LAW-Using Cash to Retain Credit Bidding Benefits in a Sale of Collateral

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Using Cash to Retain Credit Bidding Benefits in a Sale of Collateral

Mitchell A. Seider and Karen Goldstein

New York Law Journal

03-05-2012


On Dec. 12, 2011 the U.S. Supreme Court granted certiorari in River Road Hotel Partners, LLC, et. al. v. Amalgamated Bank (In re River Road Hotel Partners, LLC), 651 F.3d 642 (7th Cir. 2011). The Court will settle a split among the circuits as to whether, under §1129 of the U.S. Bankruptcy Code, a nonconsensual plan of reorganization (the plan) must give dissenting secured creditors an opportunity to credit bid1 when the plan provides for the sale of the secured creditors' collateral. Some have speculated that, if the Supreme Court overrules River Road, secured credit will become more expensive as loan markets price in a contraction in secured creditors' rights in restructuring.2 Perhaps not. As follows, while an overruling of River Road may allow for sale of collateral without credit bidding under a plan, secured creditors may, with some complications, still have the benefit of credit bidding.3

Protection of Secured Creditors

The Supreme Court has determined that secured creditors' rights in collateral include traditional state law remedies and are "property" subject to constitutional protection. Accordingly, while the Code may delay enforcement and limit repayment to the value of the interest in collateral as well as channel the form of repayment, outright stripping of secured creditors' rights has generally been struck down. See Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555 (1935); Wright v. Vinton Branch of the Mountain Trust Bank of Roanoke, 300 U.S. 440 (1937); Wright v. Union Central Life Ins. Co., 311 U.S. 273 (1940); United Savings Ass'n of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365 (1988).4

Congress codified the right to credit bid at a sale of collateral in §363(k) of the Code and protected the right to credit bid if collateral is being sold under a plan in §1129(b)(2)(A)(ii). Section 363 generally gives the debtor the right to use, sell or lease its property in the ordinary course of business (§363(c)) as well as outside of the ordinary course of business (§363(b)), subject to certain conditions. Should a debtor decide to sell collateral pursuant to §363(b), §363(k) enforces the secured creditor's right to credit bid up to the amount of its claim to purchase the asset.

Collateral may also be sold through a plan. Section 1129(b)(2)(A)(ii) of the Code (Clause (ii)) provides credit bidding rights where a nonconsensual plan impairs5 a secured class and provides for a sale of its collateral. Clause (ii) specifically incorporates §363(k). A plan's use of §1129(b)(2)(A)(iii) (Clause (iii)) to sell collateral without giving the secured creditor the right to bid its claim for the collateral6 has given rise to the circuit split described below.

Circuit Split

The U.S. Courts of Appeals for the Fifth and Third circuits have decided that a plan may provide for the sale of collateral and prohibit credit bidding but pass the "fair and equitable" test by meeting the requirements of Clause (iii) by giving the proceeds of the sale to the dissenting secured class as the indubitable equivalent of its allowed secured claim. The Seventh Circuit held the opposite.

'Pacific Lumber'. In In re The Pacific Lumber Co., 584 F.3d 229, the Fifth Circuit held that, where the dissenting secured class received the cash proceeds from the sale of their collateral equal to the amount at which the bankruptcy court had valued the allowed secured claim ($510 million), the debtor could use Clause (iii) to sell the collateral without credit bidding because the secured creditors' receipt of the $510 million in cash from the sale complied with Clause (iii), as cash is the "indubitable equivalent" of the secured claim. Id. at 248.

