Secured Creditors' Right to "Bid In" Claims in Chapter 11 Sales Challenged

Decisions in two recent bankruptcy cases have challenged a common belief that partially secured creditors have an absolute right to protect their collateral by credit bidding their entire claim in sales held pursuant to chapter 11 plans.

In a recent decision of the 5th Circuit Court of Appeals, In re Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009), written by the conservative Judge Edith Jones, the court found that the Bankruptcy Code did not always give a secured creditor the right to credit bid at a sale of its collateral as part of a chapter 11 plan.

Similarly, a recent decision of the U.S. District Court for the Eastern District of Pennsylvania in In re Philadelphia Newspapers, LLC, 418 B.R. 548 (E.D. Pa. 2009) reversed a decision of the Bankruptcy Court and found that the Bankruptcy Court could approve certain bid procedures that specifically prohibited a secured party from credit bidding at a sale pursuant to a chapter 11 plan.

The 3rd Circuit Court of Appeals granted an appeal of the District Court’s decision, and stayed the debtors’ proposed auction and sale pending the appeal. The 3rd Circuit has thus set the stage for an important decision governing secured creditors’ rights to protect their collateral in the District of Delaware, a frequent venue for complex chapter 11 cases.

5th Circuit Reasoning

In In re Pacific Lumber Co., the 5th Circuit, in a direct appeal of an order rejecting the secured lenders’ objection to the plan, stated that "paying off secured creditors in cash can hardly be improper if the plan accurately reflected the value of the [the secured lenders’] collateral.”

Moreover, the 5th Circuit concluded that the payment of cash to the secured lenders equal to the value of the collateral afforded them the “indubitable equivalent” and thus satisfied the “cram down” provisions of the Bankruptcy Code. The fact that the lenders would forego the benefit of later increases in the value of the collateral was not important, because the Bankruptcy Code protects a secured creditor’s “allowed secured claim” rather than the potential upside in the value of its collateral.

Appeal to the 3rd Circuit

In the Philadelphia Newspapers case, the 3rd Circuit Court of Appeals granted expedited appellate review of the District Court’s decision, and heard oral argument on Dec. 15, 2009. Notably, the Loan Syndications and Trading Association and the Commercial Finance Association filed a joint amicus curiae brief explaining why the absolute right to credit bid is vital to secured credit markets.

Regardless of how the 3rd Circuit rules, the issue of secured creditors’ “bid in” rights is certain to remain a controversial subject, and to affect the dynamics of negotiation between secured lenders and their financially troubled borrowers.