When an orderly going-out-of-business sale is a “genuine possibility” for a retailer in chapter 11, the Second Circuit says that secured lenders’ collateral can be valued as of the filing date at the orderly liquidation value, less expenses, not at the higher book value or replacement cost.
The Second Circuit’s October 14 opinion is an extrapolation (or perhaps departure) from Rash, where the Supreme Court commanded in a chapter 13 case that the value of collateral retained by the debtor must be based on the “actual use” of the collateral. Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997).
In the case on appeal, the “actual use” of the collateral actually turned out to be a going-concern asset sale that presumably realized more than a going-out-of-business sale. The Second Circuit nonetheless upheld a valuation for less than going-concern value.
The Second Circuit worked from the proposition that the valuation must be made as of the filing date. At that time, the appeals court believed it was reasonable to expect a going-out-of-business sale rather than a going-concern sale.
The opinion is a testament to the respect that the Second Circuit has for the findings of fact by a well-regarded bankruptcy judge, Robert D. Drain of White Plains, N.Y.
The Sears Going-Concern Sale
The opinion by Circuit Judge Richard J. Sullivan was 13 months in the making. It involves the chapter 11 reorganization of Sears, the retailer that operated almost 700 stores when the filing took place in 2018.
The debtor had first- and second-lien lenders with $2.7 billion in liens on inventory. Under Section 363, Bankruptcy Judge Drain gave them “adequate protection” for the use of their collateral in the form of replacement liens and a super-priority under Section 507(b) over all other creditors’ claims if there were a decline in value of the collateral after filing.
Unable to reorganize on its own, the debtor sold the business as a going concern to its largest secured creditor for about $5.2 billion. The buyer paid for the assets largely with non-cash consideration, including a $433.5 million credit bid. Under an intercreditor agreement, second-lien lenders were obliged to participate in the credit bid.
As Judge Sullivan said, the credit bid “for practical purposes forgave debt that the Debtors owed to [the first- and second-lien lenders] in exchange for a dollar-for-dollar reduction in the purchase price.”
The second-lien lenders, however, contended that the $433.5 million credit bid fell “far short” of the value of the collateral on the petition date. Rather, they argued there had been a diminution in the value of their collateral, entitling them to a super-priority claim.
To resolve the controversy, Bankruptcy Judge Drain was called on to fix the filing-date value of the collateral and then subtract the obligations to the first-lien lenders as of the filing date. Judge Sullivan said that the second-lien holders would “have a viable section 507(b) super-priority claim only if this figure exceeds the $433.5 million credit bid [that the buyer] already recouped in the transaction.”
Judge Sullivan described how the bankruptcy court had heard from expert witnesses whose collateral values “varied widely.” He characterized Judge Drain as having considered the full retail price as the highest valuation and a going-out-of-business liquidation for the lowest value.
Instead, Judge Drain settled on the so-called NOLV, or net orderly liquidation value, which Judge Sullivan defined to mean “an orderly company-wide going out of business sale that would sell the Debtors’ assets at more than their liquidation value, but less than their full retail price.”
Judge Sullivan said that Judge Drain adopted the “NOLV because, on the Petition Date, a complete liquidation of the Debtors’ assets was a genuine possibility.” After deducting overhead and legal fees, Judge Drain found as a fact that the filing-date value of the inventory was 87.4% of book value, or about $2.15 billion.
From the $2.15 billion, Judge Drain subtracted first-lien claims totaling almost $2 billion, yielding a net of $187 million for second-lien creditors. Since the second-lien holders “had already realized more than this from the $433.5 million credit bid, the bankruptcy court held that they were not entitled to any further recovery in the form of section 507(b) super-priority claims,” Judge Sullivan said.
The junior lenders appealed, but the district court affirmed, and so did Circuit Judge Sullivan.
