The Third Circuit in In re Philadelphia Newspapers, LLC, turns secured lenders expectations upside down--holding that secured lenders do not have a right to credit bid in the plan sale context.
In In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3d Cir. 2010), the Court of Appeals for the Third Circuit held that a secured lender does not have an absolute right to credit bid its claim in a sale by the debtor of the lender's collateral as part of a plan of reorganization. Credit bidding has long been an important tool of a secured lender--allowing it to bid its debt rather than cash in connection with a sale of its collateral. This tool permits a secured creditor to credit up to the full amount of its debt against the price of its collateral before bidding cash, thus enabling a creditor to "purchase" its collateral at a sale when the creditor believes that the collateral is being undervalued by competing bidders or by the debtor. The court's ruling was contrary to the established rule--embedded in Bankruptcy Code section 363(k)--that a secured creditor has an absolute right in a bankruptcy case to credit bid its debt when the sale of its collateral is done outside of the context of a plan, and also contrary to the conventional wisdom that the secured creditor's right to credit bid is preserved under Bankruptcy Code section 1129(b)(2)(A)(ii) if the sale of its collateral is to occur pursuant to a plan of reorganization. This decision highlights fundamentally different interpretations of section 1129(b)(2)(A) of the Bankruptcy Code which governs "cramdown" of a plan on secured creditors, and will undoubtedly impact the decision-making of lenders and debtors on a go-forward basis, especially as to how, and when, bankruptcy court sales will occur.
Philadelphia Newspapers, LLC and certain of its affiliates (the Debtors) owned and operated two of Philadelphia's major newspapers. The newspapers were purchased in July 2006 for $515 million using the proceeds of a $295 million secured loan from a syndicate of lenders (collectively, the Secured Lenders) who held first priority liens on substantially all of the Debtors' real and personal property.
Six months after filing voluntary Chapter 11 petitions, the Debtors filed a joint Chapter 11 plan of reorganization (the Plan) that provided for the sale of substantially all of the Debtors' assets free and clear of existing liens, including those of the Secured Lenders. Concurrently with filing the Plan and in anticipation of the auction of the Debtors' assets, the Debtors entered into an asset purchase agreement with a joint venture comprised of insiders of the Debtors (the Stalking Horse). The Debtors advertised the auction with the slogan "Keep it Local"--referring to the largely Philadelphia-based Stalking Horse group--and, leading up to the auction, attempted to steer the sale toward the insider-controlled Stalking Horse group.
Notably, rather than pursuing a "section 363 sale" ahead of proposing a plan of reorganization, which is a common approach used in many cases, the Debtors instead used the Plan to structure a sale under section 1129(b)(2)(A)(iii) of the Bankruptcy Code. The strategy used by the Debtors in the Plan was an apparent effort to circumvent Bankruptcy Code section 363(k) in order to prevent the Secured Lenders from credit bidding at the auction. To implement their strategy, the Debtors proposed to "cramdown" the Secured Lenders. Pursuant to section 1129(b) of the Bankruptcy Code, a debtor is permitted to confirm a plan of reorganization over the objection of an impaired class of creditors who has voted against the plan (i.e.,do a "cramdown"), provided that the dissenting class is treated fairly and equitably. The Bankruptcy Code provides for three avenues to fair and equitable treatment of impaired creditor classes, as set forth in subsections (i)-(iii) of section 1129(b)(2)(A). Subsection (i) of section 1129(b)(2)(A) contemplates, among other things, that a secured creditor retain its liens and receive deferred cash payments; subsection (ii) expressly applies to "plan sales," calls for a secured creditor's lien to attach to sale proceeds and mandates the secured creditor's right to credit bid; and subsection (iii) is a general catch-all, permitting cramdown if the impaired class receives the "indubitable equivalent" of their claims pursuant to a plan of reorganization. Even though subsection (ii) expressly applies to plan sales and includes the right to credit bid, the Debtors in Philadelphia Newspapers instead attempted to use subsection (iii), which does not on its face either apply to sales or require credit bidding. In other words, the Debtors skipped over section 1129(b)(2)(A)(ii), the provision that mandates credit bidding in a sale of a secured lender's collateral, and jumped directly to the catch-all provision of section 1129(b)(2)(A)(iii).
