Chapter III Credit Bidding in § 363 Sales in Bankruptcy

• Jurisdiction: United States

Chapter III Credit Bidding in § 363 Sales in Bankruptcy

A. § 363 Sales Generally

The majority of the chapter 11 bankruptcy cases filed in recent years have been filed not for purposes of "reorganizing" a debtor, but rather for the purpose of selling substantially all of a debtor's assets in a § 363 sale. Often, these sales have been teed up very early in the case. Indeed, in many instances, the filing itself is driven by the desire of a prospective purchaser of the debtor's assets to buy in bankruptcy, thereby obtaining the benefit of a "free and clear" order from the bankruptcy court.

Section 363(b)(1) of the Bankruptcy Code provides that the "trustee, after notice and hearing, may ... sell ... other than in the ordinary course of business, property of the estate...."³³ Further, a trustee may sell property, with or without the consent of a secured creditor who has a lien on such property, "free and clear" of such lien if one or more of the following conditions set forth in § 363(f) exists:

1. Applicable nonbankruptcy law permits sale of such property free and clear of such interest;
2. Such entity consents;
3. Such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property;
4. Such interest is in bona fide dispute; or
5. Such entity could be compelled, in a legal or equitable proceeding, to accept money in satisfaction of such interest.³⁴

There is substantial case law on the meaning of each of these five conditions to a "free and clear" sale.³⁵ The language of § 363(f) is written in the disjunctive, and thus, property of the estate can be sold free and clear of liens if any one of the conditions of § 363(f) has been met. When such a sale occurs, the secured creditor's lien on the property that is sold generally attaches to the proceeds of the sale.

The approval of a sale of assets outside the ordinary course of business, pursuant to § 363(b)(1) of the Bankruptcy Code, is left to the court's discretion. The court generally gives due consideration to the sound business judgment of a debtor.³⁶ Courts consider a variety of factors in determining whether a proposed sale satisfies this standard, including (1) whether the debtor exercised its business judgment in deciding to enter into the transaction, (2) whether adequate and reasonable notice of the sale was given to interested parties; (3) whether the sale will produce a fair and reasonable price for the property, and (4) whether the parties have acted in good faith.³⁷

In cases where substantially all of the assets of the debtor are being sold outside of a plan of reorganization, courts have been instructed to apply a more stringent analysis of the evidence to determine whether there is a good business reason for the sale. As the Second Circuit Court of Appeals noted in Lionel:

In fashioning its findings, a bankruptcy judge must not blindly follow the hue and cry of the most vocal special interest groups; rather, he should consider all salient factors pertaining to the proceeding and, accordingly, act to further the diverse interests of the debtor, creditors and equity holders, alike. He might, for example, look to such relevant factors as the proportionate value of the asset to the estate as a whole, the amount of elapsed time since the filing, the likelihood that a plan of reorganization will be proposed and confirmed in the near future, the effect of the proposed disposition on future plans of reorganization, the proceeds to be obtained from the disposition vis-a-vis any appraisals of the property, which of the alternatives of use, sale or lease the proposal envisions and, most importantly perhaps, whether the asset is increasing or decreasing in value.³⁸

In recent years, § 363 sales of substantially all of the debtor's assets have increasingly become the norm in chapter 11. Such sales are favored by purchasers because they can quickly give the purchaser the comfort of clean title, "free and clear" of all claims against the debtor, and are blessed by a federal court order. In fact, buyers will sometimes pay a premium for the comfort provided by a § 363 sale order, particularly where there may be issues lurking in the background that could give rise to challenges to the purchaser's title to the assets down the road.

Where a debtor or trustee proposes to sell assets in bankruptcy pursuant to § 363(b) and (f), the first step generally is the filing of a motion that seeks the entry of two orders, which are to be considered at two separate hearings.³⁹ The first order is the sale or bidding procedures order. This order will approve procedures for the sale process, including any protections for an initial stalking-horse bidder, and requirements for bidding (or in the case of a secured creditor, credit bidding). Where a stalking-horse bidder is present, the sale order will often reference a proposed form of purchase agreement, which is usually attached as an exhibit to the sale motion. Subsequent bidders must generally use this form of purchase agreement as the initial draft purchase agreement for any competing bids that they intend to submit. The second order is the proposed sale order that the movant will seek to have entered by the bankruptcy court at the conclusion of the auction.

