Over the past several years, secured lenders have faced greater uncertainty as to whether Bankruptcy Courts will permit them to credit bid their entire secured claim in asset sales under Section 363 of the U.S. Bankruptcy Code.
In the bankruptcy of Fisker Automotive Holdings Inc., an electric vehicle manufacturer, the U.S. Bankruptcy Court for the District of Delaware held that a secured lender could only credit bid a fraction of its secured claim (i.e., $25 million of a roughly $168 million claim). Similarly, in the bankruptcy of Free Lance-Star Publishing Company, a radio and print publishing company, the U.S. Bankruptcy Court for the Eastern District of Virginia capped the credit bid of Free Lance-Star’s secured lender, DSP Acquisition LLC, at $12.7 million, notwithstanding that the lender had a secured claim equal to $38 million. One of the court's primary rationales for limiting the right to credit bid in each of these cases was the alleged “chilling effect” of credit bidding on the sale process (i.e., the proposition that no third parties would participate in the Section 363 sale of the debtors’ assets with the secured creditor’s right to credit bid looming over their heads).
The tide may recently have turned. In the bankruptcy of Aéropostale Inc. and certain of its affiliates, the U.S. Bankruptcy Court for the Southern District of New York in August held that Aéropostale’s secured term lenders could credit bid their entire claim, despite an aggressive challenge by the debtor. Notably, the Aéropostale case suggests that any alleged chilling effect is insufficient on its own to prevent secured lenders from exercising their credit bid rights with respect to their entire claims.
Secured lenders’ credit bid right arises out of Section 363 of the Bankruptcy Code, which permits “the holder of [an allowed secured claim to]...bid at such sale, and, if the holder purchases such property, such holder may offset such claim against the purchase price of such property.”1 The majority view is that absent a bona fide dispute over the validity of secured lenders’ liens on collateral, secured lenders may bid the entire value of their claims, rather than only the value of collateral.2 As such, undersecured creditors (e.g., those with secured claims that exceed the value of collateral) can avoid a sale of collateral at a steep discount by purchasing collateral with the debt they hold against the debtor.
Credit bidding is an important tool for secured lenders, as it protects the value of collateral upon which secured lenders made their loans in the first instance. In addition, credit bidding provides an opportunity for a syndicate of lenders to participate in Section 363 sales in instances when individual lenders may otherwise have limited authority to provide further liquidity to the debtors. Finally, as discussed in more detail later, debtors have generally experienced successful Section 363 sales and reorganization in recent cases in which courts allowed secured lenders to fully exercise their credit bid rights. This suggests that there may in fact be no chilling effect caused by credit bidding.
Warming to Credit Bidding
Aéropostale sought to sell substantially all of their assets in their Chapter 11 bankruptcy, and certain affiliates of Sycamore Partners sought to credit bid at such a sale. Prior to filing its bankruptcy petition on May 4, 2016, Aéropostale had entered into a $150 million term credit facility with Sycamore, in addition to a minimum-volume agreement with MGF Sourcing US LLC, a Sycamore affiliate specializing in global sourcing. As part of the sourcing agreement, MGF received a special right to unilaterally adjust payment terms if Aéropostale’s liquidity fell below $150 million.
Aéropostale’s financial position deteriorated throughout 2015 and early 2016. In February 2016, Aéropostale provided a borrowing base certificate to Sycamore reflecting a borrowing base of approximately $131 million, and thereafter MGF exercised its right to adjust payment terms, including a requirement for Aéropostale to provide a letter of credit or payment in advance of delivery. Upon Aéropostale’s rejection of these terms and assertion that its liquidity had not fallen below $150 million,3 MGF halted delivery of all pending orders, though the parties later came to an interim agreement for MGF to ship goods under the pending orders.
After filing its Chapter 11 bankruptcy petition, Aéropostale filed a motion to exclude Sycamore from credit bidding on any Section 363 sale “for cause” within the meaning of Section 363(k) of the Bankruptcy Code. Specifically, Aéropostale asserted that Sycamore and MGF engaged in inequitable conduct by, among other things, unreasonably adjusting the payment terms pursuant to the sourcing agreement.4
On August 26, 2016, Judge Sean H. Lane of the U.S. Bankruptcy Court for the Southern District of New York, in a written decision, denied Aéropostale’s motion to limit Sycamore’s ability to credit bid its claim in full in any Section 363 sale. In its decision, the Aéropostale court first acknowledged that a secured creditor’s inequitable conduct is sufficient to deny a right to credit bid.5 However, the court noted that the cases in which a court denies such right generally involve (a) conduct that directly impacts the estate or bidding process or (b) instances in which a creditor’s lien is in dispute.6 Because Aéropostale did not allege the invalidity of Sycamore’s liens on its assets or any inappropriate behavior by Sycamore in its bankruptcy, the court denied Aéropostale’s claims.
