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Credit Bidding and Sears

posted by Adam Levitin

The Sears' auction is a really valuable teaching moment, I think (and perfectly timed for the start of the semester)—does Sears have going concern value that merits a sale of substantially all assets as a going concern, or is an immediate liquidation the value maximizing move?  

I don't have an opinion on that issue, but something strikes me as rather strange about ESL's bid for a sale of substantially all assets.  Very little of the now $5B in consideration offered is cash, less than 20%.  Instead, a large chunk is in the form of debt assumption and another large chunk is in the form of a credit bid.  It's the credit bid that looks odd to me.  ESL seems to be trying to credit bid three different loan facilities, including a second lien facility.  Here's the thing--ESL should only be able to credit bid against its collateral and then only in the amount of its collateral. I don't know what exactly is covered by the liens on each of the facilities, but I suspect that the assets being sold include things that are not covered by the liens. That would seem to create a Free-Lance Star problem for ESL.  And then there's the problem of the valuation.  In order to know what ESL can credit bid, we need to know to what extent it is secured.  To wit, consider a second lien facility.  If the collateral is worth $100 and the first lien debt is for $80 and the second lien debt for $30, the second lien debt shouldn't be able to credit bid $30 because it would only recover $20 from the sale in foreclosure.  The second lien's credit bid should be capped at $20.

The language of 363(k) is not as clear as it could be about this issue:  

At a sale under subsection (b) of this section of property that is subject to a lien that secures an allowed claim, the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.

Does "such claim" mean just "an allowed claim," or does it mean "an allowed secured claim".  The former reading is literal, but only the second reading makes sense.  Otherwise we could end up with absurdities:  imagine now that the collateral is worth $100, the first lien debt is for $80 and the second lien debt is for $150.  In that scenario, the second lien holder credit bids $150 and wins the auction, but has just paid with funny money, as $130 of that bid was a deficiency claim that might not even be enforceable at state law.  (Obviously there is something strange about doing a valuation before we have an auction--we might posit that the collateral is worth $100, but what if it sells only for $90 or for $110?  The opposite would also be silly--if we had cash bids, the credit bid by definition couldn't top the highest cash bid because the top cash bid would set the collateral price.)  I think this probably points to a need to limit credit bidding by junior lien holders, which can be done for cause under 363(k).  

The problem here reflects two basic misconceptions about secured credit.  First, is the idea that lenders actually have blanket liens that cover everything.  While that is an easy short-hand for liens that cover substantially all assets, substantially is not the same as all.  A financing statement might list "all assets," but that's not going to work for the security agreement itself under Article 9, and there are some assets that aren't lienable.  The second misconception is treating asset-based priority as part of the same system as entity-based priority.  A lien on an asset doesn't translate into priority in other assets.  Again, it's handy to talk of secured creditors having senior priority, but they only do in their collateral.  To the extent their undersecured, their just hoi polloi.  

These are just some off-hand musings.  Ted Janger has thought quite deeply about this problem.  Ted and I have some further thoughts at the end of this piece.  But I find myself uneasy with the use of credit bidding by ESL.  

Comments

I confess that I haven't given careful thought to junior lienholders' right to credit bid -- and haven't focused at all on the ESL/Sears situation. More broadly, you are certainly right that the lienholder must have a lien on the assets on which it seeks to credit bid. So there are allocation issues raised when a debtor bundles, in an auction, assets that are subject to a lien with those that are unencumbered. That problem applies equally auctions of assets that are subject only to a first lien.

As to credit bidding by the underwater junior lienholder, isn't the problem largely addressed by focusing on the treatment of the senior lienholder? If the senior lienholder is not going to be paid in full out of the proceeds of the sale, then the second lienholder will presumably take the assets subject to the first lien. In that event, if the second lienholder is willing to credit bid its junior debt for an asset that remains subject to the first lien, then (sorta by definition) the asset is "worth" the amount of the first lien plus the amount of the credit bid. It becomes no different than a credit bid by the holder of a first lien. Others don't get to say that you can't credit bid because the asset is not "worth" the amount of your credit bid.

Alternatively, if the second lienholder wants free and clear title to the asset, it presumably needs to put up enough cash to take out the first lienholder. And if it does, we are back to a world in which the credit bid is providing fair value.

More broadly, in a world in which one of the key functions of the right to credit bid is to protect a secured creditor from the risk of judicial undervaluation, it would seem odd to deny the right to credit bid because a court concludes that the second-lienholder is (based on a judicial valuation) underwater.

I don't see what's distinctive about the *second* lien. Don't your objections equally cover first-lien credit bidding (in Sears and elsewhere)?

