U.S. Supreme Court Affirms Right of Secured Lender to Credit Bid Under a Chapter 11 Plan

As we first discussed a few weeks ago, the Supreme Court of the United States heard arguments related to the legitimacy of the practice known as credit bidding. The decision was important as credit bidding is a fundamental tenet of distressed debt investing under loan to own strategies. Contributor George Mesires weighs in on the issue:

On May 29, 2012, the Supreme Court decidedly put to rest an issue that has caused secured lenders angst since 2009 when the Fifth Circuit in the Pacific Lumber case first allowed a debtor to sell assets under a plan of reorganization free and clear of a creditor’s lien without providing that lender the right to credit bid its debt in the sale. Specifically, the Court settled the split among the judicial circuits (the Seventh Circuit on the one hand, and the Third Circuit (home to the Delaware bankruptcy court) and the Fifth Circuit, on the other) by holding that a debtor “may not obtain confirmation of a Chapter 11 cramdown plan that provides for the sale of collateral free and clear of [a secured lender’s] lien, but does not permit the [secured lender] to credit-bid at the sale.”  The decision provides needed guidance to secured lenders and practitioners as the previously unsettled state of the law added uncertainty, risk and a higher cost of capital in these credit bid situations.

Generally, a debtor in bankruptcy may sell its assets in two ways: (i) under § 363 of the Bankruptcy Code; or (ii) pursuant to a plan of reorganization under § 1123 of the Bankruptcy Code.

Under § 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 clause (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, Philadelphia Newspapers, and RadLAX cases) have attempted to sell a secured creditor’s collateral pursuant to a plan of reorganization without allowing the creditor to credit bid.  Such arrangements have been upheld by two federal circuit courts (the Third and Fifth Circuits), and disallowed by another (the Seventh Circuit).  

In the RadLAX case, the debtors proposed selling substantially all of their assets under a plan of reorganization and using the sale proceeds to repay the secured lender. As part of its plan, however, the debtors sought to deny the lender the ability to credit bid its debt.  Not surprisingly, the bank objected to such treatment, since the bank would be forced to come out of pocket with cash, which adds both administrative and financing costs to the transaction, instead of using the debt owed to it as currency.

It was fitting that Justice Scalia, one of the Court’s great textualists, delivered the 8-0 opinion for the Court.  Calling the debtors’ reading of § 1129 “hyperliteral and contrary to common sense,” Justice Scalia did away with a detailed analysis of the purposes of the Bankruptcy Code, pre-Code practices and the merits of credit-bidding that lower courts focused on, and instead focused on a well established canon of statutory interpretation – the general/specific canon.  That principle of statutory interpretation provides that “specific governs the general” and where a general authorization and a more limited, specific authorization exists side-by-side, the terms of the specific authorization must be complied with.  Thus, “clause [2] of the fair and equitable standard (above)] is a detailed provision that spells out the requirements for selling collateral free of liens, while clause [3] is a broadly worded provision that says nothing about such a sale.  The general/specific canon explains that the ‘general language’ of clause [3], ‘although broad enough to include it, will not be held to apply to a matter specifically dealt with’ in clause [2].”

Justice Scalia, in a nod to the United States Department of Justice, who filed an amicus curiae brief supporting the secured lender’s position, acknowledged in a footnote that the right to credit bid is “particularly important for the Federal Government, which is frequently a secured creditor in bankruptcy and which often lacks appropriations authority to throw good money after bad in a cash-only bankruptcy auction.”

The Supreme Court’s ruling is important for at least two reasons.  First, resolution of this issue will streamline the administration of future bankruptcy cases by providing secured lenders the assurance that they can credit bid in both 363 and plan sales under the Bankruptcy Code, which will result in greater efficiency and lower costs of capital.

Second, the Court’s decision upholds the long-standing principle that 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.

George is a monthly contributor to the Distressed Debt Investing blog and practices restructuring and bankruptcy law at Ungaretti & Harris LLP.  George can be reached at grmesires@uhlaw.com.  

Read more...

