John Rapisardi and Joseph Zujkowski ()
On April 14, 2014, the U.S. Bankruptcy Court for the Eastern District of Virginia issued an opinion in In re The Free Lance-Star Publishing Co.1 in which the court found that “cause” existed to limit the right of a secured creditor to credit bid its claims in connection with an asset sale under chapter 11 of the Bankruptcy Code. Although the court’s decision was based largely on the perceived inequitable conduct of the credit bidding party, the court intimated that implementing what it referred to as a “loan-to-own” strategy in and of itself presented “cause” to limit the right of a debt acquirer to credit bid the full amount of its acquired claim in connection with a future asset sale.
The decision is especially noteworthy because it comes less than three months after the U.S. Bankruptcy Court for the District of Delaware issued a similar opinion in In re Fisker Automotive Holdings.2 As discussed in detail below, in Fisker the court capped the amount of a credit bid “for cause” at the amount a creditor paid to purchase secured debt acquired prior to the bankruptcy filing. In light of these decisions, it is imperative that distressed investors understand the risks inherent in employing a strategy to acquire secured debt as a basis to obtain ownership or control of a debtor’s assets, and are properly counseled on what conduct may result in an impairment of credit bidding rights in a chapter 11 case.
Relevant Code Provisions
Bankruptcy Code §363 allows a trustee or debtor-in-possession, after notice and a hearing, to sell estate assets outside the ordinary course of the debtor’s business.3 The sale can be accomplished “free and clear” of all existing liens, claims, and encumbrances on the transferred assets (so long as certain conditions set forth in §363(f) are satisfied), and courts generally will approve proposed 363 sales if the sale is consistent with an exercise of the debtor’s sound business judgment.4 Additionally, if the assets proposed to be sold are subject to a valid lien, Bankruptcy Code §363(k) provides the secured creditor with the right to credit bid (and offer to offset its claim against the purchase price of the assets), “unless the Court for cause orders otherwise.”5 The legislative history for §363(k) further clarifies that an undersecured creditor may credit bid the full value of its claim in connection with a sale of its collateral.6
Historically, §363(k) has allowed a secured creditor to credit bid the total face value of its claim, unless its liens are subject to a bona fide dispute. Prior to the Fisker decision, it was generally assumed that a court would limit credit bidding rights “for cause” only in rare occurrences, and many argued that such relief was only appropriate where a secured creditor had acted inequitably.7 As discussed below, the Fisker decision, which cited broader policy concerns, may widen the gap of what constitutes “cause” sufficient to cap or limit credit bidding rights.
Fisker Automotive filed for chapter 11 at the end of 2013, largely to facilitate a sale of substantially all of its assets to Hybrid Tech Holdings, LLC. Hybrid had acquired its claim against Fisker approximately a month prior to the petition date at an auction held by the U.S. Department of Energy, where it purchased the department’s loan with a face value of $168.5 million for $25 million (or $.15 cents on the dollar).8
At the outset of the chapter 11 case, Fisker sought to complete the Hybrid transaction pursuant to a private sale. However, the statutory unsecured creditors’ committee opposed the sale and demanded an auction, which would enable a potential strategic purchaser to participate. Prior to the hearing to consider the sale structure, Fisker and the committee stipulated that: (i) if Hybrid’s ability to credit bid were not capped, “there is no realistic possibility of an auction,” and (ii) if Hybrid’s claim were capped at $25 million, there would be “a strong likelihood that there would be an auction that has a material chance of creating material value for the estate over and above the Hybrid bid.”9
The Fisker court opened its analysis by recognizing that, although it is “beyond peradventure that a secured creditor is entitled to credit bid its allowed claim,” it was “equally clear…that the court may for ’cause order otherwise.’”10 According to the court, whether “cause” exists does not require a finding that the party engaged in “inequitable conduct.” Instead, the court concluded that a bankruptcy court “may deny a lender the right to credit bid in the interest of any policy advanced by the Code, such as to ensure the success of the reorganization or to foster a competitive bidding environment.”11
Applying these findings, the court limited the Hybrid credit bid to the purchase price paid for the underlying debt, finding that the evidence and stipulated facts made clear that there would be no bidding—let alone a “chilling” of bidding—if Hybrid’s credit bid were not capped. In addition, the court stressed that the proposed sale timing, which at Hybrid’s instance curtailed the transaction review period for the committee and other interested parties, was “inconsistent with the notions of fairness in the bankruptcy process.”12 Finally, the court noted that as of the time of the auction there was substantial uncertainty regarding the validity and extent of Hybrid’s liens, adding that the “law leaves no doubt that the holder of a lien the validity of which has not been determined, as here, may not bid its lien.”13 Interestingly, the court distinguished the Third Circuit’s decision in In re Submicron Systems,14 where the U.S. Court of Appeals for the Third Circuit held that the holder of an allowed undersecured claim should be allowed to credit bid its entire claim. The Fisker court found that, in contrast to Submicron, no portion of Hybrid’s underlying secured claim had been deemed allowed prior to the proposed sale.
