Credit Bargains Modified: The Significant Impact Recent Judicial Decisions Will Have on Secured Lenders’ Recoveries in Bankruptcy
The spectrum of debt financing — whether senior secured, subordinate or unsecured — ultimately reflects a lender’s tolerance for risk. Risk tolerance is quantifiable by the rate of interest charged, the value of and a lender’s priority to collateral, and the borrower’s financial condition. These are all fairly predict- able variables to project potential return on capital.
A recent flurry of judicial decisions likely will change that calculus, resulting in less predictable recoveries in bankruptcy for all lenders. This article analyzes four recent federal court cases, one by the U.S. Supreme Court, that every lender must understand: Bank of America, N.A. v. Caulkett, No. 13-1421, U.S. (S. Ct., June 1, 2015); In re AMR Corp., 485 B.R. 279 (Bankr.S.D.N.Y. 2013) aff’d 730 F.3d 88 (2d. Cir. 2013); In re Jevic Holding Corp., No. 14-1465, F.3d (3d. Cir., May 21, 2015); and In re Fisker Automotive Holdings, Inc., 510 B.R. 55 (Bankr. D. Del. Jan. 17, 2014). These cases primarily affect secured creditors’ rights and their ability to recover damages, limit their litigation expenses, and maximize the value of their bargained-for collateral when their borrowers file for bankruptcy protection. The cases cover certain ‘‘hot-topics’’ in bankruptcy, cases that will have a significant impact on a lender’s bottom line, including: the current state of chapter 7 ‘‘lien stripping’’ by debtors, lenders’ ability to enforce ‘‘make-whole’’ premiums, the controversial use of chapter 11 ‘‘structured dismissals’’ in lieu of confirmed plans of reorganization or liquidation, and newly imposed restrictions on the time- honored practice of a secured lender ‘‘credit-bidding’’ the amount of its debt upon the sale of its collateral.
I. Protection from Lien Stripping May Increase Recoveries of Subordinate Lenders
In Bank of America, N.A. v. Caulkett, No. 13-1421, U.S. (S.Ct., June 1, 2015), the United States Supreme Court held that a chapter 7 debtor cannot void or ‘‘strip’’ a junior ‘‘underwater’’ lien on a home, by definition one with zero or negative equity, if the lien secures an allowed claim against the debtor. Id. at 1. Instead, the creditor now may retain its lien and the right potentially to recover the value of collateral post-bankruptcy. By its ruling, the Supreme Court further restricted the common debtor practice of ‘‘lien stripping,’’ a practice typically upheld by bankruptcy courts to enhance an honest debtor’s fresh start chances post-bankruptcy. Caulkett, therefore, preserves second or third tier security interests and the potential that collateral may appreciate in value in the future.
A. Subordinate, Secured Lenders Benefit from Caulkett’s Interpretation of the Ambiguous Phrase ‘‘Allowed Secured Claim’’ in the Bankruptcy Code
The debtor, David Caulkett, had two mortgage liens on his home. Bank of America held the junior or subordinate mortgage. The amount owed on the debtor’s senior mortgage was greater than the home’s then current market value, thus rendering Bank of America’s junior mortgage wholly ‘‘under- water.’’ Id. at 2. Debtor in chapter 7 moved to ‘‘strip’’ or void the junior mortgage under § 506(d) of 11 U.S.C. § 101 et seq. (the ‘‘Bankruptcy Code’’). That section provides, in relevant part: ‘‘To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.’’ 11 U.S.C. § 506(d). The parties agreed that the bank’s ‘‘claim.’’ i.e., its right to repayment from the debtor, was allowed under § 502. The dispute therefore was whether the bank’s claim also was ‘‘secured,’’ within the meaning of § 506(d).
The question presented to the Supreme Court was whether a junior mortgage may be voided under § 506(d) when it secures an allowed claim against the debtor and the debt owed on a senior mortgage exceeds the present value of the property. Id. at 1. The Court unanimously answered no, resolving an erstwhile split in Circuit Court decisions. The confusion arose because nearly identical terms are used earlier in the same section of the statute in § 506(a)(1), which provides, in relevant part:
‘‘[a]n allowed claim of a creditor secured by a lien on property… is a secured claim to the extent of the value of such creditor’s interest in.. . such property’’ and ‘‘an unsecured claim to the extent that the value of such creditor’s interest… is less than the amount of such allowed claim.’’