'Philadelphia Newspapers'. In In re Philadelphia Newspapers, LLC, et al., 599 F.3d 298, the Third Circuit faced the issue in the context of the debtors' request for the approval of bid procedures that precluded the secured creditors from credit bidding for the assets the debtors intended to sell by insisting that any qualified bidder must fund its bid with cash. Id. at 302. The bankruptcy court refused to enter an order barring the secured creditors from credit bidding. Id. The district court reversed the bankruptcy court and held that "the Code provides no legal entitlement for secured lenders to credit bid at an auction pursuant to a reorganization plan." Id. at 302. The Third Circuit affirmed the district court.7

In a dissent, Judge Ambro disagreed with the majority's "plain meaning" construction of the statute. He concluded that long-established canons of statutory interpretation,8 examination of §1129(b)(2)(A) in the context of the entire Code, and the legislative history all compel reading §1129(b)(2)(A) to require "cramdown plan sales…to fall under the specific requirements of §1129(b)(2)(A)(ii) and not to the general requirement of subsection (iii)." Id. at 319.

'River Road'. In River Road, the Seventh Circuit held that a plan could not be confirmed where the debtor attempted to preclude the secured creditors from credit bidding for the assets by selling them under Clause (iii). The Seventh Circuit expressly agreed with Judge Ambro's reasoning in Philadelphia Newspapers. 651 F.3d at 649. Additionally, the Seventh Circuit determined, inter alia, that utilizing Clause (iii) for purposes of selling an asset lacks the "crucial check against undervaluation," id. at 651, and that interpreting §1129 as did the Fifth and Third circuits reads Clause (ii) out of the Code. Id. at 651-52. Lastly, the court noted that allowing a sale under Clause (iii) would "treat secured creditors' interests in a way that sharply conflicts with the way these are treated in other parts of the Code." Id. at 653.

The Supreme Court. In granting certiorari in River Road, the Supreme Court has set the stage for a final ruling on the issue. However, whether the Supreme Court reverses River Road may not be monumental to secured creditors.

Turning §1129(b)(2)(A)(iii) on Debtors

A strategic solution. If River Road is reversed and a plan provides for a Clause (iii) sale with no credit bidding allowed, the secured creditor can bid cash at the plan's collateral sale and then, assuming its bid is the clearing bid, recover the cash paid pursuant to the terms of the plan. In short, as long as secured creditors are prepared to move money from "the left pocket to the right pocket," they can avoid the harm of their collateral being sold for less than they would be prepared to credit bid.9 While this strategy is easier to employ (or reject) where the secured credit is bilateral, it can work in a multi-lender syndicate, albeit with complications.

Assume there is a syndicate comprised of 25 lenders who have each provided the debtor with a secured loan in the same amount encumbered by all of the debtor's assets. The debtor files for bankruptcy and owes the lenders $400 million (each lender is owed $16 million). The debtor has decided to cram down the lenders and is proceeding with a sale of its assets under Clause (iii) and is precluding the secured lenders from credit bidding their claim. Further assume that only 15 of the lenders would be interested in employing the "round-trip strategy." The 15 lenders would form "BidCo" and capitalize it with cash up to the amount of the syndicate's claim. Assume at auction BidCo offers the clearing bid of $300 million in cash ($20 million for each of the 15 lenders), the auction proceeds of the $300 million would then be paid to all the syndicate lenders ratably ($12,000,000 to each of the 25 lenders). At this point, the 15 lenders would be $8,000,000 short of their investment in BidCo (after receiving ratable return from BidCo of the $100 million in cash that was unnecessary for the bid). BidCo would be in possession of an asset worth $300 million, however, making the stakes of the lenders in Bidco worth $20 million to each. Thus, the 15 lenders would fully recover their investment in BidCo.

Challenges with the "round-trip strategy." As noted above, a number of obstacles might preclude lenders from using the "round-trip strategy." First, the lenders would want to assure themselves that their liens and claims are recognized as valid and not subject to challenge and that they will quickly recover their new cash through a plan distribution.10

Second, lenders must arrange the cash funding of BidCo. This may present obstacles, including that institutions may have credit limits that have already been reached with the borrower and the lenders' organizational documents might make it impossible to invest more money. Additionally, it may not be possible to raise additional funds from certain types of lenders, like collateralized loan obligations.