Unlienable assets are often held in special-purpose subs, with covenants against incurring indebtedness, and with the secured creditor having a lien on the parent's stock. (I don't know about Sears.) The secured creditor can thus credit bid for the parent's stock rather than the underlying assets. I don't know if the formal distinction is always observed as completely as it could be. But in any case, this practice mitigates the magnitude of the substance of the problem you point to, although it doesn't eliminate it.

On a different register: don't these complications suggest we should just junk asset-based priority? It's easy under an entity-based priority system to replicate asset-based priority (using subs), but comparatively hard to go the other way. If the answer is "what about tort creditors?," I get it but we don't exactly have that figured out under the current system either.

You write, "ESL should only be able to credit bid against its collateral and then only in the amount of its collateral." I agree on the former but not the latter. The concept of credit bidding does not prohibit bidding above the "value" of the collateral. Indeed, the whole idea of the auction is that we are setting the value of the collateral (and hence the deficiency). Craig is right that the second has to put up cash to take out the first and then it can credit bid. In your example, the second has to put up $80 in cash and then it can credit its debt of $30.

I also agree with Vince that the issues are not unique to second liens. The issue is what you suggested -- can ESL credit bid in an auction of assets that has collateral and non-collateral.

I think there is a second lien problem. Let's imagine that there's a first lien of $80 and a second lien of $130. If the second lien can credit bid without limit, then the second lien wins the auction with a credit bid of $130, even if the collateral would only sell for $70 in a cash sale. Yes, the second lien has now an asset worth $70, subject to a first lien of $80--there's no equity value. But the second lien never had any equity value in the first place, but it now has control over the asset, at least in the short-term, which is problematic because the second lienholder has no incentive to maintain or improve the asset--why wash someone else's car?

Functionally, Craig is right--the need to take out the first lien will typically solve the problem. But that puts the cart before the horse--we only get into the problem if we allow the second to credit bid, which requires assuming that it will pay off the first.

I'm not on the same page as Bob regarding the idea that the auction sets the value of the collateral. That's certainly true in a cash auction, but the creditor is bidding in funny money. The deficiency would sell for far less than par, and for virtually nothing if it is non-recourse, while the part of the secured part of the debt should sell for near par. That's not a second-lien problem, but a general problem with credit bidding.

Vince has a good point about unlienable assets being in special purpose subs (that's the whole SPOE move), but sometimes that's not possible with various licenses.

I'm going to have to chew over Vince's idea of junking asset-based priority. That's a HUGE jump, although an intriguing idea to consider. (Vince--there might be an article there...)

Adam, the first paragraph misstates credit bidding. A creditor can credit bid at an auction for its lien. If the auction occurs under the second's lien, then the second can credit bid but would take subject to the first like any other buyer. If the first does not want that result, the first can foreclose and force the auction under its lien. If the auction occurs under a foreclosure of both the first and the second, then the auction procedure should require the second to bid the value of the first in cash before it can credit bid on its second. I suppose a court could screw it up like it can screw up any other issue, but if done correctly, the second credit bids only after paying off the first.

Talking about "setting the value of the collateral" is a misnomer. It is really setting the amount of the deficiency or, in bankruptcy, the unsecured claim. Yes, if the deficiency/unsecured claim is uncollectible, then the secured creditor might as well bid the full amount of the debt. I don't see how this is a problem. It gives the secured creditor exactly what it bargained for -- the asset if the debtor does not pay. Other claimants to the enterprise no longer have access to the asset, but that is a (much larger) beef with secured lending, not credit bidding.

Bob, I think we're talking past each other a bit because we're not being clear about whether we're discussing a state law foreclosure sale or a 363 sale. I agree with your description as to state law, but in a 363 sale it isn't a foreclosure of a first or second lien, etc. It's just something different. Unless the sale is under 363(f), all liens will remain on the property. If it is under 363(f), and presumably most sales of assets that are someones collateral will be, then the sale works like a foreclosure by all creditors simultaneously (or maybe just be the first, depending on how you read 363(f)(3)).

So the question I have is whether for a second lien to win in a 363(f) sale with a credit bid the second lien would be required to pay off the first lien in cash. If not, I think there'd be a problem.

If we are both saying that the bankruptcy court should allow a credit bid by the second only after the second bids the amount of the first in cash, then we are in agreement. The bankruptcy court should mimic the result that would occur in a state court foreclosure auction. The phrase "for cause" in 363(k) is there exactly to allow the court by order to set out these sorts of rules.

And, surely, these are "free and clear" sales.

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