• Philadelphia Newspapers: Credit Bid Decision - How Does Losing The Absolute Right To Credit Bid In A Sale Under A Plan Of Reorganization Impact Lenders And Borrowers?
  • April 23, 2010 | Authors: Ezra H. Cohen; Hollace Topol Cohen; Jonathan L. Hauser; Jeffrey "Jeff" W. Kelley; Mitchel "Mitch" H. Perkiel; Carolyn Peterson Richter; Lee W. Stremba
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  • The recent decision of the U.S. Court of Appeals for the Third Circuit in In re Philadelphia Newspapers LLC[1] holds that a plan of reorganization that proposes an auction sale of the debtor’s assets may be confirmable, even if it denies the secured creditor with a lien on those assets the right to credit bid its debt at the sale.  This holding is consonant with a Fifth Circuit holding a few months earlier.  See Bank of New York Trust Co. N. A. v. Official Unsecured Creditors Committee (In re The Pacific Lumber Co.), 584 F.3d 229 (5th Cir. 2009).  This E-Alert looks at the impact the Third Circuit decision has on the balance between the rights of debtors seeking to reorganize, on the one hand, and secured creditors seeking to avoid undervaluation of their liens, on the other hand.

    We first look at the rationales for the majority and dissenting opinions.  We then consider the impact the majority opinion could have on secured creditors’ rights and the dynamics of a contested, chapter 11 reorganization plan.

    The decision could make it easier for debtors to “cash out” the secured creditor at the property’s value as of plan confirmation.  It could also have significant consequences for lenders in syndicated credit facilities and bond indentures, where raising money to fund a cash bid to protect the lien can require unanimous consent, and for loan-to-own creditors who rely on a credit bid of the secured debt to acquire the assets and enjoy possible future increases in the collateral’s value.

    In Philadelphia Newspapers, the Third Circuit held that a secured creditor, which has a right to credit bid in a Section 363 sale unless the court for cause shown orders otherwise, does not have that right when its collateral is sold pursuant to a plan of reorganization.  The Third Circuit held that, so long as the debtor’s reorganization plan provides the secured creditor with the “indubitable equivalent” of its secured claim, the secured creditor can be barred from credit bidding at an auction sale under a plan.  The Third Circuit remanded the case to the bankruptcy court for further proceedings and particularly for the bankruptcy court to determine whether, under the debtors’ plan, the secured creditors will receive the indubitable equivalence of their secured claim even though they are barred from credit bidding at an auction sale of their collateral.  A rehearing enbanc was denied on April 9.

    The debtors in Philadelphia Newspapers own and operate two Philadelphia newspapers and owe a syndicate of secured lenders in excess of $300 million, secured by a first lien on substantially all of the debtors’ assets.  The debtors, valuing the secured claim at about $66 million, commenced the bankruptcy case and simultaneously filed a plan of reorganization that proposed a public auction of all their assets, free and clear of liens.  The plan provided that the debtors (1) would pay to the secured creditors the purchase price of $37 million offered by the debtors’ stalking horse bidder, (2) would pay the secured creditors any increase in the purchase price as a result of competitive bidding at the auction, and (3) would deed to the secured creditors the Philadelphia headquarters, valued at $29.5 million, subject to a two-year rent-free lease in favor of the purchaser.

    Accompanying the plan was the debtors’ asset purchase agreement with the putative stalking horse bidder.  This bidder was an entity owned largely by a local pension fund and a local individual.  Until the day before the asset purchase agreement was signed, the pension fund and the local individual owned collectively 50% of the parent of the debtor corporations.  Before the commencement of the bankruptcy cases, the debtors had engaged in an extensive advertising campaign that related to the proposed auction and that promoted the message, “Keep it Local.”

