Reorganization is a tough business when capital is as inaccessible as a frightened turtle. It's no secret that true Chapter 11 reorganizations are few and far between; the Chapter 11 bankruptcy process is now used frequently as a sales mechanism, through the very powerful "363" sale process. The market demands sales, and for the highest prices the market demands the certainty of the "363." Indeed, from the perspective of the market, Chapter 11 may be the most efficient liquidation mechanism in the world.3
While the shift to "sale cases" has been widespread, it is not without controversy. One of the major developments of the past few years has been the attack on a secured lender's right to credit bid, once thought almost sacrosanct in the bankruptcy arena. There are a number of recent cases dealing with the ability of the secured lender to credit bid, and these may be a reaction, at least in part, to the perceived abuse of the "sale case," as well as the prevalence of the new "loan-to-own" strategy (where parties buy secured debt in order to take over the borrowers), and the widespread lending abuses that led to the meltdown of Wall Street.
The "363" sale (so-named because of the section of the Bankruptcy Code through which it is authorized) is a powerful liquidation tool. Better than the state law foreclosure process, it allows sellers to assign contracts to the buyer without having to get consent from the other party to the contract. Better yet, the "363" sale is memorialized by a bankruptcy court order, considered the closest equivalent to Kevlar in any distressed scenario. The order often explicitly cleanses the buyer and the assets from any liability to other creditors, including state law successor liabilities.
Credit bidding is the secured creditors' ultimate protection in the "363" sale. It is the right of a secured creditor to "bid" the amount of its outstanding claim at a sale of collateral, so that if the secured creditor has the winning bid, it simply offsets the purchase price against the existing debt – no money is required to change hands. Credit bidding is not unique to bankruptcy, but is a typical right of a secured creditor at a foreclosure sale under state law as well. The right to credit bid means no bidder can buy the collateral for less than the amount of the secured debt without the lenders' consent – because if the bid price is not acceptable to the lender, the lender simply bids in its debt at the higher amount and then takes over the collateral as the high bidder.
The "Indubitable Equivalent" Attack. One of the most recent threats to the right of a secured lender to credit bid at a bankruptcy auction comes in the form of the In re Philadelphia Newspapers, LLC4 decision, entered by the District Court for the Eastern District of Pennsylvania in late 2009, and affirmed just a few weeks ago by the Third Circuit Court of Appeals.5 In Philadelphia, the debtors proposed to sell their assets in a "363" sale as part of a bankruptcy plan of liquidation. The bid procedures specifically provided that the secured lenders were precluded from submitting a credit bid, in hopes that this would encourage more competitive bidding from outside parties for the debtors' assets. The Bankruptcy Court refused to allow this, finding the secured creditor had to be permitted to credit bid. On appeal, however, the District Court and the Third Circuit Court of Appeals both found that in the context of a sale as part of a plan, the secured lender can be denied the right to credit bid
The decision in Philadelphia hinged on the holding that under a plan of reorganization (or liquidation), the debtor has the (not-so-obvious) right to provide the secured creditor with the "indubitable equivalent" of its claim instead of the right to credit bid. The Bankruptcy Code provides a debtor with three options for treating a secured creditors' claim in a plan – (1) payment of the claim over time with interest, (2) the right to credit bid at a sale if the plan proposes a sale, and (3) the right to receive the "indubitable equivalent" of the claim.6 Conventional wisdom has generally held that if the bankruptcy plan provides for a sale, option two is exclusive and the secured creditor has the right to credit bid. Not so any longer.
Supporting the decision in Philadelphia are at least two other cases. The first is an older decision long considered an outlier, In re Criimi Mae, Inc.7, a Maryland ruling from 2000. The second, more importantly, is the 2009 decision of the Fifth Circuit in In re Pacific Lumber Co.8 Pacific Lumber held that a plan could be confirmed even though it denied secured creditors the right to credit bid, as long as the plan accurately reflected the value of the secured creditors' collateral (i.e., the "indubitable equivalent"). The Fifth Circuit's decision is not necessarily surprising, as the Fifth Circuit has long been seen as disapproving of "sale cases" and supportive of plans instead. Its decision in 1983 in In re Braniff Airways, Inc.9 was one of the seminal holdings that a "363" sale of an entire business generally cannot be held outside of a plan, a decision rejected by the courts in many other circuits, including the Third Circuit where Philadelphia was decided. See, for example, Stephens Industries, Inc. v. McClung, 789 F.2d 386 (6th Cir. 1986); In re Abbotts Dairies of Penn., Inc., 788 F.2d 143 (3rd Cir. 1986). Courts allowing "sale cases" have been generally more protective of credit bidding rights, as this is an essential part of the sale process. The new decision in Philadelphia Newspapers by the Third Circuit, arguably the most influential appeals court in the bankruptcy arena and one that has long been seen as tolerant of "sale cases," is thus more surprising. If the trend moves away from "sale cases," then secured lenders beware – because credit bid rights will increasingly come under fire where a sale is the ultimate goal.
