Reports Of Credit Bidding's Death Are Greatly Exaggerated

May 24 2010 | 2:11pm ET

By Jennifer Feldsher, Bracewell & Giuliani -- The right to credit bid under section 363 of the Bankruptcy Code has always been a formidable weapon for financial players in the distressed community.  Reduced to its simplest, section 363(k) of the Bankruptcy Code gives a secured lender the ability to credit bid up to the full face amount of his debt at an auction for his collateral.  By letting the secured lender effectively "subtract" up to the full amount of his claim from the purchase price for the assets, the lender gets the benefit of his bargain because he can take his collateral (and any attendant upside) in lieu of accepting less than payment in full on his loan. 

As markets have become more complicated, so too has the use of credit bidding.  With private equity and hedge funds frequently replacing traditional bank lenders in the capital structure, credit bidding has become more strategic, with lenders being just as likely to use credit bidding as a tool to take ownership of a company as to ward off corporate raiders looking to buy on the cheap.  Indeed, in 2009, with capital markets constrained, credit bidding became a key tool for distressed investors who bought claims at a fraction of their face value and looked to acquire assets without paying significant up-front cash.  At that time, we also saw important decisions on section 363(k) of the Bankruptcy Code handed down by courts around the country, including in such cases as In re Foamex Int'l Inc., Case No 09-10560 (Bankr. D. Del. 2009), In re Metaldyne Corp., 409 B.R. 671 (Bankr. S.D.N.Y. 2009) and In re Chrysler LLC, 576 F.3d 108 (2d Cir. 2009).  These cases confirmed that credit bidding applied not only in the simple one-lender context but also in syndicated loan transactions where loan agreements give lenders holding a majority of the debt the ability to credit bid for the entire class even over the objection of significant minority holders.  Secured lenders, therefore, had significant leverage over a debtor trying to sell assets free and clear of the lenders' liens.      

Recently, however, the U.S. Court of Appeals for the Third Circuit set the lending community abuzz with its decision in Philadelphia Newspapers that secured lenders do not have an absolute right to credit bid in an auction process carried out under a chapter 11 plan.  In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3d Cir. 2010).  In that case, the Third Circuit held that because section 1129(b)(2)(A)(iii) of the Bankruptcy Code permits a debtor to cram down secured creditors with the "indubitable equivalent" of their claim and does not expressly refer to credit bidding, the statute does not, on its face, require that secured lenders be given the right to credit bid in a sale carried out under a chapter 11 plan.  Many professionals and commentators characterized the decision as enhancing the leverage of debtors and insiders at the expense of secured lenders.  Financial participants worried – will every chapter 11 case now involve a sale under a plan? 

While the decision in Philadelphia Newspapers is undoubtedly an important one, it has not sounded the death knell for credit bidding in the bankruptcy context.  It has, however, increased the benefits available to secured lenders in a 363 sale over a plan process.  Therefore, secured lenders will need to proactively protect their right to credit bid from the outset of a bankruptcy case or risk getting the not-so-equivalent, "indubitable equivalent." 

Background

Philadelphia Newspapers and its affiliated debtors (collectively, the "Debtors") own and operate a number of print and online publications in the Philadelphia region, including the Inquirer and the Daily News.  The Debtors financed the acquisition of the newspapers in 2006 with a $295 million loan from a group of lenders (the "Secured Lenders"), secured by first priority liens on substantially all of the Debtors' assets.  In February 2009, after defaulting on the loan, the Debtors commenced chapter 11 cases in the Eastern District of Pennsylvania. 

During their chapter 11 cases, the Debtors proposed a plan that included a sale of substantially all of their assets free and clear of liens to a consortium which included various insiders.  This stalking horse bid was for a fraction of the outstanding secured debt.  Thereafter, the Debtors sought bankruptcy court approval for bidding procedures for the sale process which did not permit the Secured Lenders to credit bid their debt at the auction.  The Secured Lenders objected, arguing that any sale free and clear of liens must include their right to credit bid their claims.

