A secured creditor’s right to “credit bid” the amount of its allowed claim in a bankruptcy sale of its collateral is an important creditor protection codified in section 363(k) of the Bankruptcy Code. Even so, a ruling recently issued by the U.S. Bankruptcy Court for the Central District of California reaffirms the principle that the right to credit bid a claim is not absolute and may be limited or denied altogether “for cause.” Because the determination of whether (and to what extent) a secured claim should be allowed often “cannot be adjudicated before there is a sale of the Debtor’s assets,” the court in In re Figueroa Mountain Brewing, LLC, 2021 WL 2787880 (Bankr. C.D. Cal. July 2, 2021), ruled in an unpublished decision that it “would be unfair to limit or deny [a lender] a credit bid simply because the Debtor has filed an objection.” However, without adjudicating the claim objection, the court found that “cause” existed to deny a secured lender the right to credit bid its disputed claim in a bankruptcy sale of its collateral because there was a sufficient objective basis to support the debtor’s allegations that, among other things, its loan agreement and all payments made by the debtor under it were fraudulent transfers and the lender had dominated and controlled the debtor in an effort to take control of its assets.
Section 363(k) of the Bankruptcy Code provides that a creditor with a lien on assets to be sold outside the ordinary course of business under section 363(b) may credit bid its “allowed claim” at the sale, “unless the court for cause orders otherwise.” A credit bid is an offset of a secured claim against the collateral’s purchase price. The U.S. Supreme Court explained in RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 566 U.S. 639, 644 n.2 (2012), that “[t]he ability to credit-bid helps to protect a creditor against the risk that its collateral will be sold at a depressed price” and “enables the creditor to purchase the collateral for what it considers the fair market price (up to the amount of its security interest) without committing additional cash to protect the loan.”
The Supreme Court ruled in RadLAX that, although the right to credit bid is not absolute, a nonconsensual, or “cram down,” chapter 11 plan providing for the sale of encumbered property free and clear of a creditor’s lien cannot be confirmed without affording the creditor the right to credit bid for the property.
In the aftermath of RadLAX, the debate shifted largely to the circumstances that constitute “cause” under section 363(k) to prohibit or limit a secured creditor’s right to credit bid its claim. Because “cause” is not defined in the File Bankruptcy Code, whether it exists has been left for the courts to determine. See In re Olde Prairie Block, LLC, 464 B.R. 337, 348 (Bankr. N.D. Ill. 2011) (citing cases).
In In re Fisker Automotive Holdings, Inc., 510 B.R. 55 (Bankr. D. Del. 2014), the court limited the amount of a credit bid to the discounted purchase price actually paid by the credit bidder to purchase the secured debt it was credit bidding. The court held that limiting the amount of the credit bid was warranted because an unrestricted credit bid would chill bidding and because the full scope of the underlying lien was as yet undetermined. The court also expressed concern as to the expedited nature of the proposed sale under section 363(b), which in the court’s view was never satisfactorily explained.
Since Fisker, a handful of courts have addressed the issue, with mixed outcomes. Some courts have denied motions to limit credit bidding rights. See, e.g., In re Empire Generating Co, LLC, 2020 WL 1330285 (S.D.N.Y. Mar. 23, 2020) (denying certain minority lenders’ motion for leave to appeal a bankruptcy court order approving bid procedures and finding no cause to limit a collateral agent’s right, in accordance with the terms of an intercreditor agreement, to credit bid the full amount of an undersecured claim in a bankruptcy sale despite allegations that the credit bid was tantamount to a sub rosa chapter 11 plan, the collateral agent had no “claim” against the debtors, and the credit bid would contravene the duty of the collateral agent under the intercreditor agreement to act in the best interest of all secured lenders); In re Aéropostale, Inc., 555 B.R. 369 (Bankr. S.D.N.Y. 2016) (denying a motion to limit lenders’ ability to credit bid their secured claim in a bankruptcy sale of the company in the absence of inequitable conduct, such as collusion, undisclosed agreements, or any other actions designed to chill bidding or unfairly distort the sale process and where no party challenged the validity or extent of the lenders’ liens); In re Tempnology, LLC, 542 B.R. 50, 69 (Bankr. D.N.H. 2015) (denying a challenge to a secured creditor’s right to credit bid its claim in the absence of any evidence of inequitable conduct or that the secured claim was subject to bona fide dispute), aff’d, 558 B.R. 500 (B.A.P. 1st Cir. 2016), aff’d, 879 F.3d 376 (1st Cir. 2018); In re Charles Street African Methodist Episcopal Church of Boston, 510 B.R. 453 (Bankr. D. Mass. 2014) (denying in part a motion to limit a credit bid where the debtor’s counterclaims did not relate to the validity of the secured creditor’s claims or liens, but requiring the secured creditor to include in its bid cash in an amount equal to a breakup fee payable to the stalking-horse bidder); see also In re Aerogroup Int’l, Inc., 620 B.R. 517 (D. Del. 2020) (a secured creditor does not cap its secured claim in amount of its credit bid by making a credit bid at auction sale of its collateral, unless its credit bid is the winning bid at auction); In re Murray Metallurgical Coal Holdings, LLC, 614 B.R. 819, 835 (Bankr. S.D. Ohio 2020) (noting in dicta that “cause exists to reduce the amount of a credit bid only if there is ‘specific evidence’ demonstrating the allegation of bid chilling ‘to be true in th[e] [particular] case'” (citations omitted)).
