On April 14, 2014, the US Bankruptcy Court for the Eastern District of Virginia, in In re Free Lance–Star Publishing Co. of Fredericksburg, VA, held that cause existed to limit a secured creditor's right to credit bid at a section 363 sale of substantially all of the debtors' assets because of its "overly zealous loan-to-own strategy" and the "negative impact [its] misconduct. . . had on the auction process" (No. 14-30315, Bankr. E.D.Va. Apr. 14, 2014).

Free Lance-Star Publishing Co. of Fredericksburg, VA is a publishing, newspaper, radio and communications company that operates its business on land partially owned by a related entity, William Douglas Properties, LLC (collectively, Debtors). The Debtors' properties include three parcels of real estate and related assets used for their radio broadcasting operations (Tower Assets).

In 2006, the Debtors borrowed $50.8 million from Branch Banking and Trust (BB&T) to expand their commercial printing operations. The loan was secured by some of the Debtors' real and personal property, excluding the Tower Assets. In 2009, the Debtors breached certain of the loan covenants and signed a forbearance agreement with BB&T in 2011. While the Debtors continued to make timely payments to BB&T, adverse economic conditions prevented them from restructuring and becoming compliant with their loan covenants. In late June 2013, BB&T sold the loan to DSP Acquisition, LLC (DSP), a subsidiary of Sandton Capital Partners, LLC.

Shortly after, DSP informed the Debtors that it wanted the Debtors to file for Chapter 11 relief and sell substantially all of their assets to DSP in a section 363 sale. DSP requested that the Debtors execute three deeds of trust to encumber the Tower Assets and provided a "Restructuring Timeline" which contained DSP's expectation for the timely recordation of these deeds and a bankruptcy filing in September 2013. After negotiations broke down, DSP unilaterally, and without the Debtors' knowledge, filed UCC Fixture Financing Statements against the Tower Assets.

The parties resumed negotiations in September. DSP asked the Debtors to sign a revised forbearance agreement which did not require the Debtors to grant liens on the Tower Assets, explaining that it expected to obtain this collateral to secure its proposed DIP financing. The new forbearance agreement included a blanket release of all claims against DSP, both known and unknown.

Ninety days after DSP filed its UCC Fixture Filings, it resumed pressuring the Debtors for a speedy bankruptcy and an expedited sales process of no more than six weeks. DSP indicated that there was no reason to market the assets. DSP objected to the Debtors' retention of Protiviti, Inc. (Protiviti) as their financial consultant, who insisted on distributing marketing materials. In response, DSP required that the marketing materials highlight DSP's alleged right to a $39 million credit bid.

Protiviti also developed cash flow projections for the Debtors, which showed that they could survive in bankruptcy without DIP financing. Although DSP insisted that DIP financing was necessary, the Debtors refused the new loan, and all negotiations between the parties ceased. On January 11, 2014, DSP informed the Debtors that it no longer supported their bankruptcy and the next week recorded additional financing statements in different jurisdictions, again without informing the Debtors. On January 23, 2014, the Debtors filed their Chapter 11 cases, together with motions to sell business assets and the Tower Assets.

At a contested hearing conducted on January 24, 2014, DSP objected to the Debtors' use of the cash collateral and the Court denied its request for new liens on the Tower Assets as additional adequate protection. DSP failed to disclose that it had already filed financing statements against the Tower Assets in August 2013 and again in January 2014.

On March 10, 2014, the Court approved the bidding procedures set out by the Debtors in their sale motions, including DSP's right to credit bid its claim against the Debtors' assets on which it had valid liens. The same day, DSP filed a complaint seeking a declaration that DSP had valid and perfected liens on substantially all of the Debtors' assets, including the Tower Assets, and moved for summary judgment. The Debtors filed a cross motion for summary judgment against DSP.

Under section 363(k) of the Bankruptcy Code, a creditor is generally entitled to credit bid the full amount of its claim in a section 363 asset sale, "unless the court for cause orders otherwise." DSP argued that no cause existed to limit the value of its credit bid and that it should be entitled to utilize the full face value of its note in the credit bidding process. The Debtors, on the other hand, argued that DSP's credit bid should be limited because:

The Court ruled that DSP's credit bid should be limited to $13.9 million, consisting of $1.2 million for assets related to the Debtors' radio business and $12.7 million for assets related to the Debtors' newspaper and printing business, because:

