According to the Thompson Reuters Loan Pricing Corporation, in the first quarter of 2014 the trading volume of loans on the US secondary loan market was $139.27 billion, with $4.93 billion in distressed loan trades. The overall trading volume of loans in the first quarter is well above the $114.31 billion quarterly average seen since the first quarter of 2008. The secondary loan market is very active.

The secondary loan market benefits lenders, buyer of loans, debtors, and those seeking credit. The lender is able to liquidate an asset and improve its liquidity and lending capability. The buyer purchases at a price it deems attractive and has the opportunity to make a profit to the extent it can collect in excess of the purchase price. The debtor often has the opportunity to strike a better deal with the purchaser than the lender would make. The purchaser may provide a discount or provide additional credit. Those seeking new credit may find their lending institutions in a better position to lend.

Purchasers of distressed debt are taking a risk—possibly a significant one—but the credit-bid right and other bankruptcy principles mitigate that risk by insuring that they will either recover their collateral or be paid its value, without having to advance additional funds to do so. These protections are grounded in the takings clause of the US Constitution and part of the balance of protecting secured creditors while simultaneously affording an opportunity for the debtor's reorganization.

The credit-bid right in bankruptcy is codified at 11 USC § 363(k), and there is an exception in the statute for "cause," which is not defined. The term "cause" in this context historically has been very narrowly interpreted and found to exist only where the secured claim is subject to legitimate dispute or where the secured creditor has engaged in unlawful or inequitable conduct. The legislative history of 11 USC § 363, which requires "adequate protection" for nondebtors in all instances when the debtor proposes to use, sell, or lease property, is illuminating:

The concept of [adequate protection] is derived from the fifth amendment protection of property interests. See Wright v Union Central Life Ins Co, 311 US 273, 85 L Ed 184, 61 S Ct 196 (1940); Louisville Joint Stock Land Bank v Radford, 295 US 555, 79 LEd 1593, 55 S Ct 854 (1935). It is not intended to be confined strictly to the constitutional protection required, however. The section, and the concept of adequate protection, is based as much on policy grounds as on constitutional grounds. Secured creditors should not be deprived of the benefit of their bargain. HR Rep No 95-595, 95th Cong, 1st Sess; HR 8200 reprinted in 1978 USCCAN 5787, 6295.

Two recent decisions, however, have significantly eroded the credit-bid protection of the secured creditor: In re Fisker Automotive Holdings, Inc1 and DSP Acquisition, LLC v Free Lance-Start Publishing Co.2

FISKER Automotive Holdings, Inc.

Fisker Automotive Holdings, Inc., ("Fisker") was founded in 2007 and intended to become the leading manufacturer of high-end, plug-in hybrid cars. In what may not be the greatest moment in US government lending history, the Department of Energy ("DOE") in 2010 funded a $168 million loan to Fisker. In 2013, the Fisker loan was sold to Hybrid Tech Holdings, LLC ("Hybrid") for $25 million. The following month, Fisker filed for Chapter 11 protection in Delaware, and Hybrid was considered Fisker's senior-secured lender. On Fisker's petition date, it filed a motion seeking court approval of a sale of essentially all its assets to Hybrid for a credit bid of $75 million.

When Fisker sought court approval of its private sale to Hybrid, the unsecured creditors committee objected and requested that the assets be sold via public auction and that Hybrid be precluded from credit bidding or its bid be capped. Instead of allowing the private sale to occur, the court sided with the unsecured creditors, ordered a public auction, and also found "cause" for limiting Hybrid's credit bid.

The bankruptcy court justified limiting Hybrid's credit bid by observing that in the absence of a cap on Hybrid's credit bid, there would be no competitive bidding at the auction. The court went so far as to say that if Hybrid were allowed to credit bid its full indebtedness "bidding [would] not only be chilled . . . bidding [would] be frozen."3

With that in mind, the bankruptcy court capped Hybrid's bid at $25 million, the amount it paid for the loan, without saying how it arrived at the cap. If Hybrid wanted to bid more, it could do so, but it had to pay cash instead of using the debt that it had purchased as a credit against the purchase price.

Hybrid attempted to appeal the bankruptcy court's decision to the United States District Court for the District of Delaware, but its appeal was denied.

DSP Acquisition, LLC

Aware of Fisker, the secured creditor, DSP Acquisition, LLC ("DSP"), attempted a first strike and asked the bankruptcy court to declare that it had a right to credit bid. But the bankruptcy court was having none of that. Referencing the standard bases for cause, the bankruptcy court found that DSP's security interest was subject to dispute and that it had acted in an inequitable manner by asserting security interests that it did not have, and it capped DSP's credit bid to a fraction of its debt. Also, citing Fisker, the bankruptcy court and the district court to which DSP unsuccessfully appealed went on to tout the advantage of a "robust" bidding environment and concluded that the rights of the secured creditor could somehow be sorted out later.

Misguided Priorities

The fact that a debtor is selling all or substantially all of its assets—as was the case in Fisker and DSP—means that there is no reorganization, only a liquidation. The need to balance the rights of the secured creditor against the debtor's opportunity to reorganize does not exist. The only justification for bankruptcy in these instances, which enjoins the creditor from exercising its remedies and provides a sales mechanism, is to liquidate the assets for more than is owed to the secured creditor. If there is not a bid for more than the secured creditor is owed, and if the secured creditor does not consent, there should be no sale.

And that is what 11 USC § 363(f) provides, in addition to the credit-bid rights afforded under 11 USC §363(k). It is absurd to express concern over a "robust" market when the sales price will not even pay the secured debt.

By stripping the secured creditor of its credit bid and allowing a sale of the collateral for less than the secured creditor is owed, the court is depriving the secured creditor who cannot come up with additional funds the ability to protect its interests. It is denied statutorily mandated "adequate protection." The buyer with cash may then receive a windfall by purchasing assets for less than their value, at the expense of the secured creditor. There is no rational basis to support this approach.

If Fisker and DSP become the accepted approach to credit bidding, i.e., denying the secured creditor the right to protect its collateral and capping the credit bid based on the loan sale price, whether the court admits what it is doing or not, loan purchasers likely will lose their incentive for acquiring loans. Fisker's counsel wisely observed:

I think it's fair to ask whether the United States government would have been able to realize the $25 million that it did if there were a cloud over [the credit-bid right] or if any participant had to wonder whether, at the end of the day, its credit-bid could be disallowed if there's the prospect of higher and better recoveries for unsecured creditors.4

Any benefits realized from this approach, and it is hard to see any, do not stack up against the substantial likelihood of the disruption imposed on the secondary loan market.

Footnotes

1 In re Fisker Auto Holdings, Inc., No 13-13087, 510 BR 55 (Bankr D Del Jan 17, 2014) (Dkt No 483).
2 DSP Acquisition, LLC v. Free Lance-Start Publ'g Co., No 3:14-cv-303-HEH, 3:14-cv-304-HEH, 2014 US Dist LEXIS 63274 (ED Va May 7, 2014).
3 Fisker, 510 BR at 60.
4 In re Fisker Auto Holdings, Inc., Case No. 13-13087 (Dkt No 447) (1/10/14 Hrg Tr at 120). 

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This article is reprinted in its entirety with the permission of The Tennessee Banker, ©October 2014

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