Sears Holding: A Case Study in Valuing Collateral in Chapter 11
by | posted in: 363 Sale, Chapter 11, Reorganization, Valuation | 0

By Mark G. Douglas and Oliver S. Zeltner (Jones Day)

Mark G. Douglas
Oliver S. Zeltner

Valuation is a critical and indispensable part of the bankruptcy process. How collateral and other estate assets (and even creditor claims) are valued determines a wide range of issues, from a secured creditor’s right to adequate protection, postpetition interest, or relief from the automatic stay to a proposed chapter 11 plan’s satisfaction of the “best interests” test or whether a “cramdown” plan can be confirmed despite the objections of dissenting creditors. Depending on the context, bankruptcy courts rely on numerous different standards to value estate assets, including book, retail, wholesale, liquidation, forced-sale, going-concern, and reorganization value.

The U.S. Court of Appeals for the Second Circuit recently examined collateral valuation in a chapter 11 case for the purpose of determining whether junior secured creditors were entitled to “super-priority” administrative claims to compensate them for alleged diminution in the value of their collateral after the petition date and before the bankruptcy court approved a sale of the debtors’ business as a going concern. In ESL Investments, Inc. v. Sears Holdings Corp. (In re Sears Holdings Corp.), 51 F.4th 53 (2d Cir. 2022), cert. denied sub nom. Cyrus Capital Partners, L.P. v. Sears Holdings Corp., No. 22-765 (U.S. Mar. 20, 2023), the Second Circuit held that, given the uncertainty surrounding the retail debtors’ fate at the time they filed for bankruptcy, the bankruptcy court did not err in valuing inventory collateral at its “net orderly liquidation value,” rather than book value, going-out-of-business sale value, or forced liquidation value. The Second Circuit also found no fault with the bankruptcy court’s decision to value non-borrowing base inventory at zero and to ascribe full face value to undrawn letters of credit where, among other things, the junior lenders failed to meet their evidentiary burden of suggesting a reasonable alternative.

There are several key takeaways from the Second Circuit’s ruling in Sears Holding.

First, valuation in bankruptcy is a fact-specific inquiry, and the selection of an appropriate valuation method, guided by section 506(a) of the Bankruptcy Code, is committed to the sound discretion of the Bankruptcy Court.

Second, Sears Holding is a testament to the consequences of failing to satisfy evidentiary burdens. The Second Circuit found no error in the bankruptcy court’s decision to ascribe no value to certain inventory and to discount to zero the full face value of undrawn letters of credit because the junior lenders had the burden of proposing a reasonable alternative but repeatedly failed to do so.

Third, the Second Circuit reaffirmed in Sears Holding that applicable U.S. Supreme Court precedent regarding valuation in a chapter 13 case also applies in chapter 11, requiring the bankruptcy court to be guided in its valuation by the use or disposition likely for the subject collateral, rather than some hypothetical use or disposition.

The Supreme Court denied the junior lenders’ petition for review of the Second Circuit’s decision on March 20, 2023.

Click here to read the full article.

Tribune II: Law Firm Perspectives
by | posted in: Avoidance, Financial Firms and Safe Harbors, fraudulent transfer, Statutory Interpretation | 0

By Xiao Ma (Harvard Law School)

Xiao Ma

On December 19, 2019, the Second Circuit issued its amended opinion in In re Tribune Company Fraudulent Conveyance Litigation, 2019 WL 6971499 (2d Cir. Dec. 19, 2019), which held the “safe harbor” provision in section 546(e) of the Bankruptcy Code covers Tribune Company’s payments made to public shareholders as Tribune constitutes a “financial institution” in pursuance with the Bankruptcy Code definition, and such definition includes the “customer” of a financial institution when the financial institution acts as the customer’s “agent or custodian…in connection with a securities contract”.

The Second Circuit’s opinion was controversial in light of the Supreme Court’s recent ruling in Merit Management Group, LP v. FTI Consulting, Inc., 138 S.Ct. 883 (2018) on the scope of safe harbor, with law firms perceiving it as moving away from the position of Merit by opening new room for application of safe harbor protection. Jones Day suggests that the Tribune’s reasoning “avoided the strictures of Merit”, while Nelson Mullins finds it “shifting the focus from the financial institution as a ‘mere conduit’ to an ‘agent’.” Kramer Levin comments that the decision represents a “dramatic, and perhaps unexpected, extension of the safe harbor from the position it occupied in the immediate aftermath of Merit.” Weil calls it throwing the 546(e) safe harbor a lifeline.

Firms also find the case paving a way to protect LBO payments from subsequent attacks. King & Spalding notes that the Second Circuit’s opinion provides protection for recipients involved in LBO transaction where the debtor is the “customer” of the intermediary financial institutions. Cadwalader believes that the decision may “narrow the impact” of Merit, as market participants could structure their transaction to involve a financial institution thereby bypassing the “mere conduit” carve-out. Skadden agrees on the likely trend of structured LBOs, highlights that the customer defense is “likely to continue gaining momentum” after the Second Circuit’s decision. Parties would ensure they meet the “financial institution” and “customer” criteria methodically articulated in Tribune. “An appropriately structured principal/agent relationship could continue to shelter transfers or distributions within the ambit of section 546(e) safe harbors,” says Weil, adding that the operative facts will be key to strengthen the position.

Finally, Gibson Dunn notes that Tribune is not binding on other circuits. It remains to be seen whether such holding will be extended to different circumstances by other courts. “Some courts may find (in contrast to the Second Circuit) that the Supreme Court in Merit could not possibly have intended that its narrowing of the section 546(e) safe harbor be so easily vitiated by an argument that the Court itself acknowledged in a footnote,” says Kramer Levin.

In a prior Roundtable post, Professor Bussel noted that a plain meaning interpretation of the term “financial institution” should not include the customers of commercial banks, thus precluding a sharp change from Merit.

For Roundtable’s other posts on Tribune, see Bankruptcy Court Disagrees with Second Circuit’s Holding in Tribune, Tribune Fraudulent Conveyance Litigation Roundup. For Roundtable discussions relating to the 546(e) safe harbor, please refer to the tag #Safe Harbors.