States object to Disney's bidding advantage in Character.AI's bankruptcy sale

On 23 October 2026 a coalition of 31 states and the District of Columbia, acting through 32 attorneys general, filed a 27-page objection in the Delaware bankruptcy court to the way Character.AI wants to sell a licence to its technology. The filing targets the bidding procedures for a sale in which Disney is the opening, or stalking-horse, bidder. It is a new filing in a case that already exists, not a new bankruptcy: Character Technologies, the company behind Character.AI, filed for Chapter 11 on 12 and 13 October to run a court-supervised sale.

The objection is Docket No. 66 in case 26-11603 and answers the company's sale motion, Docket No. 15, which asks the court to name Disney Worldwide Services as the stalking horse. A hearing on the bidding procedures is set for 30 October at 10 a.m. Eastern. The states stress that they are not asking the judge to undo what the company decided before it went bankrupt. Their request is narrower: that a bidding-procedures order not be used to bless those decisions, and that rival bidders get a fair chance. The coalition is smaller than the one that signed a notice of interest on 14 October, when 39 states and DC were on it. Alaska, Georgia, Illinois, Indiana, South Dakota, Utah, Virginia and West Virginia are absent this time, and the filing gives no reason.

The deal came together in two stages, as the states tell it. Disney and Character signed a mutual non-disclosure agreement on 19 August 2026, then on 18 September an exclusivity and prepayment agreement, a binding term sheet and a transition services agreement. Under them Disney could solicit and hire company staff, required up to six key employees, including the chief executive, to accept and resign within ten days, and offered jobs to at least 60 others. Sixty-six of about 86 full-time employees accepted. Character now reports 18 active full-time employees, only eight of whom are expected to stay through key parts of the case. The company also agreed not to enforce non-compete, non-solicitation, confidentiality or invention-assignment covenants against them where Disney is concerned.

The releases are the part the states care most about. Character released Disney and every hired employee from all claims up to 18 September, including claims over use of technology those employees developed or the company owned, and the release is meant to last indefinitely. The term sheet extends it to the chief executive, including fiduciary-duty claims. Disney paid $7.5 million on signing, of which $5.5 million cannot be refunded in any circumstances and $2 million is a refundable deposit. Until the petition date Character could not talk to anyone about an IP licence, financing, a sale or a merger, and had to close its data rooms. Disney set the venue and timeline, approves the bidding procedures in its sole discretion and is entitled to a final, non-appealable sale order. A three-year non-solicitation covenant protects its new hires, and Character agreed not to meet any government authority about the deal without Disney's consent unless the law requires it. The states call that last term hard to square with the company's stated aim of negotiating with the group of 46 states and territories investigating it.

“Excluding value-maximizing bids is the definition of a chilling term.”

the states' objection, in the states' objection (Docket No. 66), as quoted by PPC Land · ppc.land ↗

Set against the estate's take, the employee money looks large. Disney put the pay of the staff it offered jobs at about $60 million a year, plus a $30 million retention pool, roughly $180 million over three years, which the term sheet says is not consideration payable to the company. The estate receives at most $20 million, including the $5.5 million already paid. The objection also notes that Character's first investment banker contacted about 28 parties between August 2025 and August 2026 and produced a single proposal nobody could act on, and that its work ended in late August. The talks with Disney in September ran through management directly. The restructuring committee now running the case was formed only after a new independent director joined on 1 October, nearly two weeks after exclusivity was signed, and the current banker, Houlihan Lokey, says it had no part in the negotiations. The states do not question the directors' independence, but argue the market check the company relies on did not test the deal actually before the court.

The arithmetic of the overbid is the centrepiece. A rival must beat Disney's $20 million plus a $700,000 break-up fee plus a $1 million increment, a floor of $21.7 million. But Character keeps the $5.5 million up front whoever wins. If Disney wins, the estate nets $20 million; if a rival bids X, it nets X plus $4.8 million, because the fee comes out and Disney's deposit goes back. So any bid over about $15.2 million leaves the estate better off, and the procedures exclude everything from $15.2 million to $21.7 million, a $6.5 million band more than 40% above break-even. The states want the floor measured against the $14.5 million actually still at stake, plus approved protections and a modest increment, and bids judged on net recovery. They add that neither the chief executive's declaration nor the banker's addresses the non-refundable payment.

