Originally published in The Legal Intelligencer
In a docket crowded with blockbuster cases this term, the Supreme Court's decision concerning the circuit split over cramdown plans precluding credit bidding by secured lenders may not stoke as much passion or fury as the cases concerning the Patient Protection and Affordable Care Act or Arizona's immigration law, but RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 132 S. Ct. 845 (2011) is arguably one of the more important business bankruptcy cases in over a decade. The issue in the case involves a bankruptcy plan that is confirmed over the dissent of a secured creditor (a "cramdown plan"), and whether the cramdown plan may preclude the secured creditor from "credit bidding" in an auction for the collateral that secures its claim. The practice of "credit bidding" allows a secured creditor to bid on such collateral when it is sold at a bankruptcy auction using, not cash, but a credit against the debt. This allows the secured creditor to bid up to the amount of the debt without paying additional cash, ensuring that either the debt will be paid in full (if the collateral is sold to another party for an amount at least as great as the debt), or the secured creditor can take back its collateral (to prevent a sale of the collateral for less than the amount of the debt). The point is to ensure that the secured creditor receive the collateral's "indubitable equivalent."
Since this issue came to the fore in In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3d Cir. 2010), where the Third Circuit Court of Appeals came down in favor of cramdown plans precluding credit bidding, it has received a great deal of attention from practitioners and scholars. There have been voiced concerns that the Philadelphia Newspapers holding disrupts the established expectations of secured lenders and borrowers (and, by extension, related financial actors in the area of distressed investments and special situations), imposes unnecessary litigation costs, and even encourages insider manipulation of the reorganization process. In River Road Hotel Partners, LLC v. Amalgamated Bank, 651 F.3d 642 (7th Cir. 2011), the Seventh Circuit Court of Appeals took up these concerns, directly contradicting the Philadelphia Newspapers holding, and creating a split in the circuits that the Supreme Court deemed worthy of reconsideration in RadLAX.
At the heart of the matter is an issue of enormous consequence to business and the economy: the access by secured lenders to the collateral securing their loans, which collateral formed the basis of the creditor's original loan extension. A lender extends a secured loan in reliance upon the expectation that it will be able to foreclose on the attached collateral in the event of the borrower's loan default or bankruptcy. Thus, limiting the lender's access to the collateral in these circumstances undermines the lender's expectations, injecting an element of uncertainty that fundamentally alters the negotiation—and thereby the practice of secured lending in general.
The Third Circuit's Philadelphia Newspapers Decision
Whether a secured creditor has an absolute right to credit bid, or whether a debtor can confirm a cramdown plan that precludes a secured creditor from credit bidding, comes down to an interpretation of Bankruptcy Code section 1129(b)(2)(A):
(A) With respect to a class of secured claims, the plan provides—
(II) that each holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder's interest in the estate's interest in such property;
(ii) for the sale, subject to section 363(k) of this title, of any property that is subject to the liens securing such claims, free and clear of such liens, with such liens to attach to the proceeds of such sale, and the treatment of such liens on proceeds under clause (i) or (iii) of this subparagraph; or
(iii) for the realization by such holders of the indubitable equivalent of such claims.
11 U.S.C. § 1129(b)(2)(A). Subsection (ii) incorporates section 363(k), which provides for credit bidding: at a sale of "property that is subject to a lien that secures an allowed claim . . . the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property." 11 U.S.C. § 363(k).
In Philadelphia Newspapers, the Court of Appeals for the Third Circuit held that Bankruptcy Code section 1129(b)(2)(A) is "unambiguous and that a plain reading of its provisions permits the Debtors to proceed under subsection (iii) without allowing the Lenders to credit bid." Philadelphia Newspapers, 599 F.3d at 318. Rather, a plan may be confirmed even if it precludes a secured creditor from credit bidding, insofar as it provides the "indubitable equivalent" of the collateral's value.
In a lengthy dissent, Judge Thomas P. Ambro insisted that the majority's interpretation of section 1129(b)(2)(A) was not the only reasonable one, and that the context and legislative history of the Bankruptcy Code compelled the conclusion that a secured creditor has an absolute right to credit bid. Id. at 319. In reaching this conclusion, Judge Ambro emphasized various practical concerns with the majority's holding: among his concerns was that the holding would undermine secured creditors' protection against undervaluation of the collateral, which would have the effect of increasing the cost of capital that lenders would demand in order to compensate for the added risk.
The Seventh Circuit's Rejection of Philadelphia Newspapers
In In re River Road Hotel Partners, LLC, No. 09 B 30029, 2010 Bankr. LEXIS 5933 (Bankr. N.D. Ill. Oct. 5, 2010), the Bankruptcy Court for the Northern District of Illinois adopted Judge Ambro's reasoning in holding that a cramdown plan may not preclude a secured creditor from credit bidding. The case was appealed directly to the Court of Appeals for the Seventh Circuit, which affirmed, thus creating a split in the circuits.
The court essentially followed Judge Ambro's lead in rejecting the Philadelphia Newspapers majority's holding. The court set out its rationale in two steps. First, it pointed out that the plain language of section 1129(b)(2)(A) does not unambiguously state that secured creditors may be precluded from credit bidding. Second, it concluded that the Philadelphia Newspapers holding violates cardinal canons of statutory construction: statutory text should be interpreted to avoid any clause being rendered superfluous, and should not be read to create a conflict with other sections of the same statute.
