Recent rulings in the Third Circuit Court of Appeals and the U.S. Bankruptcy Court for District of Delaware will be of interest to purchasers of distressed debt. The Third Circuit, in In re KB Toys Inc.1 (“KB Toys”) issued an opinion concerning whether the impairment of a claim under Section 502(d) of the Bankruptcy Code “travels with the claim” to a purchaser of the claim. In addition, the Delaware Bankruptcy Court, in In re Fisker Automotive Holdings, Inc.2 serves as a useful reminder that a secured lender’s right to credit bid its claim may be limited under certain circumstances.
PURCHASE OF CLAIMS IN BANKRUPTCY
Does a Purchaser of a Claim in a Bankruptcy Case Also Buy its Defects?
Claims purchasers have become a normal part of any middle-market or big company chapter 11 bankruptcy case, and the sophistication of the claims traders has evolved considerably. The KB Toys decision should give such claims purchasers cause to re-evaluate their contracts governing the acquisition of such claims and potentially their due diligence practices. Prior to the KB Toys decision, claims traders were able to take comfort in the Enron Corp. v. Springfield Assocs. LLC (In re Enron Corp.)3 (“Enron II”) decision from the U.S. District Court for the Southern District of New York, which held that equitable subordination and disallowance of a claim under Section 502(d) are disabilities that adhere to the claimant rather than to the claim. Section 502(d) provides that the claim of a claimant who owes a separate liability to the debtor for the avoidance and recovery of a voidable transfer (e.g., voidable preference or fraudulent conveyance) shall be disallowed to the extent of the liability on the voidable transfer. Therefore, under Enron II, if a claims trader purchased a claim from a creditor who was subject to liability for a voidable transfer, the purchaser could argue that 502(d) did not apply to it, and the claim would be allowable on the merits of the claim.
The Third Circuit, however, did not agree with the Enron II analysis, finding instead that the plain meaning of Section 502(d) operates to render a category of claims disallowable (that is, claims that belong to a creditor that had received an avoidable transfer), focusing on claims rather than claimants, stating that “the cloud on the claim continues until the preference payment is returned, regardless of whether the person or entity holding the claim received the preference payment.” Any other reading of the section would frustrate the underlying purpose of Section 502(d): to ensure equality of distribution of estate assets. Furthermore, the court pointed out that if the section was intended merely to impair the claimant, the creditor could cleanse the claim by selling it to a third party, thereby allowing the claimant to receive value for the claim that otherwise would be less valuable absent the sale.
Distressed debt investors who trade in bankruptcy claims should protect themselves with representations and warranties in the purchase documents, as well as indemnity provisions and further assurances clauses that require the seller to provide information, defend claims, assign the defense of claims to the purchaser or otherwise provide a means of mitigating damages caused by unknown avoidance action theories that diminish the value of the purchased claim. Likewise, any pre-purchase due diligence should include questions and research aimed at determining whether any potential avoidance actions exist that might impact the value of the purchased claim.
SECURED LENDERS’ RIGHT TO CREDIT BID
Credit Bidding Overview
Section 363(k) allows a lender to “credit bid” its claim when its collateral is sold in a bankruptcy case, meaning that the lender may bid an amount for the collateral and, rather than paying cash, it may credit the debt owed to the lender by the debtor. That benefits the lender in two ways: (1) it ensures that the collateral is not sold for an amount less than the claim that the collateral secures, and (2) it allows the lender to bid without requiring sufficient liquidity to purchase the collateral. Section 363(k) of the Bankruptcy Code has been interpreted to empower the secured creditor to credit bid the total face value of their “allowed” claims, including both secured and unsecured portions, regardless of the value of the collateral at the time of the sale. See, e.g., Cohen v. KB Mezzanine Fund II (In re Submicron Sys. Corp.)4
Section 363(k) also provides, however, that a court may limit the lender’s right to credit bid “for cause.” See, e.g., In re Philadelphia Newspapers, LLC.5Bankruptcy Courts have found cause to exist to deny the lender the right to credit bid where there is a formal dispute as to the validity or amount of the lender’s claim or lien and where time does not exist to litigate the claim prior to the sale (where the collateral value is declining rapidly). Other courts have limited a lender’s credit bid rights where a quick sale is necessary and the lender’s claim is in dispute by requiring a cash deposit, irrevocable letter of credit, or bond in the amount of the disputed portion of the claim.
