Credit bidding is a mechanism, enshrined in the US bankruptcy legislation, whereby a secured creditor can ‘bid’ the amount of its secured debt, as consideration for the purchase of the assets over which it holds security. In effect, it allows the secured creditor to offset the secured debt as payment for the assets and to take ownership of those assets without necessarily having to pay any cash for the purchase. Whilst there is no statutory equivalent in the UK, the process has evolved here into an accepted practice. Hedge funds, private equity firms and other distressed investors have used this device to effect their ‘loan-to-own’ strategies by buying into the debt of a distressed company at less than par and then using their secured position to take ownership, normally via an insolvency process, of the assets.
Recently, we have noted an increase in the use of credit bidding as a defensive strategy by more mainstream lenders. We have seen more traditional lenders partaking in AMA and other processes so as to maintain competitive tension (as well as being ready to transact as ‘Plan B’ should the front runner not close the deal), because they view this as their best (or only) option to protect the value of their collateral or to prevent the collapse of a business in a distressed market.
Credit bidding can give a secured creditor a significant advantage over third party bidders in terms of the price paid: any other bidder would need to pay sufficient consideration to clear the secured creditor’s position and it may be for the credit bidder that, in a falling market, there is some headroom to play with between the asset value and the amount of their secured debt. A creditor is also likely to be more familiar with the secured assets than third parties, meaning that they can undertake any diligence and transact more quickly, which is often key in a distressed scenario.
What needs to be considered in advance of any credit bid?
The secured creditor(s) would need to set up a bidding vehicle (NewCo) which will be the purchaser of the assets. There will be various considerations around the structuring of this. Secured creditor(s) may choose to hold equity in this vehicle, but for many lenders there will be concerns around such shareholdings and they may prefer to allow management (and possibly other investors) to take the equity, with them remaining as arm’s length lenders into NewCo. Where multiple creditors co-own the bidding vehicle, early consideration of the respective rights and obligations of these shareholders is essential.
The assets being purchased might be the shares owned by ‘Topco’ in one or more of its subsidiaries, possibly being sold by a fixed charge receiver appointed over those shares. Alternatively, it may be that the business and assets of the operating company are being sold by an administrator and the bid would need to be structured for those assets which the secured creditor wanted to take across to NewCo. Whatever the assets in question are, the key point is that the bidding creditor has valid (ideally first ranking) security over those assets.
In advance of entertaining any credit bid proposal, the officeholder who will be acting on behalf of the Seller, will need to be certain that the bidder holds valid security over the assets being sold. They will want to be comfortable that there isn’t a risk of any antecedent clawback e.g that the security could be challenged as a preference, a transaction at an undervalue or a transaction defrauding creditors (pursuant to sections 239, 238 or 423 of the Insolvency Act 1986 respectively). If there are any concerns on hardening periods or the circumstances around the granting of the security, the Seller (acting by its officeholder) may seek an indemnity to protect against this risk, albeit this is likely to be resisted by the secured creditor.
To the extent there are other secured creditors who rank ahead or pari passu with the bidding creditor, negotiations would be required so that they are either brought on the journey to be part of the NewCo structure – or they will need to be paid appropriate amounts to reflect what they would otherwise have received pursuant to the relevant insolvency (and any contractual) waterfall. However, having to pay out other creditors to any material extent is likely to diminish the appeal and viability of a credit bid. It might be that certain pari creditors are ready and able to partake in a credit bid whilst others are not, for any variety of reasons, including potentially reputational concerns or not having the necessary approvals in place in the available timeline. In such scenarios, we have seen arrangements negotiated between such creditors whereby certain parties transact by way of credit bid, with contractual arrangements in place alongside for (re)distribution of assets, or the shares in the bidding vehicle, amongst the other pari creditors post sale.
Another critical issue for officeholders is the question of valuation and how they can get themselves comfortable that the transaction by way of credit bid ensures the best result for creditors. It is standard practice for a competitive AMA process to be run, possibly alongside seeking independent valuations for the assets in question. The recent Government proposals for stricter scrutiny on pre-packaged administration sales to connected parties will serve to heighten these concerns. In situations where a competitive process prior to sale was for some reason not possible, we have seen sales for an agreed margin above the relevant valuation, possibly with the assets being ‘marketed’ after the transaction has occurred, with contractual provisions in the sale documentation that if any higher price could have been achieved (than was paid by the secured creditor via the credit bid), this shortfall would be paid across to the Seller.
The question of valuation and best outcome for creditors can be further complicated by the fact that one is not comparing like for like. This issue is always challenging for administrators when selling the business and assets of a company where bidders are looking to buy different pools of assets and apply different values to those assets. The various bids need to be run through the waterfall to ascertain the outcome for each class of creditors and then compared accordingly. This is further complicated in the case of a credit bid where you have cash versus credit bid/no cash deals. Discussions around how much ‘clear water’ there is between the credit bid and the next best bid are common and depending on the state of the Seller and the cash position in that company, there may also need to be a cash element to any credit bid so as to cover fees and expenses and for example any prescribed part in an administration.
How do you structure a credit bid?
There are various ways to structure the mechanics of a credit bid and which method is preferable will of course depend on the facts of a particular case and will be influenced by a variety of factors, including any tax implications. Potential structures include:
- Funds flow – the secured creditor enters into a loan instrument (possibly secured by NewCo) to put NewCo in funds in an amount sufficient to cover the consideration for the purchase of the secured assets. NewCo utilises this funding to pay the consideration to the Seller and the officeholder then makes a distribution from the Seller estate back to the secured creditor. It may be that there is actual movement of cash through these steps or alternatively there may be a deemed drawdown, payment and distribution that is covered by book entries. This can be a useful structure where the secured creditor wishes to leave part of the secured debt in the Seller so as to allow it to capture, via its secured position, any future receipts into the Seller.
- Debt assumption – an alternative mechanism (or possibly to be done in conjunction with 1 above) is for NewCo to assume some or all of the debt liability of the Seller as consideration for the assets being purchased. This can be an attractive option for the secured creditor as it should mean that they have already hardened security in Newco (as opposed to option 1 above where they would need to take new security for the new funding which would be at risk for the hardening periods in the normal course). However new security would often be taken in any event as a failsafe.
- Debt for equity – for unlisted companies, the secured creditor could do a debt for equity swap in the Seller, using the reduction or ‘write off’ of their secured debt position as consideration for the assets purchased. The same approach can be taken with listed companies, but a number of additional considerations arise because of (for UK listed companies) the Takeover Code, the Listing Rules of the UK Stock Exchange and statutory and other pre-emption rights, among other things.
Whilst not without its challenges, credit bidding can be a very useful tool for lenders and we anticipate seeing it being used more often in a defensive way by lenders to protect their collateral in what will inevitably be a period of increased corporate failure.