Advanced Distressed Debt: Collecting Default Interest From Solvent Debtors

Earlier this month, the Distressed Debt Investing blog posted an entry on the recent Washington Mutual decision issued by the United States Bankruptcy Court for the District of Delaware, which addressed the issue of whether unsecured claimants holding claims against a solvent estate are entitled to postpetition interest at the contract rate or the federal judgment rate.  In the Washington Mutual case, the court held that the federal judgment rate (which is often much lower than a contractual rate of interest) was the appropriate rate of interest.  Today’s blog entry considers the same issue, but in a case involving secured creditors (versus unsecured creditors).

This is a timely topic because with the higher incidence of default in many loan portfolios and growing emphasis at financial institutions on “revenue enhancement opportunities” in almost all business lines, lenders should be increasingly concerned as to whether they are being appropriately compensated for this additional risk in their portfolios from the defaulted assets.  One method to enhance yield is to put more emphasis on collecting interest at the higher, default rate upon the occurrence of an event of default, especially one triggered by an insolvency event.  Luckily, the United States Bankruptcy Court for the Southern District of New York handling the General Growth Properties cases recently provided some guidance on that very issue.  In re General Growth Properties, Inc., 451 B.R. 323 (Bankr. S.D.N.Y.  June 16, 2011); In re General Growth Properties, Inc., 2011 WL 2974305 (Bankr. S.D.N.Y. July 20, 2011).  Even though these decisions have been appealed, they nonetheless are instructive and have already been raised in cases pending in other districts.

As most lenders realize, the general rule under the Bankruptcy Code is that a creditor is not entitled to post-petition interest; however, Section 506(b) explicitly provides that an over-secured creditor is entitled to interest on its claim – but does not specify the applicable interest rate.  The General Growth court noted, and the debtor and lenders agreed, that there is a rebuttable presumption that an over-secured creditor is entitled to interest at the contract rate.  In addition to this statutory basis for permitting post-petition interest, there is a judicially created exception founded on the principle that creditors should receive interest as a compensation for delay due to the bankruptcy prior to any distributions to equity holders, although that result has been modified in some cases by equitable considerations (e.g., creditor misconduct and determinations that a high contractual default rate constitutes a penalty).

Both of the General Growth cases involve the applicable creditor’s objection to its treatment under the plan of reorganization because it did not receive post-petition interest at the default rate.  Due to the large amounts of money involved in the cases (amount disputed is about $100 million), they have generated some significant attention among lenders.

The loan in the first case was not in default prior to the filing of the case, and the debtor sought to “reinstate” the debt under the plan of reorganization without paying default interest.  While a significant portion of that court decision addressed issues incident to debt reinstatement matters, the opinion also contains a helpful analysis as to whether an ipso facto clause (automatically accelerating the loan at the filing of the case) can trigger the right to receive post-petition default interest.

The subject promissory note contained the fairly typical formulation that (i) a default occurs upon the borrower filing a bankruptcy petition, (ii) the occurrence of such an event automatically, without the sending of notice or any other action, caused the entire principal amount of the loan to become immediately due and payable and (iii) interest on this outstanding principal balance would accrue at the default rate.  The debtor argued, among other things, that the ipso facto clause was invalid, and thus, at the time of the filing of the case there was not a default that required the payment of interest at the default rate.

As a statutory matter, Section 365(e)(1) of the Bankruptcy Code provides that ipso facto clauses are invalid only if included in executory contracts or unexpired leases, and the promissory note was obviously not an unexpired lease and was not an executory contract because the only remaining obligation thereunder was the repayment of the outstanding loan by the debtor.  The court held that ipso facto clauses in agreements other than executory leases or unexpired leases are not automatically invalid and that, upon an examination of the facts and circumstances in the instant case, payment of default interest was appropriate because the debtor was highly solvent, the plan was confirmed on a basis that reinstated the debt and the debtor had already emerged from bankruptcy. Therefore, the lenders’ right to collect the additional interest had clearly not impaired the ability of the debtor to exercise its rights to file for bankruptcy protection and gain a fresh start through the reorganization process.

