Secured Creditors' Credit Bid Rights Under Cramdown Plan

Applicable Code Provisions

The Bankruptcy Code generally requires that, to be confirmed, a plan must either: 1) not impair a creditor's claim, or 2) be acceptable to the creditor if its claim is impaired. If a plan does not meet either of these requirements, however, a bankruptcy court may still confirm it over the objections of a class of impaired creditors, if the plan is deemed to be “fair and equitable.” Id. at *4-5. Plans confirmed over creditors' objections are colloquially referred to as “cramdown” plans because they are “crammed down the throats of objecting creditors.” Id. at 11.

A cramdown plan is deemed “fair and equitable” as to a secured creditor if it, among other things, permits the creditor to credit bid the allowed amount of its secured claim at a sale free and clear of its liens (the “Sale Prong”), “or” gives the creditor the “indubitable equivalent” of the allowed amount of its secured claim (the “Indubitable Equivalent Prong”). 11 U.S.C. ” 1129(b)(2)(A)(ii) and (iii). The Bankruptcy Code contains no specifics, however, as to what types of plans fall within the Indubitable Equivalent Prong or what constitutes the “indubitable equivalent” of a secured creditor's claim.

The statute's use of the word “or” between the two Prongs has been a source of confusion to courts evaluating cramdown plans. Specifically, courts have struggled to determine whether a plan is “fair and equitable” if it provides for the sale of a secured creditor's collateral free and clear of liens, with a distribution of sale proceeds to the creditor, but does not comply with the Sale Prong's requirement that the affected creditor be afforded credit bidding rights. In other words, is a plan “fair and equitable” if it bypasses the Sale Prong and provides for the sale of the debtor's assets free of liens under the Indubitable Equivalent Prong, thus denying a creditor its credit bidding rights under the Sale Prong? The Third and Fifth Circuits answered in the affirmative.

The Lenders in River Road (and the dissent in Philadelphia Newspapers) argued that the use of the word “or” in the statute created an ambiguity, requiring a review of the legislative history. The Lenders further argued that permitting a debtor to use the Indubitable Equivalent Prong to sell assets free and clear of liens under a “cramdown” plan would effectively swallow the Sale Prong entirely, which clearly was not Congress' intent in enacting the Bankruptcy Code.

The Seventh Circuit's Decision

Affirming the decision of the bankruptcy court, the Seventh Circuit held that the Sale Prong and the Indubitable Equivalent Prong are mutually exclusive. Thus, a debtor proposing to sell a secured lender's collateral must proceed under the Sale Prong and permit the secured lender to credit bid. Id. at *9. (“cramdown plans that contemplate selling encumbered assets free and clear of liens must satisfy requirements set forth in [the Sale Prong]“). The court also held that a creditor did not receive the indubitable equivalent of its claim when it received proceeds from an auction at which it was not permitted to credit bid. Id. at *6-7.

The Debtors contended that the plain language of the Bankruptcy Code enabled them to satisfy either the Sale Prong or the Indubitable Equivalent Prong. Id. at *6. According to the Debtors, the Indubitable Equivalent Prong is satisfied if a plan provides a secured creditor with the proceeds from the sale of an asset securing an obligation to that creditor, even at an auction that does not permit credit bidding. Id. In rejecting the Debtors'
argument, the court held that the Debtors misread the Bankruptcy Code and that, in any event, plans such as the one proposed by the Debtor did not qualify for “fair and equitable” status. Id.

First, the court held that the Sale Prong would be “superfluous” were the Debtor's interpretation correct. A plan could always qualify for treatment under the Indubitable Equivalent Prong even if it sought to dispose of encumbered assets in the manner discussed in the Sale Prong, but failed to meet the Sale Prong's requirements. Id. at *7-8. (“We cannot conceive of a reason why Congress would state that a plan must meet certain requirements if it provides for a sale of assets in particular ways and then immediately abandon these requirements in a subsequent subsection.”) The court thus held that the Bankruptcy Code's use of the word “or” between the Sale Prong and the Indubitable Equivalent Prong was not dispositive of whether they were exclusive of one another. Id. at *9, n.5.

Second, the court held that a creditor could not receive the indubitable equivalent of its claim if it was not permitted to credit bid at an auction. Id. at *6-7. The court found that what constitutes the indubitable equivalent of a secured creditor's claim depends on whether the creditor is over- or undersecured. If a creditor is oversecured, then the indubitable equivalent of its claim is its face value, whereas if the creditor is undersecured, then the indubitable equivalent is the asset's current value. Id. at *6. Determining the value of an undersecured creditor's claim, however, is problematic because it is usually difficult to discern the current market value of the types of assets sold in corporate bankruptcies. Id. at *7. Thus, the Bankruptcy Code provides secured creditors the right to credit bid as a means to protect themselves from the risk that the winning auction bid will not capture the asset's actual value. Id. (“In essence, by granting secured creditors the right to credit bid, the Code promises lenders that their liens will not be extinguished for less than face value without their consent.”) Thus, the court concluded that the text of the Indubitable Equivalent Prong “does not establish that it can be used to confirm plans that propose auctioning off a debtor's encumbered assets free and clear without allowing credit bidding.” Id.

