It cannot really be debated that the Four Horsemen of the "retail apocalypse" have arrived and are comfortably hanging around the nation's shopping districts. Dozens of retailers filed for bankruptcy in recent memory, including Bon-Ton, Claire's, Gibson Brands, and Brookstone, with more on the bankruptcy watch list. With many recognized names Liquidating through bankruptcy, perhaps no distressed industry has caused greater concerns for vendors, suppliers, landlords, and other operations-related creditors than retail.
Although not necessarily apparent at the outset of such cases, some of these liquidations may end up as potentially administratively insolvent cases. One only need to look at Toys R Us1 for such an example. The company entered Chapter 11 with assurances of a 16-month runway to accomplish a successful reorganization; and yet, just six months after the bankruptcy filing and securing more than $3 billion in debtor-in-possession (DIP) financing, Toys announced the sudden and unprecedented liquidation of all of its U.S. operations. Citing disappointing fourth quarter results for 2017, an inability to obtain certain covenant waivers from its secured lenders, and the resulting lack of any viable sale or restructuring alternatives for domestic operations, the Toys case represents a large and rapid deterioration of an established operating retail company .
Despite the disappointing outcome of the case, Toys presents a useful case study on why it is essential, at the very outset of the case, to hope for the best but plan for the worst. This is particularly true in situations where retail operating creditors (vendors, suppliers, landlords, and others) continue to provide goods and services during the bankruptcy that inure to the benefit of the secured lender, especially when that secured lender either has a lien-or is granted a lien through adequate protection claims or a postpetition financing facility-on inventory, real estate, and other operating assets. leaving little. If any, unencumbered value in the estate.
The Basic Rules
In general, expenses related to administering the debtor's estate are not chargeable to the secured creditor's collateral, but are paid from the unencumbered assets of the estate. Section 506(c) of the U.S Bankruptcy Code provides an exception permitting the surcharge of collateral in certain circumstances, provided the expenses at issue (i) are ·necessary" to preserve or dispose of the collateral. (ii) are ·reasonable; and (iii) provide a "bene fit' to the secured creditor.
Section 552(b) provides the general rule that postpetition property is not subject to a prepetition lien; however, 1ike Section 506(c), Section 552(b) provides for certain exceptions, namely that a prepetition lien continues to be valid with respect to postpetition proceeds, products, offspring, or profits from the prepetition collateral. But. these exceptions are subject to a further exception : specifically, the validity of a security interest in postpetition proceeds, products, offspring, or profits of prepetition collateral under Section 552(b)(1) can be limited or eliminated by the court "based on the equities of the case."
The next concept is the common law right to marshalling that can be used to protect junior creditors by requiring a secured creditor with recourse to multiple pieces of collateral to recover first from one source, in an attempt to avoid harming junior creditors that have access to fewer sources of collateral. For example, if the working capital lender has a prepetition lien against inventory and obtains a postpetition lien against previously unencumbered real estate, marshalling would have the lender look to the inventory first to allow for the opportunity of junior (including unsecured) creditors to benefit from the value of the real estate if the lender is repaid from the inventory. In other words, the doctrine of marshalling seeks to satisfy the claims of both creditors in a more equitable manner.
These three righ ts- surcharges under Section 506(c) and Section 552(b) and marshalling-are typically raised in the negotiation of a DIP financing order, with such orders often providing that the debtor has waived its ability to assert such rights, leaving the negotiation to the committee and others to raise. Lenders typically seek to show that the budget for the DIP financing provides for the payment of operating and other expenses (per a budget), warranting the requested surcharge waivers. This leaves open, what happens if there is a subsequent liquidation event that gives rise to a right of the lender to cease DIP financing?
Toys R Us
When Toys filed as a reorganization case with a 16-month DIP financing. like many debtors, the Toys debtors made a number of concessions to their prepetition lenders in the initially proposed DIP orders, including waiving the rights to (i) surcharge collateral under Section 506(c), (ii) assert the "equities of the case· exception of Section 552(b), or (iii) compel marshalling. Despite these waivers. the official committee of unsecured creditors negotiated certain meaningful (and prescient) improvements to the final DIP orders, including specific carve outs to the debtors' waivers of Section 506(c), 552(b), and marshalling rights.
Notably, although the original DIP orders contemplated complete waivers of estate rights under Section 506(c), 552(b) and the equitable doctrine of marshalling, the Toys committee obtained the right to assert certain Section 506(c) and 552(b) claims for unpaid administrative claims of trade vendors and landlords . Specifically, the final DIP order governing the Toys Delaware DIP facility preserved Section 506(c) and 552[b) surcharge rights to the extent of (i) the outstanding administrative expense claims of trade vendors and landlords. less (ii) the aggregate amount of postpetition payments the Toys debtors made on the prepetition unsecured claims of such trade vendors and landlords (including pursuant to the critical and foreign vendors orders).
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