Courts across the country have recently been confronted with disputes originating from the acquisition of distressed debt or loans by a party, and the subsequent chapter 11 bankruptcy case commenced by the debtor company.
Fisker and Hybrid Tech Holdings
In a much-publicized opinion in January, the U.S. Bankruptcy Court for the District of Delaware limited a secured creditor's right to credit-bid where the sale was to take place less than 50 days after the petition date in Fisker Automotive Holdings Inc.[1] Pre-petition, Hybrid Tech Holdings LLC purchased $168.5 million of the debtor's debt from the U.S. Department of Energy for $25 million. Hybrid sought approval of a pre-planned sale during which it would credit-bid $75 million of that debt to acquire nearly all of the debtor's assets.
The Fisker decision endorses the theory that where a lender acts inequitably or where a sale process does not permit robust marketing, a court may reduce the purchaser's maximum credit-bid at a § 363 sale to the amount paid for the debt, rather than the face amount of the debt. Upon the finding of "cause" under § 363(k), the court capped Hybrid's credit-bid at $25 million because "[t]o do otherwise would freeze bidding."[2] Hybrid appealed, but the district court denied the interlocutory appeal, noting that Hybrid failed to show facts sufficient to grant leave to hear the interlocutory appeal.[3]
Free-Lance Star Publishing and Sandton Capital Partners
In mid-April, the U.S. Bankruptcy Court for the Eastern District of Virginia addressed bad-faith conduct by a creditor after it acquired distressed debt in the Free-Lance Star Publishing Co. of Fredericksburg, Va.[4] case. Pre-petition, in mid-2013 BB&T sold a loan in the approximate original principal amount of $50.8 million, which was secured by much of the debtors' assets, to Sandton Capital Partners. Sandton and an affiliate, DSP Acquisition, LLC, recorded liens on certain of the debtors' then-unencumbered assets, then after 90 days began to pressure the debtor to file bankruptcy, insisting on a short § 363 sale process and limited marketing of the debtors’ assets. In addition, DSP attempted to limit the borrowers' choice of who they could hire as a financial advisor to run the sale process. DSP also required that the sale marketing materials contain a bold disclaimer that DSP held the right to credit-bid, among other actions.
The court found that DSP's actions were aimed at discouraging other bidders from participating in the process and ensuring DSP's speedy acquisition of the debtors' assets. At a preliminary hearing on the § 363 sale, the court found that DSP's witness was not credible and that a declaration filed by DSP was "false and misleading."[5] Ultimately, the court described DSP's action as a "classic loan-to-own scenario" and sanctioned DSP for its inequitable behavior.[6] The court limited DSP's right to credit-bid to a set dollar amount based on perfected, valid liens; this amount was nearly $25 million less than DSP's initial,proposed bid.
Meridian Sunrise Village and NB Distressed Debt Investment Fund Limited
In Meridian Sunrise Village LLC,[7] the U.S. District Court for the Western District of Washington held that a distressed-debt hedge fund was not an "eligible assignee" of a debtor's loan obligation as that term was defined in the underlying loan agreement. The loan agreement at issue defined an "eligible assignee" as "any commercial bank, insurance company, financial institution or institutional lender approved ... in writing and, so long as there exists no Event of Default, approved by Borrower in writing, which approval shall not be unreasonably withheld,"[8] and the debtor negotiated this definition with the intent to preclude transfers of the loan to "predatory investors."[9] Ultimately, after a non-monetary default, U.S. Bank, as agent and on behalf of three other participating banks, sought to amend the "eligible assignee" definition, but the debtor refused and later filed for chapter 11 relief. Post-petition, Bank of America, one of the lenders, assigned its interest in the loan to the NB Distressed Debt Investment Fund Limited (the "NB Fund"), which then sold portions of that interest to other distressed-debt funds (collectively, the "Funds").
The debtor successfully argued that the Funds were not "eligible assignees" under the loan agreement; as such, the bankruptcy court prohibited the Funds from voting on the chapter 11 plan, which was confirmed. On appeal, the district court upheld that ruling, reasoning that the definition of "financial institution" should be narrowly construed. Given that the Funds did not extend credit or loans, the Funds were not financial institutions that fell within the definition of "eligible assignee." The district court noted the Fund's predatory lending tactics and that negotiations surrounding the underlying agreement served as "powerful evidence that the parties to the agreement meant to (and did) limit the list to lenders, and to exclude assignment to distressed asset hedge funds who candidly admit they seek to 'obtain outright control' of assets."[10]
Potential Lessons to Distressed-Debt Buyers
These opinions each provide useful guidance about the risks of inequitable conduct for the secondary loan market and any entity that acquires a distressed loan. Courts will not permit distressed-debt buyers to exert undue pressure and utilize bankruptcy as a short-cut to acquire assets. The loan documents, including security agreements and UCC filings, as well as the law of the state that controls those documents, play a critical role and must be scrutinized for the possibility of future, adverse consequences.
Upon acquisition of an interest in, or obligation due from, a distressed borrower, any lender — hedge fund or traditional bank — needs to deliberate carefully over its actions and plans with respect to a distressed borrower. Absent careful planning and diligence, a distressed-debt acquisition that once appeared profitable may prove to be a losing investment.
[1] In re Fisker Automotive Holdings Inc., No. 13-13087-KG, 2014 Bankr. LEXIS 230 (Bankr. D. Del. Jan. 17, 2014).
[2] Id.
[3] Hybrid Tech Holdings LLC v. Official Comm. of Unsecured Creditors (In re Fisker Automotive Holdings Inc.), No. 14-CV-99-GMS, 2014 U.S. Dist. LEXIS 15497 (D. Del. Feb. 7, 2014).
[4] In re The Free-Lance Star Publishing Co. of Fredericksburg, Va., No. 14-30315-KRH, 2014 Bankr. LEXIS 1611 (Bankr. E.D. Va. April 14, 2014) (hereinafter, the "Free-Lance Star" case).
[5] Id. at *15.
[6] Id. at *20-21.
[7] Meridian Sunrise Village LLC v. NB Distressed Debt Inv. Fund Ltd. (In re Meridian Sunrise Village LLC), No. 13-5503-RBL, 2014 U.S. Dist. LEXIS 30833 (W.D. Wash. March 7, 2014).
[8] Id. at *3.
[9] Id. at *4.
[10] Id. at *13.