Pursuant to the Plan, the Secured Lenders would receive on account of their $318 million claim: (1) the cash generated at the auction (at least $37 million--the cash portion of the Stalking Horse bid) and (2) the Debtors' Philadelphia headquarters, valued at $29.5 million, subject to a two-year rent-free lease. In essence, the lien of the Secured Lenders would be stripped from their collateral in exchange for payments or distributions valued at only $66.5 million.
The Debtors' proposed auction bidding procedures specifically prohibited the Secured Lenders from credit bidding their $318 million secured claim at the auction. The Secured Lenders objected to the bid procedures, arguing that, as a matter of law, a debtor cannot strip a secured creditor's lien without permitting it to credit bid, and that the Debtors should not be permitted to sell their asset to insiders "on the cheap" by circumventing the protections intended to be available to secured creditors under the Bankruptcy Code.
In response to objections from the Secured Lenders, the Bankruptcy Court for the Eastern District of Pennsylvania held that, based on the statute, the Secured Lenders had an absolute right to credit bid their claims in any sale of their collateral, whether under Bankruptcy Code section 363 or in a plan sale context. The Bankruptcy Court ruled that subsection (ii) of Bankruptcy Code section 1129(b)(2)(A)--which explicitly provides for the right to credit bid--applies whenever a debtor is attempting a plan sale. On appeal, the District Court reversed the Bankruptcy Court, holding that the plain language of section 1129(b)(2) provides a debtor with an option to use either subsection (i), (ii), or (iii). According to the District Court, a debtor is not required to allow a secured creditor to credit bid in a plan sale; as long as such creditor receives the indubitable equivalent of its claim, a plan can be confirmed over the creditor's objection.
Third Circuit Decision
In a 2-1 decision, the Third Circuit affirmed the District Court and held that a secured creditor does not have a presumptive right to credit bid in the context of a sale pursuant to a plan. In so holding, the court reasoned that, when dealing with a sale of property subject to liens pursuant to a plan, the three subsections set forth in sections 1129(b)(2)(A)(i)-(iii) were alternative paths to satisfying the fair and equitable test, and the Debtors could, therefore, utilize subsection (iii) of section 1129(b)(2)(A)--the indubitable equivalent prong--to strip the Secured Lenders' lien from their collateral without providing the Secured Lenders with the opportunity to credit bid their $318 million secured claim. The majority was careful to explain that its decision was limited to whether the Debtors could propose to sell assets under the Plan using subsection (iii) of section 1129(b)(2)(A), and that it was leaving open for the Bankruptcy Court to decide at Plan confirmation whether, as a result of the auction and the distributions proposed to be made to Secured Lenders under the Plan, the Secured Lenders would in fact receive the indubitable equivalent of their claims.
The guiding rationale behind the majority's ruling was that the plain language and meaning of section 1129(b)(2)(A) was unambiguous and that, consequently, the court did not need to look outside the four corners of the statute for guidance. Specifically, the court held that, since subsections (i), (ii), and (iii) are phrased in the disjunctive (using "or" rather than "and"), a plan can be crammed down over a secured creditor's objection so long as any one of the three subsections is satisfied. The court noted that when a statute is written in the disjunctive, the intent of the drafters is to permit the debtor to select any one, or more, of the options presented. Accordingly, the Debtors could utilize subsection (iii) to satisfy the fair and equitable requirement of section 1129(b)(2)(A) and deny the Secured Lenders the opportunity to credit bid at the auction.