Other courts have found “cause” to limit or deny such rights. SEC v. Capital Cove Bancorp LLC, 2015 BL 449611 (C.D. Cal. Oct. 13, 2015) (finding cause to deny a creditor’s request to credit bid at a sale due to, among other things, the existence of a prima facie case against the creditor for securities fraud, evidence of a Ponzi scheme involving the creditor, the creditor’s other fraudulent acts, and the existence of a bona fide dispute regarding the validity of the creditor’s liens); In re Family Christian, LLC, 533 B.R. 600 (Bankr. W.D. Mich. 2015) (refusing to approve a credit-bid sale to a party that, as a “consultation party” to the auction, had been privy to certain information that allowed it to gain an unfair advantage over other bidders, tantamount to insider trading); In re The Free Lance-Star Publishing Co., 512 B.R. 798 (Bankr. E.D. Va.) (finding cause to limit a credit bid by an entity that purchased $39 million in face amount of debt at a discount where: (i) some of the creditor’s liens had been improperly perfected; (ii) the creditor engaged in inequitable conduct by forcing the debtor into bankruptcy and an expedited section 363 sale process in pursuing a clearly identified loan-to-own strategy; and (iii) the creditor actively frustrated the competitive bidding process and attempted to depress the sale price of the debtors’ assets); In re RML Dev., Inc., 528 B.R. 150, 155-56 (Bankr. W.D. Tenn. 2014) (limiting the amount of a secured creditor’s credit bid to the undisputed portion of its claim and noting that “a modification or denial of credit bid rights should be the extraordinary exception and not the norm”).
Buellton, California-based craft beer maker Figueroa Mountain Brewing LLC (“FMB”) filed for chapter 11 protection in the Central District of California in October 2020. At the time of the filing, White Winston Select Asset Funds, LLC (“Winston”) claimed that FMB owed approximately $9.5 million to Winston under a 2019 bridge loan. The original principal amount of the loan was $750,000, but the loan agreement was subsequently modified several times during 2019 and 2020 to increase the availability to $10.5 million. The loan was structured and treated as a revolving loan, under which FMB’s revenues were generally collected by Winston through a lockbox account and then readvanced to FMB.
The Winston loan was secured by liens on substantially all of FMB’s assets. However, with one exception, Winston’s liens were junior to a lien granted to Montecito Bank and Trust (“MBT”) securing MBT’s claim in the amount of approximately $4.3 million. Pursuant to a subordination agreement, Winston held a first priority lien in FMB inventory and proceeds up to the amount of $1.5 million.
In January 2021, Winston commenced an adversary proceeding in the bankruptcy court seeking declaratory relief regarding the validity, extent, and priority of its liens and allowance of its claim. FMB asserted various affirmative defenses, counterclaims, and cross-claims in response, including: (i) the loan was unenforceable because Winston was not validly doing business in California due to its failure to register as a foreign limited liability company; (ii) Winston dominated and controlled FMB in an effort to seize control of FMB’s assets; (iii) the loan was usurious; (iv) Winston would be unjustly enriched if its loan were repaid; and (v) recovery of the loan proceeds was barred by the doctrine of unclean hands.
The relief sought by FMB included a judgment disallowing Winston’s claim under section 502(b)(1) of the Bankruptcy Code, recharacterizing the Winston debt as equity, equitably subordinating Winston’s claim under section 510(c) of the Bankruptcy Code, avoiding the Winston loan and all payments made to Winston as preferential and fraudulent transfers under federal bankruptcy law and California law, and awarding FMB compensatory, statutory, and punitive damages due to Winston’s conduct.
