When entering into secured transactions, most secured lenders long assumed that, even in a bankruptcy, their borrowers would not be able to sell encumbered assets free and clear of the lenders’ liens without the lenders’ consent or, without at least providing the lenders the opportunity to bid their secured debt at an auction. Last year, the Third Circuit Court of Appeals dealt a major blow to the assumed rights of secured lenders when it ruled in Philadelphia Newspapers, LLC,1 that a debtor may sell encumbered assets in bankruptcy pursuant to a bankruptcy plan without permitting credit bidding so long as secured creditors receive the "indubitable equivalent" of their liens under the plan (i.e., the proceeds of the sale). On June 28, 2011, the Seventh Circuit Court of Appeals held in In re River Road,2 that bankruptcy plans contemplating the sale of encumbered assets must permit secured creditors to credit bid for the assets. The decision directly contradicts the Third Circuit’s position in Philadelphia Newspapers, LLC, re-establishing secured lenders’ rights to credit bid in a bankruptcy plan sale and presenting a circuit split that is ripe for review by the US Supreme Court.

Cramdown and the "Fair and Equitable" Test

When a debtor proposes a plan under chapter 11, secured creditors adversely affected by the plan may vote against the plan and/or object to its confirmation. However, section 1129(b)(1) of the Bankruptcy Code provides that a plan may be "crammed down" and confirmed over a dissenting creditor class if, among other things, "the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims that is impaired under, and has not accepted, the plan." With respect to secured creditors, a plan will likely be deemed "fair and equitable" if it provides:

  • That the holders of such claims retain the liens securing such claims, whether the property subject to such liens is retained by the debtor or transferred to another entity, to the extent of the allowed amount of such claims; and
  • That each holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property;
  • For the sale, subject to section 363(k) of this title, of any property that is subject to the liens securing such claims, free and clear of such liens, with such liens to attach to the proceeds of such sale, and the treatment of such liens on proceeds under clause (i) or (iii) of this subparagraph; or
  • For the realization by such holders of the indubitable equivalent of such claims.3

If the bankruptcy court finds that a plan’s treatment of a class of secured creditors meets one of the three requirements set forth above, then the bankruptcy court may confirm the plan even if the secured creditor class votes against the plan and objects to confirmation of the plan. The Philadelphia Newspapers, LLC and In re River Roads cases center on the proper interpretation of these requirements.

Philadelphia Newspapers Recap

Majority Opinion: The Third Circuit held that a debtor may confirm a plan involving a sale of encumbered assets without offering secured creditors the opportunity to credit bid on the assets on which they have a lien as long as the lenders receive the "indubitable equivalent" of their claims.

In Philadelphia Newspapers, LLC, the debtors sought to sell encumbered assets pursuant to a plan of reorganization without permitting lenders with a security interest in such assets to credit bid for them. The issue presented to the Third Circuit Court of Appeals was whether "any debtor who proposes, as part of a plan of reorganization, a sale of assets free of liens must allow creditors whose loans are secured by those assets to bid their secured debt at the auction." Philadelphia Newspapers, LLC,4 The Third Circuit, in a 2-1 decision, concluded that a plan providing for the auction and sale of assets free and clear of liens could be confirmed under 11 U.S.C. § 1129(b)(2)(A)(iii) without providing secured creditors an opportunity to credit bid at the auction.5

In reaching this conclusion, the majority relied on both a textual analysis and an analysis of congressional intent. In looking to the plain text of the statute, the Third Circuit concluded that the inclusion of "or" between the three subsections of 11 U.S.C. § 1129(b)(2)(A) evidenced congressional intent that the three subsections "were meant to be alternative paths to meeting the fair and equitable test of § 1129(b)(2)(A) . . ."6 Having established this, the Third Circuit moved to the lenders’ argument that "a plan sale of assets free and clear of liens must comply with the more specific requirements of subsection (ii)" because "the specific term prevails over the general term . . ."7 The Third Circuit rejected this argument, finding that the specific language of subsection (ii) was not intended to operate as a limitation on the broader language in subsection (iii). This decision was in accord with the decision of the Fifth Circuit Court of Appeals in In re Pacific Lumber Co.,8 which held that "a plan could be confirmed so long as it met any one of the three subsections’ requirements, regardless of whether the plan structure more closely resembled another subsection."9

