In a case lauded as a major victory for debtors in bankruptcy, and viewed as a setback to secured creditors, the Third Circuit Court of Appeals, in a 2-1 decision, held Monday that secured creditors cannot use what they are owed to bid on the bankrupt company's assets in an auction, a practice known as "credit bidding." The case is In re Philadelphia Newspapers, LLC., No. 09-4266 (3d Cir. Mar. 22, 2010).

Factual Background

In July of 2005, Philadelphia Newspapers, LLC (the "Debtors") purchased the Philadelphia Inquirer, the Philadelphia Daily News, and philly.com for $515 million, $295 million of which came from a consortium of lenders (the "Lenders"). In exchange for the loan, the Lenders received first priority liens in substantially all of the Debtors' real and personal property. After defaulting on their loan obligations, the Debtors filed for bankruptcy protection. At the time the Debtors filed their bankruptcy petitions, they owed the Lenders over $300 million.

In August of 2009, the Debtors filed a joint Chapter 11 plan of reorganization (the "Plan"), pursuant to which substantially all of the Debtors' assets would be sold at a public auction, free of liens. The Debtors also signed an asset purchase agreement with Philly Papers, LLC. The Debtors estimated that the transaction would generate approximately $37 million in cash for the Lenders. Pursuant to the Plan, the Lenders would also receive the Debtors' Philadelphia headquarters, as well as any cash generated by a higher bid at the public auction. The Debtors maintained that this return to the Lenders satisfied Section 1129(b)'s requirement that a plan sale be "fair and equitable" to secured lenders in that it provided the Lenders with the "indubitable equivalent" of their secured interest.

In their motion for approval of bid procedures for the sale, however, the Debtors sought to preclude the Lenders from using the $300 million debt owed them to credit bid for the assets. Instead, the Debtors insisted that any qualified bidder fund its purchase with cash. The Lenders objected to the proposed bidding procedures and, in particular, the Debtors' preclusion of credit bidding.

The Lower Courts' Decisions

In October of 2009, the United States Bankruptcy Court for the Eastern District of Pennsylvania agreed with the Lenders, determining that the sale of the Debtors' assets required that a secured lender be able to participate in a sale by credit bidding its debt. The District Court reversed. Specifically, the District Court concluded that the Bankruptcy Code provides no legal entitlement for secured lenders to credit bid at an auction sale pursuant to a plan of reorganization.

The Lenders subsequently appealed the District Court's decision to the Third Circuit Court of Appeals, which affirmed the District Court's decision.

The Third Circuit's Decision

The court began its analysis by identifying the two interests which Chapter 11 strives to balance: facilitating the reorganization and rehabilitation of the debtor as an economically viable entity on the one hand and protecting creditors' interests by maximizing the value of the bankruptcy estate on the other hand. In furtherance of these interests, the Bankruptcy Code permits a debtor preparing a Chapter 11 plan of reorganization to "provide adequate means for the plan's implementation", including arranging for the "sale of all or any part of the property of the estate, either subject to or free of any lien[.]"

As the Code contains no explicit procedures governing such a sale of assets, the court looked to the plan confirmation provisions of the Bankruptcy Code, Section 1129(b), which, in general, require that the sale must be "fair and equitable" to all parties, including the secured lenders. According to the court, Section 1129(b) provides three alternatives in which a plan may meet this standard: (i) a transfer of lien-encumbered assets with deferred cash payments; (ii) a free and clear sale of assets subject to credit bidding; or (iii) any other disposition that provides lenders with the "indubitable equivalent" of their secured interest.

Reading the plain language of that Section, the court explained that Section 1129(b) was phrased in the disjunctive and, therefore, operates to provide alternatives – in other words, a debtor may proceed under subsection (i), (ii), or (iii), and need not satisfy more than one subsection. Thus, where, as here, the debtor is proceeding under subsection (iii), the court concluded that the Bankruptcy Code contains no statutory right to credit bid at a sale of the collateral and, in fact, unambiguously excludes the right to credit bid. As such, the Debtors were permitted to conduct the asset sale without allowing the Lenders to credit bid.

In reaching this conclusion, the court rejected the Lenders' argument that, notwithstanding the fact that subsection (iii) contains no explicit right to credit bid, the right is necessary to provide secured lenders with the "indubitable equivalent" of their claims. Specifically, the court noted that it is the plan of reorganization, and not merely the auction itself, that must generate the "indubitable equivalent" of the lender's secured interest in the collateral. Therefore, a lender may still object to plan confirmation on a variety of bases, including that the absence of a credit bid did not provide it with the "indubitable equivalent" of its collateral. At this stage in the proceedings, however, the court simply was not able to conclude, as a matter of law, that the auction could not generate the indubitable equivalent of the Lenders' secured interest in the Debtors' assets, stating that such an analysis is properly conducted during plan confirmation, when the appropriate information is available.

Judge Thomas Ambro, a former bankruptcy attorney, authored a 47-page dissent in which he expressed concern that the court's decision preventing credit bids opened the door to insider deals. Characterizing the Debtors' plan as a "thinly veiled way for insiders to retain control of an insolvent company minus the debt burden the insiders incurred in the first place," Judge Ambro endorsed and joined the bankruptcy court's conclusions that the stalking horse bid – submitted by investors who have supported and likely will retain the Debtor's current management – was essentially an insider transaction and that the Debtors' plan was not necessarily designed to raise the most money possible for creditors.

The decision could be appealed to the United States Supreme Court.

Implications of the Decision

The Third Circuit is the second court of appeals that has addressed the issue of a secured creditor's right to credit bid in a plan sale. In September of 2009, the Fifth Circuit Court of Appeals, in In re Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009), confirmed a plan that did not permit an undersecured class of noteholders to credit bid. As in the Philadelphia Newspapers case, the debtor in Pacific Lumber proceeded under subsection (iii), providing the noteholders with the "indubitable equivalent" of their secured interest.

The Third and Fifth Circuits' decisions are significant for both debtors and secured creditors alike as they alter the level of control that those groups have over the bankruptcy and reorganization process. Significantly, Chapter 11 plans seeking to sell a secured creditor's collateral while precluding lenders from credit bidding will likely increase. At the same time, secured creditors will likely prefer and increasingly support sales under Section 363 of the Bankruptcy Code (rather than under a Chapter 11 plan as in the Philadelphia Newspapers and Pacific Lumber cases), to preserve their right to credit bid. Further, it will be interesting to see the extent to which secured creditors attempt to require certain commitments from borrowers prior to permitting use of their collateral in Chapter 11.

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