Vol 7 (2010) - Issue 1

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Cutting Back on Credit Bids: Pacific Lumber and Philadelphia Newspapers

Until recently, a secured creditor in the United States could be confident that it had the right to 'credit bid' in a plan of reorganisation that proposed to sell its collateral: any plan that denied that right would not be viable. This stick – 'you take away my right to credit bid in your plan and the debtor cannot reorganise' – provided important protection against the risk that the secured creditor’s collateral would be undervalued.

By 'credit bidding' the face value of its claim, a secured creditor could increase the potential sales price of its collateral to the fair market value without offering any new cash. If competing bids proved inadequate, the creditor could purchase the collateral and offset the amount of its claim against the purchase price. In this way, the creditor ensures that it recovers the fair market value of its collateral.

Consider, for example, a lender that issued a USD 1 million loan secured by a mortgage on real estate with a fair market value of USD 750 000. If the borrower filed for bankruptcy relief, the lender would have an allowed claim for USD 1 million. The amount that the lender ultimately recovers on its claim, however, depends on the sales price for the real estate. In a typical bankruptcy case, the lender can expect to recover nearly 100% of the sale proceeds but, at most, a fraction of the remainder of its claim. The lender, therefore, has a strong incentive to prevent other bidders from purchasing the real estate at a discount. One way the lender can do so is by credit bidding USD 750 000 at the sale. Assuming there are no higher bids, the lender could recover the real estate and reduce its bankruptcy claim to USD 250 000. The lender could then resell the real estate for USD 750 000, or hold on to the real estate for itself.

But in 2009 secured creditors’ confidence in their right to credit bid was shaken. Beginning with the Fifth Circuit Court of Appeal’s decision in Scotia Pacific Co., LLC v Official Unsecured Creditors’ Committee (In re Pacific Lumber Co.), 584 F.3d 229 (5th Cir. 2009), in September 2009, and continuing with the Eastern District of Pennsylvania’s decision In re Philadelphia Newspapers, LLC, 2009 WL 3756362, No. 09-mc-178 (E.D. Pa. Nov. 10, 2009), in November 2009, a line of cases is potentially emerging that allows a plan of reorganisation to deny a secured creditor the opportunity to credit bid. Should this trend continue to develop, secured creditors will lose an important protection against undervaluation of their collateral.