April 23, 2014
The recent decision of Judge Kevin R. Huennekens of the United States Bankruptcy Court for the Eastern District of Virginia, Richmond, in In re Free Lance-Star Publishing Co. highlights the risks of implementing a "loan-to-own" strategy and the need for access to top commercial law and bankruptcy counsel in considering and implementing any such strategy. On April 14, 2014, Judge Huennekens impaired the rights of DSP Acquisition, LLC ("DSP") to credit bid its $38 million secured claim at the auction of the radio and printing businesses of the Free Lance-Star Publishing Company of Fredericksburg, Virginia, and William Douglas Properties, LLC (together "Free Lance-Star"). Judge Huennekens capped the credit bid at $13.9 million ($1.2 million with respect to assets related to Free Lance-Star’s radio business and $12.7 million for assets related to Free Lance-Star’s newspaper and printing business).
Free Lance-Star otherwise received approval of bid procedures governing its anticipated auction sale of substantially all of its assets. This decision, following the January 2014 decision In re Fisker Auto. Holdings, Inc., continues the trend of courts’ use of the "for cause" exception to 363(k) to limit secured lenders’ rights to credit bid. Both courts focused in part on defects in the collateral package, as well as procedural weaknesses in the proposed bankruptcy sale process. Each opinion suggests that the acquisition of secured debt to gain an advantage in a bankruptcy court supervised sale process can be pursued successfully only with careful planning and diligence, both when debt is acquired and when the conversion to ownership or equity is implemented.
Background: In re Fisker Reopens Credit Bid Debate
In 2012, many observers thought the Supreme Court resolved the credit bidding issue in favor of secured creditors, but important issues remain. In RadLax Gateway Hotel, LLC v. Amalgamated Bank, the Supreme Court affirmed the denial of a Chapter 11 cramdown plan that did not provide a secured creditor the right to credit bid its claim. In discussing section 363(k), the Court in a footnote stated "[t]he ability to credit-bid helps to protect a creditor against the risk that its collateral will be sold at a depressed price." Although RadLax appeared to limit bankruptcy courts’ ability to curtail the credit bid right, it did not directly address dicta contained in the Third Circuit decision, In re Philadelphia Newspapers, LLC, in which the court recognized the ability to limit the right to credit bid "for cause". Unexpectedly, In re Fisker reopened the debate, raising concern that secured creditors, particularly investors in distressed debt instruments, would face challenges to their credit bidding rights.
Hybrid Tech Holdings, LLC ("Hybrid"), the secured creditor in In re Fisker, purchased its claim in the face amount of $168.5 million from the Department of Energy on October 11, 2013 for $25 million. Hybrid subsequently engaged Fisker in negotiations to purchase substantially all of its assets. Fisker then filed for Chapter 11 on November 22, 2013, and immediately filed a motion seeking approval of the sale to Hybrid on an expedited basis. The Official Committee of Unsecured Creditors (the "Committee") opposed the sale, arguing Fisker should conduct a competitive auction and disputing Hybrid’s ability to credit bid.
Fisker and the Committee stipulated that: (a) if Hybrid’s ability to credit bid was limited there was "a strong likelihood that there would be an auction that [had] a material chance of creating material value for the estate over and above the present Hybrid bid;" (b) if Hybrid’s ability to credit bid was not limited, there was "no realistic possibility of an auction"; (c) limiting Hybrid’s ability to credit bid "would likely foster and facilitate a competitive bidding environment;" (d) that the highest and best value for the estate would be achieved only in the sale of all of the Fisker assets as an entirety; and (e) with respect to the assets offered for sale, Hybrid held a properly perfected first priority security interest in a portion of the assets, it had no security interest in some of the assets, and its alleged security interest in the remaining assets was subject to a bona fide dispute.