Of particular import is the discussion, in both the majority and dissent, of the interplay between sections 1111(b) and 1129(b)(2)(A) of the Bankruptcy Code. Section 1129(b)(2)(A) is the basic cramdown provision that enables the debtor to confirm a plan of reorganization notwithstanding the "no" vote of the secured creditor, provided the treatment of the creditor's secured claim is "fair and equitable." Subsections (i)-(iii) of section 1129(b)(2)(A) define the minimum treatment that is fair and equitable. Section 1111(b), on the other hand, does two things: first, the section makes non-recourse secured claims recourse in Chapter 11 (which means that, notwithstanding the loan agreement or applicable state law, the undersecured non-recourse secured creditor will have an unsecured deficiency claim in the case); and, second, under certain circumstances, the undersecured secured creditor can elect to have its claim be treated as fully secured (which means the creditor can retain its lien on its collateral for the full amount of its debt even though the collateral is worth less than the debt). Thus, an undersecured creditor that is permitted to and makes the election to be fully secured must be treated differently under section 1129(b)(2)(A)(i) than an undersecured creditor that cannot or does not make the election. Congress added section 1111(b) to the Bankruptcy Code in response to the decision in Great Nat'l Life Ins. Co. v. Pine Gate Assocs., Ltd. (In re Pine Gate Assocs., Ltd.), 2 Bankr. Ct. Dec. 1478 (Bankr. N.D.Ga. 1976), where, pursuant to the plan of reorganization and over the objection of the secured creditor, the debtor was permitted to strip the lien of the secured creditor from real property and, in exchange, only pay the secured creditor the then-appraised and depressed value of the property. As a result of Pine Gate, debtors could strategically file for bankruptcy at a time when property values were depressed, strip the liens of secured creditors and benefit from any future appreciation of the property. The purpose of section 1111(b) was to prevent lien stripping. Section 1111(b) is not, however, limited to real estate loans. Although the fix to Pine Gate proposed by the Senate was only applicable to loans secured by real property interests, the House version, which was enacted as part of the Bankruptcy Reform Act of 1978, had no such limitation.
Pursuant to section 1111(b)(1)(B)(ii), a secured recourse creditor is not permitted to make a section 1111(b)(2) election if its collateral is being sold pursuant to section 363 of the Bankruptcy Code or under a plan. In theory, and as argued by the Secured Lenders, this is because such creditor (even a recourse lender like the Secured Lenders) can make a credit bid to purchase its collateral to avoid its lien being stripped. Likewise, a secured non-recourse creditor can make the 1111(b)(2) election unless the collateral is to be sold under section 363 or the plan. To protect itself, the non-recourse secured creditor can either credit bid its claim (if its collateral is to be sold by the debtor) and acquire its collateral, or make the 1111(b)(2) election (if its collateral is to be retained by the debtor) and preserve its full claim against its collateral.
In Philadelphia Newspapers, the Secured Lenders would not have been permitted to make an 1111(b)(2) election because of the exception set forth in section 1111(b)(1)(B)(ii), namely, the Secured Lenders were recourse secured creditors whose collateral was to be sold. The Debtors argued that because the sale was not under Bankruptcy Code section 363 or section 1129(b)(2)(A)(ii), the language of the statute did not mandate the Secured Lenders be given the right to credit bid. The Secured Lenders argued that, in the absence of the right to make the 1111(b)(2) election, they must be permitted to credit bid at the auction to ensure that the Debtors did not collude with the insider-controlled Stalking Horse bidder to sell the assets for less than market value. The Third Circuit dismissed this argument, holding that the Bankruptcy Code does not provide secured lenderswith an absolute right to preferred treatment in the form of guaranteed upside, but rather, limits a secured creditor's recovery to the value of its collateral. If the auction process failed to properly value the Secured Lenders' collateral, the court reasoned, the Secured Lenders could still object to Plan confirmation on the basis that they would not be receiving the indubitable equivalent of their claims.
