Overview of Section 363, Credit Bidding, and Fisker Case Study

Welcome to the 133rd Pari Passu newsletter,

Last week, we talked about Burgers. This week, we are diving into Section 363 sales, a go-to tool for quickly converting distressed assets into cash, driving value for claimholders. In these sales, debtors are given the freedom to adjust auction terms, and certain bidders play a crucial role in helping set floor prices. 

In these scenarios, secured creditors reserve the powerful right to bid with their claim value, rather than cash. This creates numerous opportunities for lenders, whether they are distressed investors seeking a “loan-to-own” strategy or lenders looking to protect collateral values. In this write-up, we’ll also dive into the 2013 bankruptcy of Fisker Automotive, which tested the limits of credit bidding and resulted in a landmark ruling. Additionally, we’ll explain the ruling and its implications on creditor recoveries and credit bidding more broadly.

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Section 363 Overview

A Section 363 sale is a court-supervised sale of a debtor’s assets under Section 363 of the bankruptcy code, which allows buyers to acquire the assets free of liens, claims, or other encumbrances. This is very important as it speeds up and simplifies the sale process. In an out-of-court sale, the seller typically must obtain consent from each lienholder to transfer a clean title to the buyer, which can be costly and time-consuming. The goal of a 363 sale is to raise funds for the estate and use them to pay off claims from creditors. It is meant to be a win-win situation, with creditors receiving improved recoveries and buyers acquiring assets at discounted prices. 

Section 363 sales typically occur during Chapter 11 bankruptcy and differ from those in a Chapter 7 liquidation. In Chapter 7, the U.S. trustee (third-party individual appointed to oversee the case) is in charge of liquidating assets, while debtors don’t have much say. On the other hand, during a 363 sale, the debtor is given control over deal terms, timing, and other important considerations [1]. Additionally, the debtor is not required to sell the entire estate if, for example, the debtor wishes to sell non-core business divisions to raise funds.

Section 363 Sale Process

A 363 sale begins with the debtor marketing assets to potential buyers, often before the company files for Chapter 11 protections. During this process, the debtor looks for a “stalking horse” bidder. The stalking horse bidder provides an initial, legally binding bid, which sets the floor price for the later sale. Being the first bidder, the stalking horse bidder typically conducts substantial due diligence to ensure a well-priced bid. In exchange for providing the first bid and resulting transaction certainty, the debtor offers the stalking horse bidder various incentives, such as expense reimbursement or breakup fees. Expense reimbursement, for example, would cover items such as legal fees, financial advisor fees, and any expenses associated with due diligence. A breakup fee is a pre-negotiated amount that the stalking horse bidder would receive if they are not the winning bidder in the eventual auction [3]. A stalking horse bidder provides a few benefits. First, it establishes a minimum bid, preventing lowball offers while providing a baseline number for creditor recoveries, which may help gather creditor support. Additionally, it reduces uncertainty, guaranteeing a buyer if nobody shows up to bid. 

After the debtor files for bankruptcy, it must file a motion seeking court approval of the 363 Sale. The motion outlines the assets being sold, auction procedures, and incentives offered to the stalking horse bidder, among other details. The auction procedures outlined may include incremental bid sizes, requirements for a qualified bid, deadlines, and any additional hearing dates. Once the motion is prepared and an initial hearing is held, the court determines whether the procedures are appropriate for maximizing the value of the debtor’s assets, and if so, they are approved. For example, providing unnecessarily large incremental bid sizes may deter potential buyers, reducing competition and lowering the possible sale price. Another example could be a compressed timeline, which wouldn’t give potential buyers enough time to conduct diligence. Once approved, the bidding period begins, which typically varies in length depending on the complexity of the assets being sold [2]. Normally, this period lasts around four to eight weeks, and it may also accelerate if the debtor is quickly burning cash and needs to be sold soon.

Upon conclusion of the bidding period, another hearing is held to approve the winning bidder. The winning bid, typically the highest bidder, will be approved if the sale has a “sound business justification” [1]. However, there may be cases where the highest bid isn’t always the best one. For example, if a potential buyer hasn’t secured financing for the purchase or would take unreasonably long to close on the deal, the debtor may choose a lower-bidding, more certain buyer. If there are no other bids, the stalking horse bidder wins the auction. While the court reserves the right to rule against a winning bid, this is rare, as the highest-priced bid usually provides a sound business justification for the sale. Once the sale is approved, the buyer acquires the assets free and clear of any previous liens on the assets. 

