A recent decision by the Third Circuit Court of Appeals has significant ramifications for relationships between borrowers and lenders that extend beyond the boundaries of bankruptcy proceedings. In In re Philadelphia Newspapers, LLC, Case No. 09-4266 (Mar 22, 2010), the court ruled that the debtor could conduct a sale of its assets under a plan of reorganization without allowing secured lenders to credit bid. This development may alter the recovery expectations of lenders to distressed borrowers and is likely to affect the respective strategies of debtors and lenders in approaching bankruptcy proceedings and lending behavior at large.
Philadelphia Newspapers, LLC (collectively with its affiliates who are debtors, the “Debtors”) own and operate the Philadelphia Inquirer and the Philadelphia Daily News among other assets. The Debtors financed their $515 million acquisition of the newspapers in 2006 with a $295 million loan from a group of lenders (the “Secured Lenders”) secured by first priority liens on substantially all of the Debtors’ assets. After defaulting on loan covenants and failing to make payments due under the loan, the Debtors commenced Chapter 11 cases in the Eastern District of Pennsylvania.
The Debtors proposed a plan of reorganization that included a sale at public auction of substantially all of their assets free of all liens. Simultaneously, they signed an asset purchase agreement with certain insiders of the Debtors. The proposed sale, which excluded the Debtors’ headquarters valued at approximately $29.5 million, would yield a recovery of approximately $37 million in cash. Under the proposed plan, the Debtors proposed to transfer the cash and the headquarters to the Secured Lenders in full satisfaction of their claims. The Secured Lenders and others objected to Debtors’ motion for approval of the sale procedures, which required competing bids to be solely in cash and, thus, prevented the Secured Lenders from credit bidding.
Bankruptcy Law Background
All sales conducted pursuant to Section 363 of the Bankruptcy Code (the “Code”) permit credit bidding. Until recently, it was generally accepted that a plan of reorganization that provided for a sale of assets must also permit credit bidding. In re Philadelphia Newspapers and In re Pacific Lumber now cast that generally accepted view into significant doubt.
Under Section 1123 of the Code, debtors are authorized, as a means of implementing a plan of reorganization, to arrange for sale of all property of the estate free of any liens. However, Section 1123 provides no guidance on procedures for such a sale. Certain procedural limitations are provided by Section 1129 of the Code, which deals with confirmation of a debtor’s plan. For a bankruptcy court to confirm a plan where a class of claims does not accept the plan or is impaired under the plan, commonly known as a “cram down,” the plan must satisfy Section 1129(b), which requires (among other things) that treatment of a creditor or class of creditors who opposes the plan is “fair and equitable.”
Section 1129(b)(2)(A) lists three circumstances by which a plan may be “fair and equitable” to a secured creditor: (i) the creditor retains liens in the property, whether kept by the debtor or sold, and receives deferred cash payments equal to the allowed amount of their claim; (ii) property is sold free and clear of the creditor’s liens in a process that gives the creditor the opportunity to bid on the property using his or her credit; or (iii) the creditor receives the “indubitable equivalent” of its claims.
A split three-judge panel of the Third Circuit upheld the District Court’s approval of the auction procedures proposed by the Debtors as part of their plan of reorganization, procedures which the Bankruptcy Court had rejected due to the Debtors’ failure to include credit bidding. Judge Fisher, writing for the majority, held that the language of the statute allows debtors the option of selling their assets under any of the three prongs of 1129(b)(2)(A), including sale free and clear of all liens under either subsection (ii), which mandates credit bidding, or subsection (iii), which doesn’t mandate credit bidding.
Judge Fisher reasoned that the plain meaning of 1129(b)(2)(A), specifically the use of the word “or” separating the three prongs, clearly allows for any of the three prongs to satisfy the “fair and equitable” standard. Further, according to the court’s analysis, subsection (ii), despite specifically referring to sales free and clear of all liens, was not the exclusive provision under which a plan premised upon asset sales could be confirmed.
The majority found that subsection (iii) was an unambiguous, intentionally broad catchall that allowed for a wide variety of debtor approaches to providing creditors with suitable return. Its analysis led it to conclude that “indubitable value” is equivalent to “unquestionable value of a lender’s secured interest in the collateral.” As this pertains to the acceptability of the plan, the creditors will have the opportunity at confirmation to show that the chosen mechanism for disposing of the assets failed to provide indubitable value. They could also argue that the failure to allow credit bidding at the asset auction failed to generate a fair market price for the assets. But the court refused to conclude that the means of providing indubitable value in an asset sale free and clear of liens necessarily included credit bidding as a matter of law, and noted that prior to the auction, it was premature to make any conclusions about what sort of value the bidding process will ultimately yield.