Judge Thomas L. Ambro, a former bankruptcy lawyer, wrote a spirited dissent in Philadelphia Newspapers in which he argued that the Bankruptcy Code does provide secured creditors with a presumptive right to credit bid when their collateral is being sold through a plan of reorganization. Judge Ambro echoed Bankruptcy Judge Raslavich's concerns that the Debtors' ulterior motive for denying the Secured Lenders the right to credit bid was to gain leverage to steer the sale to the insider group so that they could buy those assets "on the cheap" and free and clear of the Secured Lenders' liens. According to the dissent, the Debtors' attempts to "Keep it Local" by structuring the auction in a way that advantaged the insider-controlled Stalking Horse and disadvantaged the Secured Lenders was inconsistent with the goal of obtaining the "best and highest offer" at the auction.
The linchpin of Judge Ambro's dissent is that section 1129(b)(2)(A) is ambiguous and, under the principles of statutory interpretation, cannot be read in isolation. Instead, section 1129(b)(2)(A) must be read in the "context of the entire Bankruptcy Code" and the statute's legislative history. According to Judge Ambro, when the statute is read in proper context, it is clear that a debtor seeking to sell assets pursuant to a plan must comply with the specific requirements of subsection (ii) of section 1129(b)(2)(A)--which specifically permits credit bidding in order to cramdown a plan sale and strip the liens of secured creditors.
According to Judge Ambro, the three subsections of section 1129(b)(2)(A) are "distinct routes" to meeting the fair and equitable test that "apply specific requirements depending on how a given plan proposed to treat the claims of secured creditors." Clause (i) applies when the plan provides that the secured lender retains the lien securing its claim, clause (ii) applies when the plan provides for the sale of any encumbered property free and clear of liens, and clause (iii) only applies whenever the plan provides for the secured creditor to realize the indubitable equivalent of its secured claim through the plan, for example, by offering secured lenders replacement liens on other collateral or abandonment of property to secured lenders. Under this reading, debtors can only proceed under clause (iii) in situations where the treatment of secured creditors under the plan is not addressed by clauses (i) or (ii).
Noting the canon of statutory construction that "a specific provision will prevail over a general one," Judge Ambro determined that Congress would not have drafted subsection (ii) of section 1129(b)(2)(A), dealing with plan sales of property free of liens, if a debtor were able to circumvent those procedures by using subsection (iii). Such a result would render subsection (ii) "superfluous, void or insignificant."
Judge Ambro also looked to other sections of the Bankruptcy Code related to sales of encumbered property and other secured creditor protections, such as sections 1123(a)(5)(D), 363(k), and 1111(b), to demonstrate that Congress intended for a secured creditor to have a presumptive right to credit bid when there is a sale of its collateral under a plan or otherwise. Judge Ambro asserted that sections 1129(b)(2)(A)(ii) and 1111(b) are "best understood as alternative protections for the secured creditor: one to apply when its collateral is sold free and clear of liens, and the other to apply when its collateral is treated other than as a sale." Sections 1129(b) and 1111(b), enacted in conjunction with each other, were intended to provide stronger creditor safeguards than what had existed under the prior Bankruptcy Act. If one accepts the proposition that the right to credit bid and the right to make the section 1111(b)(2) election are two sides of the same coin--designed to prevent lien stripping--the secured creditor should be protected in all permutations against a low-ball valuation by the debtor either by enabling the creditor to purchase its collateral through a credit bid or maintain its lien on its collateral for the full amount of its claim. In both cases the secured creditor is able to negate any efforts by the debtor to limit the creditor's claim to the low-ball value and pay nothing (or next to nothing) to the creditor on its resulting deficiency claim.