    The bidding procedures for the sale proposed by the debtors prohibited the syndicate from credit bidding[2] their debt if they made a bid for the assets at the sale.  The lenders in this syndicate objected to the bidding procedures.  The debtors did not argue that cause existed to excuse them from accepting credit bids; rather they argued that the plan could be confirmed under the cram-down provisions of § 1129(b)(2)(A) even if the syndicate was not allowed to credit bid, so long as the plan provided for the lenders to receive the “indubitable equivalent” of their secured claims.

    Section 1129(b)(1)(2) provides that a plan is fair and equitable as to secured creditors if the plan meets any of three criteria: (i) that the plan provides that secured creditors will retain their liens and receive deferred payments equal in value to the liens; (ii) that the plan provides that the collateral will be sold, subject to § 363(k), which provides that the secured creditor can credit bid unless the court for cause shown orders otherwise, and that the liens will attach to the proceeds; or (iii) that the plan provides that the secured creditors will receive the indubitable equivalent of their secured claims.

    No party contended that the criteria set forth in (i) was relevant to this case.  Thus, the issue was whether the plan could provide for an auction sale without allowing the secured creditors to credit bid as contemplated by (ii), so long as the debtors could show that the plan provides for the secured creditors to receive value that was the indubitable equivalent of their secured claims, as contemplated by (iii).

    The debtors argued that they could avoid having to show cause under (ii) for denying credit bidding because they planned to show that, even without credit bidding, the secured creditors would receive the indubitable equivalent of their secured claims on confirmation of the plan.  In contrast, the secured creditors argued that any plan that proposed an auction sale under the plan had to meet the criteria of (ii) and thus had to allow credit bidding, unless cause could be shown why the secured creditors should not be allowed to credit bid.

    The bankruptcy court[3] sided with the lenders, and directed the debtors to amend the bidding procedures to allow for credit bidding.  Reading § 1129(b)(2)(A) in light of other provisions of the Bankruptcy Code, mainly § 363(k) and § 1111(b), the bankruptcy court found that any sale of the debtors’ assets required that a secured creditor be allowed to participate in a sale by credit bidding its debt, unless good cause could be shown for precluding credit bidding.[4]

    The district court[5] reversed the bankruptcy court, and the Third Circuit affirmed the district court.  The Third Circuit held that a secured creditor has no right, as a matter of law, to credit bid its allowed claim at a sale pursuant to a reorganization plan.  Relying on the plain language of § 1129(b)(2)(A), the Court held that, when assets are sold under a plan (rather than under § 363 outside of a plan), a secured creditor can be denied the right to credit bid so long as the sale provides to the creditor the “indubitable equivalent” value of its allowed secured claim.  The court reasoned that § 1129(b)(2)(A) provides three distinct routes to plan confirmation by using the disjunctive “or,”[6] and the right to credit bid was not incorporated into the “indubitable equivalent” route to plan confirmation.

    The Third Circuit recognized that the plain meaning rule should not be applied if it would produce a result that is demonstrably at odds with the intentions of the drafters of the Bankruptcy Code.  However, the Third Circuit concluded that precluding credit bidding is not demonstrably at odds with the intention of the drafters because § 363(k) itself provides that the court, for cause shown, may deny a secured creditor the right to credit bid.

    A strong dissent, written by a well respected former bankruptcy attorney, Judge Thomas Ambro, agreed with the lenders.  In his dissent, he stated that § 1129(b)(2)(a)  has two plausible readings, and the court should select the interpretation that is consistent with the statutory scheme of the Bankruptcy Code.  One plausible reading, he said, was that adopted by the majority opinion, that any of three alternative criteria may be met to satisfy § 1129(b)(2)(A).  The other plausible reading, resulting from the rule of statutory construction that specific provisions prevail over general ones, is that the sale prong of § 1129(b)(2)(A)(ii) sets forth the only applicable criteria when the plan proposes to sell the assets.  Judge Ambro argued that a ruling contrary to the second plausible reading would be inconsistent with the Bankruptcy Code’s protections for secured creditors, as established under Sections 1111(b) and 363(k), which protect against undervaluation of collateral by preserving the right to credit bid - a right that lenders have always enjoyed under state law at foreclosure sales.