Comment

The River Road decision creates a clear split among the Circuits, and the Debtors are now seeking an appeal to the Supreme Court. Should the Supreme Court grant certiorari, the stage would be set for a final determination on whether secured lenders must be permitted to credit bid in sales under cramdown plans. Secured lenders should be aware of the current Circuit split when engaged in pre-bankruptcy discussions with borrowers contemplating a Chapter 11 filing. In addition to the usual decisions regarding the provision of debtor-in-possession financing or consent to the use of its cash collateral, when analyzing potential exit strategies lenders must also consider the proposed venue of the filing. The venue of the case could be key to the ultimate outcome (e.g., the Third and Fifth Circuits permit asset sales under a cramdown plan without credit-bidding, but the Seventh does not). Finally, because some lenders may be willing to finance the debtor or allow use of their cash collateral only to permit a prompt sale under ' 363 of the Bankruptcy Code, a specific preservation of the right to credit bid in the financing order is essential.

Lawrence V. Gelber is a partner and James T. Bentley and Mike Paek are associates in the Business Reorganization Group at Schulte Roth & Zabel LLP.

On June 28, 2011, in a decision of great significance to secured creditors, the U.S. Court of Appeals for the Seventh Circuit held that secured creditors have a statutory right to credit bid their debt at an asset sale conducted under a so-called “cramdown” plan. River Rd. Hotel Partners, LLC v. Amalgamated Bank , __ F.3d __, 2011 WL 2547615 (7th Cir. Jun. 28, 2011). This decision is directly at odds with recent decisions in the Third and Fifth Circuits regarding a secured creditor's right to credit bid under a plan. See In re Philadelphia Newspapers, 599 F.3d 298 (3d Cir. 2010); In re Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009).

Facts

In River Road, two Chapter 11 debtors (the “Debtors”) filed proposed bid procedures and liquidating plans seeking to sell substantially all of their assets free and clear of liens at an open auction. River Road, 2011 WL 2547615 at *2. The stalking horse bids for each Debtor's assets were for significantly less than the amounts owed by the Debtors to their prepetition secured lenders (the “Lenders”), and under the Debtors' proposed bid procedures, the Lenders were not permitted to credit bid their debt (i.e., offset their proposed purchase price by the amount of their secured claim). Id. The Lenders objected to the bid procedures, asserting that the proposed plans did not satisfy Bankruptcy Code ' 363(k)'s requirement that secured creditors be given credit-bidding rights. Id. The Debtors argued that their plans complied with the Bankruptcy Code because sale proceeds would be distributed pursuant to the Bankruptcy Code's priority rules and the Lenders thus would receive the “indubitable equivalent” of their claims in accordance with ' 1129(b)(2)(A)(iii). Id. The bankruptcy court sided with the Lenders.

Applicable Code Provisions

The Bankruptcy Code generally requires that, to be confirmed, a plan must either: 1) not impair a creditor's claim, or 2) be acceptable to the creditor if its claim is impaired. If a plan does not meet either of these requirements, however, a bankruptcy court may still confirm it over the objections of a class of impaired creditors, if the plan is deemed to be “fair and equitable.” Id. at *4-5. Plans confirmed over creditors' objections are colloquially referred to as “cramdown” plans because they are “crammed down the throats of objecting creditors.” Id. at 11.

A cramdown plan is deemed “fair and equitable” as to a secured creditor if it, among other things, permits the creditor to credit bid the allowed amount of its secured claim at a sale free and clear of its liens (the “Sale Prong”), “or” gives the creditor the “indubitable equivalent” of the allowed amount of its secured claim (the “Indubitable Equivalent Prong”). 11 U.S.C. ” 1129(b)(2)(A)(ii) and (iii). The Bankruptcy Code contains no specifics, however, as to what types of plans fall within the Indubitable Equivalent Prong or what constitutes the “indubitable equivalent” of a secured creditor's claim.

The statute's use of the word “or” between the two Prongs has been a source of confusion to courts evaluating cramdown plans. Specifically, courts have struggled to determine whether a plan is “fair and equitable” if it provides for the sale of a secured creditor's collateral free and clear of liens, with a distribution of sale proceeds to the creditor, but does not comply with the Sale Prong's requirement that the affected creditor be afforded credit bidding rights. In other words, is a plan “fair and equitable” if it bypasses the Sale Prong and provides for the sale of the debtor's assets free of liens under the Indubitable Equivalent Prong, thus denying a creditor its credit bidding rights under the Sale Prong? The Third and Fifth Circuits answered in the affirmative.