11 U.S.C. § 506(a)(1). (Emphasis supplied). The Supreme Court relied on and logically extended its own precedent, Dewsnup v. Timm, 502 U.S. 410 (1992), to resolve the ambiguity. Dewsnup involved facts similar to Caulkett except that the lien at issue in Dewsnup was partially — as opposed to wholly — underwater. The Caulkett Court extended Dewsnup and held that a claim is a ‘‘secured claim’’ under § 506(d) if it is ‘‘secured by a lien’’ and ‘‘has been fully allowed pursuant to § 502,’’ irrespective of whether the judicially determined value of that property would be sufficient to cover the claim under
§ 506(a). Id. at 5. Thus, the Court declined to apply the security-reducing provision of § 506(a)(1) to the lien-voiding provision of § 506(d). If the secured claim is allowed, it is outside the scope of § 506(d).
B. Implications of Caulkett on Secured Lender Recoveries
Caulkett preserves subordinate security interests in ever changing real estate markets. Consequently, an allowed claim secured by an underwater, junior lien may pass unaffected through bankruptcy. The subordinate lender’s recourse to the collateral post-bankruptcy, as opposed to having its lien negated in bankruptcy, is a significant economic shift. If post-bankruptcy market conditions improve and the collateral appreciates, these benefits may accrue to the lender.
II. Enforceability of ‘‘Make-Whole’’ Premiums Hinges on Contract Terms
Whereas Caulkett was primarily a statutory interpretation case, In re AMR Corp., 485 B.R. 279 (Bankr. S.D.N.Y. 2013) aff’d 730 F.3d 88 (2d. Cir. 2013) centers on contract interpretation: the Bankruptcy Court for the Southern District of New York examined the terms of a lender’s premium — referred to as a ‘‘make-whole amount’’ — in its indenture with its borrower. Typically, a make-whole amount provides that, if a loan is prepaid in full before maturity or accelerated upon default, then the borrower must pay a premium to compensate the lender for the loss of interest it expected to receive over the full term of the loan. The AMR lender’s indenture, however, contained inconsistent language as to the enforceability of the make whole premium. As a result, the bankruptcy court held that the debtor was not required to pay the make whole premium, resulting in the lender having lost millions of dollars in otherwise recoverable interest.
A. The Language of the Make Whole Premium in AMR
In AMR, chapter 11 debtor American Airlines, Inc. moved before the bankruptcy court for authority to use cash on hand to repay its prepetition obligations to U.S. Bank National Association, but without having to pay the make whole premium. Id. at 283. U.S. Bank objected.
American Airlines argued the bankruptcy filing triggered the event of default under Section 4.01(g) of the Indenture, accelerating the amounts due and payable upon default, but not the make whole premium. Id. at 287. The bankruptcy court examined the following default provision:
… if an Event of Default referred to in Section 4.01(g) … shall have occurred and be continuing, then and in every such case the unpaid principal amount of the Equipment Notes then outstanding, together with accrued but unpaid interest thereon and all other amounts due thereunder (but for the avoidance of doubt, without Make-Whole Amount), shall immediately and without further act become due and payable without presentment, demand, protest or notice, all of which are hereby waived…
(Emphasis supplied). Id. at 285-86.
U.S. Bank countered that the make whole premium was due because American Airlines was voluntarily redeeming the prepetition notes, thus the amounts due and payable upon redemption included the make whole premium. Id. at 287. The court examined the following redemption provision:
[A]ll, but not less than all, of the Equipment Notes may be redeemed by the Company at any time upon at least 15 days’ revocable prior written notice to the Loan Trustee and the Noteholders, and such Equipment Notes shall be redeemed in whole at a redemption price equal to 100% of the unpaid principal amount thereof, together with accrued and unpaid interest thereon to (but excluding) the date of redemption and all other Secured Obligations owed or then due and payable to the Noteholders, plus Make-Whole Amount, if any …
(Emphasis supplied). Id. at 285.
The bankruptcy court rejected U.S. Bank’s argument and agreed with American Airlines, reasoning that: ‘‘The Court instead reads ‘if any’ to mean that payment of the Make-Whole Amount is not automatic and there are some circumstances under which a Make-Whole Amount will not be payable.’’ Id. at 303. Ultimately, the court viewed the bankruptcy induced acceleration as defining the parties’ rights and proscribing payment of the make whole amount in such circumstance. Id. at 303 (‘‘Such a reading harmonizes the language in [the redemption clause] with that in [the default clause], which specifically calls for no Make-Whole Amount after a bankruptcy default and resulting acceleration.’’). The court acknowledged that make whole amounts are generally permissible but cautioned that entitlement to those payments is a matter of contract, not policy. Id.