    The Third Circuit’s ruling is in line with a similar ruling a few months earlier by the U.S. Court of Appeals for the Fifth Circuit in In re The Pacific Lumber Co.[7]  On different facts, the Fifth Circuit denied secured noteholders the right to credit bid in a sale of their collateral under a plan on the ground that they would receive under the plan the “indubitable equivalent” of their claim.[8]

    What impact will decisions like Philadelphia Newspapers and Pacific Lumber have on the dynamics of a contested chapter 11 plan?  If § 1129(b)(2)(A) does not give lienholders a right, as a matter of law (unless cause is shown), to credit bid when their collateral is sold under a plan, then payment of their secured claims may turn on valuation of their collateral, determined by bankruptcy judges based on expert testimony, rather than by decisions made by the secured creditor to bid or not to bid by crediting (reducing) their debt.  Secured creditors could be allowed to participate in the sale but not allowed to credit bid (as in Philadelphia Newspapers), or the secured creditor could be “cashed out” by payment of its secured claim in an amount equal to the collateral’s value as determined by the court (as in Pacific Lumber).

    In an auction, the impact may be less significant if a single financial institution with liquid assets holds the debt.  Secured creditors that have liquidity can participate in an auction by bidding and paying cash at closing, trusting that the proceeds will be paid to it as the holder of the lien.  However, today’s complex financial structures often result in loan or bond debt being held by multiple creditors, represented by an agent or trustee, and a supermajority or unanimous vote is typically required to increase debt exposure to fund a cash bid for the collateral. 

    Secured creditors have avenues to challenge any attempt to strip their credit bid right, such as (i) when marketing is less than optimal because of the speed of the sale, or (ii) when the creditor can show that the valuation proposed by the debtor is not at market value, and thus only a credit bid will give it the indubitable equivalent.[9]  Any basis on which a secured lender can show it did not receive the “indubitable equivalent” of its collateral provides grounds to oppose cramdown as not fair or equitable.[10]  Secured creditors can also try to condition the use of cash collateral and DIP financing on the express agreement that they will have the right to credit bid the debt in the event of a sale under a plan.

    Decisions like Philadelphia Newspapers and Pacific Lumber no doubt give greater discretion to debtors and put secured creditors at greater risk for erroneous valuation based upon expert testimony.  What are the broader ramifications?  If secured creditors can no longer absolutely rely on their ability to credit bid in extending credit to debtors, will this risk be passed on by lenders in the form of increased interest rates and reduction in credit availability?  Non-traditional, loan-to-own lenders may also be impacted.  Those creditors extend credit or buy secured debt with a “loan to own” strategy.  They typically do not want to be “cashed out” because they are looking to future increases in the collateral’s value as a return on their investment.  If they do not have a right to credit bid the debt in a sale under a plan, they could participate in any auction only as a cash bidder, and if a sale to a named buyer is proposed rather than an auction, they face being paid the value of the secured claim in cash, losing the opportunity to enjoy anticipated increases in the collateral’s value.

    How will these decisions impact debtors’ actions in bankruptcy cases?  First, we may see some debtors eschew quick § 363 sales and instead propose plans that do not allow secured creditors to participate in a sale by credit bid, or that sell encumbered assets to a specific buyer for a price (determined by valuation testimony) in payment of the secured lien - thus “cashing out” the secured lender in a sale at a judicially determined valuation.  Second, such plans may make it easier for debtors to work around the absolute priority rule.  That rule is set forth in § 1129(b)(2)(B), and provides that before equity can receive or retain an interest in the debtor on account of that equity, allowed claims of creditors must be paid or otherwise satisfied in full under the fair and equitable standards of § 1129(b)(2).  The dissenting judge in Philadelphia Newspapers and the bankruptcy judge were clearly concerned that former insiders would under the terms of the plan own the assets by means of their majority ownership interest in the stalking horse, yet provide no cause or business justification for not allowing the secured lenders to credit bid at the auction.  The rulings of the Third and Fifth Circuits give owners of chapter 11 debtors a window of opportunity to circumvent the absolute priority rule if they (1) form a new entity, (2) have that entity purchase the assets at a sale that strips the secured creditor of its liens, and/or (3) pay the proceeds of the sale to the secured lenders in respect of their liens.  If the new value exception to the absolute priority rule exists, then debtors who take this approach may achieve their objective of continued ownership of the core assets of the business, without infusing sufficient capital to satisfy the new value exception, to the extent such exception exists.[11]


