Trends & Developments - June 2012 - Secured Lending Risk Mitigation: Lenders’ Collateral Rights in Bankruptcy Affirmed by Recent Supreme Court Ruling
In the 2004 crime thriller movie Collateral, actor Jamie Foxx plays a taxi driver who unknowingly accepts an evening fare of an engaging contract killer, played by Tom Cruise, as he makes his rounds from hit-to-hit during one night in Los Angeles. As one might surmise from the title of the movie, Jamie Foxx is unknowingly pledged as security for Tom Cruise to keep him alive in the event that there are any mishaps in his murderous evening schedule, so that he may exit the evening alive and collect on his contract. One hundred and twenty minutes of gripping action ensue.
So to, it is axiomatic that a lender will turn to its collateral for recovery in the event of financial mishaps that cause a borrower to enter the gripping throws of action of a Chapter 11 bankruptcy case. However, over recent years, certain bankruptcy courts have allowed debtors to convey assets in chapter 11 plans of reorganization for less than the amount of debt secured by the assets, while stripping the secured creditor’s liens and precluding it from credit bidding amounts owed in order to liquidate or otherwise realize value from the collateral.
On May 29, 2012, in a case involving the Radisson Hotel at Los Angeles Airport, the U.S. Supreme Court resolved a split in circuit court decisions and ruled that pursuant to §1129 of the Bankruptcy Code, a secured creditor must have the ability to credit bid in these situations.
The right to credit bid first came up in the bankruptcy case of Pacific Lumber Company. On September 29, 2009, the U.S. Court of Appeals for the Fifth Circuit ruled against the lenders' ability to credit bid. The Third Circuit Court of Appeals, which covers Pennsylvania, Delaware and New Jersey, ruled the same way on March 22, 2010, barring lenders of Philadelphia Newspapers LLC from credit bidding their debt. On June 28, 2011, the Seventh Circuit Court of Appeals sanctioned lenders' right to credit bid in the instant case, which was appealed on August 5, 2011. Shortly thereafter, the Supreme Court accepted a writ of certiorari to resolve the conflicting rulings of the circuit courts.
§1129 OF THE BANKRUPTCY CODE
Generally, §1129 of the Bankruptcy Code sets forth the requirements for confirmation of a proposed plan of reorganization by a bankruptcy court. One such requirement is that each class of claims or interests either has accepted the plan1, is not impaired under the plan2, or otherwise, the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired and has not accepted the plan.3 Pursuant to §1129(b)(2)(A) of the Bankruptcy Code, with respect to a class of secured claims, a Chapter 11 plan is fair and equitable and can be confirmed despite the objection of a secured creditor if (i) the secured creditor receives deferred cash payments equal to the present value of its collateral and retains its lien; (ii) the secured creditor is allowed to credit-bid for the debtor's assets; or (iii) the secured creditor receives the "indubitable equivalent" of its claim.
SUPREME COURT’S INTERPRETATION OF §1129(B)(2)(A)
In the case before the Supreme Court, the debtor, RadLAX Gateway Hotel LLC, asserted that its plan of reorganization was confirmable via the third option without secured lender Amalgamated Bank having the right to credit bid.
However, Justice Antonin Scalia wrote that the court found "the debtors' reading of 1129(b)(2)(A) [to be] hyperliteral and contrary to common sense," asserting that secured creditors must be allowed to credit bid in a Chapter 11 case.
Comparing the detailed wording of the second option, the ability to credit bid, not provided by the debtor in its Chapter 11 plan, with the broad wording of the third, Scalia stated that the general/specific canon avoids rendering superfluous a specific provision that is swallowed by the general one and further explained that the debtor failed to show that the cannon should not be followed in this case.
"One can conceive of a statutory scheme in which the specific provision embraced within a general one is not superfluous, because it creates a so-called safe harbor," Scalia wrote. "The debtors effectively contend that that is the case here -- clause (iii) ('indubitable equivalent') being the general rule, and clauses (i) and (ii) setting forth procedures that will always, ipso facto, establish an 'indubitable equivalent,' with no need for judicial evaluation. But the structure here would be a surpassingly strange manner of accomplishing that result -- which would normally be achieved by setting forth the 'indubitable equivalent' rule first (rather than last), and establishing the two safe harbors as provisos to that rule. The structure here suggests, to the contrary, that (i) is the rule for plans under which the creditor's lien remains on the property, (ii) is the rule for plans under which the property is sold free and clear of the creditor's lien, and (iii) is a residual provision covering dispositions under all other plans -- for example, one under which the creditor receives the property itself, the 'indubitable equivalent' of its secured claim. Thus, debtors may not sell their property free of liens under 1129(b)(2)(A) without allowing lienholders to credit-bid, as required by clause (ii)."
WHAT IS THE EFFECT OF THE SUPREME COURT’S RULING?
From a debtor’s perspective, the ruling will no doubt limit Chapter 11 debtors to fewer options in proposing plans. Strategically, with less leverage vis-à-vis the secured lender, debtors may be more inclined to sell assets pursuant to §363 of the Bankruptcy Code, where credit bidding by secured lenders is already the norm, rather than incurring the time and expense of plan negotiations that may ultimately result in the same conveyance of assets to the secured lender pursuant to a credit bid.
From a lender’s perspective, clearly the ruling will keep a debtor or other plan proponent from trying to force a sale that undervalues a secured creditor's collateral. Unchanged is the plight of unsecured creditors in cases where the amount of the secured debt exceeds the value of the collateral, as they will need to continue to creatively seek alternative sources of recovery.
Less clear is how the ruling will effect so called “value investors” or other potential purchasers of assets in bankruptcy proceedings. Here, the debtor had argued that the lenders ability to bid in excess of the value of the assets would deter potential bidders that otherwise would offer cash from participating in an auction they were unlikely to win. While credit bidding can have a “chilling” effect, a more likely result is that in situations where the face amount of the debt clearly exceeds the value of the collateral, potential purchasers are likely to seek “release” prices from the lender with the hope that the lender would rather have a portion of its claim paid than own the collateral.
Following the Philadelphia Newspapers decision, there is no doubt that lenders who extend loans with the expectation that the collateral will secure their interest had their expectations unsettled. As the Supreme Court’s decision would please Tom Cruise’s character in Collateral, so to it is reassuring for lenders, mitigating some of the “risky business” of lending in the current macroeconomic environment.
Jeffrey T. Varsalone is a Director in EisnerAmper’s Bankruptcy and Restructuring Practice Group. For more information, please contact him 212.891.8068
1A class of claims has accepted a plan if creditors that hold at least two-thirds in amount and more than one-half in number of the allowed claims of the class have accepted the plan. See §1126(c) of the Bankruptcy Code. A class of interests has accepted a plan if holders of at least two thirds in amount have accepted the plan. See §1126(d) of the Bankruptcy Code.
Trends & Developments - June 2012
- What Happens If Nothing Happens?
- U.S. & Multinational Businesses: Watch Out for Group Plan Rules – But You Can Meet the Challenge with a Little Planning!
- Important Regulations on Property Repairs
- Secured Lending Risk Mitigation: Lenders’ Collateral Rights in Bankruptcy Affirmed by Recent Supreme Court Ruling
- SEC Staff Communications Highlight Management Responsibilities for Fair Value Measurements of Investment Securities