Restructuring

Section 363(k) of the Bankruptcy Code grants secured creditors the right to credit bid up to the full amount of their claim as a form of currency to bid to purchase assets securing their claim from a debtor in connection with a stand-alone sale of assets under section 363(b). In a recent opinion from the Bankruptcy Court for the District of Delaware, In re Aerogroup International, Inc., Judge Kevin J. Carey rejected the argument that a secured creditor’s “final” credit bid established the value of the secured portion of the creditor’s claim and affirmed the conclusion that the value of an asset is established by what the market will pay for it. The opinion helps to preserve credit bidding as a tool for achieving higher and better offers and avoids creating a situation where secured creditors may be forced either to overbid for an asset or to abstain from credit bidding altogether.

Factual Background

In March 2018, debtor Aerogroup International initiated an auction under section 363 of the Bankruptcy Code to sell assets encumbered by liens of THL Corporate Finance and Polk 33 Lending, LLC. THL and Polk held first and second liens in a so called “split lien” collateral structure. At the auction, THL submitted a credit bid of approximately $12.2 million and then agreed to refrain from credit bidding any further (the outstanding indebtedness due to THL as of the petition date, was approximately $19.7 million), as two other bidders engaged in competitive bidding, one of whom eventually won with an adjusted bid of approximately $25.4 million. The sale proceeds were placed into escrow pending either an agreement between THL and Polk on their allocation or a further order of the court. Since THL argued that its claim included a lien against the enterprise value of the company, it would recover all proceeds in excess of those distributed to Polk, making it necessary to determine the value of each party’s collateral within the overall pool of assets sold at the auction.

Unable to reach a mutual agreement, Polk and THL later filed opposing motions, with Polk moving to enforce what it asserted was a prior agreement among the Debtors, THL, and Polk by which the sale proceeds would be allocated and THL moving, pursuant to section 506(a) of the Bankruptcy Code, for a valuation of the secured portion of its claim for purposes of allocating and distributing the proceeds of the sale. Polk responded to THL’s valuation motion with a motion for summary judgment.

Aiming to limit THL’s recovery, Polk cited in its summary judgment motion to a line of Third Circuit cases which it argued supported the proposition that THL’s “final” credit bid established the secured amount of THL’s claim at $12.2 million. Specifically, Polk cited In re Submicron Systems, in which the Third Circuit noted, “[i]f Lender bids $12 for [the Debtor’s truck], by definition $12 becomes the value of Lender’s security interest in” the truck,¹ and In re Philadelphia Newspapers, in which the Third Circuit noted that “a credit bid sets the value of a lender’s secured interest in collateral.”²

THL, in response, argued that cited decisions from the Third Circuit did not hold that an unsuccessful credit bid would set the value of a lender’s secured interest; rather, a winning credit bid would, like any other winning bid, represent the market value of the asset.

Section 363(k)

Section 363(b) provides that, upon notice and a hearing, a trustee or debtor-in-possession may use or sell property outside of the ordinary course of business. Expanding on this provision, section 363(k) arms secured creditors with an additional tool for such sales, providing that at a sale under section 363(b) of property that is subject to a lien, “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.” This provision serves to protect both creditors and debtors from having their collateral sold at a depressed price, as both parties benefit from more competitive auctions yielding the highest prices possible for the debtor’s assets.

The Bankruptcy Court’s Analysis

In rejecting Polk’s motion for summary judgment, the Bankruptcy Court first noted that there remains a material dispute of fact as to whether THL’s credit bid of $12.2 million represented a “final” credit bid or merely an “incremental” bid. Regardless, however, the Bankruptcy Court went on to agree with THL that Polk’s position relied on a misinterpretation of the Third Circuit’s holdings. Specifically, the Bankruptcy Court noted that, viewed in context, the passage from Submicron cited by Polk stands for a contrary proposition. In considering whether a lender can submit a credit bid without previously determining how much of its claim is secured by the collateral pursuant to section 506(a)³ , the Bankruptcy Court held that the Third Circuit made clear in Submicron that section 363(k) allows for a secured creditor to credit bid up to the value of its entire claim. Continuing, the Bankruptcy Court noted that the Submicron court stressed that any alternative to this reading would be theoretically nonsensical, since any amount bid for an asset up to the value of the secured creditor’s entire claim “becomes the secured portion of the claim by definition.”⁴ In other words, according to the Bankruptcy Court, the “language plucked … without context” by Polk meant that the value of the creditor’s security interest in the truck from the hypothetical in Submicron would be $12 because that was the highest bid, not because that was the final credit bid.⁵

Based on the foregoing analysis, the Bankruptcy Court held that “the highest bid – no matter who makes it – sets the asset’s value,” and rejected Polk’s motion for summary judgment.

Takeaways

If the court had accepted Polk’s argument that the value of a security interest is no longer based on the market value of that asset, it could potentially have reduced the utility of credit bidding altogether.

While the opinion deals with these issues in the abstract, the utility of credit bidding may be of paramount importance to both debtors and secured creditors. As the court in Aerogroup noted, “[t]he ability to credit-bid helps to protect a creditor against the risk that its collateral will be sold at a depressed price. It enables the creditor to purchase the collateral for what it considers the fair market price (up to the amount of its security interest) without committing additional cash to protect the loan.”⁶ This represents a valuable tool for secured creditors to protect their interests, but creditors may abstain from credit bidding altogether if bidding would risk limiting the distributions available to them from the proceeds of a section 363(b) sale.

In contrast, limiting the involvement of secured creditors in section 363 sales may have the undesirable effect of chilling the auction process altogether, which could reduce a debtor’s ability to maximize value or reorganize successfully. Without secured creditors’ participation in auctions due to the risk described above, auctions may become less competitive, forcing debtors to sell assets at depressed prices to what the market might actually yield. Debtors whose reorganization depend on illiquid assets being sold at auction may see their bankruptcies fail if they cannot extract the maximum realizable value for their assets.

As the court in Aerogroup articulated, “an auction allows the marketplace to determine the value of the collateral, which, in turn, determines the value of the secured portion of the claim.”⁷ The holding reached by the Bankruptcy Court in Aerogroup does not represent a radical development in the doctrine surrounding section 363, but protecting the right of secured creditors to credit bid may prove impactful in facilitating robust auctions, helping both creditors and debtors, as well as the reorganization process as a whole.

Weil summer associate Michael Akselrad contributed to this post.