United States: 'Loan-To-Own' Strategy May Lead To Limitation On Credit-Bidding

On April 14, in In re Free Lance-Star Publishing, 512 B.R. 798 (Bankr. E.D. Va. 2014), the U.S. Bankruptcy Court for the Eastern District of Virginia considered the objection of Chapter 11 debtors to a secured creditor's right to credit bid at a sale of the debtors' assets pursuant to 11 U.S.C. Section 363. The court concluded that the secured creditor—which sought to acquire the debtors rather than collect on the loan—had engaged in inequitable conduct with the intention of depressing the value of the debtors' assets for its own benefit as a buyer, rather than enhance value for the benefit of all creditors. Consequently, the court held that cause existed to limit the secured creditor's right to credit bid at the Section 363 sale.


The joint debtors in Free Lance-Star, Free Lance-Star Publishing Co. and William Douglas Properties LLC, were related entities that owned and operated printing and newspaper businesses and four radio stations. In 2006, they borrowed approximately $50 million, secured by certain real and personal property, to expand their commercial printing business and to construct a new, state-of-the-art printing facility. The collateral for the loan did not include liens on what the parties dubbed the "tower assets": three parcels of real estate and certain improvements and equipment therein used predominantly for the debtors' radio broadcasting operations, together with certain licenses, contracts and other related assets. Unfortunately, the most recent recession had an impact on the debtors' operations, and it resulted in the debtors falling behind on their debt service. After the debtors' several unsuccessful attempts to obtain refinancing, their secured loan was sold by the original lender to DSP Acquisition LLC.

The court characterized DSP's loan acquisition and administration strategy as "a classic loan-to-own scenario." In connection with this scenario, the bankruptcy court described DSP's game plan as one in which DSP pressured the debtors to cooperate in an early and abbreviated Chapter 11 case aimed at facilitating DSP's expedient purchase of the debtors' businesses through a Section 363 sale. DSP made no secret of the fact that it acquired the loan specifically in order to purchase the debtors' businesses.

During the course of its loan administration, DSP soon learned that it did not possess liens on the tower assets, which had not originally been pledged as security for the loan it had acquired. DSP also learned that the debtors were unwilling to grant such liens. Consequently, DSP employed a series of tactics aimed at obtaining liens on the tower assets.

First, despite knowing it possessed no such liens, DSP unilaterally filed UCC-1 financing statements to perfect security interests in the tower assets constituting fixtures, and did not disclose its filing to the bankruptcy court after the debtors' bankruptcy cases commenced. DSP also insisted that the debtors accept from DSP a new, post-petition debtor-in-possession loan secured by the tower assets—an offer that the debtors rejected, in part because the debtors' cash flow projections indicated that the debtors could operate in bankruptcy without the need for debtor-in-possession financing. Next, after the debtors filed their Chapter 11 petitions, DSP moved the court to grant it new liens on the tower assets as additional adequate protection to supplement the replacement liens and adequate protection payments offered by the debtors. Referring to DSP's failure to disclose the fixture filings, as well as DSP's submission of a "false and misleading" declaration in connection with DSP's request, the bankruptcy court denied the motion.

According to the court, DSP also engaged in conduct meant to stifle a competitive auction and ensure its acquisition of the debtors at a low price. For example, DSP strongly objected to the debtors' efforts to retain Protiviti Inc.—a well-known restructuring firm—as their financial advisers. DSP also tried, though unsuccessfully, to dissuade the debtors from marketing their assets. When the debtors moved ahead to sell their assets, DSP pressured them to shorten the marketing period for the sale, and insisted that the marketing materials contain a front-page statement in bold typeface declaring DSP's right to a $39 million credit bid. Later testimony from the debtors' financial advisers confirmed that DSP's conduct, including the undisclosed UCC filings, had created "genuine confusion" among potential buyers about which of the debtors' assets were encumbered with liens in favor of DSP.

Shortly after the debtors filed a sale and bidding procedures motion, DSP commenced an adversary proceeding seeking a declaration that it had valid, perfected liens on all the debtors' assets, including the tower assets. The parties filed cross-motions for summary judgment in the adversary proceeding, which prompted the bankruptcy court to consider the extent of DSP's security interests and DSP's right to credit bid at a sale under Section 363 of the Bankruptcy Code.

The Court's Analysis

Generally, secured creditors are permitted to "credit bid" the amount of their claim at a sale of their collateral. As the Free Lance-Star court explained, this mechanism allows a secured creditor to bid for its collateral using the debt it is owed to offset the purchase price. However, the right to credit bid is not absolute; Section 363(k) provides that a court may "for cause order otherwise." For example, courts may deny or limit a secured creditor's right to credit bid in order to ensure the success of a reorganization, to foster a competitive bidding environment, or for any other policy advanced by the Bankruptcy Code.

In Free Lance-Star, the debtors asserted that cause existed to limit DSP's credit-bid rights for several reasons. The debtors first argued that despite DSP's efforts to the contrary, DSP did not possess a lien on all the debtors' assets—specifically, the tower assets—and therefore it should not be permitted to credit bid against those assets in which it lacked a security interest. The debtors also argued that DSP's inequitable conduct, which resulted in a depressed sales price for the debtors' businesses, constituted cause to limit DSP's right to credit bid. Lastly, the debtors emphasized the positive impact that limiting DSP's credit bid would have on the sale by fostering a more robust bidding process.

The court agreed with each of the debtors' arguments, noting that it was "troubled" by DSP's inequitable conduct, including DSP's unilateral filing of UCC-1 financing statements on assets in which it possessed no security interests, and DSP's attempts to frustrate the competitive bidding process. In doing so, the court commented generally on the drawbacks of credit-bidding when utilized in a "loan-to-own" context. Although credit-bidding ideally operates to protect secured lenders against the devaluation of collateral sold at a bankruptcy sale, the court noted that it is susceptible to abuse by creditors who purchase secured debt in order to acquire the debtor. In such circumstances, credit-bidding may be used to depress rather than enhance market value, chill bidding prior to an auction, or discourage prospective bidders from participating in a sale. The court found that DSP's conduct had achieved all three undesirable results. Accordingly, the court was satisfied that sufficient cause existed pursuant to Section 363(k) to "order otherwise" and limit DSP's right to credit bid. After considering expert testimony, the court decided not to bar DSP's right to credit bid in whole, but to limit the amount DSP would be allowed to credit bid to approximately $14 million, and only with respect to those assets on which DSP held valid, properly perfected liens.

Admonition to Secured Creditors

Generally, the Bankruptcy Code provides secured creditors with the right to credit bid up to the amount of their claim on collateral at a bankruptcy sale. This is not an absolute right, however, and courts may limit it for cause. The court in Free Lance-Star found that such cause existed based on what it deemed a "perfect storm" of events caused by the confluence of various factors: DSP's less than fully secured status; DSP's overzealous loan-to-own strategy; and the negative impact DSP's misconduct had on the sale process. The court's decision in Free Lance-Star should serve as an admonition to secured creditors who purchase a distressed debt from a lender with the intention of acquiring the delinquent borrower: These loan-to-own lenders must carefully devise a strategy with the understanding that their right to credit bid in bankruptcy is not absolute, and implement a strategy that avoids some of the more aggressive and heavy-handed tactics employed by the secured creditor in Free Lance-Star.

This article originally appeared in The Legal Intelligencer.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. James G. Schu, Jr. practices in the area of business reorganization and financial restructuring at the firm. He also has experience with premises liability, products liability and class action litigation.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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