On December 15, 2009, the Court of Appeals for the Third Circuit heard oral argument in a closely-watched bankruptcy appeal stemming from the In re Philadelphia Newspapers, LLC chapter 11 case pending in the United States Bankruptcy Court for the Eastern District of Pennsylvania. At issue in the appeal is the right of a secured creditor of a chapter 11 debtor to credit bid its secured claims, when the debtor proposes to sell the collateral to a third party, “free and clear” of the creditor’s lien, pursuant to a non-consensual (i.e., “cramdown”) plan of reorganization. Although the bankruptcy court held that a secured creditor may credit bid in this context, the district court disagreed. The issues now before the Third Circuit in Philadelphia Newspapers are of great significance to secured lenders and should be monitored closely. As of this publication, the Third Circuit has not yet rendered its decision in connection with the appeal.
Relevant Provisions of the Bankruptcy Code
Understanding the implications of Philadelphia Newspapers requires a brief overview of the underlying statutory provisions at issue, which concern the right of a secured creditor to acquire its collateral through a credit bid, and the ability of a chapter 11 debtor to obtain confirmation of a plan of reorganization over the objection of a secured creditor. Pursuant to section 363(b) of the Bankruptcy Code, a debtor, after notice and a hearing and upon approval of the bankruptcy court, may sell estate property outside the ordinary course of business “free and clear” of existing liens, claims, and encumbrances. Section 363(k) of the Bankruptcy Code provides secured creditors the right to purchase their collateral by way of credit bidding when the debtor seeks to sell the collateral under section 363(b), unless the bankruptcy court prohibits the secured creditor from doing so “for cause.” Importantly, although section 363(k) specifically references the right to credit bid “at a sale under [section 363(b)],” section 363(k) does not address expressly whether a secured creditor may credit bid in the context of a sale of its collateral under a chapter 11 plan.2
Section 1129 of the Bankruptcy Code sets forth the requirements for obtaining confirmation of a chapter 11 plan. Specifically, section 1129 provides a mechanism for obtaining confirmation of a chapter 11 plan on a consensual basis (11 U.S.C. § 1129(a)), as well as means for achieving confirmation through a non-consensual process (11 U.S.C. § 1129(b)). Section 1129(b) lists the factors that must be satisfied to confirm a chapter 11 plan that has been rejected by an impaired class of creditors.3 One factor is that the plan must be “fair and equitable” with respect to any such class. In the case of a rejecting class of impaired secured creditors, the “fair and equitable” test requires that (i) creditors in the rejecting class retain their liens on their collateral and receive deferred cash payments on account thereof post-bankruptcy (the “Lien Retention Prong”); (ii) in the event of a sale of encumbered property, subject to the creditors’ right to credit bid under section 363(k), the creditors’ liens attach to the proceeds of the sale (the “Sale Prong”); or (iii) the creditors otherwise receive the “indubitable equivalent” of their claims (the “Indubitable Equivalent Prong”).4
Lastly, the Bankruptcy Code establishes certain unique protections for undersecured non-recourse creditors (i.e., creditors holding secured claims, which, pursuant to the terms of the applicable loan and security documentation, limit the creditors’ recourse to the underlying collateral). Specifically, section 1111(b) of the Bankruptcy Code states that a secured claim shall be treated “as if the holder of such claim had recourse against the debtor . . . whether or not such holder has such recourse,” except where (i) the collateral is to be sold under section 363 of the Bankruptcy Code or pursuant to the debtor’s plan or (ii) the secured creditor elects to have its claim treated as “a secured claim to the extent that such claim is allowed.”5
Philadelphia Newspapers, LLC and certain of its affiliates (the “Debtors”) own and operate various print and online publication businesses in the Philadelphia market, including the Philadelphia Inquirer and the Philadelphia Daily News. In February 2009, the Debtors filed voluntary chapter 11 cases in the United States Bankruptcy Court for the Eastern District of Pennsylvania (the “Bankruptcy Court”). As of the Debtors’ bankruptcy filing, the Debtors owed in excess of $300 million to their prepetition secured lenders (the “Lenders”). As security, the Debtors granted the Lenders a first priority security interest in substantially all of the Debtors’ assets (the “Assets”).
In August 2009, the Debtors filed a plan of reorganization (the “Plan”) and accompanying disclosure statement. The Plan contemplates the sale of the Assets to a proposed stalking horse bidder or, following a public auction for the Assets, an alternative bidder determined to have submitted the “highest and best” bid for the Assets. In essence, the Plan envisions a two-step process for the auction and subsequent sale of the Assets: (i) identifying the “highest and best” bid for the Assets through a public auction approved by the Bankruptcy Court (the “Successful Bid” and, the party submitting the Successful Bid, the “Successful Bidder”) and (ii) consummating the sale of the Assets to the Successful Bidder by way of confirmation and implementation of the Plan.
