Recent Decisions May Stop Secured Creditors from Credit Bidding
By Elena González
The Third and Fifth Circuits have recently ruled that when a debtor sells its assets pursuant to a plan of reorganization, a secured creditor does not have an absolute right to credit bid. In re Philadelphia Newspapers, LLC, 599 F.3d 298, 302 n.4, 320–21 (3d Cir. 2010) (A credit bid permits a secured lender to bid its debt instead of cash. Judge Ambro’s dissenting opinion provides a thorough explanation of credit bidding.) (Philadelphia Newspapers); Bank of New York Trust Co., NA v. Official Unsecured Creditors’ Comm. (docket number 08-40746) (In re Pacific Lumber Co.), 584 F.3d. 229 (5th Cir. 2009) (Jones, C.J.) (Pacific Lumber). These decisions have altered the generally accepted expectation by secured lenders of their right to credit bid in the context of a Chapter 11 plan and will impact the relationship between secured lenders and distressed debtors.
The Philadelphia Newspapers Facts
In 2006, the debtors, Philadelphia Newspapers, LLC, acquired the Philadelphia Inquirer, Philadelphia Daily News, and philly.com for $515 million with a $295 million loan secured by a first priority lien on substantially all of the debtors’ assets in favor of a group of lenders.
In February 2009, the debtors filed a Chapter 11 petition after defaulting on their loan agreements. The debtors’ proposed plan provided for a sale of substantially all the debtors’ assets at auction, generating $37 million in cash for the lenders, and provided that the lenders would receive the Philadelphia headquarters of the debtors, valued at $29.5 million. The debtors’ bid procedures required the funding of the purchase in cash and specifically precluded the lenders from credit bidding.
In October 2009, the bankruptcy court issued an order refusing to bar the lenders from credit bidding. The bankruptcy court reasoned that Section 1129(b)(2)(A) of the Bankruptcy Code, when read in conjunction with Sections 363(k) and 1111(b), required that a secured lender be able to credit bid in any sale of the debtors’ assets. The district court reversed the bankruptcy court’s decision. On appeal, the Third Circuit Court of Appeals affirmed the district court decision, relying on the plain meaning of Section 1129(b)(2)(A). Section 1129(b)(2)(A) contains a disjunctive “or” in a list of three alternative “fair and equitable” treatments of a secured creditor that does not vote in favor of the plan. This means that the debtor may select the third alternative without offering the second, which explicitly permits credit bidding. Thus, a debtor may circumvent a creditor’s right to credit bid by selecting the third alternative.
The Philadelphia Newspapers Decision
Judge Fisher, writing for the majority of the Third Circuit Court of Appeals, concluded that the auction procedures proposed in the debtors’ reorganization plan, which excluded the creditors’ right to credit bid, satisfied the requirements of the Bankruptcy Code. Finding that the language of Section 1123(a)(5)(D), which authorizes a “plan sale,” contained “no explicit procedures for the sale of assets,” the court looked for authority in Section 1129(b)(2)(A), commonly known as the “cramdown provision.” Philadelphia Newspapers at 303–04. Section 1129(b)(2)(A) states that a plan is “fair and equitable” and thus confirmable over the objections of a secured class, provided that the secured class is given the “indubitable equivalent” of its secured interest. Philadelphia Newspapers at 303. Also, before a court may “cram down” a plan over the objection of a dissenting creditor class, both the absolute priority rule and the fair and equitable standard must be satisfied. Pacific Lumber at 244 n.20 (providing a recap of the absolute priority rule). Section 1129(b)(2)(A) lists three alternative paths by which a plan may be “fair and equitable” to secured lenders:
- the secured lenders retain their liens to the extent of the allowed claims and receive deferred cash payments equal to the allowed amount of their claim;
- the property is sold free and clear of liens and the secured lenders attach their liens to the proceeds of a Section 363(k) sale, which specifically incorporates credit bidding; or
- the secured lenders realize the indubitable equivalent of their claims with no mention of credit bidding.
Philadelphia Newspapers at 304–05; Pacific Lumber at 245.
Pursuant to the plain meaning of the statute, the use of the disjunctive “or” between the three subsections permits the debtor to choose one of the three alternative paths when selling its assets free and clear of liens, and these paths are not exclusive. Philadelphia Newspapers at 305–06, 308; Pacific Lumber at 245 (reasoning that the word “includes” in the introduction to Section 1129(b)(2) is not limiting). Thus, when a debtor elects to offer the indubitable equivalent under subsection (iii), the secured lender’s right to credit bid is precluded. Philadelphia Newspapers at 310.
