Credit Bidding: A Sword and a Shield

Section 363 of the Bankruptcy Code includes an important protection for lenders confronting a sale of their collateral in a borrower’s bankruptcy proceeding – the right to “credit bid" the outstanding amount of their loan. This right also affords opportunistic investors a powerful tool for use in acquiring the assets of a distressed target. For the traditional lender, the right to bid its debt in a sale of its collateral is a backstop that preserves value if no better options present themselves for recovery. For the savvy distressed investor, the right to credit bid debt, that it likely acquired at a discount, represents an opportunity to purchase assets using “discounted” dollars. The distressed investor may choose to purchase substantially all of a target’s secured debt, or even a minority blocking position that prevents majority holders from submitting a competing credit bid without the investor’s consent. 

Credit Bidding Generally

Commonly referred to as a “363 sale,” the purchase and sale of a debtor’s assets outside of the ordinary course of its business is governed by Section 363 of the Bankruptcy Code. 363 sales are particularly attractive to purchasers because it allows them to acquire title to assets on a “free and clear basis” -- that is, the assets are not encumbered by the interests of third-parties in such property (with very few exceptions). Section 363(f) of the Bankruptcy Code provides that a debtor’s assets may be sold free and clear of a third party’s interest if, among other things: (a) applicable non-bankruptcy law allows the sale, (b) the third party consents to the sale (e.g., the party is an under-secured creditor but accepts the return), (c) the interest is a lien and the sale price is greater than the value of all liens (e.g., the interest holder is an oversecured creditor), (d) the interest is in bona fide dispute, or (e) the entity could be compelled to accept money in satisfaction of its liens.

When faced with a proposed purchase price that is at a discount to its debt, a traditional lender will often consent to a 363 sale if it has reason to believe that the sale represents the highest and best recovery for its collateral. Of course, when global conditions or market dynamics impact valuations, a lender may be presented with a purchase price that it deems unreasonable, or with no offer at all. In such a case, a lender can rely on Section 363(k) of the Bankruptcy Code. Section 363(k) generally provides that, unless the court orders otherwise, a creditor with an allowed secured claim may bid at a sale of its collateral, and if it submits the highest and best bid, it may offset its secured claim against the purchase price (i.e., credit bid). Secured lenders are thus protected from a sale of their collateral to a third party at unreasonable valuations. When no third-party bid is presented, a secured lender may offer a credit bid as a “stalking-horse” proposal in an effort to attract other offers and if not successful, obtain transferable title to its collateral in the bankruptcy case. If the goal is to attract other offers, the lender may set its credit bid at the price that it minimally acceptable and agree in advance not to increase its bid.

Strategic investors will often purchase a target’s secured debt at a discount to par value for the purpose of gaining economic advantage at a later 363 sale. Because the right to offset a successful bid against secured debt is not limited by the purchase price for such secured debt, a purchaser would benefit from the discount in a later auction (e.g., a buyer may purchase debt for 75% of face value, yet offset 100% of face value against a successful bid). Should the value of the collateral be less than the amount of the secured debt, the acquisition of some or all of the debt may further discourage third parties from participating and bidding up the purchase price. The purchase of debt on the secondary market may also be used by a cash purchaser to gain leverage. For example, in a syndicated facility a third-party stalking-horse may purchase secured debt in order to prevent the other holders of that debt from submitting a competing credit bid. The amount required to exercise the block will depend on the context of the transaction and may be that amount required to block a “required lender” vote by other holders. Of course, sponsors and their portfolio companies have in recent years worked to limit the opportunities of third parties to acquire debt through the development and expansion of so-called “black lists” in credit facilities. These (often comprehensive) schedules of competitors and certain secondary market participants that are excluded transferees may limit future opportunities for strategic credit bidding. When to a debtor’s benefit, it may ease trading restrictions with respect to certain identified transferees (e.g., to allow a stalking-horse seeking to block a competing credit bid to buy debt).

A secured creditor’s right to credit bid may be limited in certain circumstances. As noted above, Section 363(k) includes the phrase “unless the court orders otherwise,” preserving a court's discretion to restrict, or even eliminate, the right to credit bid where circumstances may warrant. The exercise of this discretion is uncommon and often limited to situations where some bad faith was exhibited on the part of the creditor or there were reasonable challenges to the existence or perfection of liens. For example, the court in In re Fisker Automotive Holdings, Inc., 510 B.R. 55 (Bankr. D. Del. 2014) limited a secured creditor’s bid to the amount of its purchase price on the secondary market. However, in In re Aéropostale, Inc., 2016 BL 279439 (Bankr. S.D.N.Y. Aug. 26, 2016), the court failed to find any conduct that would justify denying the lenders’ right to credit bid in full (the court found no “allegations of collusion, undisclosed agreements, or any other actions designed to chill the bidding or unfairly distort the sale process”). These cases are limited and more recently evidence a trend that favors protecting the rights of a secured creditor to offset the full amount of its allowed claim in connection with the acquisition of its collateral, whether or not those secured claims were acquired on the secondary market.