Finally, there may be a timing issue. Substantial coordination difficulties exist in the administration of syndicated loans, Philadelphia Newspapers, 599 F.3d at 337 (citation omitted), which might be especially acute due to the accelerated timing under which lenders would be operating. Even outside of syndicates, the accelerated timing might prove challenging.

Conclusion

In summary, while there are potential impediments, if the Supreme Court reverses River Road, secured lenders have a strategy to foil efforts to strip their right to credit bid at a sale of their collateral where a plan proposes to have such a sale under §1129(b)(2)(A)(iii).

Mitchell A. Seider is a partner and Karen Goldstein is an associate at Latham & Watkins in New York.

Endnotes:

1. The "'credit bid' allows a secured lender to bid the debt owed it in lieu of other currency at a sale of its collateral." In re Philadelphia Newspapers, LLC, et al., 599 F.3d 298, 320 (3d Cir. 2010). Analogous to set off, credit bidding protects secured creditors from sale at an undervalued price.

2. Id. at 337.

3. If the Supreme Court upholds River Road, then a plan that provides for the sale of collateral will not be confirmable above the objection of the lien holder unless the sale terms provide for credit bidding, as required in §1129(b)(2)(A)(ii).

4. In Radford, the Supreme Court listed five distinct rights of which secured creditors could not be stripped and held that the Frazier-Lemke Act violated the Fifth Amendment because it required a secured creditor to give up its collateral free of its lien without compensation. 295 U.S. at 594-95, 601-02. Radford's five distinct rights included the right to

(1) retain a lien until compensated,

(2) foreclose on collateral in a judicial public sale,

(3) determine when a sale will occur (subject to court discretion),

(4) protect its interest in property by bidding at a sale, and

(5) control the collateral during a default (subject to court discretion.

Id. at 594-95. In succeeding cases, the Court expanded on Radford. In Vinton Branch, the Court said that it had struck down the Frazier-Lemke Act because "the effect of the statute in its entirety was to deprive the mortgagee of his property without due process of law." 300 U.S. at 457. In Union Central, the Court held that a debtor had the right to redeem its property at the property's reappraised value. 311 U.S. at 277. The Court reasoned that "safeguards were provided to protect the rights of secured creditors…to the extent of the value of the property. There is no constitutional claim of the creditor to more than that," 311 U.S. at 278 (citations omitted), and there is no claim for being denied immediate possession of the collateral. Timbers, 484 U.S. at 375.

5. Under §1124, a class of claims is impaired under a plan unless, as to each claim, the plan (1) leaves the right unaltered, or (2) in the event of a default, the plan cures the default, reinstates the claim's maturity, compensates the claimholder for damages, and does not otherwise alter the creditor's rights.

6. A plan complies with Clause (iii) if it gives impaired secured creditors the indubitable equivalent of their claims. The term "indubitable equivalent" was coined by Judge Learned Hand:

[A] creditor who fears the safety of his principal will…[wish] to get his money or at least his property.… [T]he statute was [not] intended to deprive him of that…unless by a substitute of the most indubitable equivalence.

Scotia Pacific Co. LLC v. Official Unsecured Creditors' Committee, et al. (In re The Pacific Lumber Co., et al.), 584 F.3d 229, 246 (5th Cir. 2009) (citation omitted) (holding that a cash payment in the amount of the value of the collateral constitutes the indubitable equivalent of a secured claim).

7. Notably, the Third Circuit did not rule on whether the plan actually complied with Clause (iii).

8. The interpretation is that specific provisions prevail over general provisions and that no provision shall be superfluous or void. Id. at 328-31.

9. To be sure, this "round-trip strategy" comes with some obstacles (discussed below). Among them is the fact that, in larger bankruptcy cases, secured lenders are commonly members of large syndicates and it may prove difficult to coordinate the cash purchase of collateral, particularly when operating under the time constraints imposed by the Code.

10. However, typically (subject to a creditors' committee investigation period), secured claims are allowed early on in the case, namely, through orders allowing the debtor to use cash collateral or to obtain post-petition financing.


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