The Plan provides for the distribution to the Lenders of approximately $66 million in full satisfaction of their secured claims, in the form of (i) approximately $36 million in cash, to be generated primarily from the sale of the Assets to the Successful Bidder (valued at $30 million) and (ii) the surrender to the Lenders of the Debtors’ corporate headquarters in Philadelphia. Thus, the lenders are undersecured by approximately $230 million. The Plan also separately classifies the Lenders’ sizable unsecured deficiency claim from other general unsecured claims, resulting in a de minimis cash distribution to the Lenders on account of their unsecured deficiency claim.
Concurrently with the filing of the Plan, the Debtors also filed a motion seeking approval of procedures (the “Bidding Procedures”) to govern the public auction of the Assets. The Bidding Procedures require bids for the Assets to be all-cash. In addition, the Bidding Procedures bar the Lenders from seeking to credit bid for the Assets under section 363(k) of the Bankruptcy Code. In support of this prohibition against a credit bid by the Lenders, the Debtors assert in their motion seeking approval of the Bidding Procedures that “the [sale of the Assets] is being conducted under sections 1123(a) and (b) and 1129 of the Bankruptcy Code, and not section 363 of the Bankruptcy Code. As such, no holder of a lien on any of the [Assets] shall be permitted to credit bid pursuant to section 363(k) of the Bankruptcy Code.”6 Alternatively, the Debtors argue that even if section 363(k) of the Bankruptcy Code entitles the Lenders to credit bid in the context of an auction conducted in connection with a proposed “cramdown” plan premised upon satisfaction of the Sale Prong, the Lenders nonetheless still cannot credit bid because the Debtors seek confirmation of the Plan under the Indubitable Equivalent Prong. Thus, the Debtors argue, because the Debtors intend to seek confirmation of the Plan over the Lenders’ objection by satisfying the Indubitable Equivalent Prong (which by its terms does not reference section 363(k) of the Bankruptcy Code), the Bidding Procedures properly prohibit the Lenders from credit bidding.
The Lenders objected to the Bidding Procedures on various grounds, asserting that the relevant provisions of the Bankruptcy Code, when read in concert, protect a secured creditor’s interest in its collateral by granting the creditor the right to credit bid at a sale, whether pursuant to section 363(b) or a confirmed chapter 11 plan. Specifically, the Lenders emphasize the importance of reading section 1111(b) together with sections 1129 and 363 of the Bankruptcy Code, and argue that a holistic reading of the statute compels the conclusion that a secured creditor is entitled to credit bid its debt, regardless of whether the sale is contemplated to occur under section 363(b) or a confirmed chapter 11 plan. Further, the Lenders argue that “sections 1129(b) and 1111(b) read together reveal that Congress intended not to deprive a secured creditor of the protections afforded by these two sections of the [Bankruptcy] Code . . . either the right to credit bid or an election under 1111(b).”7
The Bankruptcy Court ruled in favor of the Lenders, rejecting the Debtors’ assertion that a secured lender’s right to credit bid for its collateral is limited to stand-alone sales conducted under section 363 of the Bankruptcy Code. In reaching its decision, the Bankruptcy Court looked to the applicable legislative history and noted that the “[s]ale of property under section 363 or under a plan is excluded from treatment under section 1111(b) because of the secured party’s right to credit bid in the full amount of its allowed claim at any sale of collateral under section 363(k).”8 Accordingly, the Bankruptcy Court struck from the Bidding Procedures the prohibition against the Lenders’ right to credit bid, and approved the Bidding Procedures as so modified. The Debtors appealed the Bankruptcy Court’s ruling to the United States District Court for the Eastern District of Pennsylvania (the “District Court”), which reversed for the reasons discussed below.
The Decision on Appeal
The District Court disagreed with the Bankruptcy Court’s reading of the relevant provisions of the Bankruptcy Code, finding the Bankruptcy Court’s conclusion to have been policy-driven and not grounded in the plain language of the statute. Examining the language of the Indubitable Equivalent Prong, the District Court concluded that the express statutory language “provides only that the secured creditor receive the indubitable equivalent of its claim and provides absolutely no reference to the right to credit bid created by section 363(k).”9 Accordingly, the District Court held that the Debtors could conceivably confirm a plan providing for the sale of a secured lender’s collateral under the Indubitable Equivalent Prong without implicating the credit bid rights referenced in section 363(k) and the Sale Prong. Specifically, the District Court observed, “Congress intended to provide three alternative paths to confirmation, one of which (subsection 1129(b)(2)(A)(iii)), does not entitle a secured creditor [to] the right to credit bid at a public auction.” On this basis, the District Court found that the Bankruptcy Court had committed reversible error.
