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.
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.
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:
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.
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.
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.
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.