    [1] In re Phila. Newspapers, LLC, 2010 U.S. App. LEXIS 5805 (3d. Cir. 2010).
    [2] A credit bid allows a secured creditor to bid its debt in lieu of cash at the auction.
    [3] In re Phila. Newspapers, LLC, 2009 Bankr. LEXIS 3167 (Bankr. E.D. Pa. 2009).
    [4] In short, the secured creditors argued, and the bankruptcy court agreed, that undersecured creditors are entitled to protect their investment either (i) by credit bidding pursuant to § 363(k) or (ii) by making an “election” under 1111(b).  Section 363(k) gives a secured creditor the right to credit bid on the assets up to the full amount of its claim to prevent undervaluation of collateral when it is sold.  Section 1111(b) allows a non-recourse undersecured creditor to elect to have its entire claim treated as a secured claim to prevent undervaluation of collateral that is not sold.  That secured claim is payable by the debtor in a payment stream, as to which the discounted present value is capped at the collateral’s value.  Here, the secured creditors held recourse loans, so they did not qualify for the § 1111(b) election.  The bankruptcy court emphasized that secured creditors must be able to exercise one of the two protections.  No cause to deny credit bidding was shown, and therefore the secured creditors had a right to credit bid at the sale conducted pursuant to the reorganization plan
    [5] In re Phila. Newspapers, LLC, 418 B.R. 548 (E.D. Pa. 2009).
    [6] (i) retention of liens and deferred cash payments; (ii) a free and clear sale of assets subject to credit bidding; or (iii) provision of the “indubitable equivalent” of the secured interest.
    [7] 584 F.3d 229 (5th Cir. 2009).
    [8] Pacific Lumber did not involve an auction sale; the plan proposed a transfer of property to a named buyer, for cash equal to the property’s value, as determined by the bankruptcy court based on valuation testimony, in full satisfaction of the lienholders’ allowed secured claim.  The Fifth Circuit agreed with the secured creditors that the “transfer” proposed in the plan was a “sale,” but held that the plan gave the creditors the indubitable equivalent of  their lien claims, because the secured creditors were receiving in cash the value of their secured claim.  The Fifth Circuit reasoned that therefore, preserving the right to credit bid was not imperative.  The options available to a debtor under § 1129(b)(2)(A) are jointed by the word “or,” and thus there are three independent alternatives for plan confirmation, so long as the treatment is fair and equitable. 584 F.3d at 243-249.
    [9]  In re Phila. Newspapers, LLC, 2010 U.S. App. LEXIS 5805 at *53 (3d. Cir. 2010); In re Pacific Lumber Co., 548 F.3d at 247.
    [10] In fact, the Third Circuit in Philadelphia Newspapers expressly declined to address the issue of whether the exclusion of credit bidding was a legitimate exercise of the debtors’ business judgment or whether the plan provided the secured creditors the “indubitable equivalent” of their claims.
    [11] Bank of America Nat’l Trust & Savings Ass’n v.203 N. LaSalle Street P’ship, 526 U.S. 434, 119 S.Ct. 1411, 143 L. Ed. 2d 607 (1998) (refusing to rule on whether the pre-code new value exception to the absolute priority rule survived the enactment of the Bankruptcy Code; even if it survived, this plan violated the absolute priority rule because it allowed equity to retain its interest without allowing competing bids to be offered for the equity or allow competing plans to be filed in order to expose the retained equity to market valuation).