In March 2021 (and again in June), FMB sought court approval of bidding procedures governing an anticipated auction of substantially all of its assets under section 363(b) of the Bankruptcy Code. It also filed a motion seeking an order depriving Winston of the right to credit bid its claim under section 363(k), asserting, among other things, that the claim was subject to bona fide dispute and should be disallowed due to Winston’s inequitable and domineering conduct.
The Bankruptcy Court’s Ruling
Initially, U.S. Bankruptcy Judge Martin R. Barash noted that even though section 363(k) expressly endows the holder of an allowed secured claim with the right to credit bid, “[t]he filing of an objection [to the claim] containing allegations—without more—is not enough to limit or deny a credit bid.” In this case, he explained, FMB’s request for relief was “part of a complicated adversary proceeding that has not been adjudicated and cannot be adjudicated before there is a sale of [FMB’s] assets.” Figueroa Mountain, 2021 WL 2787880, at *6.
Judge Barash next rejected FMB’s argument that Winston should not be permitted to credit bid its claim because the credit bid would chill the bidding at the anticipated auction. According to the judge, “the risk of chilling bids is [not] an independently adequate basis to limit or deny a credit bid.” Instead, he noted, there must be “other reasons” why permitting a secured creditor to credit bid the entirety of its claim is inequitable.
Judge Barash also rejected FMB’s argument that Winston should not be permitted to credit bid because it allegedly engaged in inequitable conduct, including using its contractual rights and position of power to exercise financial and operational control over FMB, exacerbating FMB’s financial difficulties, and increasing FMB’s debt to Winston by adding millions of dollars of fraudulent, unreasonable, and/or unnecessary amounts to the loan, with the ultimate objective of acquiring ownership of FMB’s assets. According to Judge Barash, although these allegations might be proven at trial, “the evidentiary record presently is not adequate to establish definitively that … Winston is responsible for the inequitable conduct of which it has been accused.” Id. at *7.
However, Judge Barash concluded that Winston’s right to credit bid should be denied because its claim was subject to genuine dispute based on an objective evidentiary record. He explained that other courts that have limited credit bidding rights where the allowance of a disputed secured claim has not been adjudicated have required a showing that a “sufficient dispute exists regarding the lien forming the basis for a credit bid,” rather than demonstration that the party seeking to limit or deny credit bidding “is likely to succeed on its challenges.” Id. at *8 (citing cases).
Judge Barash then applied the test for whether a dispute is a “bona fide dispute” under section 363(f)(4) of the Bankruptcy Code, which permits a sale of estate property free and clear of an interest in the property if the “interest is in bona fide dispute.” Under that test, he explained, the court must “determine whether there is an objective basis for either a factual or a legal dispute as to the validity of the claim.” Id. (citations and internal quotation marks omitted).
Judge Barash found that there was an objective basis in fact and law to conclude that Winston’s claim was subject to a genuine dispute. He accordingly ruled that “cause” existed under section 363(k) to deny Winston the right to credit bid its disputed claim “in any amount.”
Specifically, Judge Barash determined that a genuine dispute existed as to whether the Winston loan and all payments made under it by FMB should be avoided as constructive fraudulent transfers under section 548(a) of the Bankruptcy Code because “[t]he evidence presented provide[d] an objective basis for [FMB’s] cause of action to avoid the Bridge Loan and related transactions.” Id. at *11. Among other things, he found that the evidence supported the conclusion that FMB was insolvent at the time the loan agreement was signed and amended and that FMB did not receive reasonably equivalent value in exchange for the obligations it assumed due to exorbitant interest, fees, and other charges. He also found that Winston had not established that any value it conferred on FMB was given in good faith.
Finally, Judge Barash noted that “the evidence suggest[s] an ulterior motive on the part of” Winston and its representative who handled the relationship with FMB because there was “an objective basis to conclude that [Winston and its representative] were using their roles as a lender and ‘consultant’ to exacerbate the [FMB’s] distress and position [Winston] to acquire [FMB’s] assets.” Id. at *12 n.5.
Figueroa Mountain is an unusual case because it involved the outright denial, rather than limitation, of a secured creditor’s right to credit bid in a bankruptcy sale. The outcome appears to have been influenced significantly by the court’s perception that allegations of the lender’s egregious misconduct, even though not yet adjudicated in a pending adversary proceeding, were sufficiently colorable to rise to the level of “cause” under section 363(k). Other cases might present a more nuanced fact pattern. The ruling, however, reinforces the rubric that credit-bidding rights in bankruptcy are not absolute, but qualified.