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Avoidance Actions Can Be Key to a Successful Chapter 11

In a typical Chapter 11 bankruptcy case, the initial terms of a debtor-in-possession (DIP) financing arrangement likely include a provision granting the DIP lender a lien on the bankruptcy avoidance actions and/or the proceeds of such actions, and one of the first things a committee of unsecured creditors does upon its appointment by the U.S. Trustee is to challenge such a provision. Usually, a negotiation ensues, and the DIP lender, which has obtained other liens and claims against the debtors in connection with the DIP financing, allows the avoidance actions and/or the proceeds thereof to be prosecuted by a plan trustee or administrator for the benefit of the unsecured creditors.

Recently, however, avoidance actions have played a prominent role in cases for other constituencies and/or otherwise for the reorganization of the company. In some cases, avoidance actions have meant the difference between whether a Chapter 11 case survived or converted to Chapter 7—from administrative insolvency to administrative solvency. Additionally, avoidance actions have even been used to resolve an impasse among the constituencies.

Administrative Insolvency Solution

In In re The Wet Seal, LLC, et al., Delaware Case No. 17-10229 (Wet Seal 2), the creditors’ committee argued that the debtors’ proposed use of cash collateral would provide a windfall to the prepetition secured parties, while leaving other creditors with an administratively insolvent estate on top of their unpaid prepetition claims. Certain of the debtors’ retail landlords argued that the debtors’ uncertain cash position forced owners to risk becoming unsecured lenders in the Chapter 11, with the company, if administratively insolvent, getting interest-free use of property for bankruptcy sales.

The parties negotiated a final order authorizing the debtors’ use of cash collateral. The order provided that the debtors, the senior lender, and the committee would consult on a process for the analysis and prosecution of avoidance actions, and the debtors could not commence, settle or seek to settle, compromise, or resolve any avoidance action without the prior written consent of the committee and until the indefeasible payment in full in cash of the senior obligations. In consideration of the landlords agreeing to delay receipt of payment relating to their administrative claims for stub rent, the debtors agreed to waive any right to prosecute avoidance actions against the landlords.

The parties further agreed to a payment scheme for the net proceeds of the avoidance actions: first, to pay the senior obligations until indefeasible payment in full in cash; second, to pay the landlords’ stub rents; third, to pay Section 503(b)(9) administrative expenses up to $250,000; and fourth, to pay or reserve for payment of all other claims and obligations of the debtors in accordance with the priorities of the Bankruptcy Code.

Secured Creditor Protection

In In re M&G USA Corporation, et al., Delaware Case No. 17-12307, the final DIP order provided that the DIP collateral included avoidance action proceeds, but not the avoidance action claims and causes of action. A detailed structure for payment of such proceeds was also negotiated and incorporated into the order:

  1. Proceeds of any avoidance claim brought against the prepetition first lien lender would inure to the benefit of holders of unsecured claims and administrative expense obligations of the applicable estates (but not to the holders of prepetition lender adequate protection claims), provided that any such proceeds would be applied first to reimburse the DIP parties for any DIP loan proceeds used to fund certain limited items.

  2. Proceeds of any avoidance claim brought against the prepetition second lien party in connection with its prepetition second lien obligations would inure to the sole benefit of the DIP parties and holders of unsecured claims and administrative expense obligations of the applicable estate(s) (but not to the holders of prepetition lender adequate protection claims), provided that any such proceeds would be applied first to reimburse the DIP lender for any DIP loan proceeds used to fund certain limited items. Further, for the avoidance of doubt, all such proceeds would be paid (x) first, to the prepetition first lien lender and/or the DIP lender in accordance with their subordination agreement and the DIP credit documents, until both the prepetition first lien obligations and the DIP obligations were paid in full, and (y) second, to the holders of any unsecured claims and administrative expense obligations of the applicable estates.

  3. Proceeds of any avoidance claim not otherwise described would be applied first, to reimburse the DIP lender for any DIP loan proceeds used to fund certain limited items and second, (x) 75 percent of any remaining proceeds would inure to the DIP lender, prepetition first lien lender, and prepetition second lien lender in accordance with their priorities (provided that such lenders would first look to other sources of recovery) and (y) 25 percent of any remaining proceeds would inure to the holders of any unsecured claims and administrative expense obligations of the applicable estate(s).