‘Free Lance-Star Publishing’
Free Lance-Star Publishing Co. of Fredericksburg, Va., the owner and operator of several radio stations and a printing and newspaper business, filed for chapter 11 on Jan. 23, 2014. Immediately following the petition date, Free Lance-Star sought and obtained court approval of bidding procedures for an auction of substantially all of its assets. The bidding procedures permitted DSP Acquisition, LLC, an entity operated by alternative credit investment firm Sandton Capital Partners, to credit bid in connection with the sale of those assets in which it had an enforceable lien, to be determined by court order or pursuant agreement among the parties. Concurrently with the entry of the bidding procedures, DSP filed an adversary proceeding against Free Lance-Star seeking a declaration that DSP had a valid and perfected lien on substantially all of Free Lance-Star’s assets. However, following a three-day evidentiary hearing, the court concluded that DSP did not have a valid, perfected security interest over certain contested property and, accordingly, lacked the right to credit bid against property on which it lacked an enforceable lien.
The court also found that DSP had engaged in certain inequitable conduct “requiring curtailment of DSP’s credit bid rights.”15 Specifically, (i) DSP recorded UCC financing statements related to property in which it knew it was not granted a security interest by Free Lance-Star, (ii) strongly discouraged Free Lance-Star from marketing the subject assets and later insisted that the marketing period be shortened, and (iii) pressured Free Lance-Star to advertise the amount of DSP’s credit bid in the marketing materials. Based on the foregoing, the court was “troubled by DSP’s efforts to frustrate the competitive bidding process.”16
However, in the court’s analysis regarding DSP’s inequitable conduct, it appeared to take a broader position on the role of a “loan-to-own” strategy, suggesting that such a strategy, standing alone, may provide a basis to limit credit bid rights. Specifically, the court stated that the:
[C]redit bid mechanism that normally works to protect secured lenders against the undervaluation of collateral sold at a bankruptcy sale does not always function properly when a party has bought the secured debt in a loan-to-own strategy in order to acquire the target company. In such a situation, the secured party may attempt to depress rather than to enhance market value.17
The court also stressed that “DSP’s motivation to own the Debtors’ business” and the activity taken in furtherance of that goal “depressed enthusiasm for the bankruptcy sale in the market-place.”18 Specifically, the court relied on the testimony by the debtor’s financial advisor that “genuine confusion [existed] among potentially interested parties over…what assets DSP has a lien and on how the auction process may unfold,” and that “limiting DSP’s credit bid would help restore a competitive bidding environment and engender enthusiasm for the sale.”19 Based on this testimony, several portions of which were placed under seal, the court capped DSP’s credit bid on account of its $38 million claim at $13.9 million. The method used to calculate this cap was not explained, other than that the expert “eliminated the unencumbered assets of the Debtors from the potential credit bid and applied a market analysis to develop an appropriate cap for a credit bid that would foster a competitive auction process.”20
While the Fisker and Free Lance-Star decisions raise a number of policy arguments in limiting credit bidding rights “for cause,” they highlight several common problems secured creditors should be aware of in preparing for an asset sale. First, both decisions reflect a serious concern over the degree of control exercised by the credit bidding party over the sale process. Such control resulted in a curtailed period for other interested parties to review the proposed transaction and discouraged traditional marketing efforts to maximize value. Accordingly, secured creditors looking to acquire assets through a private sale at the outset of a chapter 11 case or debtors seeking to conduct an asset sale on an expedited timetable with a limited marketing process must be prepared to establish that the value of the assets to be transferred is quickly deteriorating or that a sale on an accelerated timetable is otherwise permissible.
