The Not-So-Secured Right to Credit Bid
On March 22, 2010, the Third Circuit Court of Appeals, which covers the districts of New Jersey, Pennsylvania and Delaware, issued a decision that is of ground breaking importance to secured lenders. This decision arises out of the Philadelphia Newspapers, LLC1 bankruptcy case pending in the Eastern District of Pennsylvania and seriously affects the right of secured lenders to credit bid in a sale effected in connection with a plan of reorganization.
It is very common for a debtor to sell some or all of its assets in a sale approved by the bankruptcy court pursuant to §363 of the Bankruptcy Code. In fact, it appears that in this very difficult economic environment it is more common to have assets sold through the bankruptcy process than to have a debtor restructure through the confirmation of a plan of reorganization. In sales effected pursuant to §363, secured creditors have a statutory right under §363(k) to “credit bid” their loan balances against the purchase price. Notably, a lender can bid the full value of its claim, not simply the value of the collateral. This acts to set the amount of the floor for other bids.
Given the economic climate, courts are often approving creative solutions to keep debtor companies operating. The Chrysler and General Motors cases, each emerging from the Bankruptcy Court for the Southern District of New York, are examples of pushing the envelope in order to effect a solution. In both Chrysler and General Motors, the sales were approved by the bankruptcy court on the basis that, among others, to the extent junior creditors received any value, it was provided by the new owner, rather than by the debtor. Therefore, according to the court, the sales were not deemed to be sub rosa plans and the priority scheme of the Bankruptcy Code was not violated. Courts have said that “the debtor and the bankruptcy court should not be able to short circuit the requirements of Chapter 11 for confirmation of a reorganization plan by establishing the terms of the plan sub rosa in connection with a sale of assets.” These creative solutions demonstrate the latitude at which courts will interpret rights under the Bankruptcy Code to ensure that sales are made, which enables the company to continue to operate, keep people employed and feed the stream of commerce.
However, a recent case has given rise to the emergence of a new doctrine. In this case, Philadelphia Newspapers LLC, which owns both the Philadelphia Inquirer and the Philadelphia Daily News (together, the debtors), owed approximately $300 million to a group of senior lenders whose debt was secured by substantially all of the debtors’ assets. At the time of the bankruptcy filing on February 22, 2009, the debtors valued their assets at an amount substantially lower than the amount of the debt, making the secured lenders significantly undersecured.
The debtors proposed a plan of reorganization that provided for competitive bidding of substantially all assets where the principal owner of Philadelphia Newspapers LLC would act as the stalking-horse bidder. In order to better assure that the proposed sale would go forward (which would result in the continued existence of the publication of both the Philadelphia Inquirer and the Philadelphia Daily News), the debtors, together with the Official Committee of Unsecured Creditors (the committee), proposed a plan of reorganization that prohibited credit bidding by the secured lender. Pursuant to the terms of the plan, the secured lenders would receive approximately $36 million in cash proceeds from the sale of the assets and would obtain title to an office building allegedly worth $30 million. These collective amounts were significantly less than the amount of secured claims. The court’s decision was rendered in connection with the debtor’s motion to approve the sale process.
Notably, the debtors took the position that credit bidding was not necessary because the sale was being conducted pursuant to §1123 and §1129 and not §363. They also argued that allowing credit bidding in this particular instance would chill competitive bidding because the size of the lenders’ claim was substantially larger compared to the value of the assets. Section 1123 (a)(5)(D) states that the contents of a plan of reorganization must provide for the methodology of its implementation, which may include a “sale of all or part of the property of the estate, either subject to or free of any lien…” Unlike §363(k), §1123 does not expressly provide for credit bidding.
The secured lenders objected to the bidding procedures on the basis that §1129(b)(2)(a)(ii) guaranteed their right to credit bid whether or not the sale was conducted under the aegis of §363 or §1129. The bankruptcy court agreed with the secured lenders and sustained their objection. The debtors and the committee appealed to the District Court, which reversed the bankruptcy court’s decision in November 2009.