Some may argue that this decision should be restricted to debt that is reinstated pursuant to a plan and therefore does not have a broader application, such as to loans that matured during the pendency of a bankruptcy case.  However, the same bankruptcy court rejected that view when it adopted its reasoning in a second matter.  The loan in this second General Growth proceeding was already in default at the time the debtor filed for bankruptcy, although the creditors had not yet filed an acceleration notice (the underlying credit agreement contained the same mechanism as in the first matter described above).  In its discussion of upholding the ipso facto clause and automatic acceleration, the court explained that failing to uphold such provisions would deter creditors from withholding an acceleration notice during pre-petition workouts, which acceleration could trigger cross-defaults under other agreements and have the effect of pushing the borrower into seeking bankruptcy protection.  The court noted that the refusal to enforce the automatic acceleration would have the effect of penalizing the lenders for attempting to negotiate a consensual resolution when such result is not clearly mandated by the Bankruptcy Code.  Thus, the court determined that the loan had been automatically accelerated.

The court went on to state that the creditor was also entitled to post-petition interest at the default rate.  Since the presumption that an over-secured creditor is entitled to interest at the contractual rate can be overcome, the bankruptcy court reviewed the circumstances in which courts have typically modified the contractual arrangements between private parties: (a) creditor misconduct, (b) the default rate would be unfair and cause harm to unsecured creditors, (c) the default rate was a penalty and (d) the default rate would hinder a fresh start.  The court determined that such facts did not apply, and therefore it held that the presumption was not rebutted and the creditor was entitled to default interest.

While these decisions are currently on appeal, they should still give secured creditors comfort that their contractual rights for default interest upon a bankruptcy default are likely to be upheld if the debtor is solvent.  Underlying both of these decisions is the fact, undisputed by any party, that the debtors were exceedingly solvent upon their emergence from the bankruptcy cases, so the ultimate result may differ greatly depending on the debtor’s solvency.  (The possibility of ultimately not having the right to default interest, of course, may be a relevant consideration to lenders considering how to structure their compensation in an out-of-court restructuring that could give a currently solvent debtor that is losing money and headed to insolvency more time to “turn it around.”)

Finally, these decisions serve as a useful reminder that a creditor should insist, whether as a sole lender, part of a “club deal” or a member of a syndicated financing, that the documentation governing its loans provide that all of the loans are automatically accelerated upon a bankruptcy default to preclude any argument that acceleration is not effective without sending a notice that could be prohibited by the automatic stay.

Epilogue: General Growth Properties’ brief in support of its appeal is due on May 18, 2012.  Briefing will continue this spring and summer.  We will keep readers apprised of any developments and of the decision when it is issued.

George is a monthly contributor to the Distressed Debt Investing blog and practices restructuring and bankruptcy law at Ungaretti & Harris LLP.  George can be reached at grmesires@uhlaw.com.  Don Schwartz is the chair of Ungaretti & Harris’ Finance and Restructuring practice, and can be reached at dlschwartz@uhlaw.com.  Rob Drobnak is a partner in the practice group, with a focus on lending and restructuring, and can be reached at radrobnak@uhlaw.com.

Read more...

Advanced Distressed Debt Concepts: Contesting Priming Liens in DIP Financing

Each month, we hope to feature a number of posts from some of our guest writers that we discussed about in the beginning of the year.  Last month I introduced readers to George Mesires, partner in the Finance and Restructuring Practice at Ungaretti & Harris LLP, who will be contributing articles focused on bankruptcy concepts for the blog.  Enjoy!

Contesting Priming Liens in DIP Financing
Within any chapter 11 business bankruptcy, a secured creditor runs the risk of having its interest primed in favor of a lender who provides the debtor additional operating capital during the pendency of the bankruptcy proceedings through debtor-in-possession (“DIP”) financing under § 364 of the Bankruptcy Code.  Such risk is not easy to quantify, is highly fact-specific, and may depend on, among other things, whether the creditor sought to be primed is oversecured or undersecured.  A recent case in the Bankruptcy Court for the Northern District of Illinois is illustrative of the circumstances under which a priming lien will be granted, and provides insight into the Court’s analysis for those secured lenders who would like a deeper understanding of this issue.  The case is notable for the detail the Court provides in its analysis of when a priming lien under § 364(d) is appropriate.  Fullsome court decisions have been few and far between in recent years as most DIP financing arrangements are consensual.

