For many secured lenders, the concept of credit bidding in bankruptcy is generally understood yet infrequently explored in practice. In today’s extremely uncertain economic environment, third-party alternatives may not present themselves as M&A activity and acquisition financing have slowed significantly with the spread of COVID-19. As a result, credit bidding could gain momentum as lenders look for self-help alternatives to maximize their recoveries. In three related posts, we will address (i) the statutory predicates for a credit bid, (ii) certain mechanics involved in structuring and consummating a credit bid, and (iii) the need to raise cash to close a credit bid, as well as items to consider when drafting loan documentation that may facilitate a credit bid in the event of a borrower’s bankruptcy.
A credit bid allows a secured creditor to bid its debt in a sale of its collateral. Traditionally, this right has often been considered a failsafe – a last option to preserve value should more attractive third-party alternatives fail to arise in the context of the borrower’s bankruptcy. In today’s new paradigm, lenders to troubled borrowers will need to consider their self-help options and give careful consideration to submitting credit bids for their collateral, whether as a “stalking-horse” to initiate a sales process or to consummate a quick acquisition of their collateral. Section 363 of the Bankruptcy Code governs the rights of a debtor to sell its property out of the ordinary course of its business, often referred to a “363 sale.” One of the hallmarks of a 363 sale, and why they are attractive to purchasers, is that the purchaser can often take title to assets free and clear of most third-party interests in such property. This is of particular import when acquiring assets from a distressed seller. Section 363(f) of the Bankruptcy Code provides that property may be sold free and clear of an entity’s interest if, generally, (a) applicable non-bankruptcy law permits the sale, (b) the entity consents, (c) the interest is a lien and the sale price is greater than the value of all liens, (d) the interest is in bona fide dispute, or (e) the entity could be compelled to accept money in satisfaction of its liens. When considered in the context of the typical blanket lien of a leveraged lender to a distressed borrower, a lender’s consent is often required.
Certainly, many lenders will consent to a sale of their collateral at a price less than their claim amount when they believe that the price represents the highest and best recovery. When market forces and/or cyclical climates lead to a perceived temporary weakness in prices, a lender may look to Section 363(k) of the Bankruptcy Code to enforce its rights to credit bid. Today’s severely depressed environment may be such a time when lenders resist accepting significantly discounted value from a third-party (if such an option is even available). Section 363(k) provides generally that, unless the court orders otherwise, a creditor with an allowed secured claim may bid at a 363 sale of such creditors’ collateral, and if successful, offset such claim against the purchase price (i.e., credit bid its debt). This single sentence in the Bankruptcy Code provides a critical protection to secured lenders, allowing them to acquire ownership of their assets at a 363 sale if third-party bids are unavailable or unacceptable. Moreover, a secured creditor’s right to credit bid, even if not exercised, may serve to keep other bidders honest when the purchase price is expected to be less than the amount of the secured claim. Lenders must also be careful that their right to credit bid not be an impediment to an active auction where collateral value is less than the debt (e.g., secured lenders may agree to cap their credit bid so that interested third parties have comfort that their efforts will not be wasted if they are willing to meet a certain threshold). A credit bid may also be used as a stalking-horse bid to kick-start a competitive auction with cash purchasers. In such instances, the lender may not be afforded some of the more common bidding protections often available to third party stalking-horse bidders (e.g., a break-up fee).
The right to credit bid, however, is not absolute. Section 363(k) preserves a court’s discretion to limit or eliminate a secured creditor’s right to credit bid. While uncommon, courts have intervened to restrict the rights of secured creditors that purchased their claims at a discount for the strategic purpose of getting an economic advantage in a later auction. These cases are limited and 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.
In Part II, we will address certain of the mechanics associated with the offer, and consummation, of a credit bid.