#438 1992 · U.S. bankruptcy courts (Section 363 sale practice) · Bankruptcy law / distressed M&A
Bankruptcy courts started paying the losing bidder to make everyone else compete harder
the problem
In a distressed asset sale, no rational bidder wants to go first
background
A bankruptcy sale under Section 363 of the Bankruptcy Code is supposed to work like a real auction: the more genuine bidders compete, the higher the price a bankrupt company's creditors recover. But going first is expensive and one-sided — the initial bidder has to fund real due diligence, negotiate a real purchase agreement, and set a real price, all of which then becomes public once the sale is filed with the court. As one bankruptcy court itself put it, without protection "bidders would be reluctant to make an initial bid for fear that their first bid will be shopped around for a higher bid from another bidder who would capitalize on the initial bidder's... due diligence."
The obvious fix — simply require or hope for competitive bidding, or keep the process quiet so rivals can't free-ride — does not work: bankruptcy sales are legally required to be transparent and court-supervised, so there is no way to hide the first bidder's price once it is filed, and nothing stops a rival from waiting for exactly that number before bidding a dollar more. Every party in the room understood the incentive ran backwards; no single participant in a single deal could fix it alone.
what everyone would do
The obvious answer is to just require or hope for real competitive bidding — publish the sale broadly, set a deadline, let the market decide. But every bidder faces the same rational calculation a bankruptcy court itself recognized: whoever goes first absorbs the cost of diligence and negotiation and hands every rival a free, ready-made floor price to beat, so the individually rational move for everyone is to wait.
what they saw
The shortage was never bidders' willingness to buy the assets — it was willingness to go FIRST. Rather than try to ban free-riding on someone else's diligence, which is impossible once a bankruptcy sale is legally required to be public and court-supervised, courts let the seller pay the first credible bidder directly for the service of going first, regardless of whether that bidder ultimately wins.
the move
Bankruptcy courts, formalized nationally by the Southern District of New York's 1992 ruling in In re Integrated Resources, Inc., began routinely approving "stalking horse" bid protections: the buyer willing to go first and set the auction's floor price is paid a breakup fee — the court in that case found the industry average ran about 3.3 percent of the purchase price — plus expense reimbursement, collected even if that bidder ultimately loses the auction to someone else.
why it works
A breakup fee — courts found the industry average ran about 3.3 percent of the sale price — plus expense reimbursement converts the first bidder's exposure from a pure loss (spend real money on diligence, then possibly get outbid by a free rider) into a guaranteed floor return whether they win or not. That is what makes going first rational again, and a credible first bid with a real price attached is exactly what then draws additional serious bidders into the room rather than repelling them — courts require the fee stay small enough, roughly under three percent of price in most approvals, that it compensates the first mover without itself scaring off the second and third bidders it exists to attract.
the payoff
The mechanism became a near-universal fixture of Section 363 distressed-asset sales rather than an occasional accommodation. Courts developed and still apply a three-part test to police it — whether the fee was the product of honest arm's-length dealing rather than insider self-dealing, whether it is proportionate to the purchase price, and whether it invites rather than chills further bidding — the same framework Integrated Resources established, still cited in bankruptcy sale approvals today.
where it breaks
The fee only helps if it is sized to attract more bidders rather than chase them away — courts have specifically struck down larger breakup fees as functioning like a poison pill on the auction itself, particularly where the sale was already widely marketed and a stalking horse offered little real diligence value. It also assumes a genuinely arm's-length negotiation between seller and stalking horse; where courts found the fee was the product of insider self-dealing rather than real risk compensation, they refused to approve it at all.
what came after
The doctrine has been refined rather than replaced: courts have struck down oversized fees (one case flagged 4.4 percent) as functioning like a poison pill on the very auction they were meant to encourage, and the Third Circuit narrowed the theory further by requiring stalking horses to show an actual, demonstrable benefit to the estate. The core structure — pay the first credible bidder for going first, win or lose — remains the standard architecture for nearly every distressed company sold out of bankruptcy.
references
- [1]Bidding Procedures — Stalking-Horse Protections and CollusionAmerican Bankruptcy Institute / New York University School of Law, Pollack Center for Law & Business, 2013wlrk.com
- [2]The Aftermath of a Complicated Breakup: Third Circuit Holds Stalking Horse Bidder May Assert Potential Administrative Expense ClaimHarvard Law School Bankruptcy Roundtable, 2021bankruptcyroundtable.law.harvard.edu