The Erosion Of Credit-Bid Protection In Bankruptcy And Its Effects

According to the Thompson Reuters Loan Pricing Corporation, in the first quarter of 2014 the trading volume of loans on the US secondary loan market was $139.27 billion, with $4.93 billion in distressed loan trades. The overall trading volume of loans in the first quarter is well above the $114.31 billion quarterly average seen since the first quarter of 2008. The secondary loan market is very active.

The secondary loan market benefits lenders, buyer of loans, debtors, and those seeking credit. The lender is able to liquidate an asset and improve its liquidity and lending capability. The buyer purchases at a price it deems attractive and has the opportunity to make a profit to the extent it can collect in excess of the purchase price. The debtor often has the opportunity to strike a better deal with the purchaser than the lender would make. The purchaser may provide a discount or provide additional credit. Those seeking new credit may find their lending institutions in a better position to lend.

Purchasers of distressed debt are taking a risk—possibly a significant one—but the credit-bid right and other bankruptcy principles mitigate that risk by insuring that they will either recover their collateral or be paid its value, without having to advance additional funds to do so. These protections are grounded in the takings clause of the US Constitution and part of the balance of protecting secured creditors while simultaneously affording an opportunity for the debtor's reorganization.

The credit-bid right in bankruptcy is codified at 11 USC § 363(k), and there is an exception in the statute for "cause," which is not defined. The term "cause" in this context historically has been very narrowly interpreted and found to exist only where the secured claim is subject to legitimate dispute or where the secured creditor has engaged in unlawful or inequitable conduct. The legislative history of 11 USC § 363, which requires "adequate protection" for nondebtors in all instances when the debtor proposes to use, sell, or lease property, is illuminating:

The concept of [adequate protection] is derived from the fifth amendment protection of property interests. See Wright v Union Central Life Ins Co, 311 US 273, 85 L Ed 184, 61 S Ct 196 (1940); Louisville Joint Stock Land Bank v Radford, 295 US 555, 79 LEd 1593, 55 S Ct 854 (1935). It is not intended to be confined strictly to the constitutional protection required, however. The section, and the concept of...