In examining §1129, the District Court found the statute plainly provides that the right to credit bid is one of the three possible alternatives set forth in §1129(b)(2)(A), and due to the disjunctive language, it is not mandatory as long as one of the other alternatives was satisfied. Specifically, under §1129(b)(2), in order for a plan to be confirmed over the objections of secured creditors, the plan must provide that the secured creditors: 1.) retain their liens and receive deferred cash payment of their secured claims; 2.) retain the right to credit bid at any sale of lender collateral; or 3.) receive the “indubitable equivalent” of their secured claims. Here, the District Court ruled that debtors could preclude credit bids in asset sales conducted pursuant to a plan of reorganization (not pursuant to §363), and since the creditors received the “indubitable equivalent” of their claims, the secured lenders were not statutorily entitled to credit bid. Following the same reasoning, the Third Circuit affirmed the District Court’s decision.
Prior to the Third Circuit’s decision, the effect of the District Court decision was solely within the Eastern District of Pennsylvania. However, now with the Third Circuit having affirmed the District Court, the effect of that decision impacts not only Pennsylvania, certainly an important bankruptcy jurisdiction, but it also now becomes the law of the land for the Districts of New Jersey and Delaware. The ramifications of this decision are likely to be great as the District of Delaware is the bankruptcy court of choice second only to the Southern District of New York.
The Third Circuit joins (and goes beyond) the prior decision, In re Pacific Lumber Co., which arose from the Fifth Circuit of Appeals (Texas, Louisiana and Mississippi). Similar to Philadelphia Newspapers LLC, the Fifth Circuit held that the language of §1129(b)(2)(A) unambiguously requires the satisfaction of only one of its three subsections. The Fifth Circuit then held that the cash payments provided under the plan afforded the secured lenders with the “indubitable equivalent” of their allowed claim because the plan satisfied the dual concerns of secured credit — repayment of principal and the time value of money.
These decisions are significant because they erode the rights (or perceived rights) of secured creditors to use credit bidding to preserve their economic interests and exercise additional leverage in plan negotiations. However, the Philadelphia Newspapers LLC decision leaves several questions unanswered. First, it does not address what form of sale proceeds (e.g., cash, equity or some other currency) will constitute the “indubitable equivalent” of secured claims. Second, the decision left open the question of how far in advance of a plan a debtor can conduct an auction to sell assets and still qualify that sale as being under a plan, which seeks to prohibit credit bidding.
Nonetheless, what is now known is that as a result of this determination, lenders must take heed and protect themselves against potential hostile sales which may now be authorized in both the Third and Fifth Circuits and, perhaps other circuits that may follow suit. Lenders would be wise to include in their cash collateral and debtor-in-possession financing orders, clauses that expressly provide that no confirmed plan of reorganization proposed by the debtor shall impair or modify the rights of the lender under the order or other financing documentation. Additionally, it would be prudent for lenders to include similar language at the onset of drafting credit and loan agreements to preserve such rights should they need to be exercised at a later point. It would also be in lenders’ best interests to provide a clause in the initial lending agreements to establish the secured party’s right to credit bid as superior to any proposed plan of reorganization establishing otherwise.
Only time will tell whether other circuits will follow the decisions of the Third and Fifth Circuits and sidestep the rights of secured creditors to credit bid under §363. One thing that is certain is that within the last several months, two significant bankruptcy disputes with credit bidding at their center have reached Courts of Appeal, and this should serve as a signal that bankruptcy professionals and their clients would be well advised to familiarize themselves with the nuances of credit bidding, and draft accordingly with an eye toward the future.
Jeffrey A. Wurst is a partner at Ruskin Moscou Faltischek, P.C. in Uniondale, NY, where he chairs the firm’s Financial Services, Banking and Bankruptcy Department. Michael T. Rozea is an associate in that department.
 In re Philadelphia Newspapers, LLC, No. 09-11204.
 In re Chrysler, LLC, 405 B.R. 84 (Bankr. S.D.N.Y. May 31, 2009).
 In re General Motors Corp., 407 B.R. 463 (Bankr. S.D.N.Y. July 5, 2009).
 See generally In re Chrysler LLC, 405 B.R. at 98-99; In re General Motors Corp., 407 B.R. at 496-98.
 In re General Motors Corp., 407 B.R. at 495 [citing Pension Benefit Guar. Corp. v. Braniff Airways, Inc. (In re Braniff Airways, Inc.), 700 F.2d 935, 940 (5th Cir. 1983)].
 584 F.3d 229 (5th Cir. 2009).