The Fisker Decision
Fisker is the manufacturer of plug-in electric hybrid vehicles who, prior to filing bankruptcy obtained a secured loan from the U.S. Department of Energy (“DOE”), secured by substantially all of Fisker’s assets. Later, when the loan balance was $168 million, the DOE then sold the loan to Hybrid Tech Holdings, LLC (“Hybrid”) for $25 million. In Fisker’s bankruptcy, it filed a motion to approve the private sale of substantially all of its assets to Hybrid in exchange for a credit bid of $75 million, alleging in the sale motion that the cost and delay of running an auction would be unlikely to increase the value for the debtors’ estates.
The Official Committee of Unsecured Creditors (the “Committee”) objected to the sale and demanded a competitive auction process, claiming that another business, Wanxiang America Corporation (“WAC”) had already claimed an interest in purchasing Fisker’s assets and that such interest would encourage competitive bidding and help maximize the value of Fisker’s assets for the creditors.
Central to the Fisker decision is a stipulation between the debtors and the Committee of certain facts and conclusions that was reached to limit the area of dispute, including: (1) if Hybrid’s credit bid was capped or denied, there would be a strong likelihood of an auction that would create substantial value for the estates; (2) if Hybrid’s credit bid was not capped or denied, WAC would not place a bid and there would be no realistic possibility of a competitive auction; (3) the highest and best value for the estates would be achieved only through the sale of all of the debtors’ assets as an entirety; and (4) a material portion of the assets being sold were not subject to a properly perfected lien in favor of Hybrid or were subject to a lien in favor of Hybrid that is in bona fide dispute.
Bankruptcy Judge Kevin Gross ultimately ruled that Hybrid’s credit bid was limited to the amount it paid for the DOE loan, $25 million, and ordered an auction of Fisker’s assets. The bases for the ruling included: (1) if he did not limit Hybrid’s credit bid, the auction process would not only be chilled, but it would likely no occur at all, which would undermine the importance of promoting a competitive bidding environment; (2) because Hybrid’s claim is partially secured, partially unsecured, and partially of uncertain status, the Submicron case was factually distinguishable; and (3) he criticized the timing of the proposed sale, noting that Fisker provided only 24 business days for parties-in-interest to challenge the sale motion, which occurred over the Thanksgiving and Christmas holidays (and even fewer days for the Committee, which had only recently been appointed), and pointed out that neither Fisker nor Hybrid could identify why the sale of a non-operating debtor had to occur in such a short period of time. In his ruling, Judge Gross relied upon the Philadelphia Newspapers’ admonition that “a court may deny a lender the right to credit bid in the interest of any policy advanced by the Code, such as to ensure the success of the reorganization or to foster a competitive bidding environment.”
Hybrid filed an emergency motion seeking leave to appeal and a motion for expedited consideration; however, on February 7, Judge Sleet of the U.S. District Court for the District of Delaware denied Hybrid’s appeal.
The auction was held on February 14, and WAC emerged with the winning bid estimated to be worth $149.2 million, consisting of $126 million in cash, $8 million in assumed debt, and an equity stake for creditors estimated to be worth $15 million. On February 18, the Bankruptcy Court approved the sale of Fisker’s assets to WAC, leaving the creditors and Hybrid to fight over who will receive the proceeds of the sale given that part of the Hybrid’s secured claim is disputed.
Distressed debt investors need not view the Fisker case as a fundamental assault on the rights of secured lenders to credit bid in a bankruptcy auction (whether pursuant to a pre-confirmation Section 363 sale or a plan of liquidation). Instead, the Fisker decision represents a useful reminder of the limitations imposed on the right to credit bid that exist in the “for cause” text of Section 363 of the Bankruptcy Code. The Fisker case featured a combination of facts prior to the sale that lend themselves to a judicial intervention into the “emergency” sale that has become commonplace in modern chapter 11 practice (particularly in Delaware and New York), and the substantial increase in the value of the assets that resulted from the court’s intervention will undoubtedly be utilized by creditors’ committees in future cases to justify limitations on credit bid rights in future sale cases. For distressed debt investors, Fisker serves as a playbook on how not to structure the sale to avoid a similar exercise by the Bankruptcy Court of the “cause” language contained in Section 363(k).