On June 28, 2011, the U.S. Court of Appeals for the Seventh Circuit held that secured creditors have a statutory right to credit bid1 their debt at an asset sale conducted under a "cramdown" plan. In re River Road Hotel Partners, LLC, ___ F.3d. ___, 2011 WL 2547615 (7th Cir. June 28, 2011).2 The Seventh Circuit's decision creates a split with recent decisions in the Third and Fifth Circuits regarding a lender's ability to credit bid its secured debt. See In re Philadelphia Newspapers, 599 F.3d 298 (3d Cir. 2010); In re Pacific Lumber, Co., 584 F.3d 229 (5th Cir. 2009). As discussed below, this decision has important practical significance to secured lenders and debtors.
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 initial (or so-called "stalking horse") bids for the assets were for significantly less than the amounts owed to the Debtors' prepetition secured lenders (the "Lenders"), and the Debtors' proposed bid procedures did not permit the Lenders to credit bid their debt. Id. The Lenders objected to the bid procedures, asserting that the proposed plans could not satisfy the Bankruptcy Code's requirement that secured lenders be given credit-bidding rights. Id. The Debtors argued that their plans comported with the Bankruptcy Code because sale proceeds would be distributed pursuant to the Bankruptcy Code's priority rules and thus, the Lenders would receive the "indubitable equivalent" of their claims. Id.
Applicable Code Provisions
The Bankruptcy Code generally requires that plans either (i) not impair a creditor's claim, or (ii) be acceptable to the creditor if its claim is impaired. A bankruptcy court may confirm a debtor's plan over the objections of a class of impaired creditors even if the plan does not comply with this general rule, however, if the plan is "fair and equitable." Id. at *4-5. A plan is "fair and equitable" to a secured creditor if, among other things, it provides the creditor with (1) the right to credit bid the allowed amount of its secured claim at a sale of its collateral (the "Sale Prong"), or (2) the "indubitable equivalent" of the allowed amount of its secured claim (the "Indubitable Equivalent Prong").3 11 U.S.C. §§ 1129(b)(2)(A)(ii) and (iii). The Bankruptcy Code, however, does not specify what types of plans fall within the Indubitable Equivalent Prong, or what constitutes the "Indubitable Equivalent" of a secured creditor's claim.
The Court of Appeals
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 assets that secure an obligation must proceed under the Sale Prong and permit secured lenders 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 (credit bidding is a "crucial check against undervaluation" of a debtor's assets).
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 the obligation to the 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. Plans could thus qualify for treatment under the Indubitable Equivalent Prong even if they 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 *7-84 ("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.").
Second, the court held that a creditor could not receive the indubitable equivalent of its claim if it were 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 creditors' 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 against 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 [Bankruptcy] 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.
Comments and Practical Considerations
The Seventh Circuit's decision adopts much of Judge Ambrose's well-reasoned dissent in Philadelphia Newspapers. The decision also sets the stage for a potential appeal to the Supreme Court, which, absent congressional intervention, would have the final say on the proper interpretation of Section 1129(b) of the Bankruptcy Code and whether secured lenders must be permitted to credit bid in sales under plans. Secured lenders should be aware of this circuit split in any pre-filing discussions that they have with borrowers considering Chapter 11 protection. A lender should consider the proposed venue of the filing and whether it is willing to extend debtor-in-possession financing or the consensual use of its cash collateral. A lender may consider funding only to permit a prompt sale under Section 363 of the Bankruptcy Code, specifically preserving the right to credit bid in the financing order. In any event, the venue of the case could be critical to the ultimate outcome (e.g., Delaware and Texas courts would permit the debtor to prohibit credit-bidding, but Illinois courts would not).