There are two types of asset sales that can occur in a Chapter 11 bankruptcy case. The first is a sale under § 363 of the United States Bankruptcy Code (the “Code”) which occurs during the course of the bankruptcy case. Under § 363(k), secured creditors are generally allowed to credit bid at the sale of their collateral. The second type of sale occurs as part of the Chapter 11 plan. Historically, secured creditors have enjoyed the right to credit bid at such plan sales. However, as discussed in this article, that right may be in jeopardy.
Section 1129(b)(2)(A) outlines circumstances where a Chapter 11 reorganization plan may be confirmed over the negative vote of a secured creditor. Under that section, a secured claim may be reduced to the present value of the collateral, leaving the deficiency as an unsecured debt. This process, referred to as a “cramdown,” requires treatment of secured creditors to be “fair and equitable.”
Section 1129(b)(2)(A) enumerates three circumstances under which a plan may be deemed “fair and equitable” to holders of secured claims despite their objection: (i) when the holders retain their liens and receive deferred cash payments equal to at least the present value of the collateral (“Subsection (i)”); (ii) when the secured property is sold free and clear of liens, with the lienholders having the right to credit bid pursuant to 11 U.S.C. § 363(k), and with the liens attaching to the proceeds (“Subsection (ii)”); or, (iii) when the holders receive the indubitable equivalent of their claims (“Subsection (iii)”). While secured creditors have traditionally enjoyed the right to credit bid when their collateral is sold in a plan sale, two Circuit Courts have recently approved circumvention of this right when the plans calls for secured creditors to receive the “indubitable equivalent” of their claims under Subsection (iii).
In re The Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009).
In Pacific, the Fifth Circuit Court of Appeals approved a plan that deprived secured creditors of the right to credit bid at a sale of their collateral and instead contemplated a cash payment to the secured creditors of the judicially determined value of their collateral.
The Debtors were six affiliated entities involved in growing, harvesting and processing redwood timber. The appeal concerned two of the Debtors, Palco and Scopac. Scopac was a special purpose entity that owned 200,000 acres of timberland. The appellants included certain noteholders (the “Noteholders”). Scopac owed the Noteholders approximately $740 million which was secured by Scopac’s assets. The bankruptcy court valued the collateral at only $513.6 million.
The plan proposed, inter alia, to create two new entities, Townco and Newco, to which the assets of Palco and Scopac would be transferred. Additionally, the plan proponent would contribute $580 million to pay the claims against Scopac. The plan proposed to cramdown the Noteholders and pay them, inter alia, $513.6 million in cash on their secured claim. In confirming the plan, the bankruptcy court concluded that the Noteholders could be deprived of a right to credit bid on the assets because the plan called for them to receive the “indubitable equivalent” (i.e. $513.6 million) of their secured claim under Subsection (iii).
In contending, on appeal, that they should have been afforded the right to credit bid on the assets, the Noteholders argued that because Subsection (ii) (which contemplates credit bidding) is more specific, it should control over the more general “indubitable equivalent” language of Subsection (iii). Additionally, the Noteholders argued, Subsection (ii) is superfluous if sales of collateral free and clear of liens are permitted under Subsection (iii).
The Fifth Circuit ruled that because Subsections (i), (ii) and (iii) are joined by the disjunctive “or,” they are non-exhaustive alternatives and thus, Subsection (ii) does not control over Subsection (iii). Additionally, Subsection (iii) afforded a distinct basis for confirming a plan, the court of appeals ruled, because it offered the Noteholders the “indubitable equivalent” of the secured claim; namely, a cash payment of the judicially determined value of the collateral.
The Noteholders offered two additional contentions as to why they should have been allowed to credit bid: (1) by depriving them of the right to credit bid, the plan prevented them from foreclosing on the collateral and realizing possible subsequent increases in the collateral’s value; and (2) the collateral would have been better valued at a public auction than through a judicial determination. With respect to the first point, the Court ruled that the Code does not protect a secured creditor’s interest in the upside potential of collateral to be sold. To the second point, the Court found that the Noteholders did not timely object to the bankruptcy court’s procedures and did not establish prejudice.
In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3rd Cir. 2010).
In this case before the Third Circuit Court of Appeals, secured lenders were deprived of a right to credit bid at an auction of their collateral. However, they did retain the right to object to confirmation of the plan if the sale did not result in the “indubitable equivalent” of their claim under Subsection (iii).
