Introduction

A secured lender has the ability to “credit bid” the full amount of its debt when its collateral is sold in a bankruptcy case. This fundamental right set forth in the Bankruptcy Code ensures that collateral pledged to a lender is not sold for less than the amount of its secured claim. However, the Bankruptcy Code also provides that a court may cut off a lender’s right to credit bid “for cause,” and the definition of cause is left undefined.

Most cases in which a lender’s right to credit bid has been cut off or limited have involved a creditor whose lien was disputed in some manner, or who engaged in bad faith. However, a pair of recent decisions in the bankruptcy cases of Fisker Automotive and Free Lance-Star Publishing Co. of Fredericksburg, Va. have called into question whether the circumstances in which secured creditors are able to credit bid their debt are limited in new ways.

Recent Cases Appear Adverse to Credit Bidding in “Loan to Own” Scenarios

In the Fisker Automotive case, Fisker originally had a $168 million loan with the U.S. Department of Energy. After Fisker sank into financial trouble, the DOE sold its loan through an auction to Hybrid Tech Holdings, LLC for $25 million. Hybrid and Fisker later entered into an asset purchase agreement pursuant to which Hybrid was the stalking horse bidder through a contemplated bankruptcy sale process pursuant to which it would credit bid its claim for $75 million.

As part of the sale process, Hybrid imposed an extraordinarily short timeline for approval of the asset purchase agreement. That expedited timeframe wound up backfiring. The bankruptcy judge questioned the need for such an accelerated timeline for sale approval, particularly when the unsecured creditors’ committee objected to Hybrid’s credit bid, and supported a bid by Wanxiang America Corporation. Wanxiang was interested in bidding, but only if Hybrid’s credit bid was capped at $25 million.

In a surprise decision, the bankruptcy court judge limited Hybrid’s credit bid to $25 million and gave three primary reasons for the decision. First, the judge stated that if he didn’t limit the credit bid, not only would the auction process be chilled, but there likely would be no competitive bidding at all. Second, the judge noted that uncertainty regarding the extent of Hybrid’s secured lien was further “cause” to limit the credit bid. Finally, the court noted that Hybrid’s attempt to speed the sale approval process at the outset of the bankruptcy case in only 24 days was inconsistent with “the notions of fairness” inherent in bankruptcy cases.

Secured lenders hoping that the Fisker decision was merely an outlier were recently treated to another unpleasant result in April 2014 when a bankruptcy court in the Eastern District of Virginia also limited a secured lender’s right to credit bid. In the bankruptcy case of Free Lance-Star Publishing Co., the debtor’s original secured lender sold its debt at a discount to an investor that intended to eventually purchase the borrower’s assets. However, the lender discovered that it did not have security interests in all of the borrower’s assets, and attempted to persuade the debtor to grant it security interests in those assets and sell all of their assets to it through an expedited bankruptcy sale process. Those efforts failed, and Free Lance-Start filed for bankruptcy without the lender’s support.

The bankruptcy court the court limited the amount of the lender’s credit bid on the basis that it did not have liens on all of the debtor’s assets, it had engaged in an overly zealous loan-to-own strategy, and its actions chilled bidding at an auction by discouraging competing bidders from even considering a bid. The court commented that it is problematic when a secured party attempts to depress rather than enhance a debtor’s market value through its credit bids.

Takeaways for Distressed Debt Investors

Distressed debt investors hoped (and many assumed) the Fisker decision was an aberration. However, the subsequent decision in Free Lance-Star Publishing Co., further underscores that distressed debt investors need to exercise caution before and after purchasing distressed debt, and prepare for additional court scrutiny as they devise and execute “loan to own” strategies in the future.

One takeaway is to attempt to ensure that liens are properly secured in all the assets being sold. That may be able to be done through the due diligence process in conjunction with purchasing the debt. Alternatively, the lender could attempt to establish the validity and extent of its liens after the bankruptcy case is filed, but prior to the auction. This poses issues as well since it slows down the auction process, which a lender usually wants to occur early in a bankruptcy case.

Moreover, secured lenders must be careful not to overplay their hand by forcing unrealistic timetables for bankruptcy sales, discouraging a borrower from getting valuations in conjunction with a sales process, or by failing to fully disclose their security position to the bankruptcy court.

These recent cases do not sound a death knell for credit bidding, which still enjoys protection under the Bankruptcy Code. Rather, lenders and investors must exercise caution and obtain appropriate counsel in connection with such efforts.