The secured lenders argued that other, similar protections afforded to secured creditors in the Bankruptcy Code, such as those in 11 U.S.C. §§ 363 and 1111(b), counseled in favor of requiring credit bidding in this context and demonstrated a congressional intent to require credit bidding for any sale of collateral. The Third Circuit refused to address this argument because it found the plain language of the statute to be clear, and "where the statutory directive is clear we are bound to enforce that directive." Philadelphia Newspapers, LLC, 599 F.3d at 317.

Ambro Dissent: Judge Ambro opined that a debtor may not confirm a plan involving a sale of encumbered assets unless it permits secured creditors to credit bid on assets in which they have an interest.

The Third Circuit dissenter, Judge Ambro, wrote a detailed dissent, rejecting the majority’s conclusion that the plain language of 11 U.S.C. § 1129(b)(2)(A) was unambiguous. He instructed that "we cannot simply look to [the statute’s] text alone in determining what Congress meant in enacting it."10 Judge Ambro reasoned that "[w]hen we apply long-established canons of statutory interpretation of § 1129(b)(2)(A), examine it in the context of the entire Bankruptcy Code, and look at the section’s legislative history and the comments of Code drafters, they all point to the conclusion that the Code requires cramdown plan sales free of liens to fall under the specific requirements of § 1129(b)(2)(A)(ii) and not to the general requirement of subsection (iii)."11

As a result, under Judge Ambro’s view, plans contemplating the sale of encumbered assets free and clear of liens must permit credit bidding. Indeed, Judge Ambro noted that this reading prevents an "anomalous distinction between those sales free of liens conducted prior to plan confirmation under § 363 and those sales free of liens conducted as part of a cramdown plan under § 1129(b)(2)(A)."12

Lower Court River Road Litigation

In 2007 and 2008, River Road Hotel Partners, LLC, and RadLAX Gateway Hotel, LLC, along with their affiliates (collectively, the "Debtors"), independently purchased and developed two properties using loan facilities of approximately $155,000,000 and $142,000,000, respectively. Each facility, secured by the relevant property, was provided by a syndicate of lenders (together the "Secured Lenders"), the agent for whom was Amalgamated Bank.

On June 4, 2010, the Debtors filed their Chapter 11 Plans of Reorganization (the "Plans") in the Bankruptcy Court for the Northern District of Illinois. The Plans both provided for the sale of substantially all of the Debtors’ assets. At the same time they filed the Plans, the Debtors submitted and sought court approval for bidding procedures in connection with the asset sales. The bidding procedures provided for stalking horse bidders and auction processes, but prohibited the Secured Lenders from credit bidding in the auction process.

Amalgamated Bank, on behalf of the Secured Lenders, objected to the proposed bidding procedures, asserting that the bankruptcy court could not confirm the proposed Plans because a sale of encumbered assets free and clear of liens that did not permit secured lenders to credit bid violated 11 U.S.C. § 1129(b)(2)(A)(ii) and was unconfirmable. The Debtors replied that, as set forth in Philadelphia Newspapers, LLC, while the sale of collateral free of liens did not comply with the credit bidding requirement of 11 U.S.C. § 1129(b)(2)(A)(ii), the Plans could nonetheless be approved as "fair and equitable" under 11 U.S.C. § 1129(b)(2)(A)(iii) so long as the Secured Lenders received the indubitable equivalent of their liens (i.e., the proceeds of the sales).

