Asset-based lenders take heed — especially those who loan money or purchase debt as part of a “loan-to-own” strategy: They may have to start bidding cash (a lot more cash) if a debtor tries to auction their collateral.

That is not what a secured lender typically expects. Instead of bidding cash for its collateral at a bankruptcy auction, an asset-based lender ordinarily can “credit bid” up to the amount of its secured claim as an off-set against the purchase price. Bidding up the purchase price in this fashion is one method of ensuring that any other successful bidder pays fair value for the secured creditor’s collateral. A secured creditor’s right to credit bid is contained in §363(k) of title 11:

At a sale under [§363(b) of title 11] of property that is subject to a lien that secures an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.

Credit bidding is a powerful tool, but it is not absolute. For example, only a secured creditor whose claim is “allowed” can credit bid. If the amount of its claim is disputed, the creditor may not credit bid. Likewise, a secured creditor may not credit bid if “the court for cause orders otherwise.” The statute does not define what “cause” means, but courts have limited credit bidding if (among other reasons) the validity of a creditor’s lien is at issue or if its lien does not encumber all of the assets that the debtor or its trustee propose to sell.

Two recent bankruptcy court decisions raise new questions about this “for cause” limit on credit bidding. In Fisker Automotive Holdings, Inc., 2014 Westlaw 210593 (Bankr. D. Del, Jan. 17, 2014), the court decided that (at an auction of the debtors’ assets) a purchaser of someone else’s secured debt could only credit bid an amount that, as it happens, equaled what the purchaser had paid to acquire that secured debt — not the much larger face amount. And in The Free Lance-Star Publishing Co. of Fredericksburg, Va., Case No. 14-30315-KRH (Bankr. E.D. Va. April 14, 2014), the court (relying in part upon Fisker) capped a secured lender’s credit bid at less than 36% of its total secured claim. Both courts capped the credit bids, primarily, to encourage competitive bidding. How other courts interpret Fisker and Free Lance may have significant repercussions for distressed debt buyers and for asset-based lenders.

Fisker manufactured electric cars, until it slammed on the brakes and went bankrupt. Fisker and related debtors filed their bankruptcies for the purpose of selling substantially all of their assets to Hybrid Tech Holdings before liquidating. Pre-bankruptcy, the Department of Energy held a senior secured position for $168.5 million. About five weeks before the bankruptcies, Hybrid purchased DOE’s position for $25 million. The debtors then negotiated with Hybrid to acquire the debtors’ assets for a “credit bid” of $75 million. Fisker thus was a “loan-to-own” situation; Hybrid bought senior secured debt so it would be in the best position to buy the assets (via the credit bid). To save time and money, the debtors initially proposed to sell their assets to Hybrid at a private sale. The official committee of unsecured creditors (committee) opposed the private sale. Instead, the committee pressed for an auction with Wanxiang America Corporation.

At a hearing regarding the sale, the debtors and the committee agreed to stipulations that framed the issue for the bankruptcy court. Among other things, they stipulated that (i) “if at any auction Hybrid either would have no right to credit bid or its credit bidding were capped at $25 million, there is 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 present Hybrid bid”; (ii) if Hybrid’s ability to credit bid is not capped, an auction would not occur because no one would bid more than Hybrid’s asserted secured claims; (iii) limiting Hybrid’s ability to credit bid would “foster … a competitive bidding environment”; and (iv) the sale included material assets that were not subject to Hybrid’s liens or on which the validity of Hybrid’s liens was disputed. Based on these stipulations, the bankruptcy court found that if Hybrid was permitted to credit bid more than $25 million, Wanxiang would not participate and no auction would take place.

Having stipulated to these and other points, the debtors and committee then asked the bankruptcy court to decide whether Hybrid’s ability to credit bid should be limited based solely on three arguments the committee advanced: First, that credit bidding should not be permitted at all because Hybrid did not have or might not have valid liens on all of the assets that were to be sold as an entirety; second, that “cause” existed to cap Hybrid’s credit bid because Hybrid did not have a lien on all of the assets; and third, that “cause” existed to cap its credit bid because “limiting the credit bid will facilitate an open and fully competitive cash auction.”

In its decision, the Fisker court acknowledged that a secured creditor is entitled to credit bid its allowed claim. Therefore, Hybrid would be permitted to credit bid. The only question was: in what dollar amount? The court’s answer: Hybrid’s credit bid should be capped at $25 million — the amount Hybrid paid to buy the debt.