The bankruptcy court limited Hybrid’s right to credit bid, for cause, to $25 million. In doing so, the court found, based on the stipulations between Fisker and the Committee, that a potential second buyer had indicated that, if Hybrid’s credit bid were to be more than $25 million, the second buyer would not enter the auction. The court also found that Fisker and Hybrid had insisted upon a "hurried process" without explanation, raising fairness concerns. Regarding the disputed collateral, the court found that, where the validity of a lien has not been determined, the holder may not bid its secured debt. Based on these findings, the court concluded that failing to cap Hybrid’s credit bid would freeze bidding, and identified this as the "for cause" basis for limiting Hybrid’s credit bid.
On February 7, 2014, the United States District Court of the District of Delaware denied Hybrid’s motion for leave to appeal, noting that Philadelphia Newspapers recognized that a court may limit the right to credit bid in order to foster a competitive bidding environment. The district court did not discuss Radlax. Following the ruling, commentators dismissed In re Fisker as a limited ruling based on bad facts; however, the recent ruling in In re Free Lance-Star may provide evidence of a trend.
In re Free Lance-Star Publishing Co. Limits Secured Lender’s Credit Bid
In June 2013, DSP, a company operated by Sandton Capital Partners, purchased from Branch Banking and Trust its $50.8 million secured loan to Free Lance-Star, a newspaper, radio, and communications company located in Fredericksburg, Virginia. Shortly thereafter, DSP informed Free Lance-Star that it wanted the company to file for Chapter 11 relief and sell substantially all of its assets to DSP pursuant to section 363. Free Lance-Star agreed to work with DSP on implementing a plan for a Chapter 11 filing, but DSP ultimately decided it did not support a filing under the terms proposed.
On January 23, 2014, Free Lance-Star filed for relief under Chapter 11 and immediately sought approval of bidding procedures for an auction of substantially all of its assets. On March 10, 2014, the court approved the bidding procedures, including the right of DSP to credit bid its claim against the assets on which it had valid liens. The same day, DSP filed a complaint seeking a declaration that DSP had valid and perfected liens on substantially all of Free Lance-Star’s assets and that it had the right to credit bid its claim at the sale. DSP also filed a motion seeking summary judgment on all counts set forth in its complaint. Free Lance-Star filed a cross motion for summary judgment against DSP, arguing that cause existed to limit DSP’s credit bid amount.
Ruling from the bench, the court found (similar to the findings in In re Fisker) that (a) DSP did not have valid, properly perfected liens on certain contested property; (b) DSP could not credit bid a claim against assets on which it lacked a valid lien; and (c) DSP had engaged in inequitable conduct that required the court to limit its credit bid right to foster a competitive bidding process. The court found DSP had engaged in inequitable conduct by influencing the asset sale process through (a) exerting pressure on Free Lance-Star for a speedy bankruptcy filing; (b) insisting Free Lance-Star shorten the marketing period for the sale; and (c) insisting Free Lance-Star conspicuously advertise DSP’s credit bid right in the sale marketing materials. Based on these findings, the court held that "[t]he confluence of (i) DSP’s less than fully-secured lien status; (ii) DSP’s overly zealous loan-to-own strategy; and (iii) the negative impact DSP’s misconduct has had on the auction process has created the perfect storm, requiring curtailment of DSP’s credit bid rights."
In its analysis, however, the court made two comments that suggest an expansion of the approach taken by the Fisker Court. The court started by reaffirming the importance of the credit bid process, stating, "[a] secured creditor should be entitled to credit bid the full amount of its claim" and that the right to credit bid "is an important safeguard that insures against the undervaluation of the secured claim at an asset sale." However, the court, relying, inter alia, on In re Fisker and Philadelphia Newspaper, continued on to note that credit bidding "is not an absolute right."
Concluding that DSP did not have liens on the contested property, the court found DSP did not have a right to credit bid on assets that did not secure its allowed claim. The court also noted that, even though DSP knew that it did not have the contested liens, it nonetheless recorded financing statements in various jurisdictions without giving any notice to Free Lance-Star. The court expressed disappointment that DSP failed to disclose the recording at an earlier hearing. Importantly, the court did not rely on findings (as were entered in In re Fisker) that the collateral had to be sold as a complete package to maximize value.
