The ability of a secured creditor to credit bid its debt in connection with a sale of a debtor’s assets received a strong boost in a decision last month in the Chapter 11 case of Aeropostale from U.S. Bankruptcy Judge Sean Lane of the Southern District of New York.  Two recent decisions, Fisker Automotive and Free Lance-Star Publishing Co., had surprised many observers by narrowing the rights of secured creditors to credit bid, and resurrected uncertainty about a debtor’s ability to limit those rights (a dispute that had appeared to have been resolved in favor of secured creditors only a few years earlier by the Supreme Court’s decision in RadLax Gateway Hotel).  In particular, Fisker Automotive and Free Lance-Star Publishing Co. suggested that the potential of a credit bid to “chill” bidding by other prospective buyers could suffice to limit a secured creditor’s rights.  Judge Lane’s ruling in Aeropostale significantly walks back those decisions and narrows the grounds on which credit bidding rights can curtailed.  (Kelley Drye & Warren LLP represents parties in the Aeropostale case but took no part in the matters discussed here.)

Section 363(k) of the Bankruptcy Code provides that secured creditors may credit bid the full amount of their debt when their collateral is sold, “unless the court for cause orders otherwise . . . .” (emphasis added).  Credit bidding in bankruptcy protects the expectations of secured creditors under non-bankruptcy law to be able to look to their collateral in the event of a default.  The Bankruptcy Code does not define what constitutes “cause”, but for many years it was generally viewed as being narrow in scope, such as a creditor’s bad faith or misconduct.  A controversy arose a few years ago when the U.S. Court of Appeals for the Third Circuit unexpectedly limited a secured creditor’s right to credit bid in the absence of “cause” in the Philadelphia Newspapers case.  That decision was effectively overruled by the Supreme Court’s decision in RadLax.

Fisker Automotive and Free Lance-Star Publishing Co. put the issue of credit bidding back on the table, creating controversy over how broadly courts could define the meaning of “cause” under Section 363(k).  Specifically, although there was evidence in each case of inequitable creditor conduct and possible invalidity of security interests, both rulings suggested that “cause” could be based solely on the goal of fostering a competitive auction process, i.e., not “chilling” the bidding.  This aspect of the rulings in Fisker Automotive and Free Lance-Star Publishing Co. raised particular concern for secured creditors.  Credit bidding can nearly always be said to “chill” competing offers.  In one sense, that is its very purpose – to protect a secured creditor from being forced to accept a cash payment that is below the value the secured creditor believes the collateral possesses.

In Aeropostale, the debtors engaged in a sale of substantially all of their assets, and sought to limit the ability of its secured lenders to credit bid.  The lenders are affiliates of a private equity firm, Sycamore Partners, that through other affiliates also owned equity in in Aeropostale and held a controlling interest in one of its largest suppliers.  The debtors alleged a broad range of inequitable conduct against Sycamore Partners and its affiliates arising from the multi-faceted connections, in an effort to show that the “cause” standard under Section 363(k) was satisfied.  Relying on Fisker Automotive and Free Lance-Star Publishing Co., the debtors also contended that permitting the secured lenders to credit bid would deter other parties from putting forward offers and would “chill” the bidding.

Following a multi-day trial, Judge Lane rejected the allegations regarding inequitable conduct on the part of Sycamore Partners and its affiliates, finding that each of the Sycamore related entities had acted in accordance with its contractual rights and had taken reasonable steps to protect its financial interests.  This left the question of whether “cause” could be shown merely by the possible negative effect on the sale process of permitting the secured lenders to credit bid.

Judge Lane expressly declined to give Fisker Automotive and Free Lance-Star Publishing Co. the expansive readings requested by the debtors.  He acknowledged that “courts will sometimes refer to concerns about the chilling of bidding as a factor [in considering whether to limit the ability to credit bid].”  However, he observed that the court in each those cases found both evidence of inequitable conduct on the part of the secured creditor, and questions regarding the extent and validity of the security interests held.  In contrast, Judge Lane found no bad actions on the part of the Sycamore partners and its affiliates in Aeropostale.  He also noted that no party had challenged the extent and validity of the secured lenders’ liens and security interests.  Judge Lane made clear that absent those factors, “cause” could not be shown.  “[T]he Court is unaware of any cases where the chilling of bidding alone is sufficient to justify a limit on a credit bid.” (emphasis added).

He also referenced the recent comprehensive report published by the American Bankruptcy Institute Commission to Study the Reform of Chapter 11.  The report has been criticized by banking groups and associations for certain recommendations which have been viewed as contrary to the interests of secured creditors.  With respect to credit bidding, however, the report came down firmly on the side of such interests.  Judge Lane cited its finding regarding “the fundamental role of credit bidding under state law and section 363(k)”, and conclusion that “the chilling effect of credit bidding alone should [not] suffice as cause under section 363(k).”

Judge Lane’s comprehensive Aeropostale opinion squarely addresses the key question that arose from Fisker Automotive and Free Lance-Star Publishing Co.  If followed by other courts, it will resolve that credit bidding rights may not be limited “for cause” where a secured creditor exercises its rights in good faith, and in the absence of any malfeasance or issues regarding the extent or validity of liens.  Even if doing so would enhance the prospects of a competitive auction for a debtor’s assets, Aeropostale makes clear that limitations on credit bids should not be permitted.