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Supreme Court Rules that a Secured Lender Has a Right to Credit Bid in a Sale of Collateral Under a Chapter 11 Plan

On Tuesday, the United States Supreme Court ruled that a secured lender must be given the opportunity to credit bid when a debtor proposes to sell the lender’s collateral free and clear of its liens pursuant to a chapter 11 plan.

The Supreme Court’s 8-0 decision (with Justice Kennedy not participating) in RadLAX Gateway Hotel, LLC v. Amalgamated Bank[1] resolves an issue that attracted a great deal of attention in the lending and bankruptcy communities after the Third Circuit, in Philadelphia Newspapers,[2] ruled that a debtor could propose a plan involving a sale of a secured creditor’s collateral free and clear of the liens without allowing credit bidding. The Seventh Circuit reached the opposite conclusion.[3] The Supreme Court granted certiorari in order to resolve this split and, on Tuesday, affirmed the Seventh Circuit.

The lending community will applaud the Supreme Court’s decision since most lenders believe that the ability to credit bid is an important aspect of their collateral package. Credit bidding is particularly important for lending syndicates since often some members of the syndicate are unable to come up with cash, either because they are prevented from raising new funds by their organic documents or the practical fact that obtaining authority for yet more cash — “good money after bad” — can be difficult. Secured lenders also have argued that credit bidding is necessary to prevent a debtor from attempting a sale at a depressed price. Indeed, in Philadelphia Newspapers, the debtor proposed a sale to an insider group favored by management and attempted to prevent credit bidding in order to make it difficult for the secured lending syndicate to outbid the insider. In contrast, debtors sometimes argue that the specter of a large credit bid can chill bidding by dissuading third parties from spending the time and effort to make a bid.

The issue before the Supreme Court was the interpretation of Bankruptcy Code § 1129(b)(2)(A) — the provisions allowing for confirmation of a plan over the dissent of a class of secured creditors (a so-called “cram down”). The debate involved the application of the “plain meaning” doctrine of statutory construction, so it is particularly interesting that the opinion was written by Justice Scalia, generally acknowledged to be the father of “plain meaning.” Justice Scalia did not join the debate about whether credit bidding is good or bad policy, although he did observe in a footnote that the “ability to credit-bid helps to protect a creditor against the risk that its collateral will be sold at a depressed price.”

Rather, the opinion focuses on the language used in Bankruptcy Code § 1129(b)(2(A), which requires that any plan rejected by a class of secured creditors be “fair and equitable” and that “fair and equitable” includes the following: (i) the lenders retain their liens and their debt is stretched out such that the present value of the stream of payments equals the value of the collateral; (ii) the sale of the collateral free and clear of the liens with the secured lenders being able to credit bid (unless the court orders otherwise “for cause”); or (iii) the lenders receive the “indubitable equivalent” of their secured claims.

The argument against allowing credit bidding focused on the fact that these three prongs were separated by the word “or.” From that, the argument went that the “plain meaning” of the statute allowed a debtor to select among these three alternatives. Thus, if a debtor could show that an auction would yield a fair market price for the collateral and this sum was paid to the secured lender, that lender would receive the indubitable equivalent of its secured claim and the plan would pass muster under clause (iii) even if the lender was not allowed to credit bid at that auction as clause (ii) might seem to require.

Justice Scalia accepted the premise that the statute was unambiguous and, therefore, it was not appropriate to consider the legislative history or 30 years of past practice, both of which would have indicated that credit bidding should have been allowed. But he strongly disagreed that the “plain meaning” doctrine supports an interpretation of Bankruptcy Code § 1129 that would allow a plan to provide for a sale free and clear of liens without credit bidding.

Justice Scalia found “the debtors’ reading of § 1129(b)(2)(A), under which clause (iii) permits precisely what clause (ii) proscribes, to be hyperliteral and contrary to common sense.” This pronouncement will likely reverberate throughout the legal community and have an impact on other decisions for it is a strong message from the Supreme Court in general, and Justice Scalia in particular, that “plain meaning” may not be used to reach illogical results that might be supported by a literal, or more accurately, hyperliteral interpretation of the words used by Congress.

The Court was primarily guided by the well-established principle of statutory construction that the specific governs over the general. Justice Scalia pointed out that courts often apply this principle when the specific is a subset of the general, but it is equally applicable when “a general authorization and a more limited, specific authorization exist side-by-side. There the cannon avoids not contradiction but the superfluity of a specific provision that is swallowed by the general one, ‘violat[ing] the cardinal rule that, if possible, effect shall be given to every clause and part of a statute.’”