In In re hhgregg, Inc., et al., Southern District of Indiana Case No. 17-01302, the DIP collateral included, among other things, “any claims and causes of action to which the Debtors may be entitled to assert by reasons of any avoidance or other power vested in or on behalf of the Debtors or the estates of the Debtors under chapter 5 of the Bankruptcy Code and any and all proceeds in whatever form, recoveries and settlements thereof[.]”

However, the unsecured creditors’ committee was granted the exclusive right to bring the avoidance actions, in consultation with the DIP lenders. The proceeds of such claims were for the benefit of the debtors’ estates, meaning they would be available to junior creditors, such as the committee, should the DIP lenders be repaid in full.


 

Preference and other avoidance actions can provide a critical path to a plan of  reorganization and a means to avoid liquidation.

 


In In re Magnetation LLC, et al., Minnesota Case No. 15-50307, the DIP lender did not receive a lien on the debtors’ avoidance actions, but was granted a first priority security interest in and lien on (a) all proceeds or property recovered from non-preference avoidance actions (e.g., fraudulent conveyances and post-petition transfers), and (b) all proceeds or property recovered from any preference actions against certain prepetition lenders and other parties. The DIP liens did not attach to proceeds or property recovered from successful preference actions against any other party. The DIP lender was also granted a superpriority claim which was payable from, among other things, any non-preference avoidance action proceeds.

Litigation Settlement Funding

In In re AFA Investment, Inc., et al., Delaware Adv. Proc. 12-50710, an employee class representative commenced a WARN Act lawsuit against certain of the debtors. The complaint sought damages in the amount of 60 days’ wages and benefits for each of approximately 450 class members for the relevant statutory period under the WARN Acts (60 days in California, 90 days in New York). The complaint further asserted that the alleged damages were entitled to first administrative priority status pursuant to Section 503(b)(1)(A) of the Bankruptcy Code.

The parties reached an agreement to settle the litigation (which likely would have been protracted and expensive, with an uncertain outcome) involving, among other things, a payment by
the debtors to the class of up to the first $1.65 million of net recoveries from avoidance actions. There were no opt-outs of any class member and no objections to the proposed settlement filed by any party-in-interest. The settlement was approved by the court, allowing the bankruptcy case to move forward.

Not to Be Overlooked

Preference and other avoidance actions can provide a critical path to a plan of reorganization and a means to avoid liquidation. Furthermore, such actions can provide a valuable means for recovery for creditors of the debtors’ estate beyond just unsecured creditors. Secured creditors can avail themselves of the benefits of such actions (i.e., the proceeds) even without obtaining the actions themselves. Detailed agreements can be negotiated and incorporated into a final DIP order, as in M&G, or other order, as in the settlement order in AFA.

It is important to give due consideration to preference actions in any bankruptcy case. They should not be forgotten or underestimated by the various constituencies, including, the debtor, secured creditors, administrative expense creditors, and litigation plaintiffs.

 

Edward Neiger

Edward E. Neiger

ASK LLP

Edward E. Neiger is a managing partner at ASK LLP, where his practice focuses on representing unsecured trade creditors in complex bankruptcy cases. Prior to joining ASK, Neiger founded Neiger LLP, where he represented clients in the bankruptcy cases of Lehman Brothers, American Airlines, and General Motors, among others. As an attorney with Weil, Gotshal & Manges LLP, he worked on behalf of such debtors as Enron, Worldcom, and Global Crossing.

Jennifer Christian

Jennifer A. Christian

ASK LLP

Jennifer A. Christian is a partner at ASK LLP, where her practice focuses on representing indenture trustees, secured and unsecured creditors, liquidating trustees, and other major constituencies in complex bankruptcy cases. She has more than 15 years of experience, having served as counsel at Thompson & Knight LLP, as an associate with Kelley, Drye & Warren LLP and Bryan Cave LLP, and as a law clerk to a federal bankruptcy judge before joining ASK LLP.

Topics: 
Bankruptcy
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