On March 22 the U.S. Court of Appeals for the Third Circuit ruled that secured lenders do not have a statutory right to "credit bid" their claims in connection with a sale of the debtor's assets, free and clear of the secured lender's liens, in a Chapter 11 reorganization plan.
The decision in the Philadelphia Newspapers case has far-reaching implications that upset secured creditors' long-standing expectation regarding their right to credit bid, and it probably will dramatically diminish a secured creditor's leverage to determine the course of a borrower's bankruptcy case.
Credit bidding is expressly authorized in section 363(k) of the Bankruptcy Code. For a secured lender, the right to credit bid is an essential component of its property interest in the collateral and is one way of ensuring that the lender gets the opportunity to obtain the benefit of its bargain with the borrower. The lender can bid the full value of its claim, not simply the value of the collateral, and set that amount as the floor for other bids. If cash bids exceed the amount of the credit bid, the lender reaps the benefit by being paid in full. If no higher bid is made, the lender obtains title to its collateral.
In the Philadelphia case the debtors proposed a Chapter 11 plan that contemplated the sale of all of their assets at a public auction free and clear of all liens to a stalking-horse bidder that was largely controlled by the debtors' current and former management and equity holders. A sale to the stalking-horse bidder would generate about $37 million in cash for the debtors' senior secured lenders, an amount far less than the senior lenders' claims. However, the debtors' proposed bidding procedures explicitly provided that credit bidding by the secured lenders would not be permitted because the sale was to be conducted as part of a chapter 11 plan, not pursuant to section 363 of the Bankruptcy Code.
The court held that the code creates no legal entitlement for secured lenders to credit bid at an auction held in association with a reorganization plan. Specifically, the court held that a plan of reorganization is confirmable, notwithstanding its structure as an asset sale excluding the secured creditors' right to credit bid, so long as the proposed cash payout would give secured lenders the "indubitable equivalent" of their claims.
The court also signaled in a footnote that it might be willing to place new restrictions on secured creditors' right to credit bid in connection with a section 363 sale. Under section 363(k), a secured creditor has a right to credit bid "unless the court for cause orders otherwise." The court rejected the secured lenders' argument that the "for cause" exemption in section 363(k) applied only to situations in which the secured creditor has engaged in inequitable conduct. Rather, a court "may deny a lender the right to credit bid in the interest of any policy advanced by the [Bankruptcy] Code, such as to ensure the success of the reorganization or to foster a competitive bidding environment."
Before the Philadelphia Newspapers and Pacific Lumber Co. cases, it was taken for granted that any plan that contemplated an asset sale had to give secured creditors the opportunity to credit bid their collateral. Now secured lenders may potentially be forced to accept payment in an amount far less than their claims and to lose their collateral. If the decision sticks, debtors will probably decide to carry out most future sales through a Chapter 11 plan rather than under section 363, in order to block secured creditors from credit bidding their claims.
Indeed, the true beneficiaries of this decision may be equity sponsors that are willing to invest new money to reacquire their insolvent portfolio companies. Without a minimum sale price set by the secured lenders' credit bid, such equity sponsors will have stronger negotiating power and may be able to reacquire their portfolio companies "on the cheap."
Secured lenders should preserve their right to credit bid their claims — in a section 363 sale or a Chapter 11 reorganization sale — in any stipulation under which they consent to the use of cash collateral or debtor-in-possession financing. Secured lenders should also consider whether to make a debtor's consensual use of cash collateral conditional on the debtor's filing its bankruptcy petition in a jurisdiction that recognizes a secured lender's right to credit bid in connection with a Chapter 11 sale.
The most disconcerting aspect of the decision for secured creditors is the court's apparent willingness to consider restricting creditors' right to credit bid in a section 363 sale. Historically, courts have applied the section 363(k) "for cause" exemption only to situations in which the secured creditor had engaged in inequitable conduct or the creditor's liens were subject to a bona fide dispute. If this interpretation of section 363(k) is adopted by other courts, it would significantly reduce secured lenders' ability to recoup their investments and influence the direction of borrowers' bankruptcy cases.