The court cited three reasons to limit Hybrid’s credit bid. First, it ruled that this would encourage Wanxiang to bid. The court relied upon the Third Circuit’s decision in the case In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3d Cir. 2010). The Third Circuit opined that a “court may deny a lender the right to credit bid in the interest of any policy advanced by the [Bankruptcy] Code, such as to ensure the success of the reorganization or to foster a competitive bidding environment.” The debtors and committee had stipulated that limiting Hybrid’s credit bid would “foster a competitive bidding environment” as contemplated in Philadelphia Newspapers. The bankruptcy court concluded that “the evidence in this case is express and unrebutted that there will be no bidding — not just the chilling of bidding — if the Court does not limit the credit bid.” The court therefore ruled that “the ‘for cause’ basis upon which the Court is limiting Hybrid’s credit bid is that bidding will not only be chilled without the cap; bidding will be frozen.”

Second, because the extent of Hybrid’s liens was unresolved, no one then knew how much of Hybrid’s claim actually was “secured.” Third, the court was worried that the extremely short schedule Hybrid wanted would freeze out other potential suitors. Neither the debtors nor Hybrid explained why the sale of non-operating debtors required inordinate speed. Also, Hybrid set a January 3, 2014 “drop dead” date for sale and plan confirmation hearings, but continued its effort to purchase the assets even after that deadline came and went. This behavior displeased the court. It concluded that Hybrid’s deadline was “pure fabrication,” “designed to place maximum pressure on creditors and the Court,” and that Hybrid’s “rush to purchase” was “inconsistent with the notions of fairness in the bankruptcy process.”

Ultimately, the Fisker court’s decision achieved the desired outcome — an auction at which the assets sold for cash far exceeding $75 million. While the district court was rejecting Hybrid’s attempts to appeal, the bankruptcy court approved an auction sale process. Wanxiang was the prevailing bidder; its bid was valued at $149.2 million. The bankruptcy court approved the sale to Wanxiang during February 2014. The sale closed in March. Finally, the parties agreed on how the sale proceeds should be divided — Hybrid would receive $90 million (a $65 million profit), unsecured creditors would split $20 million (plus $15 million in equity in Wanxiang affiliates), and “priority claim” holders would receive $8 million.

Free Lance also involved a “loan-to-own” scenario. DSP Acquisition bought a secured loan against the debtors for an undisclosed amount. Then, DSP pressured the debtors to file bankruptcy so that DSP could purchase their assets via a credit bid. Once DSP realized that it did not have a lien upon certain important assets, DSP engaged in what the court later found to be inequitable conduct — such as (without telling the debtors) repeatedly filing UCC financing statements that listed assets against which DSP did not have liens, lobbying the debtors not to market their assets and requiring that marketing materials contain a conspicuous statement that DSP had a right to credit bid $39 million.

Following an evidentiary hearing (at which DSP presented no witnesses), the Free Lance court decided to cap DSP’s bid for three reasons. First, DSP had no right to credit bid against assets that did not secure its allowed claim. Second, based upon unrebutted testimony from the debtors’ financial advisor, the court found that DSP’s actions frustrated the competitive bidding process. Third, the debtors’ witness testified that capping DSP’s credit bid would help restore a competitive bidding environment and reinvigorate enthusiasm for the sale.

In the court’s view, “[t]he confluence of (i) DSP’s less than fully-secured lien status; (ii) DSP’s overly zealous loan-to-own strategy; and (iii) the negative impact DSP’s misconduct has had on the auction process has created a perfect storm, requiring curtailment of DSP’s credit bid rights.” To determine the extent of that curtailment, the court accepted the methodology that the debtors’ financial advisor used — eliminate the unencumbered assets from the potential credit bid and apply a market analysis to develop an appropriate cap that would foster a competitive auction. The court limited DSP’s $39 million credit bid to a total of $13.9 million.

So what are the takeaways from Fisker and Free Lance? Lenders need to watch out, especially in loan-to-own scenarios. Lenders who are “too zealous” may invite accusations of inequitable conduct that could undercut their right to credit bid. And, even if no inequitable conduct exists, the goal of “fostering a competitive bidding environment” may become a rallying cry for trade creditors or others to pre-emptively challenge secured lenders’ claims or liens in an effort to curtail their credit bidding rights.

Harry W. Greenfield is a shareholder for Buckley King. He handles matters in the Ohio state and federal courts involving receiverships, mechanic’s liens, collections, foreclosures, lease defaults, and issues under the Uniform Commercial Code on behalf of both corporate debtors and creditors.

Jeffrey C. Toole is a shareholder for Buckley King. He advises lenders and borrowers in working out problem loans, and navigates confidently through business bankruptcy cases and receiverships.