The bankruptcy arena is fast becoming a sale barn for distressed assets. Modern chapter 11, codified in 1979, was launched amid well-intentioned statements about preserving jobs, preserving going concern value, and allowing troubled companies to right-the-ship and move on.

The present reality is that the vast majority of companies that find their way into the chapter 11 process opt for a sale of assets, as compared to an "old fashioned" reorganization. Bankruptcy sales have aspects of traditional auctions, with some definite wrinkles.

Everybody likes a good auction; the excitement of the bidding, the adrenaline charged atmosphere, and the winning bid, followed by second guessing by both bidders. The winner wonders if they bid too much; the also-rans wonder if they should have gone higher.

A presumption in the auction world is that all bidders are on an equal footing. All bids must be in "American dollars", and the successful bidder must "settle-up" with dollars.

Imagine, however, if one bidder could bid with play money (think colored Monopoly money). If they outbid the others, they settle-up with their play money and walk away with the prize.

That is how it appears when a secured creditor exercises its credit bidding rights at a sale of its collateral conducted in a bankruptcy case. Sales of property, both real estate, and personal property (equipment, fixtures, machinery, etc.) are authorized by Bankruptcy Code section 363(b). Built into the process, however, is an overbid procedure.

Normally, the seller, either a trustee or a chapter 11 debtor-in-possession, first enters into a purchase agreement with an interested purchaser, referred to in bankruptcy parlance as the "stalking horse bidder", with a clear understanding that the sale is subject to overbids.

On the appointed sale day, the Bankruptcy Court hears the motion for authority to sell property, like it would any other motion. The auction part of the sale, however, differs in setting depending on the judge. Some Judges enjoy acting as auctioneer, calling the bids, keeping careful track of whose bid is the high one, calling out "going once, going twice", and slamming down the gavel when the bidding is concluded.

Other judges ask that you "take it outside". The parties then retire to the hallway, or a coffee/snack-bar venue, and the auction is conducted by the attorney for the selling party. In cases where the sale is complicated (ex.- sales of hospitals, going businesses with multiple locations, etc.) the auction may be held offsite in an attorney's conference room, or even on-line, and may last the entire day.

Credit bidding by a creditor which has a valid and enforceable mortgage, trust deed, or security interest in the property being auctioned, is authorized by Bankruptcy Code section 363(k). The creditor simply bids in all or part its debt, while other bidders bid with real money.

As can be imagined, credit bidding has caused more than a little resentment on the part of the seller, and other bidders, and has caused some legal controversy.

Often the company in a chapter 11 case, as seller, fight's against credit bidding by a strategic (read "vulture") buyer who has purchased the company's debt at a deep discount and now wants to bid the purchased debt in order to buy the company's assets. The company may have in mind a friendly sale, for money, to a company that will employ current management, and minimize the disruption of current relationships.

A variety of attacks have been mounted by creative debtor/sellers seeking ways to derail an unwanted creditor/purchaser’s credit bid. In the recent case of Aeropostale, Inc., the company, in order to fight off a creditor's anticipated credit bid for all of the company's assets, sought an order from the Bankruptcy Court “equitably subordinating” the creditor’s claim under Bankruptcy Code section 510(c). If the debtor had been successful, the creditor’s claim would have been subordinated to all other claims, and, as a practical matter, stripped of its credit-bidding power.

Equitable subordination is strong medicine, and is not dispensed by courts lightly. The party seeking equitable subordination that must show that: 1) the claimant must have engaged in some type of inequitable conduct; 2) the misconduct must have resulted in injury to the other creditors in the case or conferred an unfair advantage on the misbehaving creditor; and 3) equitable subordination would not be inconsistent with other provisions of the Bankruptcy Code.

The debtor/seller argued that equitable subordination was appropriate due to its allegations that the creditor had traded in Aeropostale stock while in possession of “material non-public information”. The Bankruptcy Court for the Southern District of New York rejected this argument, finding that 1) the debtors’ own employees had traded that stock using the same information, with no complaint from management, and 2) the debtor/seller had not shown that the debtor, or other creditors, were harmed by the creditor’s alleged use of the “insider information”.

Further, the Court noted that, even if it was holding insider information, the creditor sold its shares of the debtor’s stock at a huge loss, and did not use any insider information to protect its possession. The equitable subordination argument was rejected, and the sale of Aeropostale’s assets went forward, credit bidding and all. The courts have recognized that creditors can take actions to protect and enforce their claims, which the debtor may find unpleasant, without crossing the line that could lead to equitable subordination or denial of credit bidding rights.

Another argument made by debtor/sellers is that credit bids will "chill the bidding", scaring away cash bidders, and allowing the secured creditor to place a cap on the bidding equal to the amount of its debt. The courts have been largely unimpressed with the chill the bidding arguments, absent a showing of bad behavior by the creditor.

The courts reason that if Congress had been concerned about credit bidding chilling the bidding in all bankruptcy sales, they would have addressed the issue. Instead, the credit bidding rights allocated to secured creditors in bankruptcy closely follow the credit bidding rights of creditors under state law. This follows the trend in bankruptcy policy that the law regarding property interests follows state law, except where contradicted by a specific provision of the Bankruptcy Code.

The Bankruptcy Code does, however, have a built-in limitation on credit bidding. The court can deny or limit credit bidding, “for cause”. As stated by the United States Court of Appeals for the Third Circuit in the case of Philadelphia Newspapers, LLC, "a court may deny a lender the right to credit bid in the interest of any policy advanced by the Code, such as to ensure the success of the reorganization or to foster a competitive bidding environment."

The Bankruptcy Courts have not hesitated to deny credit bidding rights to creditors for cause, when egregious facts have been shown. In the case of Fisker Auto. Holdings, Inc., the Bankruptcy Court for the District of Delaware found that cause existed to limit the secured creditor’s credit bidding rights to the amount that the creditor had paid for the claim, where it was shown that the secured lender had “chilled the bidding process by inequitably pushing the debtor into bankruptcy so that it could short-circuit the bankruptcy process”.

Similarly, in the case of Free Lance-Star Publishing Co., the Bankruptcy Court for the Eastern District of Virginia found that a lender, which had pursued a “loan-to-own” strategy, the last steps of which were to push the debtor into bankruptcy and acquire the debtor/borrower’s assets in a rushed bankruptcy sale, had engaged in inequitable conduct, and was not allowed to credit bid when the assets were sold.

The Court commented that the purpose for the credit bid provision in the Bankruptcy Code is to protect the creditor against a depressed price at a sale. The creditor should not be forced to sit idly by while its collateral is sold at a depressed price. If it is the creditor who is attempting to depress the price, however, then such action is viewed as cause to deny, or greatly limit, credit bidding rights.

A more pedestrian method for a debtor to defeat the creditor’s attempts to credit bid is to show that there is a bona fide dispute as to the creditor’s claim. The dispute can be in the form of a defense regarding the obligation itself, or, even if the obligation is valid, that the secured status of the claim is subject to a bona fide dispute. The showing of a bona fide dispute can be grounds for the court denying credit bidding rights.

In conclusion, a secured creditor’s credit bidding rights in a bankruptcy sale are not absolute. If the creditor has engaged in inequitable conduct, the courts will not hesitate to deprive them of any right to credit bid. Based on the cases in recent years, creditor/purchasers are well advised of the risks of being “too smart by half” in using strategies that have the effect of chilling bidding in bankruptcy sales.

By David M. Reeder