In In re Olde Prairie Block Owner, LLC, 448 B.R. 482 (Bankr. N.D. Ill. 2011), the Debtor owned “two parcels of choice real estate” located adjacent to McCormick Place in Chicago (one of North America’s leading convention centers), where the Debtor intended to develop a hotel complex to serve those visiting McCormick Place.  At an evidentiary hearing on the prepetition secured creditor’s lift stay motion, the Court found the value of the Debtor’s property to be approximately $81 million, based on evidence offered by the Debtor’s expert witness.  Because the prepetition lender was unwilling to advance any additional funds, the Debtor sought DIP financing that included a priming lien over the prepetition lender’s $48 million mortgage on the parcel.  Thus, the prepetition secured lender was oversecured by over $30 million.

Judge Schmetterer issued a thoughtful decision that set forth the analytical framework for considering priming DIP loans.  A debtor can obtain credit secured by a senior or equal lien on encumbered estate property with court approval and after notice and a hearing only if: (1) the debtor is unable to obtain credit otherwise and (2) the interest of the creditor to be primed is adequately protected.  11 U.S.C. § 364(d).  Generally, “adequate protection” requires that a secured lender receive compensation or something of value during the pendency of the bankruptcy case to protect it against the diminution or erosion in value through depreciation, dissipation, or any other cause, including the dollar value of the priming DIP loan.  Adequate protection can take many forms, including, but not limited to, periodic cash payments, postpetition security interests (replacement liens), liens in unencumbered property, or an “equity cushion” (the amount by which the secured lender is oversecured).

Under § 364 of the Bankruptcy Code, there is no requirement that the debtor explain or justify its proposed use of funds.  However, as the Court explained, if the Debtor’s borrowing request was granted, the funds would become property of the bankruptcy estate and therefore subject to the usage limitations set forth in § 363 of the Bankruptcy Code.  Under § 363, a debtor may use or sell estate property outside the ordinary course of business only after notice and a hearing, and after the debtor demonstrates an “articulated business justification” for the use of the funds.

In Olde Prairie, the Debtor demonstrated that it was not able to obtain credit under less onerous terms than those offered by the DIP lender.  Next, the Debtor was able to demonstrate that the existing senior lender’s interest was adequately protected by virtue of the large equity cushion (approximately 38% of value) to protect the senior lender from any potential diminution in value during the pendency of the case.  However, the Court noted that a large equity cushion is not a “debtor's piggy bank and the uses contemplated for the new loan must have serious likelihood of benefitting the property and advancing the purposes of reorganization. A priming lien without such a showing would impose an unwarranted burden on the secured creditor if reorganization fails.”  The Court further noted that because the valuation was based on expert opinion, which is not a substitute for testing the market to obtain actual sales or funding, “allowing a priming lien should be considered with caution to avoid transferring the entrepreneurial risk of failure by Debtor's investors and principals onto the secured creditor…Given the inherent uncertainty of determining valuation through methods commonly used by experts in appraising real estate, some restraint in allowing priming liens to fund particular expenses is warranted.”

The Court found that most of the expenses the Debtor sought to fund with the DIP loan would likely advance the value of the bankruptcy estate and further the Debtor’s reorganization. The Debtor anticipated using the funds to lobby for certain tax benefits, which would increase the overall value of the parcel and encourage outside investment.  The Debtor was also using the funds to further its hotel development plans.  The Court thus found that the Debtor had shown under § 363 that it had articulated a “serious . . . business justification for most of the proposed uses of the requested loan, regardless of whether they are inside or outside the ordinary course of business, and that those uses are in the best interest of the estate.”