The court also rejected the argument that the Code’s overall statutory scheme evinces an approach to secured debt that requires secured creditors to have the right to credit bid. Judge Fisher reasoned that, notwithstanding the protections afforded by the Code in giving non-recourse lenders the option to have their deficiencies treated as secured under Section 1111(b) and all lenders the right to credit bid in non-plan sales of assets outside the ordinary course of business under Section 363, the provisions of the Code on the whole have always balanced the interests of secured creditors and the interests of the reorganized entity. As such, they have had the purpose and effect of limiting a secured creditor’s recovery to the value of its interest. When the interest is collateral property, the court sees this value is limited to the property’s present value, not the value of its potential appreciated up-side which mandatory credit bidding would allow a creditor to ensure.
As applied to Philadelphia Newspapers, unless the Third Circuit decision is overturned on appeal, the Debtors will be allowed to proceed with an auction at which the Secured Lenders will not have the opportunity to credit bid. At plan confirmation, the Secured Lenders will have the opportunity to contest the sale on the grounds that it did not provide the Secured Lenders with the indubitable equivalent of their claims’ value.
A lengthy dissent by Judge Ambro contests the plain meaning of 1129(b)(2)(A), laying out an alternative reading. Under the dissent’s interpretation, the three subsections of 1129(b)(2)(A) are “not mere examples, but specific requirements to be applied in distinct scenarios” and subsection (iii), although still a catchall, cannot be used as an alternative for the dispositions specifically dealt with in subsections (i) and (ii). Notably, the dissent observes that the reading given to subsection (iii) by the majority renders subsection (ii) superfluous – if debtors can effectuate plan sales free of liens under subsection (iii), they are unlikely to subject sales of lender collateral to lenders’ rights to credit bid.
The dissent lamented that the majority’s decision frustrates the settled expectations of possible outcomes for lenders’ interests in bankruptcy, which were relied on in extending credit to the debtors. It concludes that undervaluation of collateral property is the inevitable outcome that will result from the sale auction of the Philadelphia Newspaper assets and other assets sold free of liens without credit bidding in the future.
Impact on Future Bankruptcy Asset Sales and Beyond
The decision in Philadelphia Newspapers clearly alters the long-held view that secured lenders have a right to credit bid on a sale of assets. The Third Circuit now joins the Fifth Circuit in allowing a plan to provide for asset sales free of liens without credit bidding. The Third Circuit, by virtue of Delaware, handles a sizable percentage of large commercial bankruptcy cases, giving its decision added significance.
In liberalizing the sale mechanism available to debtors under the plan, the Third Circuit’s decision has the potential to lead debtors to seek sales of assets within the context of a plan rather than under Section 363. Lenders, in turn, could seek to force sales to occur under Section 363 earlier in bankruptcy proceedings. The court also opened the door through dicta to the possibility that the Section 363 right to credit bid is not as iron clad as previously believed. The majority indicated that the right to credit bid under Section 363(k) could be denied for cause, including any policy interest that the Code serves. However, given that such instances to this point have not been frequent, lenders would most likely prefer the familiarity of Section 363 sales than the newly changed landscape of a Section 1129 sale.
The emphasis on plan sales could lead to difficult confirmation fights when lenders are dissatisfied with their return. By moving debtors towards plan sales as opposed to sales under Section 363, the Philadelphia Newspaper decision will likely increase administrative costs by necessitating litigation related to confirmation (including a determination of the value of the debtor). The likelihood of contested confirmation hearings and their inherent uncertainty for winners of asset sale auctions may turn off potential bidders and diminish return for secured creditors further. On the other hand, the absence of a credit bidding lender may encourage more potential buyers to bid on the assumption that they have a realistic chance of acquiring the assets.
Allowing plan sales without credit bidding may also alter incentives of debtors, pushing them away from maximizing return for creditors and towards maximizing benefits for insiders. By preventing credit bidding, the Third Circuit’s decision may allow debtors and buyers they find desirable to exploit the difficulties for creditor syndicates to participate effectively in cash bidding for a company in which they hold a secured interest. Credit syndicates often have an agent authorized to credit bid on their behalf, but the syndicate or individual lenders within the syndicate may not have the same freedom to put up new cash, thus making coordination of a competing cash bid difficult. This allows those with cash to buy the company at a less competitive auction and lower price. This is exactly what Judge Ambro believed was occurring in Philadelphia Newspapers. To defend against the vulnerabilities of secured lenders without the ability to credit bid, secured lenders may become more aggressive in seeking to be the provider of DIP financing with an order ensuring their ability to credit bid at any later asset sale or to approve any plan of reorganization submitted by the debtor.
Outside of bankruptcy, the impact of tilting the playing field in debtors’ favor may have the effect of increasing the cost of credit and further diminishing its availability in a time where lenders are already reluctant. Uncertainty in lenders’ ability to acquire underlying assets may also negatively impact the market for distressed debt.The creditors in Philadelphia Newspapers may still request a hearing by the Third Circuit en banc or appeal to the Supreme Court. Barring a reversal from either of those two panels, the decision of the Third Circuit will likely have game-changing implications for debtors and secured creditors in bankruptcy and borrowers and lenders outside of bankruptcy.