Debt is a weapon.

A Supreme Court hearing scheduled for next month that pits debtors against their lenders will make that clear.

The American Bankers Association, the Financial Services Roundtable and other banking groups are rallying to defend lenders' use of debt as currency in bankruptcy auctions — a frequent tactic to protect collateral a debtor wants to unload fast to help repay others.

So-called credit bidding has gone on for a long time, but debtor interests are forcing a rare second look at the Bankruptcy Code's treatment of it. The Supreme Court has not taken up a Chapter 11-related case in more than decade.

"Any time you have a company where the value is concentrated in one or two assets, this is a huge issue," Elliot Ganz, the general counsel of the Loan Syndication and Trading Association, said in explaining the stakes.

Here's how credit bidding works: Say a debtor owes $100, and the loan is secured by an asset that the creditor values at $60. In a bankruptcy auction for the asset, the creditor bids $60 of that debt, reducing the debtor's liability to $40, in exchange for taking ownership of the asset.

In an airport hotel bankruptcy case last year, the 7th U.S. Circuit Court of Appeals in Chicago sided with the hotel's lenders, who had insisted that they should be able to use debt to bid for the collateral, rather than being forced to raise cash. But the year before, in the 3rd Circuit in Philadelphia, the publisher of two Philadelphia newspapers succeeded in barring creditors from bidding their debt at auction. The 7th Circuit's decision also conflicted with another by the 5th Circuit in New Orleans in 2009.

The LSTA argues that credit bidding is a critical tool for protecting a secured lender from having its collateral undervalued. That's because, if the creditor is not satisfied with the competing bids, it can obtain the property by bidding more, using the amount of its unpaid debt as currency in the auction.

Nine other trade groups that represent secured creditors have sided with it including the ABA, the Roundtable, the Clearing House Association, the Commercial Finance Association, the Mortgage Bankers Association and the Securities Industry and Financial Markets Association. These groups signed an amicus brief supporting the hotel's lenders.

Oral arguments in the case are scheduled for April 23.

In the case, RadLAX Gateway Hotels vs Amalgamated Bank, the debtors owned the Radisson Hotel at Los Angeles International Airport and an adjacent parking structure. In November 2007, they obtained a $142 million construction loan from the Longview Ultra Construction Loan Investment Fund to acquire the property, renovate the hotel, and build a new parking structure. Amalgamated Bank serves as trustee and administrative agent for the lender.

The debtors filed for Chapter 11 bankruptcy in the Northern District of Illinois in August 2009. At the time, they owed over $120 million secured by first priority lien on substantially all of the debtor's assets, according to court documents.

Unable to solicit offers from outside investors to fund a reorganization plan, the debtors proposed to auction the hotel and parking garage, subject to an initial stalking-horse bid of $47.5 million. However, the would-be buyer did not want to allow the debtor's secured lenders to bid their claims at the auction. Amalgamated, the administrative agent for the lending group, objected. The Bankruptcy Court for the Northern District of Illinois sustained the objection but certified the question for immediate appeal to the Seventh Circuit, which affirmed.

As a general rule, a Chapter 11 plan must be accepted by all impaired classes of creditors to be confirmed. But a section of the bankruptcy code permits confirmation of a plan despite the rejection of certain secured creditors — in other words, a cramdown — if certain conditions are satisfied. One of these appears to provide a loophole; it says the plan may be considered "fair and equitable" to the dissenting class if the creditors will realize the "indubitable equivalent" of their secured claims.

The LSTA's position is that "you can't have the indubitable equivalent of an auction that permits credit bidding with an auction with no credit bidding," Ganz said. "If I invite you to a playoff hockey game, then say I can't get tickets to that, let's go to regular season hockey game, it's not the indubitable equivalent."

Preventing someone from bidding does not serve the bankruptcy process, Ganz said. "The most it will do is reduce the dollar amount of the auction, and the main point of bankruptcy is to maximize the value of the estate. The more bidders, the more debt is extinguished. So why set up a situation where fewer people bid, and you will have lower result?"

The trade group believes that the debtors are attempting to steer the collateral to a bidder with insider ties at a substantial discount at the expense of the secured creditor. "The Bankruptcy Code is specifically designed to prevent this type of mischief and ensure that secured creditors get the value they are entitled to receive," Ganz said.

David Neff, a Perkins Coie attorney who represents the debtor in the hotel bankruptcy case and will be arguing on its behalf before the Supreme Court, argues that credit bidding does not necessarily generate higher and better bids.

"Our position would be that this is not necessarily the case," Neff said. "In our situation, the stalking horse bidder specifically wanted to preclude credit bidding because the lender indicated it had no desire for the property to be sold. … It did not want a third party to obtain it. … Other parties were willing to be a stalking horse, just at not at as high a price."

Ganz declined to speculate how lenders might react to a decision in favor of the debtors, but said, "it's logical that they will have to really take that into account in pricing their credit. One would think it would increase the cost of secured credit."

Neff predicted bidders would lobby Congress to change the law if they lose the case.

He downplayed the possibility that more borrowers would use the strategy if his side wins. It normally involves unusual circumstances, he said. "Those debtors who do file for bankruptcy with the goal of selling assets usually have some motivating factor to do so, and usually it is with the consent of their secured creditors."

Legal scholars from the University of Chicago, Georgia State University, Fordham University, Indiana University and Stanford University supported the lenders. The academics submitted an amicus brief saying that credit bidding permits the debtor's assets to sell for the highest price. It also: keeps a debtor company's officers from selling the bankrupt business to a low value bidder in exchange for some personal benefit; reduces transaction costs, since a creditor would have to pay interest to borrow cash to bid; and ups competition by increasing the pool of knowledgeable bidders.

"Barring credit bidding creates risk that the would-be credit bidder will be unable to secure cash financing in time to participate in the bankruptcy auction. And keeping a credit bidder from the auction risks excluding the high-value bidder, reducing the expected winning price for the debtor's assets," the academics wrote.

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