Bankruptcy Court and District Court Rulings

The bankruptcy court for the Eastern District of Pennsylvania agreed with the Secured Lenders and denied the Debtors' bidding procedures motion.  On appeal, the U.S. District Court for the Eastern District of Pennsylvania reversed and held that under the plain language of section 1129(b)(2)(A), there is no legal requirement that secured lenders be given a right to credit bid in sales pursuant to a chapter 11 plan.  According to the district court, so long as secured lenders are given the "indubitable equivalent" of their claims, including a lien on proceeds of the sale of their collateral, a debtor could proceed without providing them the right to credit bid at the auction.    

Third Circuit Ruling

On appeal, the Third Circuit affirmed the district court.  The Third Circuit interpreted section 1129(b) of the Bankruptcy Code to provide that a plan can be confirmed over the objection of secured creditors if the plan is "fair and equitable" to such creditors by satisfying at least one of the three alternatives provided for in sections 1129(b)(2)(A)(i)-(iii).  These alternatives include

(i) the lenders' retention of the liens securing their claims and their receipt of deferred cash payments totaling at least the allowed amount of the secured claim;

(ii) a sale, subject to section 363(k), of the lenders' collateral free and clear of liens, with the lenders' liens attaching to the proceeds of the sale; or

(iii) the lenders' receipt of value that is the "indubitable equivalent" of their allowed claim.

See 11 U.S.C. § 1129(b)(2)(A).  Judge Ambro strenuously dissented, finding section 1129(b)(2)(A) ambiguous and the alternatives described in sections 1129(b)(2)(A)(i)-(iii) to correspond to what a particular plan proposes.  Under his read, a sale of assets free and clear of liens could only be accomplished under a plan that satisfies 1129(b)(2)(A)(ii) and, therefore, is subject to section 363(k) of the Bankruptcy Code.  Notably, the Third Circuit left for determination by the bankruptcy court the question of whether giving secured lenders the proceeds of a sale in which they were denied the right to credit bid could constitute the "indubitable equivalent" for confirmation purposes. 

Ultimately, the Secured Lenders were forced to bid in cash at the auction.  They won, bidding nearly $140 million for the assets.  Interesting, this result is consistent with laws in the U.K. and Australia where secured lenders do not have the right to credit bid and fund a plan or acquisition that recycles the proceeds back to them with minimal leakage.

Take Aways

The Philadelphia Newspapers decision reaffirms the significant leverage a debtor enjoys when it comes to the plan confirmation process.  Relying on exclusivity and the notice and solicitation rules set out in the Bankruptcy Code, courts have given debtors a lot of leeway with respect to plans of reorganization.  Therefore, now more than ever, it is imperative that secured lenders be proactive and protect their rights from the outset of the bankruptcy process, especially in courts where material asset sales are only permitted if they are done under a chapter 11 plan and not under section 363.  Failing such actions, secured lenders risk losing significant leverage over a debtor and its insiders. 

On the other hand, Philadelphia Newspapers leaves untouched the right of a secured lender to credit bid in asset sales under section 363.  To mitigate the risk of a "runaway" debtor or the undervaluation of their collateral, secured lenders must push for the debtor's agreement that sales of assets will be done only under section 363 of the Bankruptcy Code if they want to preserve their right to credit bid.  Leverage points exist and can be exploited in negotiations over adequate protection in connection with DIP financing and the use of cash collateral, exclusivity extensions and plan confirmation.  Barring that, holders of secured debt will continue to have the ability (individually or together) to bid in cash at an auction to thwart a "low ball" offer, with the understanding that a substantial portion of the bid will flow back to them on account of their secured claims.  Indeed, that was how the lenders in Philadelphia Newspapers ultimately got their assets back.

Jennifer Feldsher is a partner in the New York office of law firm Bracewell & Giuliani LLP.  Her primary area of practice is corporate restructuring and insolvency law.  Ms. Feldsher represents interested parties in bankruptcy proceedings and complex corporate debt restructurings, as well as advising special situations investment firms on all aspects of their investments and acquisitions.  She may be contacted at jennifer.feldsher@bgllp.com.  


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