As is well known, the right to credit bid is the entitlement of a secured lender to bid the amount of its outstanding claims at the sale of its collateral. If the secured lender places the winning bid, no money is exchanged and the purchase price is offset against the existing claims. Credit bidding provides an important right to secured lenders in ensuring that their collateral is not sold for a depressed value. If a secured lender thinks its collateral is being sold too cheaply, it has the option of taking the collateral in exchange for some or all its claims. Credit bidding can also be used as part of an acquisition strategy. Potential acquirers can purchase distressed secured claims in the secondary market, often at a substantial discount, and bid those claims at up to face value in a bankruptcy auction. Although credit bidding can be a useful in a distressed acquisition strategy, one of the risks is that a bankruptcy court will deny or limit credit bidding “for cause” under section 363(k) of the Bankruptcy Code.¹

Earlier this year, a decision in the chapter 11 cases of In re Fisker Automotive, Inc. surprised many in the restructuring world by capping a secured lender’s right to credit bid at the sale of its collateral to the amount the lender paid for the debt in the secondary market.² While some immediately viewed Fisker as a likely anomaly, a March 2014 ruling in In re Free Lance-Star Publishing Co. similarly capped a secured lender’s right to credit bid in order to promote a more competitive auction.³ While the extent to which Fisker is applied in other “loan to own” situations is yet to be seen, the decision provides a useful illustration of the potential pitfalls of purchasing distressed secured claims with a view toward acquiring the debtor-company.

Facts and Background of Fisker

Fisker Automotive Holdings, Inc. and Fisker Automotive, Inc. (the “Debtors”) were manufacturers of plug-in hybrid electric vehicles.⁴ In April 2010, the United States Department of Energy (the “DOE”) offered funding to the Debtors through a senior secured loan.⁵ Before the Debtors’ bankruptcy filing, the DOE conducted a public auction⁶ for the senior secured loan and in October 2013, Hybrid Tech Holdings, LLC (“Hybrid”) purchased DOE’s outstanding debt of $168.5 million under the senior secured loan for $25 million (approximately 15 cents on the dollar).⁷ Following the DOE auction, the Debtors agreed to sell all of their assets to Hybrid in exchange for consideration including a $75 million credit bid as part of a section 363 bankruptcy sale.⁸

The Debtors filed for bankruptcy on November 22, 2013 and requested approval of a private sale to Hybrid.⁹ Notably, the sale was requested on an expedited basis — no later than January 3, 2014, i.e., only 24 business days after the bankruptcy filing and even less time for the Official Committee of Unsecured Creditors (the “Committee”), which was not appointed until December 5, 2013.¹⁰

The Committee objected to the private sale and argued that Hybrid’s credit bid should be denied or, at a minimum, capped at $25 million, the amount Hybrid paid for the claim.¹¹ In particular, the Committee argued that (i) “cause” existed under section 363(k) of the Bankruptcy Code because limiting Hybrid’s credit bid would facilitate an open and fully competitive auction or, in the alternative, (ii) “cause” existed because a material portion of the Debtors’ assets being sold were either not subject to a properly perfected lien in favor of Hybrid or were subject to a lien in favor of Hybrid that was in bona fide dispute.¹² At the sale hearing on January 10, 2014, the Debtors and the Committee announced several stipulated agreements to limit the areas of dispute, including, among other things:

1. if Hybrid’s credit bid was denied or capped at $25 million, there would be a strong likelihood of an auction that would create material value for the Debtors’ estates over and above the present Hybrid bid;
2. if Hybrid’s ability to credit bid was not denied or capped, there would be no realistic possibility of an auction;
3. the highest and best value for the estate would be achieved only through the sale of all the Debtors’ assets as an entirety; and
4. within the package of assets offered for sale at the auction, there were (a) material assets consisting of properly perfected Hybrid collateral, (b) material assets not subject to properly perfected liens in favor of Hybrid and (c) material assets subject to bona fide dispute as to whether Hybrid had a properly perfected lien.¹³
    

The Bankruptcy Court’s Decision

After hearing the parties, Judge Gross ruled from the bench that: (i) approval of the private sale to Hybrid was denied, (ii) the Debtors should conduct a public auction for their assets and (iii) Hybrid’s credit bid at the public auction would be capped at $25 million, the price Hybrid paid for its secured claim.¹⁴ Shortly after the sale hearing, Judge Gross issued a written opinion supplementing his bench ruling.