Additionally, in both cases, all parties were in agreement that the credit bidder did not have a lien on certain of the assets to be transferred and the validity of its liens on other assets was subject to dispute. As such, secured creditors should avoid seeking to use the credit bidding process to expand the scope or validity of their liens and, in the first instance, seek recognition of the validity of such liens in any order approving debtor-in-possession financing or the use of cash collateral entered at the outset of a case.
While these practical reminders are helpful, the policy arguments raised in both decisions are troubling. First, the argument that “cause” to limit credit bidding exists where not doing so would chill bidding seems contrary to basic economic realities. As Judge Thomas Ambro noted in a dissenting opinion issued in In re Philadephia Newspapers, a secured creditor intent on credit bidding does not chill bidding any more “than a deep-pocketed cash bidder would chill less-well-capitalized cash bidders,” recognizing that merely “[h]aving the ability to pay a certain price does not necessarily mean there is a willingness to pay that price.”21
Similarly, finding “cause” to limit credit bidding rights in the acquisition of secured debt at distressed prices, even where the acquirer does so in the hope of acquiring substantially all of a debtor’s assets, seems contrary to well-established precedent. Both the legislative history accompanying §363(k) and subsequent case law clearly recognize that even undersecured creditors should be allowed to bid the full value of their claims in connection with a sale of their collateral. In light of such authority, whether secured debt is transferred on the secondary markets, or the price at which it may have been acquired, is irrelevant to whether “cause” exists to limit credit bidding rights.
The Fisker and Free Lance-Star decisions clearly raise red flags for investors considering purchasing secured debt with the hope and expectation of acquiring some or substantially all of a debtor’s assets. Such investors should seek out counsel to make sure they do not take any actions, similar to those discussed above, that may trigger a limitation of their credit bidding rights. Moreover, and just as importantly, they should be prepared to challenge any amorphous notion that the acquisition of secured debt at depressed prices is a sufficient basis for limiting or capping a credit bid “for cause” in order to further other goals or objectives reflected in the Bankruptcy Code.
John J. Rapisardi is a partner at O’Melveny & Myers. Joseph Zujkowski is a counsel in the firm. Matthew P. Kremer, an associate of the firm, assisted in the preparation of this article. Ben Logan and Evan Jones, partners in the firm’s Los Angeles office, provided guidance on the issues discussed in this article.
1. No. 14-30315-KRH, 2014 Bankr. LEXIS 1611 (Bankr. E.D. Va. April 14, 2014).
2. No. 13-13087, 2014 WL 210593 (Bankr. D. Del. Jan. 17, 2014).
3. 11 U.S.C. §363(b)(1).
4. See In re General Motors Corp., 407 B.R. 463 (Bankr. S.D.N.Y. 2009).
5. 11 U.S.C. §363(k).
6. Senate Report No. 95-989, 95th Cong. 2d Sess. 55 (1978). This clarification is consistent with §1111(b) of the Bankruptcy Code, which generally provides that an undersecured creditor may elect to treat its entire claim as a secured claim notwithstanding Bankruptcy Code §506, which generally bifurcates an undersecured claim into a secured claim in the amount of collateral value and an unsecured deficiency claim. 11 U.S.C. §§506(a),1111(b).
7. See, e.g., Fisker, 2014 WL 210593, at *4 n. 14.
8. Id. at *2.
9. Id. at *2-3.
10. Id. at *4-5.
11. Id. at *4-5 n. 14.
12. Id. at *5.
13. Id. at *5-6.
14. 432 F.3d 448 (3d Cir. 2006).
15. Free Lance-Star, 2014 Bankr. LEXIS 1611, at *26.
16. Id. at *22.
17. Id. at *23.
19. Id. at 24.
20. Id. at 25.
21. In re Philadelphia Newspapers, LLC, 599 F.3d 298, 319 (3d Cir. 2010).