In a “loan-to-own” investment, an investor acquires secured debt at a discount to leverage the face amount of the debt in an asset purchase or debt-to-equity swap. For example, if an investor can buy US$50 million worth of debt for US$25 million, it can, in a bankruptcy proceeding, bid on the underlying assets that secure the debt at a 50 percent discount, because the investor can credit bid the face value of the debt as the equivalent of cash in a sale of collateral in bankruptcy, thus creating a competitive advantage over cash or strategic bidders.
In Fisker,1 an investor’s right to credit bid its US$168 million debt claim was capped at only US$25 million, the amount the investor paid for the debt. The US Bankruptcy Court for the District of Delaware reasoned that, in addition to traditional “for cause” bases to cap a credit bid, “[a] court may deny a[n investor] the right to credit bid… to foster a competitive bidding environment” [emphasis added]. Broadly construed, this appears to undercut the value proposition for distressed debt investors, since any credit bid in excess of an initial cash bid from a competing bidder might result in a cap on the credit bid to a common floor value among the bidders.
Traditionally, the right to credit bid could only be limited “for cause.” That meant (i) procedural irregularities (e.g., failure to comply with bidding procedures); (ii) lien and/ or claim disputes; and/or (iii) misconduct (e.g., collusive bidding, or rushing a sale to preclude other bids). While the reasoning inFisker appears novel, the factual foundation and support for the decision is not, because (i) the investor tried to expedite the bidding process using a drop-dead date, which the court found was “pure fabrication,” inconsistent with the notions of fairness; (ii) certain of the investor’s liens were not properly perfected, or were disputed; and (iii) the investor tried to credit bid on unencumbered assets, the latter two of which are reasons to limit a credit bid since under applicable law credit bidding is confined to secured debt. These underlying issues thus fall squarely within the traditional “for cause” reasons to limit credit bidding.
The decision expressly states, however, that “the ‘for cause’ basis upon which the court is limiting [the investor]’s credit-bid is that bidding will not only be chilled without a cap; bidding will be frozen.” Fiskercan, therefore, be read to create a new limitation on credit bidding, a cap that will allow others to bid in order to maximize purchase price at an auction.
Whether this language constitutes a new limitation or not, the decision creates significant uncertainty. However, “loan to own” investors still have the ability to mitigate or even circumvent the Fiskerlimitations. As a general matter, investors can protect against risks of a Fisker result by, among other things, selecting commercially reasonable sales procedures and a well-reasoned bidding timeline. Moreover, a prudent investor can try to establish the validity and extent of its claim amounts and liens prior to an auction, whether by stipulation or otherwise, although the compressed timetable for bankruptcy asset sales at the outset of a bankruptcy case may make that difficult or impossible.
An investor can also incentivize a debtor by providing new post-bankruptcy financing with priming liens conditioned on the investor’s right to credit bid and the debtor’s stipulation to the validity of the liens of the pre-bankruptcy debt. Similarly, the investor may want to consider acting as a stalking horse bidder (an initial bidder that offers a floor bid) and including purchase agreement covenants or conditions that require a debtor to defend the investor’s liens and any objections to a face-value credit bid. Finally, an investor could offer a debtor a credit enhancement, for example a letter of credit or escrowed cash, to offset any infirmities determined in subsequent litigation over the validity and extent of liens.
If Fisker really stands for the proposition that fostering a “competitive bid” process is an entirely independent, stand-alone basis to limit credit bidding, an investor could also voluntarily limit its credit bid. For example, a lower credit bid could be submitted to avoid the objection and thereafter increase it at auction. It could also agree that its credit bid would be increased, but must always trail a full cash bid, thereby limiting any credit enhancement or cash component of a bid required of the investor. While the chosen route will depend on facts and circumstances, an investor may take comfort in higher repayment on its debt as a backstop, on account of competitive bidding.
Other bankruptcy judges may not follow Fisker or may find Fisker is factually distinguishable. Note also that Fisker may not apply in non-bankruptcy court situations, like UCC or real property foreclosure sales.
In summary, “loan-to-own” strategies remain a viable value proposition for proactive investors prepared with practical solutions. Investors that are prepared, and that have considered these and other strategies, will be armed for any dispute raised by “out-of-the-money” constituencies, such as the argument of a creditors’ committee (a committee of unsecured creditors selected to act as a check and balance to the debtor) that Fisker permits an outright cap on a credit bid so as to permit a competitive auction.