The Loan-To-Own/Motive Attack. Another attack on the right of secured lenders to credit bid has come in response to secured creditors' attempts to execute a "loan-to-own" strategy. The defense of unsecured creditors is often to ask that courts in this situation reject the right of the debt buyer to credit bid, and instead require a debt buyer to pay in cash the value of its bid. For example, in In re Radnor Holdings Corp.,10 the Official Committee of Unsecured Creditors objected to "363" sale procedures on the grounds that the secured lender should not be allowed to credit bid. Instead, according to the Committee, the lender should be required to pay its bid in cash, with the sale proceeds to be returned to the lender through its distributions as the secured creditor under a plan (i.e., the "sale case" is converted to a plan case, and, as bankruptcy leverage goes, in order to get a plan confirmed the secured lender likely has to agree to some distribution for the unsecured creditors). In Radnor Holdings, the argument was unsuccessful, with the court finding that unless there were grounds for equitable subordination, the right of the secured creditor to bid at the sale was paramount. But more attacks like this are likely on the horizon.
The Equitable Subordination Attack. Equitable subordination – the de-prioritizing of a lender's claims because of outrageous conduct by the lender – is a weapon that has often been trained on secured lenders, but usually with little success. The recent and hotly-reported case of In re Yellowstone Mountain Club, LLC11 is the exception, however, and there, unsecured creditors were able to use equitable subordination to significantly curtail the right of the secured lender to credit bid. In Yellowstone, Credit Suisse as the secured creditor made a $375 million loan to the debtors, despite red flags and allegedly inadequate due diligence. The court in Yellowstone found that Credit Suisse's prime motivation for making a worthless loan was the fees it was earning from the loan transaction, and that the loan resulted in financial ruin for the debtors. The Court found the actions "so far overreaching and self-serving that they shocked the conscience of the Court."12 As a consequence, the Court subordinated Credit Suisse's first lien position to that of the debtor-in-possession lender and to the allowed claims of unsecured creditors.13 Credit Suisse was allowed to submit a credit bid for the amount of its allowed secured claim, but since its claim was equitably subordinated, Credit Suisse was required to provide (as a component in addition to its credit bid) sufficient funds to pay the debtor-in-possession financing, the administrative fees and costs of the debtors' estate, and the allowed unsecured claims of many of the creditors.
The "Not-So-Free/Not-So-Clear Attack." Finally, the one decision which has struck fear in the hearts of all watchers of "363" sales and credit bids is In re Clear Channel14, where the 9th Circuit Bankruptcy Appellate Panel in 2008 found that a lender's successful credit bid at a "363" sale did not wipe-out junior liens against the assets. In this decision, the Court found that it was unclear that the assets could be sold free and clear of the junior liens without the consent of the junior lenders. While most state foreclosure laws would have allowed the sale to wipe out junior liens, the Court in Clear Channel did not believe it was obvious that there was a similar basis for wiping out junior liens in a "363" sale. Clear Channel has been widely cited as a significant hurdle to future "363" sales because of its broad reasoning. On its facts, however, Clear Channel is simply an attack on the rights of a lender to credit bid, and whether Clear Channel applies in any other context is a significant question, as is whether its reasoning will be adopted by any other courts.
Conclusion. So, the hits just keep on coming. The attacks on credit bidding, in the likes of cases such as Philadelphia, Pacific Lumber, Radnor Holdings, Yellowstone, and Clear Channel, may be a reflection of distaste for "sale cases" in the new bankruptcy world. The market demands sale cases, but what the market demands the market does not always get. The evolution of "sale cases" and the continued assaults on the sanctity of the credit bid will be an evolution worth watching over the next few years.
Footnotes
*. Originally published in The Journal of Corporate Renewal, May 2010, and reprinted by permission.
2. Bobby Guy is a member of the law firm of Frost Brown Todd, and is based in the firm's Nashville, Tennessee office. He is a certified in Business Bankruptcy Law by the American Board of Certification, and can be reached at bguy@fbtlaw.com. Jennifer O'Guinn is an associate with Frost Brown Todd practicing in the areas of business bankruptcy and restructuring, and is based in the firm's Cincinnati, Ohio office. She can be reached at joguinn@fbtlaw.com.
3. See, e.g., Domenic Pacitti, Securing Value in Undesirable Circumstances: Why Chapter 11 May Be the Best Option for Liquidation, Morris Anderson & Company's Renaissance Newsletter, Fall 2009.
4. 418 B.R. 548 (E.D. Pa. 2009).
5. In re: Philadelphia Newspapers, LLC, ___ F.3d ____, 2010 WL 1006647 (3rd Cir. March 22, 2010).
6. What is an "indubitable equivalent," you ask? Yes, there is a rock band of bankruptcy professionals which is named the "Indubitable Equivalents," but that's not what we're talking about. In bankruptcy, a number of things have been found by courts to be the indubitable equivalent of a creditor's claim, such as abandonment of collateral or a replacement lien on similar collateral.
7. 251 B.R. 796 (D. Md. 2000).
8. 584 F.3d 229 (5th Cir. 2009).
9. 700 F.2d 935 (5th Cir. 1983).
10. 353 B.R. 820 (Bankr. D. Del. 2006).
11. 2009 Bankr. LEXIS 2047 (Bankr. D. Mont. May 13, 2009)
12. Id. at *25.
13. Id. at *31.
14. 391 B.R. 25 (9th Cir. B.A.P. 2008).
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