Events Since the Third Circuit Decision
Following the Third Circuit's ruling, the Secured Lenders requested a stay of the sale and en banc review of the panel's decision, both of which requests were denied. With no chance for certiorari prior to the auction, the Secured Lenders had two choices: (1) bid cash at the auction to drive up the price and/or take control of the company or (2) allow the auction to go forward without bidding, risk that the insider-controlled Stalking Horse group could acquire the assets for less than fair-market value, and object to confirmation of the Plan on the grounds that the Plan did not provide the Secured Lenders with the indubitable equivalent of their claims as required under Bankruptcy Code section 1129(b)(2)(A)(iii). Ultimately, the Secured Lenders chose the former, bidding cash at the auction on April 28, 2010, and winning the assets with a bid valued at approximately $138.9 million ($105 million of which was cash). In essence, the Secured Lenders paid themselves with their own cash. The Bankruptcy Court confirmed the Debtors' Plan on June 28, 2010, which provided for the company to be sold to Philadelphia Media Network Inc., an entity owned by the Secured Lenders. That sale did not close, however, as a result of a dispute between the Secured Lenders and one of the labor unions representing the Debtors' employees. Accordingly, the Bankruptcy Court conducted another auction in September 2010. The Secured Lenders prevailed again at the second auction and subsequently reached labor agreements with each of the Debtors unions. The sale of the Debtors' assets to the Secured Lenders closed in early October 2010.
Implications for Secured Lenders
While the Philadelphia Newspapers decision did not prevent Secured Lenders from taking control over their collateral because they chose to bid cash at the auction, the decision still marks a dramatic shift in existing law regarding the right of secured creditors to credit bid their claims.
While the plain language of section 1129(b)(2)(A) of the Bankruptcy Code provides for multiple avenues for a debtor to prove it is treating its secured creditors "fairly and equitably" in a cramdown, the majority decision failed to adequately address the schism between a literal interpretation of section 1129(b)(2)(A) and legislative intent. The practical result of majority's decision--that secured creditors can credit bid in 363 sales but cannot credit bid when their collateral is sold pursuant to a plan--is hard to reconcile with what seems to be a clear indication that the drafters of the Bankruptcy Code intended section 1111(b), 363(k), and 1129(b)(2)(A) to work together to prevent a debtor from stripping a secured creditor's lien without providing the secured creditor with a right to credit bid. It is simply unlikely that Congress intended this distinction.
The decision may have a serious impact on the relationship between secured creditors and borrowers. As Judge Ambro noted in his dissent, this decision effectively denies secured creditors the "benefit of their bargain" and "uproots settled expectations of secured lending." Going forward, lenders may insist on including provisions in loan documents that guarantee them the ability to credit bid in the plan sale context. In addition, distressed companies contemplating a Chapter 11 filing may also feel pressure by their lenders to file outside of the Third Circuit--where the law on this issue has not yet been settled and could possibly fall in the secured creditor's favor. Future debtors in possession in the Third Circuit and elsewhere may jump at the opportunity to usePhiladelphia Newspapers as precedent and strip the liens of their undersecured creditors while an insider buys the business on the cheap. Especially troubling is the prospect that Philadelphia Newspaperscould be used as a roadmap for mischief by a Chapter 11 debtor seeking to circumvent subsection (ii) and its credit bidding requirement by structuring a hybrid sale that also provides for abandonment (or quasi-abandonment--as the Debtors attempted through a proposed abandonment their headquarters subject to a two-year, rent-free lease by the Debtors) of some portion of the collateral. In addition, whether a debtor can provide a secured creditor with the indubitable equivalent of a secured claim if the secured creditor has not been given the opportunity to credit bid remains unclear. There may be instances where a secured lender chooses not to, or cannot, make a cash bid when faced with a plan sale of its collateral that does not allow credit bidding. Not every creditor group will be able (or willing) to raise cash from its multiple and possibly disparate members. In such circumstances, it is unclear whether a court would find that the auction process adequately valued the collateral absent credit bidding by the secured lenders. As such, the lasting impact of thePhiladelphia Newspapers decision cannot yet be fully known.