Credit Bid: How a Secured Lender Buys With Its Debt

When a business fails, a secured lender's recovery is set by the sale of its security. If the market for the assets is thin (specialised plant, a business whose value is its staff and contracts, a sector out of favour), the best cash offer may sit well below what the lender believes the assets would fetch after a year of steadier trading. A credit bid lets it buy the assets itself, repair the business and sell later. Lenders use it defensively, to put a floor under a sale process; investors who buy distressed debt at a discount use it to take control, a strategy often called loan to own.

It works because of where the money would go. Cash paid by the lender would come straight back to it under the recovery waterfall, since it ranks first on those assets. Paying with the debt removes the round trip.

The legal footing differs by market. In the United States the Bankruptcy Code lets the holder of a secured claim bid at a court-supervised sale and offset the claim against the price, unless the court for cause orders otherwise. New Zealand, Australia and the UK have no general statutory right of that kind, though New Zealand's Property Law Act does let a mortgagee bid at an auction of mortgaged land run by the Registrar of the High Court. Otherwise the bid is an offer to whoever is selling: a receiver, an administrator, or the lender itself as mortgagee selling to a company it controls, a sale the courts examine closely. The seller accepts it only if it can show the price was proper. In New Zealand a receiver selling property owes a statutory duty to obtain the best price reasonably obtainable as at the time of sale. In Australia a receiver or other controller selling a company's property must take all reasonable care to sell for not less than market value, or the best price reasonably obtainable where there is no market value.

The cash element is the part lenders underestimate. The receiver's or administrator's costs come first. Claims the law puts ahead of security over circulating assets such as stock and debtors must be paid in money: certain employee entitlements in all three markets, certain tax debts in New Zealand and the UK, and in England and Wales the prescribed part of floating-charge realisations set aside for unsecured creditors. A creditor ranking ahead of the bidder, and duties on the transfer, also need cash. And because the buyer is the creditor the seller acts for, the seller needs evidence of value: genuine marketing, an independent valuation, and every cash offer run through the waterfall beside the bid.

A ski-field operator, constructed for this page like every figure in it, owes its bank US$42m secured over all its assets. After two poor seasons the bank appoints receivers. Three months of marketing produce one serious cash offer, US$24m, from a buyer that would close one of the two lift systems. An independent valuation commissioned by the receivers puts the business at US$30m if it trades through another season. The bank forms a new company and bids US$31m. Figures below are in US$m and belong to the example.

On paper the bid recovers US$7m more, and the receivers can show it beats both the only cash offer and the valuation, which is the evidence their duty on price needs. The bank's reading is less comfortable. Its US$29.2m is now a stake in a ski field, worth that only if next season beats the last two. It must fund the company to open (US$3m in the example), find management and plan a sale, and its US$12.8m claim is against a company with nothing else of value.

The price cuts both ways. A bid set too low invites the argument that the receivers sold cheaply. A bid set high costs no extra cash, but every dollar of it reduces the claim the bank can bring against a guarantor.

Both turn a lender's debt into ownership, and they are confused for that reason. In a debt-for-equity swap the company survives: the lender takes shares in it, by agreement with the shareholders or through a court-approved plan, and the company keeps its other liabilities. A credit bid buys assets out of a company in an insolvency process. The new company takes the assets, contracts and staff it chooses, and the old company is left with its other creditors and is usually liquidated.

Nor is a credit bid a timing device. A pre-pack sale arranges a sale before an appointment so it completes at once; a credit bid is a way of paying. The two can meet, when a pre-pack buyer is the lender's vehicle.

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Before the seller looks at the price, it checks the security. A credit bid is only as good as the debt being bid, so the seller confirms the security was validly granted and perfected and is not open to challenge, for example as a voidable preference or for want of registration. A defect there can leave the buyer exposed to a later claim.

With more than one lender, the bid is a lenders' decision. The facility or intercreditor agreement usually says which majority can instruct the security trustee to bid and release debt, and many bind objecting lenders to a distressed disposal. A lender that did not want to own a ski field can end up holding shares in one.

Inside the bank, the bid is approved as a new exposure. Holding an operating business is treated differently from holding a loan, in policy and in capital, so the credit paper sets out the funding the new company needs, who will run it and how it will be sold.

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