Other terms, they say, tilt the field. Rivals must commit to close by 30 November while Disney's own outside date is 17 December, and no declaration explains the gap. Only five key employees, chosen jointly by Disney and Character, must be available for diligence, and for no more than 20% of their time, while Disney may wall off up to 20% of the hires from any rival's recruiting. A winning rival must release Disney from claims since 1 August 2026 to receive transition services, which the states describe as waiving claims for misuse of the very technology it is buying. Bids must match the stalking-horse terms, including the estate's general release of Disney, and all consideration must be cash, which rules out royalties and earn-outs that could suit a creditor body facing many injury claims.

On the fee itself, a 3.5% break-up payment is allowed in the Third Circuit only if it is truly necessary to preserve the estate's value. The states say the company's own witnesses undercut that: a declaration says the release and exclusivity were critical to Disney agreeing to be stalking horse, and the agreement pays the fee in return for Disney's time and expense in hiring former employees. They answer that the cost of hiring a workforce Disney keeps whoever wins is not a cost of preserving the estate. If outbid, Disney would still hold the employees, the releases and the carve-out, and they argue it has little need of compensation for losing. They ask the court to deny the fee or cap it well below $700,000 for documented out-of-pocket costs, payable only from a closed alternative deal, and they oppose advance approval of the same 3.5% protections for any further stalking horse named by 9 November.

On the releases, the states say a debtor's release of its own claims is a compromise that needs a motion under Bankruptcy Rule 9019, which the company has not brought. They suggest the releases could be avoidable as constructive fraudulent transfers, conceding that balance-sheet insolvency may be disputed given the $57 million in cash and no funded debt, but pointing to the multistate group's claims, a burn of $8 million to $9 million a month and a runway the company calls limited. The sale also includes unreleased claims against former employees who join Disney, valued at nothing. A buyer acquiring claims against its own staff, including the former chief executive, is in their words not purchasing something it intends to enforce but taking a release under another name. They also fault the motion's statement that no agreements exist between Disney and current management, since the chief executive's job with the debtor ended in the very transaction.

The calendar is the last complaint. As proposed, sale objections are due 13 November, bids 20 November, the auction is 23 November and the sale hearing 24 November, so creditors must object a week before they know who the buyer is or what it pays. The states cite the Third Circuit's Boy Scouts decision, under which challenges to releases tied to a sale can become moot once it closes without a stay, so the sale hearing may be their only real chance. They ask for at least 21 more days before bids, an objection deadline after the winner is announced, notice to every party engaged before the filing, and confirmation that nothing limits Character's contact with regulators or the US Trustee.

Notice to users is the final substantive point. The company serves about 12 million monthly users and the claims against it arise largely from minors' use. The states say the transaction notice does not reveal that the proposed order would permanently enjoin claimants and regulators from suing any buyer party, including the former chief executive, or bar successor and product-liability claims. They want a plain-language notice served on injured users and their lawyers, on each member of the multistate group and on the platform itself. They also reserve whether a consumer privacy ombudsman is needed, since Disney staff would reach user data under the services agreement, and arguments based on the Purdue Pharma decision about the limits of injunctions and releases.

Disney had sent Character.AI a cease-and-desist letter over unauthorised characters in September 2025 and hired Karandeep Anand, the company's former chief executive, as its chief technology officer in September 2026. Character.AI says the court-supervised sale is its best route to maximise value for everyone with a stake and that service will continue with minimal disruption. It has moved toward microdramas after settled lawsuits over teen self-harm, and Pennsylvania has sued over a bot that claimed a medical licence. TheWrap expects an auction in late November or early December.