Justice Scalia also rejected the argument that deciding that clause (ii) governs would transform the word “or”, which separates the three clauses of § 1129(b)(2)(A), into “and.” The use of the word “or” does not mean that the debtor is free to pick any of these three alternatives. Rather, the question is “which one of the three they must satisfy.”

Finally, the Supreme Court rejected the argument that it was premature to consider the credit bidding question in the context of a motion to approve bid procedures rather than in connection with confirmation of the chapter 11 plan. The debtor in Philadelphia Newspapers, in contrast, had used this argument to persuade the Third Circuit to focus on an abstract legal question rather than whether the specific plan for which these bid procedures were proposed might be confirmed. Justice Scalia called this a “nonstarter” for the bid procedures proposed by the debtors could not possibly satisfy § 1129(b)(2)(A) and the “distinction between approval of bid procedures and plan confirmation is therefore irrelevant.”

While significant, the decision in RadLAX does not address some of the more troubling issues that have been highlighted by the competing Circuit Court decisions that deal with credit bidding. For example, RadLAX does not address what might constitute “cause” for denying credit bidding. Bankruptcy Code § 363 governs sales outside a plan, and § 363(k) requires credit bidding in such a sale unless the court orders otherwise for “cause.” The cram down provisions of Bankruptcy Code found in § 1129(b)(2)(A)(ii) incorporate § 363(k) by reference, so if there is “cause” to prevent credit bidding, credit bidding can be prohibited by a court whether the sale is proposed pursuant to § 363 or a plan. In Philadelphia Newspapers, the Third Circuit suggested that the prospect that a credit bid could chill bidding could establish “cause” under § 363(k). The Supreme Court’s decision in RadLAX does not reach this issue, so this dicta in Philadelphia Newspapers has not been overruled.

Further, the Supreme Court’s decision does nothing to eliminate the specter that a plan can provide for a sale to a third party subject to (as opposed to free and clear of) a lien under § 1129(b)(2)(i) with a stretch out of the secured lender’s debt and without allowing for either credit bidding or an 1111(b) election. Section 1129(b)(2)(A)(i) allows a “transfer,” which includes a “sale,” of collateral to another entity subject to a lien while permitting the stretch out of the lender without either a right to credit bid or make an 1111(b) election.[4] This scenario raised by the Philadelphia Newspapers court and actually carried out by the debtor in the Pacific Lumber case decided by the Fifth Circuit[5] may open up a particularly powerful alternative means of cramming down a plan on a secured lender -- any plan can be structured as a “sale” to a newly-formed company.

CONCLUSION

The Supreme Court’s decision in RadLAX may significantly reduce uncertainty in secured lending transactions and restore leverage to secured lenders in chapter 11 cases that had been eroded recently by Philadelphia Newspapers and Pacific Lumber.

It is also a welcome reminder that the “plain meaning” doctrine is not to be used to justify nonsensical results or ignore other traditional tools of statutory interpretation.

Nevertheless, the decisions in Philadelphia Newspapers and Pacific Lumber may still provide a road map for an aggressive debtor to thwart secured lenders by either objecting to a credit bid for “cause” or proposing a plan that provides for a sale subject to the liens with the debt stretched out and the secured lenders unable either to credit bid or make an 1111(b) election.

For more information, please contact Ben Logan or Jennifer Taylor, both of whom were involved in O’Melveny’s representation of the Committee in Philadelphia Newspapers.

[1] Case No. 11-166 (May 29, 2012).
[2] In re Philadelphia Newspapers, LLC, 599 F. 3d 298 (3d Cir. 2010).
[3] River Road Hotel Partners, LLC v. Amalgamated Bank (In re River Road Hotel Partners, LLC), 651 F.3d 642 (7th Cir. 2011).
[4] Section 1111(b) of the Bankruptcy Code provides a safeguard for a secured lender against what it believes to be an inappropriately low judicial valuation of its collateral. Specifically, § 1111(b) provides that a class of secured creditors may elect to have the entire amount of its debt treated as secured even if the collateral has a lower value (i.e., the creditor is undersecured). Under § 1129(b)(2)(A)(i), if the debtor retains the collateral subject to the liens, a plan can be crammed down on a class of secured creditors that makes the 1111(b) election only if this class receives a payment stream equal to the amount of the claim, but with a present value equal to the value of the collateral. An electing secured creditor may receive a note that will be worth less than par, but the principal amount of the note will be the full amount of the debt so that the lender presumably will receive the full amount it is owed if a reorganized debtor later resells or refinances the collateral. However, the 1111(b) is inapplicable when collateral is sold free and clear of liens under a sale conducted under § 363 or pursuant to a plan.
[5] In re Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009).