In addition, the court went on in dicta to suggest that the fact that a debt holder engaged in a "loan-to-own" strategy in and of itself may be sufficient "cause" to limit credit biding. The court noted the situation was a "classic loan-to-own scenario" and that DSP had pressed for expedited bankruptcy process since it bought loan. The court opined that, "[t]he credit bid mechanism that normally works to protect secured lenders against the undervaluation of collateral sold at a bankruptcy sale does not always function properly when a party has bought the secured debt in a loan-to-own strategy in order to acquire the target company. In such a situation, the secured party may attempt to depress rather than to enhance market value."
The court found that DSP’s actions had "depressed enthusiasm for the bankruptcy sale." Citing the testimony of a Free Lance-Star witness that limiting DSP’s credit bid would "help restore a competitive bidding environment and engender enthusiasm for the sale," the court held that sufficient cause existed to limit the credit bid amount. The court did not explain the method then used to calculate the credit bid cap other than to state that Free Lance-Star’s witness "eliminated the unencumbered assets and applied a market analysis to develop an appropriate cap." Due to concerns regarding the sensitive nature of the testimony of the Free Lance-Star witness, the testimony was placed under seal. The court did note that DSP did not refute the testimony of the Free Lance-Star witness and declined the court’s invitation to provide evidence of the amount it paid for the loan, which evidence, the court implied, might have provided a method for setting an appropriate limit to DSP’s right to credit bid.
On April 15, 2014, DSP filed a motion for leave to appeal.
In re Free Lance-Star Publishing Co. Raises Concerns for "Loan-to-Own" Transactions
Both In re Fisker and In re Free Lance-Star should cause concern for any purchaser of distressed debt, particularly if the ultimate acquisition of the underlying collateral is an important part of the strategy. In both cases, the expectations of the bidders were frustrated due to defects in the collateral package, defects in the bid process, and concerns about the ability to conduct a value-enhancing auction in light of the bidders’ right to credit bid.
One issue from In re Free Lance Star that may be particularly transportable to other cases is Judge Huennekens’s explanation of how credit bid incentives may change in the "loan-to-own" context such that the credit bid mechanism that normally protects secured lenders may depress the collateral’s market value to the detriment of other creditors. The Radlax footnote explains that an important function of the credit bid process is to prevent the collateral from being sold at a "depressed price." Judge Huennekens’s reasoning regarding the "loan-to-own" scenario could be a basis for arguing that, in certain instances limiting credit bidding can actually further the policy expressed in Radlax as it prevents the secured lender from depressing the value of the collateral to protect the impact of its credit bid. This reasoning, if adopted by other courts, would dramatically expand the "for cause" exception discussed in In re Philadelphia Newspapers and pose a substantial challenge to any loan-to-own transactions, as well as disrupting the market for distressed debt. However, creditors in both In re Fisker and In re Free Lance-Star may have overlooked arguments that support a loan-to-own buyer’s credit bid right where it causes no loss in value to any other party in interest. Given the fact-specific nature of both cases, lenders facing credit bid challenges should be aware of the need to access to top commercial law and bankruptcy counsel to address their specific circumstances.
 11 U.S.C. § 363(k) ("At a sale under subsection (b) of this section of property that is subject to a lien that secures an allowed claim, 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.").
 Id. at 316, n.14 (stating "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 Tech Holdings, LLC v. Official Comm. Of Unsecured Creditors of Fisker Auto. Holdings, Inc. (In re Fisker Auto. Holdings, Inc.), 2014 U.S. Dist. LEXIS 15497, 16, Case No. 14-CV-99 (GMS) (D. Del. Feb. 7, 2014).
 The court set out its reasoning regarding the existence of DSP’s liens in a separate opinion. In re Free Lance-Star Publ’g. Co., 2014 Bankr. LEXIS 1644, Case No. 14-30315-KRH, APN 14-03038-KRH (Bankr. E.D. Va Apr. 14, 2014). All references herein to "In re Free Lance-Star" are to the court’s previously referenced opinion regarding DSP’s ability to credit bid its claim.
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