A Victory for Secured Creditors

August 19, 2013

A 2012 ruling by the United States Supreme Court gave secured creditors worried about their collateral cause for celebration. Enacted in 1978, Chapter 11 of the Bankruptcy Code balanced the rights of competing creditors and provided financially distressed organizations with an equitable means for restructuring. It was drafted in an era where secured creditors enjoyed limited control over the debtor’s operations and restructuring plan because the debtor management controlled the process along with influential junior creditors. Chapter 11 equalized the rights of the secured creditor among the participants of a bankruptcy restructuring plan. One of those rights is the right to credit bid.  This right maintains the secured creditor’s collateral if it is being sold, or in the event of a “cram-down” reorganization plan.

Secured creditors are entitled to full payment up to the value of their collateral prior to unsecured creditors.  This entitlement exists inside or outside of bankruptcy.  Outside of bankruptcy, the secured creditor is able to realize its security by foreclosing on the collateral, thereby repossessing the collateral and selling it.  During the sale of the collateral, the secured creditor normally has the option to bid its own debt and purchase the collateral itself (i.e., a credit bid).  This protects the secured creditor from a low sale price.  Under Section § 1129(b)(2)(A)(ii) of the Bankruptcy Code, the right to credit bid is maintained when the collateral is sold inside the debtor’s proposed plan.[1]

This right to credit bid was threatened, however, as recent appellate court decisions began to split regarding a secured creditor’s entitlement to collateral.  The resulting question was this: when the collateral is being sold, is the secured creditor always entitled to invoke its right to credit bid; or could the debtor’s proposed plan deny the secured creditor the right to bid, with the secured creditor instead receiving the “indubitable equivalent” of its secured claim?[2] Such an “indubitable equivalent” would be valued by the bankruptcy court under Section § 1129(b)(2)(A)(iii). In 2009 and 2010, the Fifth and Third Circuits, respectively, concluded that the secured creditor did not have an absolute right to credit bid if it received an indubitable equivalent of its claim. In contrast, the Seventh Circuit ruled in two 2011 cases that the secured creditor’s right to credit bid could not be taken away by a judicial estimation of indubitable equivalence. In the second case, RadLAX Gateway Hotel, LLC v. Amalgamated Bank, the debtor appealed the Seventh Circuit decision and the Supreme Court granted certiorari.

On May 29, 2012, the Supreme Court ruled on the question “[w]hether a debtor may pursue a chapter 11 plan that proposes to sell assets free of liens without allowing the secured creditor to credit bid, but instead providing it with the indubitable equivalent of its claim under Section § 1129(b)(2)(A)(iii) of the Bankruptcy Code,” and unanimously decided that the answer was no.[3]  The oral arguments suggested the Justices were concerned that a lender could lose its collateral if it did not have cash with which to bid in the bankruptcy auction.  Justice Scalia’s opinion, however, focused on a narrow textualist approach to the question.  The opinion found no textual ambiguity regarding a Chapter 11 plan to sell assets free of liens without allowing secured creditors the right to credit bid on their collateral.  Instead, the specific language of Section § 1129(b)(2)(A)(ii) – which stated the requirement for selling collateral free of liens and permitting credit bids –  governed the broader Section § 1129(b)(2)(A)(iii) that did not refer to such sales.[4]  Therefore, the Court rejected the debtor’s argument that the sections should be viewed separately and, thus, prevented debtors from circumventing the procedural protection for secured creditors set up by Congress in Section § 1129(b)(2)(A)(ii).

In the end, this was a victory for secured creditors, arguably in line with the intentions of the drafters of Chapter 11 of the Bankruptcy Code.  The Supreme Court’s ruling clarifies the rights of secured lenders when a debtor wants to sell a major asset that is the collateral of a secured creditor or lender.

[1] 11 U.S.C. § 1129(b)(2)(A)(ii) (2011).

[2] Ralph Brubaker, Cramdown of an Undersecured Creditor Through Sale of the Creditor’s Collateral: Herein of Indubitable Equivalence, the §111(b)(2) Election, Sub Rosa Sales, Credit Bidding, and Disposition of Sale Proceeds, BANKR.LAW LETTER, Dec. 2009 at 10.

[3] http://www.law.cornell.edu/supct/cert/11-166

[4] RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 132 S.Ct. 2065, 2071-2 (2012).