The outcome might have been different in the Olde Prairie case had the prepetition secured lender been undersecured (that is, if the value of the collateral was less than the secured lender’s claim). Indeed, there is ample authority that holds that an undersecured creditor cannot be primed when the value of the prepetition secured lender’s collateral will decrease during the bankruptcy case and the debtor cannot provide any adequate protection for such decrease.  See, e.g., In re Swedeland Dev. Group, Inc., 16 F.3d 552 (3d Cir. 1994) (denying DIP financing on priming basis where debtor sought postpetition financing to fund construction of residential units on a partially finished real estate development, the prospects of which were inherently risky); In re Fontainebleau Las Vegas Holdings, LLC, 434 B.R. 716 (Bankr. S.D. Fla. 2010)(denying postpetition priming loan where debtors sought postpetition financing to complete development of a hotel and casino that was only 70% complete and was not operating or generating any cash); In re YL West 87th Holdings LLC, 423 B.R. 421 (Bankr. S.D.N.Y. 2010 )(denying postpetition financing where debtor owned an unfinished real estate development project and its prospects for success were highly speculative).

In addition, an undersecured prepetition lender who holds a blanket lien on a debtor’s assets typically argues that it cannot be adequately protected for the diminution in value of its collateral caused by the priming loan because the debtor has no unencumbered assets to pledge as security for such decrease in value during the pendency of the bankruptcy case.  See e.g., In re Swedeland, 16 F.3d 552, 567 (3d Cir 1994)(“[t]he law does not support the proposition that a creditor ... undersecured by many millions of dollars, may be adequately protected when a superpriority lien is created without provision of additional collateral by the debtor.”).

After considering these cases, can a secured lender draw a bright line and conclude that a debtor can prime an oversecured lender but not prime an undersecured lender?  Not exactly; for there are circumstances where a debtor may provide an undersecured prepetition lender with adequate protection by preserving and maximizing the value of its collateral during the bankruptcy case.  See e.g., In re Hubbard Power & Light, 202 B.R. 680 (Bankr. E.D.N.Y. 1996)(holding that the secured creditor was adequately protected where a first priority priming lien “would enable the [d]ebtor to commence operating and as an operating business, all of the [d]ebtor’s assets would increase in value [and] [a]lthough it [was] not clear what that value would be, it certainly would be of a greater value than the value of the [d]ebtor’s property in its [non-operational] state”); see also In re 495 Cent. Park Ave. Corp., 136 B.R. 626 (Bankr S.D.N.Y. 1992) (holding that a prepetition secured creditor was adequately protected because “the value of the debtor’s property [would] increase as a result of the renovations funded by the proposed financing”)(“Although appraisers for both sides disagree as to what the value of the building would be following the infusion of approximately $600,000.00, there is no question that the property would be improved by the proposed renovations and that an increase will result.  In effect, a substitution occurs in that the money spent for improvements will be transferred into value.  This value will serve as adequate protection for Hancock’s secured claim.”); In re Yellowstone Mountain Club, LLC., No. 08-61570, 2008 WL 5875547 (Bankr. D. Mont. Dec. 17, 2008)(holding that secured creditors were adequately protected because, among other things, without the proposed financing, the debtor’s business would “go dark” to the detriment of all creditors and the DIP financing would, therefore, “preserve the value of their collateral and in fact enhance it in an amount that exceeds the amount of the DIP Loan by multiples.”).  Thus, in situations where a secured lender is undersecured, it may still be primed if the debtor can demonstrate that the value of the secured lender’s collateral will be preserved or enhanced through the DIP financing.

Because DIP financing is often the lifeblood of a debtor during a chapter 11 bankruptcy case, participants are well-advised to be familiar with the circumstances when a priming lien may be granted and when it may not.

George is a monthly contributor to the Distressed Debt Investing blog and practices restructuring and bankruptcy law at Ungaretti & Harris LLP.  George can be reached at grmesires [at] uhlaw.com.

Read more...

Bankruptcy Concept: Credit Bidding and the Supreme Court

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.  

Read more...