5th Circuit Affirms Texas Bankruptcy Court Ruling Slamming Bankster's Attempt To Squeeze Loan Guarantors By Recovering More Than Amount Due On Foreclosed Mortgage; Lender Fails In Claim That Its Credit Bid Should Not Be Used As Basis For Reducing Loan's Outstanding Balance
- A bank made loans to the debtor to finance construction of a golf course. The loans were secured by senior liens on the debtor’s assets, limited guaranties of its principals, and a $1.2 million certificate of deposit. During a sale of the debtor’s assets ordered by the bankruptcy court, the holder of the senior debt submitted a credit bid. Spillman involved a dispute over the effect of the credit bid.
After the debtor filed bankruptcy, a junior lender (Fire Eagle) that had loaned the debtor $4.1 million, purchased the senior debt from the bank. At that time, the parties stipulated that the outstanding balance of the senior loans were ~$9.1 million.
After the bankruptcy court refused to confirm any of the proposed plans of reorganization, it ordered a sale of the debtor’s assets under Section 363 of the Bankruptcy Code. After the bidding at the sale reached a cash bid of $9.2 million, Fire Eagle submitted a credit bid of $9.3 million, which was the winning bid.
The debtor and most of the guarantors brought an action in the bankruptcy court seeking a declaratory judgment that the guarantors were released from their obligations. Fire Eagle argued that its credit bid did not result in the senior debt being paid in full. Instead, it contended that the court should have determined the fair market value of the assets, and only that value should have been credited against the senior debt. Assuming the value was less than the debt, Fire Eagle argued that it could still recover the deficiency from the guarantors.
The bankruptcy court found that the credit bid paid the senior debt in full so that there was no deficiency claim left and Fire Eagle was not entitled to recover from the guarantors. Consequently, the bankruptcy court granted summary judgment to the guarantors holding: “This is not rocket science. The Senior Loan has been PAID!!!!”(1)
On appeal Fire Eagle proposed three arguments to support this position:
(1) Credit bidding in a bankruptcy auction affects only the claim in the bankruptcy and not any underlying debt.
(2) Bankruptcy events “do not typically ‘inure to the benefit of non-bankrupt guarantors.’”
(3) The guaranties provided that the guarantors’ obligations would not be affected by a bankruptcy.
The 5th Circuit rejected the first argument as “logically unsound.” The court noted that if Fire Eagle had been outbid by a cash bid, the cash would have been applied against the senior debt, and if the debt was paid in full with cash, it would be absurd to allow Fire Eagle to collect again from the guarantors. Otherwise it could recover more than the face value of the senior debt notwithstanding that the guaranties explicitly provide for termination upon payment in full.
So, Fire Eagle had to be arguing that a credit bid is not equivalent to a cash payment. However, the 5th Circuit found that the provision in Section 363(k) of the Bankruptcy Code that allows credit bidders to offset their claims against the purchase price implicitly assumes the equivalence of the value of the credit bid with cash.
As for the second argument, the cases cited by Fire Eagle addressed situations where the debt was not paid in full. Consequently those cases were not applicable. Similarly with respect to the third argument, relying on provisions in the guarantees that a bankruptcy does not affect the validity of the guarantee ignores the fact that the guarantees also provide for termination upon payment of the guaranteed debt.
So, the 5th Circuit agreed with the lower courts that the credit bid had the effect of paying off the senior debt so that Fire Eagle could not collect on the guarantee agreements.
The very nature of a credit bid is that the bidder holds debt secured by a lien on the assets that are being sold. If the bidder paid cash, the seller would have to turn around and apply that cash to the bidder’s debt. Rather than require an unnecessary back and forth payment of cash, the bidder is allowed to “credit” or setoff its bid against the debt owed to it.
It is important to remember that, although money doesn’t actually change hands, there is still in effect a payment and a repayment. A credit bid is not “funny money,” rather it actually reduces the debt. Similarly, it is key that the seller be required to return the sale proceeds to the bidder in repayment of its debt. If instead a third party held a lien that was senior to the bidder’s lien, payment would have to be applied first to the third party debt, and only any excess would have been returned to the bidder. Thus, the bidder would have to pay cash to the extent of the senior lien, and could credit bid only the excess.
It is surprising that people often don’t “get it.” As the bankruptcy court said, this isn’t rocket science.