The Law on Chapter 11 Valuations, According to the Second Circuit
The junior lenders argued on appeal that the bankruptcy court should have valued the inventory at book value or replacement value. Judge Sullivan measured the argument against Rash and Section 506(a)(1). The section says that the value of collateral “shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property . . . .”
Rash was a chapter 13 case involving a truck. The Supreme Court held that the bankruptcy court was required to use “replacement value” because the debtor retained and continued to use the truck. Judge Sullivan characterized Rash as respecting “the debtor’s ‘actual use’ of the collateral, ‘rather than’ taking cues from ‘a foreclosure sale that will not take place.’” Rash, supra, at 963.
The Sears valuation intimately involved Section 506, which requires consideration of the “disposition or use” of collateral. Judge Sullivan said that Rash “had no need to address” Section 506. He also said that Rash did not involve the valuation of retail inventory.
Still, Judge Sullivan said that Rash was “instructive” because the debtor had elected to use the truck to generate income. Thus, he said, “actual use” was the proper guide for valuation.
Judge Sullivan inferred that “Rash contemplated that one particular use or disposition must be proposed, and that this proposal must guide the valuation exercise.” [Emphasis in original.] Deferring to the bankruptcy court’s findings, he said that Judge Drain “reasonably decided” on using NOLV because it assessed “what the Debtors would likely be able to recoup from the collateral.” He characterized NOLV as “somewhere between a forced liquidation and . . . full retail price.”
“Far from being erroneous,” Judge Sullivan said that NOLV “was, by any measure, a sensible one.”
No to Retail Value
Because the debtor did not liquidate immediately, the junior lenders argued that the court should have used retail value, given that the stores continued operating after filing.
“But,” Judge Sullivan said, valuation “turned on the value of the collateral on the Petition Date, without inquiring into how the collateral was ultimately used.” [Emphasis in original.] In a footnote, he noted how the lenders proffered no authority for the idea that the court must make the filing-date valuation “in light of subsequent developments.”
Again deferring to the bankruptcy court’s findings, Judge Sullivan said that Judge Drain’s “decision to settle on an orderly liquidation value was therefore not an unreasonable conclusion.”
Judge Sullivan ended his review of inventory valuation by focusing on whether 87.4% of book value was “clear error.” He found “no error of fact or law.”
The last few pages of Judge Sullivan’s opinion dealt with two other types of collateral. One was inventory in transit on the filing date, to which Judge Drain gave no value. The other was almost $400 million in letters of credit that were undrawn on the filing date and were the lenders’ collateral.
As to both, the lenders suffered from a failure of proof. Judge Sullivan said that Judge Drain “reasonably rejected” the only valuation proffered by the lenders for in-transit inventory. With regard to the letters of credit, he said that the lenders made “little effort to defend a valuation other than ‘zero.’”
Affirming the lower courts, Judge Sullivan ruled that “the bankruptcy court did not commit clear error by denying the second-lien holders’ section 507(b) claims.”
When an orderly going-out-of-business sale is a “genuine possibility” for a retailer in chapter 11, the Second Circuit says that secured lenders’ collateral can be valued as of the filing date at the orderly liquidation value, less expenses, not at the higher book value or replacement cost.
The Second Circuit’s October 14 opinion is an extrapolation (or perhaps departure) from Rash, where the Supreme Court commanded in a chapter 13 case that the value of collateral retained by the debtor must be based on the “actual use” of the collateral. Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997).
In the case on appeal, the “actual use” of the collateral actually turned out to be a going-concern asset sale that presumably realized more than a going-out-of-business sale. The Second Circuit nonetheless upheld a valuation for less than going-concern value.
The Second Circuit worked from the proposition that the valuation must be made as of the filing date. At that time, the appeals court believed it was reasonable to expect a going-out-of-business sale rather than a going-concern sale.
The opinion is a testament to the respect that the Second Circuit has for the findings of fact by a well-regarded bankruptcy judge, Robert D. Drain of White Plains, N.Y.