.

    S363 sales are underutilized because, outside Delaware, they normally take three to five months. Even in Delaware there are only about half a dozen S363 sales a year. The precedent supporting "expedited" S363 sales was established on appeal of the Abbotts Dairy case, Third Circuit Court, 1991. The model for expedited S363 sales in Delaware was established in 1992 when Days Inn filed for Chapter 11 with a deal in hand and a first day motion to approve the bidding procedure; all went quickly and smoothly.

    With an expedited S363 sale, it is essential that all due diligence is completed prior to filing. In the IRDC case, however, given the substantial uncertainties, there was a real question as to whether devoting resources to due diligence made sense. Mayer Brown & Platt in Chicago, which performed the legal due diligence for the buyer and provided bankruptcy advice, was able to establish early on that major problems were unlikely to arise in the course of legal due diligence. With regard to the many contracts, permits and the like covering the long-term research studies, for example, they were able to quickly determine that these would transfer in a S363 sale.

    Qualifying for a S363 sale isn't easy, but for debtors who qualify, the whole process can be over in a few weeks. To qualify, the debtor's assets must be wasting and there must be a consensus of the major parties at interest. Given this, Delaware bankruptcy judges fast-track the process, with the goal of maximizing the going concern value of the assets.

    The debtor who files a motion for a S363 sale must be able to demonstrate good faith--no sweetheart deals for existing owners or top management, for example. In the IRDC case, for example, it was a positive that the debtor was being run by a turnaround professional who had no real stake in the outcome one way or another. Also, all parties at interest, including all potential investors who had expressed an interest in, or been approached about, buying the assets, must be properly noticed. As a practical matter, a successful S363 sale in Delaware needs the support of creditors. When this is lacking, the motion for a S363 sale is almost always denied (as it was in the well-known Lomas case).

    While there are some similarities between a S363 sale and Chapter 11 prepaks, the fundamental difference is that the prepak is a plan of reorganization, whereas under a S363 sale, all the assets are sold outside a plan of reorganization. In addition, a S363 sale is relatively simple, quicker than the quickest prepak, generally costs substantially less, and doesn't usually require the same degree of consensus as a successful prepak.

Dealing with Environmental Problems

In virtually every state, including Michigan until very recently, there has been a scheme of strict environmental liability, often coupled with impractical clean-up standards. The result is inequitable burdens on innocent parties, restricted redevelopment of usable, contaminated property, and money wasted on transaction costs and remediation activities that are often of little or no benefit to human health or the environment. The new Michigan law reflects a national movement to reform environmental regulations so as to encourage the use of so-called "brown field" sites.

    In particular, environmental liability problems have been a significant deterrent to the swift and efficient reorganization of troubled enterprises. Even in asset sales the environmental liabilities are attached to the real assets being sold, thereby defeating one of the core reasons for Chapter 11 to exist in the first place-to separate liabilities from the assets so that the assets may continue to be used efficiently. Many of the noteworthy bankruptcies of recent years have been extended greatly by the need to provide a way for addressing environmental liabilities for the successor entity in a reorganization or the purchaser in an asset sale.

    On June 5, 1995, roughly five weeks before the ultimately successful buyer became interested in the assets of IRDC's contract research business, Michigan's new and path-breaking environmental law became effective. One result is that now clean-ups can be expected to proceed more quickly and at a lower cost, while continuing to assure protection of public health and the environment. Liability is no longer imposed strictly, but only on those responsible for the activity that caused the contamination.

    Of course, the environmental laws that created so many intractable problems were not specifically aimed at bankruptcy. And the solution, which the new Michigan law embodies, isn't either. However, the positive effects of the new Michigan law on bankruptcies are every bit as important as the negative effects of previous environmental laws. The new Michigan law allows assets to be sold largely free of preexisting environmental liabilities, with those responsible for the contamination remaining on the hook. Prior to this, in many cases the inability to cleanse businesses of environmental liabilities had often made reorganization impossible, entrenching underperforming management.

    It was key for the buyer to understand the implications of the new environment rules before moving forward, especially given the absence of any meaningful environment audits. Attorneys at Warner Norcross & Judd LLP in Grand Rapids, Michigan were active in the legislative process that led to the new environmental law, and were able to quickly provide the requisite level of comfort that the new laws could be used to great effect in the IRDC transaction. They were also able to quickly establish that IRDC's problems with permits and the like could be cost-effectively resolved.

Closing the Deal

The initial work and insights of Caledonia Group, Warner Norcross, Mayer Brown & Platt and others were able to dispel the fog of uncertainty over IRDC's basic situation and prospects, and make it possible to articulate a clear and cost-effective plan for quickly validating their initial work and insights through a complete due diligence effort. Thus, the Parfet interests were able to proceed with a high degree of confidence that, when completed, full due diligence would support a concern acquisition of IRDC's research assets at a price acceptable to the secured lender. Caledonia Group initiated negotiations with the lender and the price settled on, $6.1 million, was the price paid for these assets at the bankruptcy auction.

    Under management by Caledonia Group, full-scale due diligence quickly got underway. This included comprehensive pro formas, legal and environmental audits, and the like, and an audit of the facility to determine the costs of the improvements needed to satisfy federal and state regulators. When completed, there were no surprises; the final results accorded with expectations. Given that no other potential investors had performed, or were performing due diligence on the research assets, the Parfet interests were confident of prevailing.

    On September 26, IRDC, represented by Young, Conaway, Stargatt & Taylor, a Wilmington, Delaware law firm experienced in S363 sales, filed for Chapter 11 with a first day motion for a S363 sale. Everything was in order and the proceedings progressed quickly despite several legal challenges. Motions for temporary restraining orders and injunctions, for example, were filed in various jurisdictions. None were granted. One objecting party who filed in Delaware was given the option of a quick hearing, but was advised by the judge that his chance of succeeding on the merits of his case were slim. The party withdrew.


On November 2, 1995, MPI Research took over IRDC's contract research business. In mid April 1996, as this book goes to press, the business was progressing as expected, and the Village of Mattawan's largest employer and biggest taxpayer looks forward to a prosperous future, its 300 jobs now secure.

    The assets of IRDC's contract research business, the skin care products unit, and the medical devices unit (which didn't have a buyer going in) were sold to different buyers at the bankruptcy auction. The proceeds, which totaled about $10 million, enabled the secured lender to recover nearly half of what it was owed, far more than would likely have been recovered under any other alternative.

    It is often said that expedited S363 sales are relatively common in Delaware because Delaware has a bias toward debtors. We haven't seen any such bias with respect to the S363 sales we're familiar with. Like IRDC, typical S363 debtors in Delaware, whether owners or managers, are out on the street in three to five weeks, with pockets empty. A S363 sale also keeps professional fees lower, by a wide margin, compared to alternatives.

    In fact, the sine qua non of debtor favoritism is the sometimes endless extensions of exclusivity so often granted to Chapter 11 debtors, while creditors are held at bay, often for years. Such practices have been eroding the goals of bankruptcy for some time. Where appropriate, as in the IRDC case, a S363 sale is a powerful tool in advancing bankruptcy's ability to separate the good elements from the bad elements and put the good elements quickly back into productive use.

Ida L. Walters and Robert W. Kamphuis, Jr. are principals of Caledonia Group Inc., a Detroit-based management consulting firm specializing in implementing lean production. Caledonia was the adviser to William U. Parfet, a principal of MPI Research LLC, which acquired the assets of IRDC' s contract research business out of bankruptcy in early November 1995.
The 1996 Bankruptcy Yearbook & Almanac Pages 333-337
  Copyright 2011 - Caledonia Group Inc.