After the debtors obtained court approval of bidding procedures to auction substantially all of their assets, a secured creditor sought a court determination that it had valid perfected liens on the assets, and the debtors sought to limit the secured creditor’s right to credit bid in the bankruptcy sales.
The debtors borrowed ~$50.8 million secured by certain assets to expand their commercial printing business. The debtors also owned three parcels of property improved with guy wired masts that were used in the debtors’ radio broadcasting operation (the Tower Assets). The debtors did not grant any liens on the Tower Assets to secure the loan.
The debtors went into default under certain loan covenants and entered into a forbearance agreement. They were not able to get back into compliance or refinance with another lender. Eventually the lender sold its loan to a third party.
The new lender told the debtors that it wanted them to file bankruptcy and sell substantially all of their assets to the new lender in a Section 363 sale. The debtors agreed to cooperate on the condition that the sale of assets was in the best interests of the bankruptcy estates and within the fiduciary duties of the officers and directors.
Shortly afterwards an entity (DSP) formed by the new lender to acquire the assets asked the debtors to execute deeds of trust covering the tower parcels. DSP’s counsel pushed a timetable that included recording the deeds of trust and then commencing bankruptcy within a month. However, communication stopped abruptly. During the hiatus DSP unilaterally filed UCC fixture filings against the Tower Assets. The debtors were not aware of the filings.
When negotiations resumed, DSP no longer required the deeds of trust, but instead required a blanket release of all claims against DSP. This change of heart came because DSP expected to pick up the Tower Assets as collateral in connection with the post-petition financing.
Ninety days after the UCC fixture filings were recorded, DSP renewed its push for a bankruptcy filing. DSP saw no reason to market the assets and insisted there should be a sale, with its credit bid, with its closing no more than six weeks after the bankruptcy was filed. DSP objected to engagement of a financial consultant, and insisted that any marketing materials con debtor-in-possession (DIP) tain a bold statement on the front page that DSP had a right to credit bid $39 million.
Based on advice from their financial advisers, the debtors concluded that they did not require a post-petition DIP facility. Negotiation ceased when the debtors refused the proposed loan. DSP informed the debtors it no longer supported a bankruptcy filing. It also recorded additional financing statements in various locations without giving notice to the debtors.
After bankruptcy was filed, DSP objected to the debtors’ use of cash collateral and asked for liens on the Tower Assets as adequate protection. It did not disclose that it had already recorded financing statements against the Tower Assets. The court denied this request on the basis that its interest was already adequately protected.
Generally a secured creditor has a right to credit bid under Section 363(k) of the Bankruptcy Code (emphasis added):
At a sale [outside the ordinary course of business] 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 objective is to protect the secured creditor against undervaluation of its collateral. When it believes the bidding is too low, it can submit a bid as high as the amount of its claim.
However, it is often overlooked that the right to credit bid is not absolute. Quoting a 3rd Circuit case (Philadelphia Newspapers): “a court may deny a lender the right to credit bid in the interest of any policy advanced by the Code, such as to insure the success of the reorganization or to foster a competitive bidding environment.”
In this case the debtors argued that DSP’s right to credit bid should be limited because (1) it did not have a lien on all assets, so it could not credit its claim against the assets in which it has no security interest, (2) it engaged in inequitable conduct that depressed the potential sale, and (3) limiting its credit bid will “restore enthusiasm for the sale and foster a robust bidding process.”
The court determined that DSP did not have valid liens on the Tower Assets, motor vehicles, FCC licenses, insurance policies or bank account deposits, and found that it could not credit bid for assets that were not its collateral.
Turning to the inequitable conduct argument, it was clear that this was a “classic loan-to-own scenario.” DSP purchased the loan in order to acquire the debtors’ assets. It continually pushed for a quick bankruptcy sale in which it would be the successful bidder using a credit bid.
The court found that papers filed in support of DSP’s complaint were “both false and misleading.” The court concluded that DSP knew it did not have a valid lien when it filed the financing statements – which “troubled” the court. The court was also “disappointed” that DSP “neglected” to disclose the fixture filings when it was before the court asking for liens. The court was “equally troubled” by their efforts to frustrate the competitive bidding, for example by shortening the marketing period and conspicuously noting its credit bid rights. In sum, the court found that DSP engaged in inequitable conduct.
Given that DSP did not have liens on all of the debtors’ assets in combination with its inequitable conduct, the court decided to limit its right to credit bid to $1.2 million for assets relating to the radio business and $12.7 million for assets relating to the newspaper and printing business – in each case only for assets subject to its lien. This is a far cry from $39 million.
The court had this to say about DSP’s loan-to-own strategy:
The credit bid mechanism that normally works to protect secured lenders against the undervaluation of collateral sold at a bankruptcy sale does not always function properly when a party has bought the secured debt in a loan-to-own strategy in order to acquire the target company. In such a situation, the secured party may attempt to depress rather than to enhance market value. Credit bidding can be employed to chill bidding prior to or during an auction, or to keep prospective bidders from participating in the sales process. DSP’s motivation to own the Debtors’ business rather than to have the Loan repaid has interfered with the sales process. DSP has tried to depress the sales price of the Debtors’ assets, not to maximize the value of those assets. A depressed value would benefit only DSP, and it would do so at the expense of the estate’s other creditors. The deployment of DSP’s loan-to-own strategy has depressed enthusiasm for the bankruptcy sale on the marketplace.
As articulated by the court, a lender that acquires or holds debt with the goal of using the debt to purchase the collateral has markedly different incentives than a lender that holds debt with the goal of getting repaid. This case is a reminder that a bankruptcy court has many tools to fine tune the process to avoid what it perceives as an inequitable consequence, and is something to keep in mind when considering a loan-to-own strategy.