On October 5, 2010, the bankruptcy court denied approval of the Debtors’ requested bidding procedures, holding that the Plans must comply with 11 U.S.C. § 1129(b)(2)(A)(ii) and permit credit bidding (unless the Debtors could show "cause" under 11 U.S.C. § 363(k)). One month later, the bankruptcy court entered an order certifying the cases for direct appeal to the Seventh Circuit pursuant to 28 U.S.C. § 158(d), and the Seventh Circuit consolidated the cases and authorized the appeal.13

Seventh Circuit River Road Proceedings

Oral Argument

Debtors’ argument

During oral argument, counsel for the Debtors relied almost entirely on a textual argument that paralleled the majority opinion of Philadelphia Newspapers, LLC. The Debtors’ counsel argued that section 1129(b)(2)(A) is straightforward on its face, and insisted that the "or" language between subsections (ii) and (iii) conclusively establishes that subsections (i), (ii) and (iii) provide freestanding, independent avenues for proving that a cramdown sale is "fair and equitable." The Seventh Circuit panel (Judges Cudahy, Hamilton and Manion) expressed concern that the Debtors’ reading of the statute would render subsection (ii) superfluous. Indeed, during oral argument, the panel inquired why any debtor would elect to proceed under 1129(b)(2)(A)(ii) if the debtor could merely proceed under the more general subsection (iii) instead.

Secured Lenders’ argument

Counsel for the Secured Lenders argued that both the text and the policy of the Bankruptcy Code support the conclusion that the Seventh Circuit must require credit bidding in sales pursuant to bankruptcy plans because an asset sale plan which releases the liens of secured creditors may only proceed under section 1129(b)(2)(A)(ii). Counsel made the textual argument set forth in Judge Ambro’s Philadelphia Newspapers, LLC dissent, and noted the potential danger in prohibiting credit bidding in cases such as this. Judge Hamilton agreed, observing that debtors and purchasers could collaborate in schemes of "mutual back-scratching" through which insider buyers purchase debtors’ assets for under-market prices. The panel of Judges (and Secured Lenders’ counsel) suggested that this potential for abuse explains why, in the plan asset sale context, even an "indubitable equivalent" requirement may not obviate the need for credit bidding as a protection to secured creditors.

Holding

The Seventh Circuit agreed with the Secured Lenders and found that encumbered assets could not be sold free and clear of liens without permitting secured lenders to credit bid on the assets. In so ruling, the Seventh Circuit largely adopted the reasoning of Judge Ambro in his Philadelphia Newspapers, LLC dissenting opinion.

The Seventh Circuit found that, because the Plans involved a sale of encumbered assets free and clear of liens, the Plans were only confirmable if they complied with section 1129(b)(2)(A)(ii) and permitted the Secured Lenders to credit bid. The Seventh Circuit began by interpreting the plain language of the statute, examining "whether the language of Section 1129(b) unambiguously authorizes the confirmation of reorganization plans such as those proposed by the Debtors under Subsection (iii)."14 The Seventh Circuit rejected the Debtors’ argument that section 1129(b) was unambiguous, explaining that "we find the statutory analysis articulated by Judge Ambro in his Philadelphia Newspapers dissent to be compelling."15 Consistent with Judge Ambro’s dissenting opinion, the Seventh Circuit found that the "or" language in subsection (ii) is not dispositive as to the statute’s plain meaning, and thus, that there is no clear statutory directive as to whether subsection (iii) can apply in all situations or only in situations different from those addressed in subsections (i) and (ii).16

The Seventh Circuit also emphasized that, even if it were to examine subsection (iii) alone, it is not clear from the text of the statute that a plan involving a sale of collateral would be "fair and equitable" to secured creditors without credit bidding.17 The Seventh Circuit noted that "there is an increased risk that the winning bids in these auctions [auctions in which credit bidding is prohibited] would not provide the Lenders with the current market value of the encumbered assets."18 Thus, it deemed credit bidding "a crucial check against undervaluation," and expressed concern that its absence from the auction process would undercut the "fair and equitable" treatment of creditors’ claims that would be required even under subsection (iii).19