B. Implications of AMR on Secured Lender Recoveries
AMR appears to have been an easy case of contract interpretation based on the specific agreement between the American Airlines and U.S. Bank. In order to avoid a similar result in future cases — U.S. Bank lost millions of dollars in interest—lenders should carefully bargain for and draft their financial instruments to consistently require payment of make whole premiums upon redemption, default, and acceleration (inclusive of a bankruptcy default and acceleration).
III. Structured Dismissals May Enable Secured Lenders to Exit Borrower Chapter 11 Bankruptcies More Efficiently
Traditionally, bankruptcy courts considered three primary avenues to exit a chapter 11 bankruptcy: reorganization, liquidation, or an unconditional dismissal, wherein all parties are returned to their pre-filing status. Recently, however, the Third Circuit in In re Jevic Holding Corp., 787 F.3d 173 (3d Cir. 2015) approved an alternative route: a ‘‘structured’’ dismissal, which is a disposition that concludes a bankruptcy case with certain conditions such as obtaining releases, the reconciling and paying of creditor claims, and certain other relief typically found in the chapter 11 plan process.
A. The Structured Dismissal Approved by the Jevic Decision
Jevic Transportation, Inc. (‘‘Jevic’’) filed for chapter 11 bankruptcy protection in May of 2008. At that time, it owed about $53 Million to secured creditors Sun Capital Partners (‘‘Sun’’) and CIT Group (‘‘CIT’’) and another $20 Million to its tax and general unsecured creditors. Id. at *1. The bankruptcy encompassed two lawsuits: (i) a class action by a group of Jevic’s former employees (the ‘‘Employees’’) alleging violations of federal and state WARN Acts,1 and (ii) a fraudulent conveyance action by the Official Committee of Unsecured Creditors (the ‘‘Committee’’), on behalf of Jevic’s bankruptcy estate, against CIT and Sun. Id. After almost three years of litigation, Jevic’s only remaining assets were approximately $1.7 million in cash, which was subject to Sun’s lien, and the litigation against Sun and CIT. Id. The Committee elected to settle its action. The settlement provided that: (i) the parties would exchange releases and the fraudulent conveyance action would be dismissed with prejudice; (ii) Sun would assign its lien on Jevic’s remaining $1.7 million in cash to a trust, which would pay tax and administrative creditors first, with the balance, if any, to general unsecured creditors; and (iii) Jevic’s chapter 11 case would be dismissed. Id. The ‘‘structured’’ settlement and dismissal, however, provided no recovery to the Employees in consideration of their uncontested WARN Act claims. Id.
The Employees and the United States Trustee (the ‘‘US Trustee’’) objected to the proposed dismissal because it distributed property of the estate to creditors of lower priority than the Employees under § 507(a) of the Bankruptcy Code,2 thus violating the ‘‘absolute priority rule’’ whereby senior creditors must be paid in full before a junior class of creditors receive any distribution or value. Id. at *3. The U.S. Trustee further objected to the proposed settlement, asserting that the Bankruptcy Code does not permit structured dismissals. Id. The Bank- ruptcy Court rejected these arguments, approved the settlement, and dismissed Jevic’s chapter 11 case.
On appeal, the Third Circuit likewise disagreed with the Employees and U.S. Trustee. The Third Circuit held that ‘‘absent a showing that structured dismissal has been contrived to evade the procedural protections and safeguards of the plan confirmation or conversion processes, a Bankruptcy Court has discretion to order such a disposition.’’ Jevic at *5. Considering whether settlements could skip a class of objecting creditors in favor of more junior creditors, the Court noted that when Congress codified the absolute priority rule, it did so in the specific context of plan confirmation. Neither Congress nor the Supreme Court has ever stated that the rule applies to settlements reached in connection with a bankruptcy case. Id. at *7.
