478243863Earlier this month, in the In re The Free Lance-Star Publishing Co. bankruptcy cases, Judge Huennekens of the Bankruptcy Court for the Eastern District of Virginia issued a memorandum opinion which laid out the Court’s decision limiting the right of a secured creditor to credit bid.  The Court, pointing to a “perfect storm” of factors which required the “curtailment of . . . credit bid rights,” limited a loan purchaser’s asserted $39 million credit bid to $13.9 million.  The factors cited by the Court for limiting the bid included the creditor’s (i) less than fully-secured status; (ii) overly zealous loan-to-own strategy; and (iii) misconduct, which had a negative, chilling impact on the debtors’ auction process.

What Happened?

The Free Lance-Star (with an affiliated entity, the “Debtors”) is a publishing and communications company.  In 2006, the Debtors obtained a loan (the “Loan”) in the amount of $50.8 million secured by certain real and personal property (which excluded a number of other assets).  In late June 2013, the lender sold the Loan to DSP Acquisition, LLC (“DSP”), an affiliate of Sandton Capital Partners.  On July 3, 2013, DSP informed the Debtors that it wanted to purchase the Debtors’ assets in a section 363 sale in bankruptcy.  DSP told the Debtors that it intended to keep management in place, and the Debtors tentatively agreed to cooperate.

Later in July, DSP requested that the Debtors execute deeds of trust which would further secure the Loan with property that was not previously encumbered.  In early August, DSP followed up on the request by providing the Debtors with a “Restructuring Timetable” that included an expectation for the timely recordation of the deeds.  Subsequently, communication between the parties ceased.  During this time, DSP unilaterally filed financing statements with respect to the unencumbered property in question.

On September 24, 2013, DSP relented as to the deeds of trust, and resumed negotiations with the Debtors, ultimately entering into a forbearance agreement.  On December 3, 2013 (ninety days after DSP had recorded the financing statements mentioned above), DSP renewed its pressure on the Debtors for a bankruptcy filing, this time accompanied by a six week sale process, which included a credit bid of the Loan.  DSP objected to the Debtors’ retention of Protiviti, a financial consultant, in connection with the bankruptcy and the sale.  One of the reasons for DSP’s objection was that Protiviti insisted upon distributing marketing materials in connection with the bankruptcy sales process.  While DSP lost this battle, DSP was able to require that the materials contain, on the front page, in bold font, a statement that DSP had a right to a $39 million credit bid.

By January 11, 2014, DSP removed any support for the Debtors or their bankruptcy, and all negotiations between the Debtors and DSP ceased.  The next week, DSP recorded additional financing statements in various jurisdictions, again without giving any notice to the Debtors.  The Debtors commenced their cases on January 23, 2014, and filed a motion to sell their assets in two sales.  The motion and the bidding procedures (which were approved on March 10, 2014) provided that DSP could credit bid the claim as to which it had valid liens or security interests, as either agreed to by the Debtors and the official committee of unsecured creditors or determined by the Court at a hearing to be held on March 24, 2014.

At this evidentiary hearing, which was held over the course of three days, the Court determined that, among other things, DSP had engaged in inequitable conduct that required the Court to limit DSP’s credit bid right in order to foster a robust auction.

The Court’s Analysis   

The Court observed that the right to credit bid is codified in section 363(k) of the Bankruptcy Code, and that this right is an important safeguard that insures against the undervaluation of a secured claim at an asset sale.  By enabling the secured creditor to purchase the collateral at issue for what it considers the fair market price (up to the amount of its security interest) without committing additional cash, the secured creditor is protected against the risk that its collateral will be sold at a depressed price.  However, section 363(k) also provides that the court may, for cause, order otherwise and that there is no absolute right to credit bid.

The Court, citing the In re Fisker Auto. Holdings, Inc. case, stated that generally a court may deny a lender the right to credit bid in the interest of any policy advanced by the Code, such as to foster a competitive bidding environment.  The Court noted that the Fisker court had found that cause existed where the “secured lender had chilled the bidding process by inequitably pushing the debtor into bankruptcy so that it could short-circuit the bankruptcy process.”  In that case, the court limited the secured creditor’s credit bid to what it paid for the debt, which was $25 million, rather than the original amount of the debt, or $168.5 million.

The Court found that such cause also existed in this “classic loan-to-own scenario” as DSP engaged in inequitable conduct.  The Court was troubled by DSP’s “unilateral decision to expand the scope of its security interest” through its recordation of financing statements, as well as DSP’s efforts to “frustrate the competitive bidding process.”  The Court returned to the policy supporting the right to credit bid, stating that the “credit bid mechanism that normally works to protect secured lenders against the undervaluation of collateral sold at a bankruptcy sale does not always function properly when a party has bought the secured debt in a loan-to-own strategy . . .  In such a situation, the secured party may attempt to depress rather than enhance market value.”

The Court held that DSP’s motivation to own the Debtors’ business rather than to have the Loan repaid interfered with the sales process.  Therefore, it was necessary to limit DSP from bidding the full amount of its claim against all of the Debtors’ assets in order to foster a fair and robust sale.

Key Takeaway

The Free Lance-Star case (along with Fisker) marks the second case in 2014 where a Bankruptcy Court has limited the right of a secured creditor to credit bid.  In Free Lance-Star, it appears that the secured creditor engaged in some fairly egregious activity in an attempt to obtain liens on assets that were not pledged as security for its purchased loan, and also attempted to exert heavy influence on the sale process in an effort to chill any bidding in the auction process.  Similar facts are not likely to exist in most cases.  Regardless, secured creditors should take heed of the warnings present in both Free Lance-Star and Fisker.  Such creditors that find themselves in a potential credit bidding situation must avoid the appearance of attempting to unduly influence the sale process to the detriment of other creditors.  As of this writing, the Free Lance-Star decision has been appealed.  We will continue to monitor the progress of this case.