Credit Bidding: Converting Secured Loans to Winning Bids

When a company enters bankruptcy, its assets are often sold to the highest or best bid. Secured lenders — those who have perfected liens on the company's assets — have a unique advantage under Section 363(k) of the Bankruptcy Code: they can bid, subject to review for cause, with their secured debt. For example, a secured lender who is owed $10 million could potentially use that secured debt (up to $10 million) as consideration for the purchase. This process is known as credit bidding.

While powerful, this right is not absolute. Other creditors, particularly those without security interests or with junior liens, can, and often do, scrutinize and challenge these bids.  In such cases, unprepared lenders might face tough choices: settle for less favorable terms or risk losing the ability to credit bid altogether.

This article outlines essential steps secured lenders should take to protect their credit bidding rights. While working closely with legal counsel is crucial, understanding these fundamentals can help such lenders avoid common pitfalls in bankruptcy sales.

1. Ensure Liens Are Valid 

A credit bid is only as strong as the underlying security interest. Begin with a thorough review of all loan documents to verify three critical elements:

First, confirm that the collateral description explicitly covers the assets to be purchased. Second, identify any pre-existing liens that might have priority. Third, ensure all security interests are properly "perfected" — meaning all necessary legal steps have been taken to make the liens enforceable.

For example, without proper control in place for the company's bank accounts, there may be no claim to that cash. This potentially can be addressed before bankruptcy by tracking how the cash flows from the collateral. If this problem has to be addressed during the bankruptcy case, it may be too late.  

2. Support a Clean Sale Process

Bankruptcy courts demand transparency and fairness in asset sales. This becomes especially critical when a lender plans to credit bid but also has other roles in the company — for instance, serving on the board or acting as a financial sponsor. In these cases, the lender must step back from any decisions about how the sale is conducted to avoid accusations of self-dealing.

3. Identify Potential Red Flags in the Lending Relationship

Bankruptcy courts can limit or deny credit bidding rights if they spot problematic behavior or questionable loan structures. Two major risk areas demand attention:

First, avoid any actions that could suggest bad faith. For example, courts have blocked credit bids when lenders tried to rush the sale process in ways that discouraged other potential buyers. Patience and fairness are essential.

Second, ensure the documents reflect a lending relationship and function like a loan. Bankruptcy courts have the power to reclassify supposed "loans" as equity investments if the economic reality suggests that is what they really are. Factors that can raise red flags include:

• The names given to the instruments evidencing the indebtedness
• The presence or absence of a fixed maturity date and schedule of payments
• The presence or absence of a fixed rate of interest and interest payments
• The source of repayments/whether repayment depends on success

4. Be Ready for the Challenge Period

Creditors' committees have a limited window to challenge credit bid rights. The key to minimizing these challenges is preparation. Loan documentation should be assembled and made available to prove the validity and priority of liens, especially regarding:

• The scope of the security interest, including in the company's cash
• The priority of liens versus other creditors

*     *     *

Unsecured creditors frequently challenge credit bids to gain leverage and extract value. The best defense is thorough preparation: lenders who understand their security rights and have their documentation in order can confidently defend their position and maximize their recovery.

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.