B. Structured Dismissals May Save Costs for Lenders
The Jevic decision appears to enhance secured creditors’ recoveries by minimizing costs that lenders may incur provided; however, certain facts and circumstances warrant use of structured dismissals. For example, the Jevic court was very careful to predicate its ruling on the fact that there was no prospect of a confirmable chapter 11 plan of reorganization or liquidation, and, absent the settlement, all assets were subject to the liens of secured creditors. If the right facts exist, bankruptcies could be ended quickly and without the cost and expense of a protracted chapter 11 plan confirmation process. Lenders could also seek to structure dismissals conditioned on the release of lender liability claims.
IV. Capping Secured Lenders’ Credit-Bids Will Create Uncertainty and Impair the Mitigation of Damages
One of the most important protections afforded a secured creditor, one that gives it some certainty and control over recoveries in bankruptcy by mitigating its damages, is its right to ‘‘credit bid’’ the amount of its secured debt at any sale of its collateral. Recently, the United States Bankruptcy Court for the District of Delaware, in In re Fisker Automotive Holdings, Inc., 510 B.R. 55 (Bankr. D. Del. 2014), impaired this right. Fisker held that time honored right of a lender to credit bid the full amount of its debt could be impaired for ‘‘cause,’’ ruling that ‘‘cause’’ included the need to foster competitive bidding at a Section 363 auction.
A. Credit Bids May Be Capped at the Debt Acquisition Price When Liens Are Disputed
Fisker, an electric automobile developer, owed approximately $168.5 Million in secured debt to the Department of Energy (the ‘‘DOE’’). Hybrid Tech Holdings, LLC (the ‘‘Secured Creditor’’) purchased the secured debt for $25 Million resulting in the Secured Creditor succeeding to the DOE’s position as the Debtors’ secured lender. Id. at 56- 57. The Debtors then sought to sell substantially all their assets to the Secured Creditor in a bankruptcy sale for a $75 Million credit bid. Id.
The Official Committee of Unsecured Creditors (the ‘‘Committee’’) objected to the sale, arguing that the credit bid should be capped at the $25 Million debt acquisition price because such cap would increase the likelihood of competitive bidding at the auction and creation of value for the estate. The Debtor and the Committee agreed that some of the assets to be sold were not subject to properly perfected liens of the Secured Creditor or subject to disputed liens. Id. at 57-58. The parties further agreed that no one would bid more than $168.5 Million for the Debtors’ assets.
The Court conceded that the Secured Creditor is entitled to credit bid its allowed claim, the only question being in what amount. Id. at 59. The Court also noted that the law is equally clear that a credit bid may be limited or restricted ‘‘for cause’’ under § 363(k) of the Bankruptcy Code.4 Id. One example of cause is when ‘‘.. .the holder of a lien, the validity of which has not been determined, [ ] may not bid its lien.’’ Id. The Court acknowledged it did not yet know how much of the Secured Creditor’s claim was in fact secured because the parties stipulated that the claim was partially secured, partially unsecured, and of uncertain status for the remainder. Id. at 61. Additionally, the parties stipulated that no one would bid more than $168.5 Million for the Debtors’ assets. The Court used this fact to further hold that there would be no bidding, not just ‘‘chilled’’ bidding, if it did not limit the Secured Creditor’s credit bid. Id. at 60 (‘‘the ‘for cause’ basis upon which [the Court] is limiting the credit bid [to $25 million] is that bidding will not only be chilled without a cap, but bidding will be frozen.’’). Thus, according to the Fisker Court, there was ‘‘cause’’ to restrict the credit bid in order to (i) facilitate an open and competitive auction process and (ii) avoid allocating encumbered, unencumbered, and disputed liens to a credit bid at sale.
B. Potential Impact of Fisker on Secured Creditor Recoveries
Fisker is most troubling because of the uncertainty it injects into the process by which lenders acquire distressed debt and the extent of their rights in the bankruptcy sale process. In Fisker, the Court was myopic, looking solely to the fact that the existence of a large credit bid would have the effect of freezing out any other bidders for the Debtors’ assets. Although the Secured Creditor had cut a deal to purchase over $168 Million in debt for $25 Million, the Bankruptcy Court declined to preserve the benefit obtained by the Secured Creditor. Whether the rationale in Fisker will be adopted by the Bankruptcy Courts in other circuits is unclear. Nevertheless, the Fisker Court has injected a level of uncertainty for recoveries by lenders acquiring distressed debt at a discount.
Reprinted from Commercial Damages Reporter with permission. Copyright 2015. Matthew Bender & Company, Inc., a LexisNexis Company. All rights reserved.