In his written opinion, Judge Gross began his analysis by rejecting the Committee’s argument that Hybrid should not be able to credit bid at all, finding “[i]t is beyond peradventure that a secured creditor is entitled to credit bid its allowed claim.”¹⁵ For Judge Gross, the “only question” was the amount of Hybrid’s credit bid.¹⁶ In this regard, Judge Gross considered the text of section 363(k) of the Bankruptcy Code, which provides that a court may “for cause order[ ] otherwise” with respect to a secured creditors’ right to credit bid.¹⁷

Judge Gross held that the “for cause” clause of section 363(k) of the Bankruptcy Code justified limiting Hybrid’s credit bid to $25 million, or the amount Hybrid paid for its secured claims.¹⁸ Citing to a footnote in the Third Circuit’s opinion in In re Philadelphia Newspapers, LLC,¹⁹ Judge Gross stated that a court may deny the right to credit bid in order to foster a competitive bidding environment.²⁰ As a result, Judge Gross said “cause” existed to limit Hybrid’s credit bid to $25 million because the unrebutted evidence showed that “bidding will not only be chilled without the cap; bidding will be frozen.”²¹

Judge Gross also noted that neither the Debtors nor Hybrid “ever provided the [c]ourt with a satisfactory reason why the sale of the non-operating Debtors required such speed” and found that “Hybrid’s rush to purchase . . . [was] inconsistent with the notions of fairness in the bankruptcy process.”²² Finally, Judge Gross noted that it would not be unprecedented to limit credit bidding because Hybrid’s claim was partially secured, partially unsecured and partially of uncertain status. Thus, the facts in Fisker were distinguishable from the Third Circuit’s seminal decision in Cohen v. KB Mezzanine Fund II, LP (In re SubMicron Sys. Corp.), where the court held an undersecured creditor was permitted to credit bid the face amount of its allowed secured claim.²³ According to Judge Gross, unlike Submicron, where the entire secured claim was deemed allowed, the bankruptcy court did “not yet know how much of Hybrid’s claim is secured.”²⁴

Impact of the Decision

Although the bankruptcy court’s reasoning was based on highly case-specific factors and is said to be non-precedential, the decision will undoubtedly be used by committees and other parties in interest as a litigation tactic against secured lenders, especially those who are not original holders of the secured claims.²⁵ The recent ruling in Free Lance-Star is an example of this last point, although the case also involved assets not subject to a properly perfected lien in favor of the secured lender.²⁶

As an initial matter, however, it is important to recognize that nothing in the Fisker opinion fixed the amount of Hybrid’s secured claim. Accordingly, Hybrid is entitled to “round trip” the proceeds of the sale, i.e. receive any cash proceeds paid for the Debtors’ assets to the extent Hybrid holds a properly perfected lien.

That said, the Fisker decision does pose a number of unresolved questions for secured lenders and other parties in interest. First, exactly how far will Fisker extend beyond its limited facts? For example, can the right to credit bid be capped or denied solely to promote a more competitive auction? Second, what happens when the secured facility is a credit agreement or indenture and only a portion of the debt is purchased on the secondary market? In that situation, there would be a mixture of par and distressed holders. Would the prices at which the distressed holders purchase their claims negatively impact the par holders? Third, is there more likely to be cause to deny or limit credit bidding where the secured claims are bought at a substantial discount? Although the fact that Hybrid purchased its secured claims at 15 cents on the dollar was not explicitly mentioned as a reason to cap Hybrid’s credit bid, it is possible it played a role.

In any case, the Fisker decision underscores the importance for secured lenders who become would-be acquirers to determine the extent of their properly perfected liens in the debtor’s collateral and to carefully structure sale agreements for such collateral. For example, secured lenders should consider allocating their overall bid between a credit bid component for undisputed collateral and a fixed cash bid or other consideration for collateral subject to a disputed lien. Similarly, secured lenders may consider offering a letter of credit or other assurance to the bankruptcy court with respect to liens that are in bona fide dispute to preserve their right to credit bid in full.²⁷ Separately, secured lenders may attempt to negotiate the parameters of their right to credit bid as part of a cash collateral order or, alternatively, as part of a stipulation or other agreement with various parties in interest.