Credit Bid Mechanics and Questions

The mechanics for effecting an acquisition of assets through a credit bid are important and often raise unsettled questions. Rather than purchase assets through an entity that was not organized for that purpose, lenders will regularly organize a new entity to execute the credit bid and, if successful, thereafter hold the assets. Because lenders often submit a credit bid as a backstop, hoping for higher cash bids, they will do so in that capacity (or through an agent) while also reserving their right to assign that bid to a newly created entity should the bid be successful. Where secured lenders are members of a syndicate, and those lenders submit a successful credit bid, each lender will typically contribute a pro rata portion of the debt to the newly organized acquisition vehicle immediately prior to the closing. This contribution will preserve each lender’s pro rata ownership of the acquired collateral. The dynamics of every group and nature of the assets acquired will dictate the type of acquisition vehicle that is used (often an LLC) and the terms and conditions of the governing documents. The various lenders’ voting rights will often be an important issue to address. The lenders may, for example, determine that those “sacred rights” in the credit agreement (i.e., decisions that require a 100% vote), will similarly require unanimity under the organizational documents. Alternatively, certain lenders (or interest holders post-closing) may plan to take a more active role in oversight or management of the acquired assets and therefore negotiate preferential treatment. Among the many governance issues that will need to be addressed include participation on a board, “drag-along” and “tag-along” rights, and the timing of distributions.  

Of course, large syndicated facilities include many types of lenders, operating under different regulatory regimes and having different cost basis. It is therefore not surprising that lenders may not agree on a common, preferred path to maximize recovery when facing a borrower’s bankruptcy. Some lenders may, for example, prefer a cash distribution rather than equity in an acquisition vehicle that may, over time, produce greater value. The right to credit bid would be illusory in a syndicated facility if a single lender could prevent its exercise on behalf of all lenders. For example, with a veto, a competitor (if not an excluded transferee) could acquire a nominal amount of debt in order to prevent the lenders from collectively exercising a credit bid to protect their interests. Instead, courts have relied on “collective action” principles and found that the remedial provisions in syndicated facilities govern credit bid rights (even if not expressly stated). Often, “required lenders” are able to direct the agent to exercise remedies, including submitting a credit bid, on behalf of the syndicate or to accept non-cash proceeds from a related bidder (majority lender) to offset the full amount of the syndicated loan.  

A number of issues, however, remain without guidance from the courts. For example, if the required lenders direct the agent to submit a credit bid pursuant to the remedial provisions, must the agent do so on behalf of all lenders on a pro rata basis? If not, consenting lenders might direct the agent to bid only the secured debt held by them (if such debt was sufficient to prevail at auction). In that case, those non-consenting lenders will arguably continue to hold debt, rather than equity in the acquisition vehicle, and will be left to enforce the typical “sharing provisions” in the credit agreement (i.e., provisions that require a lender that receives more than its pro rata share to distribute such excess to other lenders). If not successfully challenged – likely outside of the bankruptcy court -- those lenders would be left with no power to influence the management of the newly organized acquisition company- and arguably only entitled to their pro rata share of distributions to the consenting lenders. 

Additional Considerations

A lender’s debt is the primary consideration in any credit bid. Complex acquisitions, however, are rarely so simple as to require only the setoff of secured debt. For a variety of reasons, lenders may also include a cash or non-cash component. For example, cash may be needed to satisfy the debt secured by any senior liens that may exist on the collateral. To the extent that any such debt or liens are subject to challenge, an amount sufficient to pay such debt in full may be funded in escrow, subject to return upon a successful challenge.

Proper diligence is necessary to uncover any senior liens, including the existence of statutory liens that may not be recorded due to their nature. For example, in certain states, vendors and suppliers benefit from creditor-friendly mechanics’ and materialmen’s liens that need not be noticed until after a bankruptcy case has been commenced. In those states, although a vendor’s or supplier’s claims may arise from invoices in the months immediately preceding a bankruptcy case, their liens may date back to the dates from which they first provided, and continued to provide, services to the debtor. If those services began prior to the date of the lender’s secured financing, that lender may be subordinated to the prior statutory lien holder.

Lenders in typical leveraged and other credit facilities often do not have a lien of all assets. Collateral packages may exclude categories of assets for which perfection was considered costly or impractical at the time of the loan (e.g., automobiles, intellectual property, or real estate). Collateral packages may also suffer from errors in grants or perfection (e.g., an important subsidiary was organized but failed to execute a joinder). Because a lender’s credit bid is limited to those assets on which it has a valid, perfected lien, cash consideration may be needed if unencumbered assets are critical to preserve the value of the collateral. 

Practical concerns may also require a secured creditor to include cash in its credit bid. Absent extraordinary circumstances, bankruptcy courts are reluctant to approve credit bids that strip the estate of substantially all of its assets, leaving few avenues for recovery for unsecured creditors or otherwise wind-up the case. While cash is one obvious answer to this problem, a secured lender might alternatively offer to release its lien on certain assets (perhaps including cash) to allow for the confirmation of a plan and a distribution to unsecured creditors.

Consideration must also be given to the post-closing costs associated with management, maintenance or storage of the assets pending monetization. As we mentioned above, a credit bid is often a means for a secured lender to protect against unreasonable valuations of its collateral. It may take years before market forces shift and values recovers. Lenders are typically not positioned to manage and operate their assets during this period and will need to retain assistance from third-parties. Depending on the assets or business, this can be expensive and will likely require access to cash promptly after closing of the credit bid. Other assets that may be stored pending an improvement in the business, storage costs must be addressed.

One common solution is for cash to be advanced by the credit bidding lender to the acquisition vehicle. This is particularly important in the case of a syndicated loan where less than all lenders are participating in either the credit bid or the new money financing to preserve the pro rata returns in respect of the offset debt. 

Credit bidding a great tool for the acquisition of distressed companies by distressed investors, private equity funds and credit funds and experienced counsel will guide you through structuring a process in coordination with debtor’s counsel. Credit bidding is also an important protection for lenders that are seeking a safeguard against the disposition of their collateral at below-market values. Please call us with any questions.