Having found the language of section 1129(b) to be unambiguous and controlling, the District Court held that “resort to other Bankruptcy Code sections, canons of statutory interpretation, non-binding case law and legislative history are unwarranted.”11 The District Court disposed of each of the Lenders’ objections in turn, rejecting the Bankruptcy Court’s assertion that to interpret section 1129(b) properly, one must read it in conjunction with section 1111(b). The District Court emphasized that “neither the text nor the legislative history of section 1129(b)(2)(A) suggests that [it] is to be informed by the provisions of section 1111(b),”12 and recognized that, although it may be preferable policy to read these provisions together, “a court’s policy preferences cannot override the clear meaning of a statute’s text.”13 The District Court therefore did not consider the text of section 1111(b) or its legislative history in reaching its decision.
The District Court further held that the disjunctive nature of the Lien Retention Prong, the Sale Prong, and the Indubitable Equivalent Prong permitted the Debtor to choose the prong under which to seek confirmation of the Plan. The District Court reasoned that the Indubitable Equivalent Prong did not subsume the Sale Prong, but rather provided flexibility, allowing for a sale even when creditors are not permitted to credit bid, so long as they receive the indubitable equivalent of their claims.
Under the District Court’s ruling, a debtor could sell an asset pursuant to a plan and potentially satisfy the Indubitable Equivalent Prong, without permitting a creditor holding a lien on that asset to credit bid.
However, it is important to note that the District Court did not address the issue of whether the proposed Plan would, in fact, provide the Lenders with sufficient value to constitute the “indubitable equivalent” of the Lenders’ liens. The dispute in Philadelphia Newspapers arose in the pre-confirmation context of the Bidding Procedures Motion, and thus the issue of indubitable equivalence was not before the Bankruptcy Court. This is likely to be a critical confirmation issue in this case, and indeed in any case where a borrower/debtor proposes to sell collateralized assets under a chapter 11 plan for less than the face amount of the debt owed, and seek confirmation of that plan under the Indubitable Equivalent Prong.
Additionally, absent section 1111(b) of the Bankruptcy Code, non-recourse undersecured creditors would not be able to assert an unsecured deficiency claim, and thus such creditors’ recoveries in chapter 11 would always be limited to the value of their collateral. Congress enacted section 1111(b) to protect the interests of secured creditors. The Court’s argument that Congress intended section 1111(b) to be read together with sections 1129(b) and 363(k) of the Bankruptcy Code has merit. Indeed, section 1111(b) represents Congress’ reaction to a problem illustrated in the 1976 decision of In re Pine Gate Associates.15
At the time of Pine Gate, (before the enactment of section 1111(b)), debtors could confirm chapter 11 plans over the objection of secured creditors by retaining or transferring collateral to secured creditors under the plan, and by making cash payments to those creditors over time in full satisfaction of their secured claims. However, confirmation required only that the payments equal the present value of the creditors’ underlying collateral – incentivizing chapter 11 debtors to ascribe excessively depressed values to the creditors’ security. A secured creditor stood to receive payments amounting only to a mere fraction of the indebtedness owed, in full and final satisfaction of the creditor’s claim. Further, the debtor that elected to retain the collateral could discharge its obligation to its secured creditor while keeping the property and, importantly, any future appreciation that may accompany it.
Understandably, Pine Gate left secured lenders concerned that bankruptcy courts would, as a general rule, value their collateral security at its lowest amount, while allowing debtors to retain ownership and all opportunity for appreciation in property value. Congress sought to remedy this problem with section 1111(b) of the Bankruptcy Code, pursuant to which (as discussed above) non-recourse undersecured creditors may elect to have their claims treated as fully secured up to the full amount of the allowed claim, not the value of the underlying collateral. Importantly, this election is not available in certain specific situations – namely, in the event of a sale of the creditor’s collateral under section 363(b) of the Bankruptcy Code or pursuant to a chapter 11 plan. Logically, however, secured creditors whose collateral is proposed to be sold under either one of the foregoing do not need the protection of section 1111(b) of the Bankruptcy Code as, under those circumstances, secured creditors are protected by the right to credit bid up to the full amount of their allowed claims at the sale.16
The District Court’s decision does not address the broader statutory scheme that Congress put into place following Pine Gate to protect secured creditors. However, the court also does not consider how section 1111(b) would be observed in a plan that sold the assets at issue for less than the full face amount.
The conflicting decisions in Philadelphia Newspapers go to the heart of a secured creditor’s ability to safeguard its collateral and protect its economic interests in a borrower’s chapter 11 case, and implicates fundamental statutory protections for secured creditors in bankruptcy proceedings. In deciding whether a secured creditor may credit bid its claims in the context of a sale under a plan, the Third Circuit is expected to establish important precedent in this critical area of bankruptcy jurisprudence. Secured lenders should track closely how the Third Circuit resolves this issue.