The Court started by examining both the text and the underlying policy of section 363(k). While the Court noted that the right to credit bid is an important safeguard that insures against the undervaluation of a creditor's collateral, it stressed that the plain text of section 363(k) provides that the right to credit bid can be limited if the court "for cause order[s] otherwise." The Court explained that credit bidding is not an absolute right as generally, a court may deny a lender the right to credit bid in the interest of any policy advanced by the Bankruptcy Code, such as to ensure the success of the reorganization or to foster a competitive bidding environment. The Court observed that in the recent In re Fisker Automotive Holdings, Inc. case, "cause" existed under section 363(k) where a secured lender had "chilled the bidding process by inequitably pushing the debtor into bankruptcy so that it could short-circuit the bankruptcy process" (see No. 13–13087, (Bankr. D. Del. Jan. 17, 2014) and Legal Update, In re Fisker Automotive: Delaware Bankruptcy Court Caps Credit Bid to Amount Paid for Claim).

The Court agreed with the Debtors' first argument concerning DSP's liens. Because the Court had separately ruled that DSP did not have valid, properly perfected liens on certain assets, including the Tower Assets, the Court held that DSP had no right to credit bid on these assets.

Turning to DSP's inequitable conduct, the Court noted that from the moment DSP bought the loan from BB&T, it pressured the Debtors to agree to an expedited bankruptcy sales process. The Court was "troubled" by DSP's decision to unilaterally expand the scope of its security interest in the Debtors' assets by filing financing statements against the Tower Assets in August 2013 and again in January 2014, even after the Debtors explicitly rejected requests to grant those liens. Moreover, the Court was "disappointed" that DSP failed to disclose these filings at the January 24, 2014 cash collateral hearing, during which DSP requested the Court to grant it those same liens. Finally, the Court was "equally troubled" by DSP's attempts to "frustrate the competitive bidding process" by pressuring the Debtors to shorten the marketing period and insisting that the marketing materials conspicuously advertise DSP's credit bidding rights.

While holding that DSP's conduct was inequitable, the Court suggested in dicta that the mere use of a loan-to-own strategy may be sufficient "cause" to limit credit bidding. The Court explained that while credit bidding normally works to protect secured lenders against the undervaluation of their collateral, in loan-to-own transactions a secured party can use credit bidding to chill bidding during or before an auction, or to discourage prospective bidders from participating in the sales process. This works to depress, rather than maximize, the sales price of the assets only for the benefit of the secured creditor at the expense of the estate's other creditors.

The Debtors' expert witness, Roski, presented the only testimony on the proposed bidding procedures and auction process. Roski testified that while many parties expressed preliminary interest in the Debtors' assets, most were confused and awaiting resolution of the credit bidding issue before engaging in further due diligence. Therefore, Roski concluded that potential bidders were less likely to participate in the sale process and that limiting DSP's credit bid would help restore a competitive bidding environment and promote enthusiasm for the sale. Roski eliminated the unencumbered assets from the potential credit bid and applied a market analysis to propose an appropriate cap for a credit bid that would foster a competitive auction process but warned that her conclusions did not reflect a valuation of the Debtors or any of their specific assets. DSP offered no evidence to refute Roski's testimony and failed to provide the Court with an alternative method for limiting the credit bid. Therefore, the Court adopted Roski's recommendation to limit the credit bid to $13.9 million, consisting of $1.2 million for assets related to the Debtors' radio business and $12.7 million for assets related to the Debtors' newspaper and printing business.

On May 7, 2014, the US District Court for the Eastern District of Virginia denied DSP's emergency appeal on procedural grounds (see DSP Acquisition, LLC v. Free-Lance Star Publ'g Co. of Fredericksburg, VA, No. 3:14cv303-HEH, (E.D. Va. May 7, 2014)). The auction is scheduled for May 15, 2014.

Free Lance-Star is a reminder that secured creditors must exercise caution both before and after purchasing distressed debt to execute a loan-to-own strategy. This case, together with Fisker, may indicate an emerging trend by some courts to expand the "for cause" exception to limit credit bidding by closely scrutinizing a secured creditor's motives and conduct (see Legal Update, In re Fisker Automotive: Delaware Bankruptcy Court Caps Credit Bid to Amount Paid for Claim). However, these cases leave open the question of whether courts can limit credit bidding rights to promote a competitive and robust sales process in the absence of inequitable conduct. If so, this could negatively impact the claims trading market for distressed debt.

To avoid the result in both Fisker and Free Lance-Star, secured creditors planning to exercise a loan-to-own strategy should:

For more information on credit bidding, see Practice Note, Credit Bidding in Section 363 Bankruptcy Sales.