A few months ago, I asked volunteers for writers for the blog as we expand our coverage of all things distressed. We have three writers that have volunteered - one that will focus on
structured finance concepts and two that will focus on legal concepts. In addition, I am looking for two other writers - one to cover European situations and one to cover domestic distressed situations.
With that out of the way, I want to introduce George Mesires, partner in the Finance and Restructuring Practice at Ungaretti & Harris LLP, who will be contributing an article once a month for the blog. I asked George a few weeks ago to delve further into the Supreme Court's decision to look at the ability of secured creditors to bid their claims in a bankruptcy auction as it has been topical on a number of case in the past 18 months. Enjoy!
U.S. Supreme Court to Provide Guidance on Credit Bidding Rights
On December 12, 2011, about six months after the Seventh Circuit issued its decision in the River Road Hotel bankruptcy case and split from its brethren in the influential Third Circuit (home to the Delaware bankruptcy court) and the Fifth Circuit, the U.S. Supreme Court agreed to hear whether a secured creditor has an absolute right to credit bid its debt under a plan of reorganization whereby a debtor proposes to sell the lender’s collateral free and clear of the lender’s liens. The Supreme Court’s decision, expected near the end of the Supreme Court’s term in June 2012, should provide needed guidance to lenders. Although the Seventh Circuit’s River Road decision provided some comfort to secured lenders (at least to those in Illinois, Indiana, and Wisconsin!) that they may exercise their right to credit bid under an auction sale proposed under a plan of reorganization–– the unsettled state of the law has added uncertainty and risk in these credit bid situations, resulting in a higher cost of capital.
What is credit bidding?
Credit bidding is the ability of a secured lender to bid at the sale of the lender’s collateral using the lender’s outstanding loan balance as credit against the purchase price of the collateral. By using the amount of the outstanding claim as currency, the secured lender does not have to come out of pocket with cash, which eliminates the costs – administrative and financing – associated with making a cash bid. Credit bidding protects the secured lender against an attempt by a debtor to sell the collateral too cheaply. If the secured creditor thinks the collateral is worth more than the sale price, the lender may credit bid its debt, and if the lender’s bid prevails, it will have preserved its ability to participate in any appreciation of the value of its collateral in the future.
Credit bidding in bankruptcy.
Generally, a debtor in bankruptcy may sell its assets in two ways: (i) under section 363 of the United States Bankruptcy Code the (“Bankruptcy Code”); or (ii) pursuant to a plan of reorganization under section 1123 of the Bankruptcy Code.
Under Section 363, it is not disputed that a secured creditor may credit bid its debt (unless the court in very limited circumstances finds that “cause” exists to deny the secured lender the right to do so).
Alternatively, a debtor can sell its assets pursuant to a plan of reorganization. In certain circumstances, a debtor can “cramdown” a plan of reorganization over the objection of creditors, including a secured creditor. To cramdown a secured creditor, among other things, the reorganization plan must be “fair and equitable” to the secured creditor. The “fair and equitable” standard may be satisfied by showing that the plan provides: (1) that the holders of such claims retain the liens securing such claims and receive deferred cash payments having a present value equal to the value of their collateral; (2) for the sale of the collateral free and clear of liens (with such lien attaching to the sale proceeds of the sale) but subject to the secured creditor’s right to credit bid; or (3) for the realization of the secured creditor’s claim by some means which provides the secured creditor with the “indubitable equivalent” of its claim.
Thus, the plain language of section (2) above states that a secured creditor shall have the right to credit bid in a sale of its collateral pursuant to a plan of reorganization. Indeed, historically, there has been little dispute that a secured lender had the right to credit bid its debt in such cases. Recently, however, several creative debtors (see e.g., debtors in the Pacific Lumber and Philadelphia Newspapers cases) have sold a secured creditor’s collateral pursuant to a plan of reorganization without allowing the creditor to credit bid. And such arrangements have been upheld by two federal circuit courts.
In the River Road bankruptcy case, the debtors proposed selling substantially all of their assets, consisting mainly of the InterContinental Hotel Chicago O’Hare, pursuant to a plan of reorganization. As part of its plan, the debtors sought to deny the lenders the ability to credit bid their debt.
But rejecting the rationale of the Third and Fifth Circuits, the Bankruptcy Court for the Northern District of Illinois denied the debtors’ attempt to bar the secured lenders from credit bidding, which was immediately appealed by the debtors. In June 2011, the Seventh Circuit upheld the bankruptcy court’s decision. Not only did the Seventh Circuit find support for its decision in the plan language of the cramdown provision of the Bankruptcy Code, but the court also was influenced by the way auctions are recognized and the way secured creditors are treated elsewhere in the Bankruptcy Code. The Seventh Circuit recognized that under both section 363 and the plan cramdown provision, a secured creditor is permitted to credit bid, which “promises lenders that their liens will not be extinguished for less than face value without their consent … Because the Debtors’ proposed auction would deny secured lenders the ability to credit bid, they lack a crucial check against undervaluation. Consequently, there is an increased risk that the winning bids in these auctions would not provide the Lenders with the current market value of the encumbered assets.”
With its decision, the Seventh Circuit split from the Third Circuit’s decision in 2010 in Philadelphia Newspapers and the Fifth Circuit’s decision in 2009 in Pacific Lumber, setting up a clear dispute among the circuit and bankruptcy courts, which made this issue ripe for consideration by the Supreme Court.
Why it Matters.
The Supreme Court’s ruling will be important for at least two reasons. First, in recent years, most chapter 11 bankruptcy cases have resulted in asset sales – not reorganizations. Thus, resolution of this issue is critically important to the administration of bankruptcy cases and to providing secured lenders clarity as to whether they can credit bid their bid in both 363 and plan sales under the Bankruptcy Code. Continued uncertainty and disagreement among the circuits will lead to disparate results, higher risk, and increased costs of capital.
Second, without clarification by the Supreme Court that a secured creditor has an absolute right to credit bid, over 100 years of bankruptcy jurisprudence stands to be undermined. Generally, bankruptcy law has not permitted a secured creditor to lose its lien in bankruptcy without the lender’s consent, payment in full, or surrender of the collateral to the lender. The continued ability by debtors to block secured creditors from credit bidding will shake the lending community’s faith in the bankruptcy system, and be reflected in higher costs of capital at a time when the economy is still on fragile footing.
Bankruptcy practitioners are following this case closely. Briefing on the case should be completed by early March 2012, with oral arguments to follow. A decision will likely be issued near the end of the Court’s term in June 2012. We will report on this case as soon as a decision is issued.
