The U.S. Court of Appeals for the Seventh Circuit recently affirmed a bankruptcy court’s decision refusing to confirm debtors’ reorganization plan that included auction procedures that forbade secured creditors from “credit bidding” for the assets. In re River Road Hotel Partners, LLC, No. 10-3597, 2011 WL 2547615 (7th Cir. June 28, 2011). In that case, the debtors (owners of various hotel properties) proposed a plan of reorganization that included auctioning certain properties encumbered by security interests. The lenders holding security interests in the properties to be auctioned objected to the plan of reorganization because the proposed plan did not allow them to credit bid, that is, to offset the price offered in the auction against the amount the debtor owes the creditor.

A Chapter 11 plan of reorganization may include among its provision the “sale of all or any part of the property of the estate, either subject to or free of any lien[.]” 11 U.S.C. § 1123(a)(5)(D).  Section 1123, however, does not specify the procedures for the sale of assets that secure debts of the estate. Courts, therefore, look to § 1129(b), which provides the procedures for such a sale. Under that section, a court may confirm a reorganization plan, even over the objections of secured lenders, so long as the plan is “fair and equitable.”

Section 1129(b)(2)(A) sets forth three alternative circumstances that make a plan “fair and equitable.” First, if the assets are sold subject to existing liens; second, if secured creditors are permitted to credit bid at auction; and third, if secured creditors are given the “indubitable equivalent” of their secured claims.

(A) With respect to a class of secured claims, the plan provides--

(i)(I) 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 (II) 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;

(ii) 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

(iii) for the realization by such holders of the indubitable equivalent of such claims.

11 U.S.C. § 1129(b)(2)(A).

Section 1129(b)(2)(A)(ii), by incorporating § 363(k), gives secured creditors the right to credit bid in a plan confirmed under that subsection.  Section 363(k) provides:

At a sale under subsection (b) of this section of property that is subject to a lien that secures an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.

The Seventh Circuit held that whenever assets are to be sold free and clear of liens, secured creditors must be given the opportunity to credit bid. The court reasoned that if secured creditors could not credit bid at auction, they lacked an important protection against the undervaluation of their claims. “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, according to the Seventh Circuit, subsection iii’s option of providing the indubitable equivalent of a secured creditor’s claim cannot provide an alternative to subsection ii when a plan of reorganization involves an auction where property subject to a security interest will be sold free and clear of liens.

In reaching its holding, the Seventh Circuit created a division of authority among the circuit courts. Both the Third Circuit and the Fifth Circuit have held confirmed plans of reorganization that prohibited credit bidding. In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3d Cir. 2010); In re Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009).