The Debtors were owners and operators of newspapers. Certain lenders (the “Lenders”) were owed $318 million on their undersecured claim. The Debtors filed a Chapter 11 plan providing for the sale of their assets at a public auction free and clear of liens. Simultaneously, the Debtors signed an asset purchase agreement with another entity, which was controlled by the Debtors’ current and former management and equityholders. Under the plan, the purchase would generate $37 million in cash for the Lenders; additionally, the Lenders would receive the Debtors’ headquarters (valued at $29.5 million), subject to a two-year rent-free lease for the entity that would operate the newspapers. The purchase agreement would then be marketed and subject to higher and better offers at a public auction and the Lender would receive any cash generated by a higher bid. In seeking approval of the bid procedures, the Debtors sought an order precluding the Lenders from credit bidding at the auction. The bankruptcy court refused to bar the Lenders from credit bidding. On appeal, the District Court reversed, finding that the Lenders could be properly barred from credit bidding under Subsection (iii).
The Third Circuit Court of Appeals upheld the District Court on three primary grounds. First, following the lead of the Fifth Circuit in In re Pacific Lumber Company, the Third Circuit ruled that Subsections (i), (ii) and (iii) provide three alternative paths to meeting the “fair and equitable test” of § 1129(b)(2)(A). Moreover, Subsection (ii) (which includes the right to credit bid) does not provide the exclusive means for a debtor to transfer collateral. Instead, the court of appeals found that Congress included Subsection (iii) to leave open the potential for alternate methods of conducting asset sales. Second, the Third Circuit rejected the Lenders’ argument that the term “indubitable equivalent” was ambiguous and ruled that “indubitable equivalent” under Subsection (iii) means the “unquestionable value of a lender’s secured interest in the collateral.” Thus, because Subsection (iii) is not ambiguous, a right to credit bid cannot be read into it. Finally, the court of appeals rejected the Lenders’ contention that the Code guarantees secured recourse lenders the right to credit bid. The court of appeals ruled that the right to credit bid is not absolute.
Despite its approval of the sale procedures proposed in the plan and its interpretation of Section 1129(b)(2)(A), the Third Circuit also ruled that the Lenders retained the right to object to confirmation of the plan if the plan sale did not result in their receipt of the “indubitable equivalent” of their secured interests.
A lengthy dissent was prepared by Circuit Judge Ambro. Judge Ambro reasoned that § 1129(b)(2)(A) limits plan sales (free and clear of liens) to Subsection (ii), which includes the presumptive right to credit bid. Specifically, Judge Ambro classified the subsections in § 1129(b)(2)(A) as follows: Subsection (i) applies whenever secured creditors are to retain their liens; Subsection (ii) applies whenever the collateral is to be sold free and clear of liens; and, Subsection (iii) is a “catchall” that applies in those situations not addressed by Subsections (i) or (ii). Judge Ambrose found it unlikely that Congress would outline procedures in Subsection (ii) to deal with plan sales free and clear of liens only to have the language in Subsection (iii) entirely sidestep those very procedures.
By permitting plan sales to proceed without credit bidding, the rulings in Pacific Lumber and Philadelphia Newspapers diverge from the traditional interpretation of § 1129(b)(2)(A). A number of potential ramifications exist.
As the dissent in Philadelphia Newspapers noted, when lenders cannot credit bid, debtors may be better able to steer the sale to a desired purchaser. In fact, in Philadelphia Newspapers the Debtors had engaged in an advertising campaign related to the auction with the message “Keep it Local.” Apparently, the Debtors’ desired purchaser was an entity compromised of the Debtors’ insiders. By denying the Lenders the right to credit bid, the Debtors clearly had more leverage to steer the sale to their desired bidder. (If this had not been the Debtors’ intent, it is difficult to formulate a meaningful reason as to why they sought to prevent the Lenders from credit bidding.) While it may be argued that even in the absence of credit bidding secured parties have the right to bid by effectively writing a check to themselves, this is often much easier said than done - - particularly when the loan is large and involves multiple participants.
If the secured party cannot participate by credit bidding, fewer proceeds may be realized from the sale. Certainly, the more bidders that participate, the more competitive the bidding; and, the more competitive the bidding, the more funds garnered. Removing perhaps the most qualified bidder may very well mean less proceeds received for the collateral, thus creating an opening for the secured creditor to argue that the sale did not result in the “indubitable equivalent” of its secured claim. Additionally, a decreased return on the collateral means a greater unsecured deficiency for the secured creditor and a dilution of the unsecured creditors’ pool (to the detriment of the other unsecured creditors).
If the plan calls for judicial valuation of the secured claim, other issues arise. Judicial valuations provide fertile ground for disputes. There is always the potential for an objection from the creditor that its secured claim should be valued differently. Alternatively, credit bidding removes any dispute that a secured party may have concerning the value of its secured claim, because it places the burden squarely on the secured party to make its own determination through the bidding process. To boot, the judicial valuation process is expensive and often prolonged.
Finally, most lenders make secured loans knowing that they generally will have the right to credit bid if a sale of their collateral becomes necessary. In light of the rulings in these cases, lenders can no longer rely on that assumption, at least in the context of Chapter 11 plan sales. Will there be a chilling effect on lenders’ desire to make loans? Will there be a further tightening of lending standards in an already tough credit market? To be certain, the analysis will continue.