Credit Bidding Under Attack — Again

Two years after the Supreme Court seemingly affirmed the right of secured debtholders to use liens on borrowers' assets as currency in 363 corporate bankruptcy sales, some legal experts are worried lower court judges could be chipping away at the ruling.

There is a growing belief among some observers that federal judges are calling into question the right of a lender or a secondary creditor to "bid" the full value of their claims in Chapter 11 cases.

For struggling banks considering bankruptcy to resolve their issues, these potential changes speak to the benefits of settling with senior or secured debtholders before filing for legal protection.

Federal judges, in two cases this year, have limited the amount of credit bids in court-supervised 363 auctions. Credit bids let lienholders bypass cash bids and use forgiven debt as their offer and apply it toward their purchase — ensuring the assets are not sold for less than the size of the claim.

In the most prominent case, involving car manufacturer Fisker Automotive, a $169 million secured creditor's bid was capped at $25 million — the creditor's purchase price of the loan in the secondary market — after a federal judge ruled in January that the bid was discouraging more robust bidding and limiting the maximum return for other creditors.

The judge based his ruling, several observers say, on a novel use of the "cause" enforcement powers a federal bankruptcy judge has to curtail credit bids, which to this point was only used in cases of creditor misconduct.

"That's really huge," says Michael Friedman, a partner at Chapman and Cutler. "Until January of this year, it was thought to be a bedrock principle... that if I buy a claim before or after bankruptcy, I step into the shoes of the creditor and I have a right to assert the full amount of the claim."

In a case Friedman said was "clearly influenced" by Fisker, a Virginia court last month restricted a $38 million credit bid to just $13.9 million in the bankruptcy of The Free Lance-Star newspaper after debtors and a creditors' committee objected to a credit bid that involved some unsecured assets in a loan-to-own ploy by a distressed-assets investor.

More bankruptcy cases are likely to involve credit-bid challenges from debtors or subordinate creditors due to these decisions, industry experts say.

Bankruptcy courts and associated 363 auctions have become a drastic, but viable, method to recapitalize struggling banks in recent years, allowing the banks to divorce themselves from underwater holding companies.

Most of the holding companies are weighed down by trust-preferred securities. More banking companies could seek a bankruptcy solution given dividend hikes tied to the preferred stock issued in the Troubled Asset Relief Program. Such capital instruments are unsecured, so those who hold the securities are barred from making credit bids.

Still, holders of bank stock loans, a key form of capital prior to the 2008 banking crisis, could make credit bids for banks, says Van Durrer, a lawyer at Skadden, Arps, Slate, Meagher & Flom who has worked on several of bank holding company bankruptcies including those at AmericanWest Bancorp and Anchor BanCorp Wisconsin.

"In the bank context specifically, there have been some credit bids proposed, but no one has won that way," Durrer says. The difficulty for credit bids, he says, is regulation. Anyone planning to bid — either with cash or credit — would need to involve regulators.

Banks that hold the debt might find that process easier, but secondary buyers who are contemplating a credit bid might not be as well-versed in a regulated environment. Buying defaulted debt issued by a bank holding company may also require regulatory approval, especially if the buyers intend to buy the bank.

"It is not as clean and tidy as we see elsewhere in bankruptcy where there is no such regulatory overlay," Durrer says.

The possibility of credit bids can still concern potential bidders and investors. Durrer says the key is to secure agreements with debtholders in advanced of filing for bankruptcy to avoid problems. "This issue might arise where a private group is making a bid on a bank where the secured debt hasn't agreed to accept a fixed amount in advance," he says.

Recent court rulings also have many in the leveraged-loan and investor community concerned that the decisions will be detrimental to the secondary market for trading distressed loans. Instead of recognizing the strategy of distressed-asset investing — buying a risky asset at a discount to reap a windfall — these decisions seemed more concerned with credit bids becoming an unfair leg up on other creditors who are unwilling to ante up with an equivalent cash offering.

"You could use that argument in every single case, that if you let these [secured lenders] credit bid, who is going to bid against them?" says Elliot Ganz, general counsel of the Loan Syndications and Trading Association. "The answer is it doesn't matter.... They are still entitled to bid."

That is what the Supreme Court ruled in 2012, reiterating the right of secured creditors to count outstanding debt obligations in the purchase a bankrupt entity. The court sided with Amalgamated Bank after the bank objected to a plan by owners of a Los Angeles-area hotel to bypass the credit-bid process and sell assets through a cash-only auction outside of the 363 process.

Amalgamated wanted to credit bid the $120 million it was owed, but the owners sought to sell the property to a stalking horse bidder for $55 million. While upholding the right to credit bid through a 363 plan or a pre-planned reorganization, the court left undecided whether credit bidding itself was an immutable feature of the 1978 bankruptcy code.

Justice Antonin Scalia, writing for the majority, declared that was a decision for Congress to make. But it now appears to be a matter than bankruptcy judges are deciding.

In the Fisker case, Friedman says, federal judge Kevin Gross introduced the idea that the purchase price of a secondary claim is the true value of the credit bid, rather than the original $169 million loan from the Department of Energy that Fisker defaulted on.

Hybrid Tech Holdings bought the loan for $25 million and, after Fisker filed for bankruptcy protection last November, sought to buy Fisker for $75 million in a 363 sale that was also pursued by Fisker's ownership (Fisker filed for the auction in January).

The creditors' committee objected to the sale, saying it had found a buyer that would exceed the $75 million, and sought the exclusion of Hybrid's credit bid.

That interpretation has no basis in prior case history, several observers say. "At no time did a court say, because you're not secured by all assets, therefore we need to value your lien and determine what it's really worth before we allow you to credit bid," Friedman says.

"The scope of the lien and the value of the lien are two different concepts that should not go together," Friedman adds. "If you take a step back, it really is detrimental to what the credit bidding right is supposed to accomplish."

The case had unusual circumstances, including an expedited sale date less than 45 days after the company declared bankruptcy, Friedman says.

The court's decision to back the creditors' committee with a ruling that barred an auction due to "cause" based on the fact a higher bid was available was pulled out of whole cloth, Ganz says. "The idea that 'cause' includes chilling other bidders is just made up," he says.

The court in February approved Fisker's sale to the Wanxiang Group of China.

Ganz says he believes the Supreme Court's backing of credit bids in plan sales or 363 auctions was clearly intended to undergird the rights to use credit bids.

"You have a right to protect yourself from lowball bids through the construct of the credit bid," he says. "Unfortunately that did not make it into the opinion, but it was clearly the spirit of the argument."

There is a potential chill on the secondary market for debt claims, Ganz says, if credit bid challenges begin to crop up more in corporate bankruptcies.

Though it is too soon to consider the ramifications on volume, pricing or securitization, "we're definitely worried about it," he says. "If you don't have right to credit bid, you've lost a very, very important right, and it will make secured credit less attractive."