In summary, a Section 363 sale provides the debtor with a platform for a quick, value-maximizing sale. The debtor aims to secure a stalking horse bidder to offer a certain and floor-setting bid before gaining court approval to open up an auction process to other interested buyers. The best bid, once approved by the court, receives the assets free and clear. This process seriously simplifies the sale process in distressed situations. It also eliminates the possibility of certain creditors holding out to oppose the sale, as court approval overrides objections from individual lienholders. 

Credit Bidding Overview

If the 363 sale’s winning bidder is a secured creditor, the court will evaluate its ability to submit a credit bid under Section 363(k) (the subsection that outlines credit bids) [5]. A credit bid allows a secured creditor with a lien on the asset being purchased to offset its claim by the purchase price, rather than paying cash for the asset. The bidding creditor may bid up to the face value of its debt [6]. For example, if its secured debt is worth $2mm but only trading at $1.5mm, the creditor may submit a credit bid of up to $2mm. Additionally, the bidding creditor must clearly specify that it is bidding with a secured claim, rather than cash, at or before the time it submits the bid.  

Similarly to a cash bid, the court reserves the right to deny or limit a credit bid. This is typically limited to situations where the creditor exhibits bad faith or lacks a valid and perfected lien on the asset. 

Valid lien: The lender must have a legally enforceable claim against the asset, meaning there really is debt owed and the credit agreement or mortgage gives the lender the right to seize the asset if the borrower defaults.

Perfected lien: To be classified as secured, the lender must put everyone on notice by filing the proper paperwork. For most loans, that means filing a Uniform Commercial Code-1 (UCC-1) statement, usually with the state’s Secretary of State. For real estate, it involves recording a mortgage or deed of trust with the county recorder [4].

If a lender hasn’t established both a valid and a perfected lien, the court will treat its claim as unsecured, and it won’t be allowed to submit a credit bid.

Additionally, Section 363(k) provides the courts with a lot of freedom, allowing them to deny or limit a credit bid “for cause” [5]. This essentially means the court has the ultimate say on whether a credit bid is allowed. For example, imagine an insider secured creditor looking to credit bid with its claim. Because the creditor is an insider, the debtor agrees and attempts a quick sale process, with the insider creditor as stalking horse bidder, along with large incremental bid sizes. Because the value of the debtor's assets is uncertain, no third-party bidders are willing to submit a higher cash bid. As a result, the actual cash value of the assets would be untested, while giving the insider creditor access to the assets. If the insider creditor bought the debt at a discount, the judge may limit its bid to the amount it bought it for, to potentially deliver more value to the estate. 

Credit Bidding Strategies

The mechanics of a credit bid, specifically the fact that lenders may bid with the face value of their debt, provide a couple of valuable strategies for secured creditors to enhance returns. These are known as offensive and defensive strategies, and we’ll dive into both, providing a hypothetical example for each. 

Offensive Credit Bids

An offensive credit bid targets asset ownership by converting debt into possession. Opportunistic investors often purchase secured debt at a discount, with the hopes of using it to own the secured collateral down the line, ideally worth more than the purchase price of the debt [6]. 

Assume Manufacturing Co., an industrial widget manufacturer, is approaching distress due to macroeconomic headwinds, and its secured debt is trading at 75 cents on the dollar. The secured debt is worth $100mm and secured on the borrower's manufacturing equipment, valued initially at $125mm. Investor Co. takes notice of this opportunity and purchases the loan for $75mm. Later on, Manufacturing Co. files for Chapter 11 after struggling to effect a successful turnaround. The debtor determined that the best way to preserve value was to initiate a 363 sale of its manufacturing assets, raising funds for the estate to pay off claims. 

During the marketing process, Manufacturing Co. finds a stalking horse bidder willing to pay $ 75mm for the assets. The judge approves the stalking horse bid and subsequent auction procedures, and Manufacturing Co. ends up finding another bidder willing to pay $85mm. In theory, both bids would provide a positive return to Investor Co., yielding breakeven and 13% returns on the original $75mm payment for the debt, excluding any other expenses. However, Investor Co. believes the fair market value of the debtor’s equipment exceeds $85mm and is looking to maximize returns. As a result, Investor Co. submits a credit bid of $100mm, the full face value of its claim. The court determines that the bid was not made in bad faith and that the creditor has a valid and perfected lien on the equipment. The credit bid is approved, and the Investor Co. acquires the equipment free and clear after winning the auction. Assuming the equipment's actual market value ended up at $100mm, Investor Co. was able to earn a par recovery along with a substantial 33% return. Additionally, if Investor Co. plans to operate the new assets, rather than sell them, there is potential for significant upside. Investor Co. made a speculative debt investment and, by utilizing an offensive credit bid, was able to maximize returns.

Defensive Credit Bids

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