The Lenders in River Road (and the dissent in Philadelphia Newspapers) argued that the use of the word “or” in the statute created an ambiguity, requiring a review of the legislative history. The Lenders further argued that permitting a debtor to use the Indubitable Equivalent Prong to sell assets free and clear of liens under a “cramdown” plan would effectively swallow the Sale Prong entirely, which clearly was not Congress' intent in enacting the Bankruptcy Code.

The Seventh Circuit's Decision

Affirming the decision of the bankruptcy court, the Seventh Circuit held that the Sale Prong and the Indubitable Equivalent Prong are mutually exclusive. Thus, a debtor proposing to sell a secured lender's collateral must proceed under the Sale Prong and permit the secured lender to credit bid. Id. at *9. (“cramdown plans that contemplate selling encumbered assets free and clear of liens must satisfy requirements set forth in [the Sale Prong]“). The court also held that a creditor did not receive the indubitable equivalent of its claim when it received proceeds from an auction at which it was not permitted to credit bid. Id. at *6-7.

The Debtors contended that the plain language of the Bankruptcy Code enabled them to satisfy either the Sale Prong or the Indubitable Equivalent Prong. Id. at *6. According to the Debtors, the Indubitable Equivalent Prong is satisfied if a plan provides a secured creditor with the proceeds from the sale of an asset securing an obligation to that creditor, even at an auction that does not permit credit bidding. Id. In rejecting the Debtors'
argument, the court held that the Debtors misread the Bankruptcy Code and that, in any event, plans such as the one proposed by the Debtor did not qualify for “fair and equitable” status. Id.

First, the court held that the Sale Prong would be “superfluous” were the Debtor's interpretation correct. A plan could always qualify for treatment under the Indubitable Equivalent Prong even if it sought to dispose of encumbered assets in the manner discussed in the Sale Prong, but failed to meet the Sale Prong's requirements. Id. at *7-8. (“We cannot conceive of a reason why Congress would state that a plan must meet certain requirements if it provides for a sale of assets in particular ways and then immediately abandon these requirements in a subsequent subsection.”) The court thus held that the Bankruptcy Code's use of the word “or” between the Sale Prong and the Indubitable Equivalent Prong was not dispositive of whether they were exclusive of one another. Id. at *9, n.5.

Second, the court held that a creditor could not receive the indubitable equivalent of its claim if it was not permitted to credit bid at an auction. Id. at *6-7. The court found that what constitutes the indubitable equivalent of a secured creditor's claim depends on whether the creditor is over- or undersecured. If a creditor is oversecured, then the indubitable equivalent of its claim is its face value, whereas if the creditor is undersecured, then the indubitable equivalent is the asset's current value. Id. at *6. Determining the value of an undersecured creditor's claim, however, is problematic because it is usually difficult to discern the current market value of the types of assets sold in corporate bankruptcies. Id. at *7. Thus, the Bankruptcy Code provides secured creditors the right to credit bid as a means to protect themselves from the risk that the winning auction bid will not capture the asset's actual value. Id. (“In essence, by granting secured creditors the right to credit bid, the Code promises lenders that their liens will not be extinguished for less than face value without their consent.”) Thus, the court concluded that the text of the Indubitable Equivalent Prong “does not establish that it can be used to confirm plans that propose auctioning off a debtor's encumbered assets free and clear without allowing credit bidding.” Id.

Comment

The River Road decision creates a clear split among the Circuits, and the Debtors are now seeking an appeal to the Supreme Court. Should the Supreme Court grant certiorari, the stage would be set for a final determination on whether secured lenders must be permitted to credit bid in sales under cramdown plans. Secured lenders should be aware of the current Circuit split when engaged in pre-bankruptcy discussions with borrowers contemplating a Chapter 11 filing. In addition to the usual decisions regarding the provision of debtor-in-possession financing or consent to the use of its cash collateral, when analyzing potential exit strategies lenders must also consider the proposed venue of the filing. The venue of the case could be key to the ultimate outcome (e.g., the Third and Fifth Circuits permit asset sales under a cramdown plan without credit-bidding, but the Seventh does not). Finally, because some lenders may be willing to finance the debtor or allow use of their cash collateral only to permit a prompt sale under ' 363 of the Bankruptcy Code, a specific preservation of the right to credit bid in the financing order is essential.

Lawrence V. Gelber is a partner and James T. Bentley and Mike Paek are associates in the Business Reorganization Group at Schulte Roth & Zabel LLP.