Because the Seventh Circuit’s plain meaning analysis was not dispositive, it looked beyond the plain meaning of the statute and "appl[ied] well-established principles of statutory interpretation to determine which of these understandings [of the statute] is superior."20 The Seventh Circuit found it persuasive that "[u]nder [the Debtors’] interpretation, plans could qualify for treatment under Subsection (iii) even if they seek to dispose of encumbered assets in the ways discussed in Subsections (i) and (ii), but fail to meet these Subsections’ requirements. This understanding of Section 1129(b)(2)(A)(iii) is unacceptable because it would render the other subsections of the statute superfluous."21 The Seventh Circuit further emphasized that "[w]e cannot conceive of a reason why Congress would state that a plan must meet certain requirements if it provides for the sale of assets in particular ways and then immediately abandon these requirements in a subsequent subsection."22 Rather, "the infinitely more plausible interpretation of Section 1129(b)(2)(A) would read each subsection as stating the requirements for a particular type of sale and ‘construing each of the [] subparagraphs . . . [as conclusively governing] the category of proceedings it addresses.’"23

In addition to the textual analysis, the Seventh Circuit found that the Debtors’ interpretation of the statute "treats secured creditors’ interests in a way that sharply conflicts with the way that these interests are treated in other sections of the Code."24 In drawing this conclusion, the Seventh Circuit again relied on the analysis from Ambro’s dissent. Judge Ambro looked to other parts of the Bankruptcy Code in analyzing section 1129(b)(2)(A) because all portions of the Bankruptcy Code "are part of a comprehensive arrangement enacted by Congress to avoid the pitfalls of undervaluation, regardless of the mechanism chosen, and thereby ensure that the rights of secured creditors are protected while maximizing the value of the collateral to the estate and minimizing the deficiency claims against other unencumbered assets."25 The Seventh Circuit noted that sections 363(k) and 1129(b)(2)(A) "provide a secured creditor with the right to credit bid whenever the debtor attempts to sell the asset that secures its debt free and clear of its lien."26 The Seventh Circuit also noted that "[s]ection 1111(b) provides secured creditors with a means to protect their claims when a debtor seeks to retain possession of an encumbered asset."27 Thus, other provisions of the Bankruptcy Code provide protections similar to those sought by the Secured Lenders. However, "the Code does not appear to contain any provisions that recognize an auction sale where credit bidding is unavailable as a legitimate way to dispose of encumbered assets."28 As a result, because the Seventh Circuit found the Secured Lenders’ interpretation of the statute to be consistent with the protections afforded to secured lenders elsewhere in the Bankruptcy Code, and because the Debtors’ interpretation would strip those protections and be unique in the Bankruptcy Code, the Seventh Circuit found in favor of the Secured Lenders.

Implications

The decision of the Seventh Circuit may give secured lenders some comfort that, at least in the Seventh Circuit, assets securing their liens will not be sold in bankruptcy without an opportunity for the lenders to credit bid. However, the Seventh Circuit’s decision also sharply diverged from precedent created by the Third and Fifth Circuits in Philadelphia Newspapers, LLC and In re Pacific Lumber Co. Indeed, the Seventh Circuit unapologetically disagreed with the statutory interpretation applied by those Circuits, and the panel acknowledged in oral argument that such a circuit split could bring the issue to the attention of the Supreme Court. In oral argument, Judge Hamilton noted to counsel for the Secured Lenders that "[i]n essence, you are asking us to send this to the Supreme Court. To agree with you [counsel for the Secured Lenders], we have got to create a circuit split."

Further, in its opinion, the Seventh Circuit noted that "[t]his opinion has been circulated among all the judges of this court in regular active service pursuant to Circuit Rule 40(e). No judge asked to hear this case en banc."29 Thus, there will not likely be further review from the Seventh Circuit on this matter. Instead, the issue is ripe for Supreme Court review.