The Seventh Circuit court addressed the debtor's contention that the plain language of section 1129(b)(2)(A) allows for confirmation of a cramdown plan that precludes credit bidding, so long as the secured creditor receives the "indubitable equivalent" of the collateral's value under subsection (iii). Citing Judge Ambro's dissent, the court explained that "[n]othing in the text of Section 1129(b)(2)(A) directly indicates whether Subsection (iii) can be used to confirm any type of plan or if it can be used to confirm plans that propose disposing of assets in ways that can be distinguished from those covered by Subsections (i) and (ii)." River Road, 651 F.3d at 649. Because "there are two plausible interpretations" as to whether subsection (iii) has "global applicability" (under Philadelphia Newspapers) or has "a much more limited scope" (as Judge Ambro argued in dissent), the court concluded that the statute does not have a single plain meaning. Id. at 650.
Moreover, even analyzing subsection (iii) in isolation, the court expressed doubt as to whether a cramdown plan precluding a secured creditor from credit bidding could provide value that is the "indubitable equivalent" of the collateral's value. Id. The court reasoned that establishing the "indubitable equivalent" of an asset's value in the absence of a market check creates a basic problem with respect to valuation:
Id. This reasoning is flawed, according to the court, as there are several risks inherent in such an auction: first, "the speed and time of the a bankruptcy auction often results in undervaluation"; second, logistical constraints create an "inability to provide sufficient notice to interested parties"; third, "there is an inherent risk of self-dealing on the part of existing management[,]" which has an incentive to favor a "white knight" favorably disposed to retaining the incumbents; fourth, the credit markets continue to suffer from constrained liquidity, which keeps potential bidders on the sidelines and inhibits competitive bidding; and finally, the bidding process itself is costly, and bidders will include these transaction costs in their bids, pushing down the price paid for the assets. Id. at 651, n. 6. These factors culminate in a risk that the assets sold in a bankruptcy auction will be undervalued, and without the ability to credit bid, secured lenders would be deprived of a crucial protection against receiving less than the "indubitable equivalent" value of the collateral. "Nothing in the text of Section 1129(b)(2)(A) indicates that plans that might provide secured lenders with the indubitable equivalent of their claims can be confirmed under Subsection (iii)." Id. at 651.
According to the court, the Philadelphia Newspapers holding violates two cardinal rules of statutory construction. Reading subsection (iii) as providing for plan confirmation without regard to the credit bid procedure provided in subsection (ii) would effectively render subsection (ii) superfluous. The court explained, "[w]e cannot conceive of a reason why Congress would state that a plan must meet certain requirements if it provides for the sale of assets in particular ways and then immediately abandon these requirements in a subsequent subsection." Id. at 652. The "infinitely more plausible interpretation" would be to construe each subsection "as conclusively governing the category of proceedings it addresses." Id. (citing Bloate v. United States, 130 S. Ct. 1345 (2010)). Furthermore, this reading "treats secured creditors' interests in a way that sharply conflicts with the way that those interests are treated in other parts of the Code"—namely, section 1129(b)(2)(A)(ii), section 363(k), and section 1111(b), which are geared toward providing protection for secured creditors' claims. Id. at 653. On the other hand, there is no other provision of the Bankruptcy Code that limits the right of secured creditors to credit bid. Id.
Therefore, the court reasoned, because the debtors' reading of subsection (iii), based on Philadelphia Newspapers, is not unambiguous, and because this reading would "nullify its neighboring subsections and ignore the protections for secured creditors recognized in other Code provisions," the court rejected this interpretation. "Instead, we find that the Code requires that cramdown plans that contemplate selling encumbered assets free and clear of liens at an auction satisfy the requirements set forth in Subsection (ii) of the statute." Id. at 653.
In our view, permitting confirmation of cramdown plans that preclude secured creditors from using the credit bidding mechanism to ensure collection of the full value of their collateral is inconsistent with the general framework of the Bankruptcy Code, and disruptive of the established expectations of lenders and borrowers. The irony of Philadelphia Newspapers is that the holding does not ultimately help debtors: lenders will simply respond to the holding by charging higher interest rates and demanding more restrictive terms at the front end in order to compensate for increased uncertainty and greater transaction costs on the back end. RadLAX presents the opportunity for the Supreme Court to square section 1129(b)(2)(A) with the rest of the Bankruptcy Code, bringing it back into alignment with established business norms, and eliminating an unnecessary and avoidable inefficiency.
As summer blockbusters go, RadLAX is probably not the case that will attract the most protesters, grab the most headlines, or most affirmatively assert the Court's role in controversial legal issues. But as an increasingly rare opportunity for unanimity based on careful statutory construction, RadLAX may be the Court's best opportunity this term to maintain its role in the application of the law to business and economics. In the process, RadLAX has great potential to pay policy dividends: reassuring secured lenders that they will receive the benefit of their bargain, reducing the cost of capital for borrowers, and facilitating the lending transactions between banks and businesses that are our economic system's lifeblood.
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 litigationand creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.
Aaron J. Margolisis an associate with the firm's business reorganization and financial restructuring department. He attended Washington University in St. Louis, graduating 2010 with a J.D./M.B.A.
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