The Fifth Circuit in Pacific Lumber reached the same conclusion. There, the two principal debtors of six affiliated entities that filed separate petitions in 2007 were Pacific Lumber Co. (Palco) and Scotia Pacific LLC (ScoPac). Pacific Lumber at 236. Palco owned and operated a sawmill, a power plant, and the town of Scotia, California. In 1998, Palco transferred 200,000 acres of prime redwood timberlands to ScoPac to facilitate the sale of $867.2 million in notes secured by the timberlands and other assets. ScoPac was to repay the noteholders with the proceeds from its sales to Palco, that had the sole right to harvest ScoPac’s timber. Pacific Lumber at 237. Terminating the debtors’ exclusivity period after one year, the court confirmed the plan proposed by a secured creditor and a competitor of Palco. The plan consisted of a sale of assets to the plan proponents, free and clear of liens. In return, noteholders received the full cash value of their undersecured claims, but were excluded from credit bidding on the assets. Pacific Lumber at 238–239, 245. Although rejecting the noteholders’ contention that subsection (ii) of Section 1129(b)(2)(A) guaranteed a right to credit bid, for the reasons discussed above, the court noted that “a credit bid option might render clause (ii) imperative in some cases, [but] it is unnecessary here because the plan offered a cash payment to the Noteholders.” Pacific Lumber at 246.
In Philadelphia Newspapers, Judge Fisher commented on the approach in Pacific Lumber as one focused on “fairness to creditors over the structure of a cramdown.” Philadelphia Newspapers at 308. Rather than requiring the debtor to proceed under subsection (ii) when a debtor proposed a plan involving a sale of assets, the debtor merely had to satisfy any of the three alternative subsections, regardless whether the plan’s structure more closely resembled a sale under subsection (ii). Philadelphia Newspapers at 308. Thus, because the plain language of the statute supported an approach permitting great flexibility to the debtor in selecting the appropriate method of treatment of a secured creditor’s claim, the court found no reason to limit the debtor’s options solely to subsection (ii). Philadelphia Newspapers at 309.
Discussing the limitations of the court’s ruling, Judge Fisher noted that Pacific Lumber,as well as the district court’s decision in Philadelphia Newspapers,contemplated that credit bidding may be required in some instances. Philadelphia Newspapers at 316; Pacific Lumber at 246. However, neither the Third Circuit nor the Fifth Circuit decisions discussed these instances in detail. Further, while the court’s interpretation of the statute gives Chapter 11 debtors more leverage in structuring sales under a plan, the court emphasized that lenders retain the right to object to the plan at confirmation on the grounds that “the absence of a credit bid did not provide it with the ‘indubitable equivalent’ of its collateral.” Philadelphia Newspapers at 316.
The dissent by Judge Ambro argued that all cramdown plan sales free of liens must be executed pursuant only to subsection (ii) of 1129(b)(2)(A), giving creditors the presumptive right to credit bid. Philadelphia Newspapers at 334. Judge Ambro espoused the view that the Bankruptcy Code intends to “preserve the bargains for treatment made under state law unless a federal interest directs a different result,” and found that no such interest exists here. Judge Ambro’s concern is that the majority opinion permits an ex-post facto modification of the bargained-for loan. Philadelphia Newspapers at 332. Whereas secured lenders have previously relied on their ability to credit bid at the time that they extended credit to the distressed debtor, future creditors will have to “adjust their pricing accordingly, potentially raising interest rates or reducing credit availability to account for the possibility of a sale without credit bidding.” Philadelphia Newspapers at 332.
The Expected Impact of These Decisions
Philadelphia Newspapers and Pacific Lumber represent a significant blow to secured creditors’ expectations. Secured creditors previously believed that they held an automatic right to protect their interests in a Section 363 sale by bidding the full amount of their debt, irrespective of the value of the collateral. But these decisions have challenged that expectation by shifting the risk of debt undervaluation back onto creditors. Although creditors still receive a lien on the proceeds and adequate protection, the automatic ability to participate at an auction sale by bidding up to the full amount of the claim has become subject to a debtor’s election. The impact will be to force secured creditors into a cash-only purchase option during an economic downturn when access to capital is limited.
Because the Bankruptcy Code leaves the parties’ state law rights intact, the expected fallout of the decision will be to lead lenders to seek to negotiate the right to credit bid upfront in their DIP financing terms or in cash collateral orders. However this approach is not failsafe. The inclusion of such terms may trigger denial of a creditor’s right to credit bid pursuant to the “for cause” safety valve built into Section 363(k). 11 U.S.C. § 363(k) (stating “unless the court for cause orders otherwise. . . .”). Not only does a debtor have an obligation to find the least onerous DIP financing terms, but defensive DIP loan terms forcing a Section 363 sale may be viewed by some courts as inequitable conduct. (An analogous circumstance can be seen in Judge Gerber’sdecision In re DBSD North America, Inc., 421 B.R. 133 (Bankr. S.D.N.Y. 2009) (designating votes of a creditor that acted in bad faith when it purchased its claims and voted to reject the debtor’s reorganization plan)).
Another effect of these decisions is that, at the time of confirmation, litigation will be focused to the meaning of “indubitable equivalent,” first coined by Judge Learned Hand in 1935, see Pacific Lumber at 246 (citing In re Murel Holding Co., 75 F.2d 941, 942 (2d Cir. 1935)), and already part of the analysis in Pacific Lumber. See Pacific Lumber at 246–47 (providing analysis on the issue, and stating, “[t]he question then becomes how to define Clause (iii). . . .”).
Contact Elena González.
Law Clerk to the Hon. Robert E. Grossman, United States Bankruptcy Court, E.D.N.Y. Professor Edward Janger, David M. Barse Professor of Law at Brooklyn Law School, and panel participants at the 2010 ABA Section of Litigation Annual Conference provided helpful comments in the writing of this article.