Perhaps more importantly, the Aéropostale court qualified the holding in In re Fisker Auto Holdings, Inc., 510 B.R. 55 (Bankr. D. Del. 2014), in which the court found that a secured creditor’s credit bidding may be restricted “for cause” to encourage competitive bidding when such bidding would otherwise be “frozen.” The Aéropostale court held that the mere fact that credit bidding may chill the competitive sale process is insufficient to deny a creditor’s right to credit bid absent at least one other factor.7
For example, the Aéropostale court indicated that the secured creditor in Fisker acted improperly when the lender insisted on a hurried process and that in any event, the validity of the secured creditor’s liens had not been determined in that case.8 In addition, the Aéropostale court noted that in In re Free Lance-Star Publishing, 512 B.R. 798 (Bankr. E.D. Va. 2014), another case involving “chilled” competitive bidding, the secured creditor improperly filed financing statements covering assets over which it knew it did not have a valid lien.9
Finally, the Aéropostale court looked to the “Final Report and Recommendations” promulgated by the American Bankruptcy Institute Commission to Study the Reform of Chapter 11, which asserted that the commission “did not believe that the chilling effect of credit bids alone should suffice as cause under section 363(k).”10 Because Aéropostale did not allege that Sycamore or MGF had acted improperly in its bankruptcy or during the bidding process, no factor in addition to the alleged chilling of competitive bidding existed. As such, the court denied Aéropostale’s claims.
Tempering the Aéropostale court’s ruling is the fact that no chilling effect on competitive bidding likely existed in the first instance. For example, Aéropostale contacted 99 parties and 21 were still interested in late June 2016,11 which is quite dissimilar from Fisker, where no bidding would have occurred without the restriction on credit bidding. In addition, the Aéropostale court noted that Sycamore has been “relatively cooperative with the process by, among other things, agreeing to...a one-week extension of the sale process.”12 As such, it nevertheless remains unclear post-Aéropostale whether courts will be willing to find cause based on a chilling effect in instances in which the secured lender is uncooperative.
Testing the Waters
Recent cases suggest that credit bidding in a Section 363 sale may not result in the chilling effect described in prior bankruptcy cases, notably Fisker and Free Lance-Star Publishing. For example, in the Chapter 11 bankruptcy of clothing retailer Pacific Sunwear of California Inc. (PacSun), Golden Gate Capital, one of the debtor’s secured lenders, successfully acquired all of the outstanding equity of PacSun in exchange for a reduction in the company’s indebtedness from $88 million to $30 million and an additional investment in an amount equal to approximately $20 million.13 As a result, PacSun was able to exit bankruptcy with reduced debt and more amenable leases with landlords.14
In addition, the auction in Aéropostale (which included an active credit bidder as described earlier) resulted in a sale of the business to a group of third parties in an amount equal to $243.3 million.15 The group indicated that Aéropostale will continue to operate at least 229 stores in the U.S.16 Each of these cases demonstrates that the exercise of the credit bid right can facilitate successful reorganizations of distressed companies out of bankruptcy. This suggests that the chilling effect purportedly caused by secured lenders’ use of credit bidding may not be as substantial as some believe.
On the other hand, at least one recent case where credit bidding was otherwise absent in a Chapter 11 bankruptcy resulted in a full-chain liquidation. In Sports Authority, none of the sporting goods retailer’s secured lenders meaningfully sought to exercise their credit bid rights. Instead, a consortium of liquidators acquired the majority of Sports Authority’s assets (e.g., inventory) and Dick’s, one of the Sports Authority’s competitors, acquired the Sports Authority brand name and related intellectual property.17 Thereafter, the Committee of Unsecured Creditors sought to convert the case from Chapter 11 to a Chapter 7 liquidation, which was subsequently rendered moot by a settlement among Sports Authority, its lenders, and other creditors.
Credit bidding is a valuable tool for secured lenders, as it (a) protects the value of collateral upon which secured lenders made their loans in the first instance, (b) provides an opportunity for a syndicate of lenders to participate in Section 363 sales when individual lenders may otherwise have limited authority to provide further liquidity to the debtors, and (c) as discussed earlier, may facilitate a successful reorganization of bankrupt debtors.
The Aéropostale case indicates that the specter of a chilling effect is insufficient on its own to limit secured lenders’ credit bid rights. As a result, secured lenders may continue to exercise their credit bidding rights in full, which may continue to produce successful outcomes for debtors out of bankruptcy.