It is, of course, imperative that parties closely examine these documents. In particular, parties (including proposed purchasers) will want to familiarize themselves with the proposed sale procedures order, and object to the extent that the sale procedures are unfair or will result in a sale process that chills bidding or otherwise does not aid in a fair process that will maximize the value of the debtor's assets. Proposed sale procedures are often pre-negotiated with the debtor's secured creditor and/or the stalking-horse bidder, and it is not uncommon for parties to object to the proposed order and, thereafter, for the bankruptcy court to blackline that order at a hearing. Once the sale procedures order is entered, it is extremely important that prospective purchasers familiarize themselves with the order to ensure that they comply with all requirements in submitting their bids and participating in any auction.

B. Credit Bidding in § 363 Sales

The term "credit bid" is not defined or even found in the Bankruptcy Code; rather, it is a colloquial term used to express a secured creditor's right to bid at the sale of its collateral and then, at closing, offset the purchase price by the value of its outstanding claim secured by the collateral being purchased.⁴⁰ This right is expressly incorporated into the Bankruptcy Code in § 363(k), which provides:

At a sale under subsection (b) of this section of property that is subject to a lien that secured an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of the property.⁴¹

In short, § 363(k) generally allows the secured creditor to bid for its collateral in a bankruptcy sale auction without having to put in new cash.⁴²

Credit bidding protects the secured creditor from the risk that its assets will be sold at the sale for an unreasonably low amount.⁴³ In other words, it enables a secured creditor to purchase its collateral "for what it considers the fair market price (up to the amount of its secured interest) without committing additional cash to protect the loan."⁴⁴ Of course, if the creditor's lien reaches only some of the property to be sold, the creditor cannot credit bid its secured claim for the unencumbered property, but rather must pay cash for such property.⁴⁵

Nearly all courts agree that a secured creditor in bankruptcy can credit bid the entire face value of its secured claim, including the unsecured deficiency portion created pursuant to § 506(a)(1) of the Bankruptcy Code.⁴⁶

This view is consistent with the legislative history of § 363(k).⁴⁷ The reason for this result is that a credit bid "by definition ... becomes the value of [the] [l]ender's security interest in [the collateral]."⁴⁸ Indeed, this issue was specifically addressed by the Third Circuit Court of Appeals in In re Sub-micron Systems,⁴⁹ where the court allowed the secured creditor to credit bid the full face amount of its claim, despite its undersecured position.⁵⁰Judge Ambro, writing for the Third Circuit, noted that "logic demands that § 363(k) be interpreted in this way" because interpreting the statute "to cap credit bids at the economic value of the underlying collateral is theoretically nonsensical."⁵¹ The court provided a hypothetical to illustrate this point:

Assume that Debtor has a single asset: a truck, T. Lender is a secured creditor that has loaned Debtor $15, taking a security interest in T. Debtor is in Chapter 11 bankruptcy and has filed a § 363 motion to sell T to Bidder for $10. Debtor argues that Lender can only credit bid $10 for T and must bid any excess in cash if it wishes to outbid Bidder.⁵²

This hypothetical, the court explained, reveals the logical problem with capping a secured creditor's bid at the actual value of its collateral:

If Lender bids $12 for T, by definition $12 becomes the value of Lender's security interest in T. In this way, until Lender is paid in full, Lender can always overbid Bidder. (Naturally, Lender will not outbid Bidder unless Lender believes it could generate a greater return on T than the return for Lender represented by Bidder's offer.) As Lender holds a security interest in T, any amount bid for it up to the value of Lender's full claim becomes the secured portion of Lender's claim by definition.⁵³

Following up on In re SubMicron, Judge Ambro stated as follows in his Philadelphia Newspapers dissent:

The practical rationale for credit bidding is that a secured lender would "not outbid [a bidder] unless [the] lender believed it could generate a greater return on [the

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