In Re: Sears Holdings Corporation

Background

Sears Holdings Corporation and affiliated debtors filed for Chapter 11 bankruptcy protection on October 15, 2018. The debtors’ assets were subject to approximately $2.68 billion in secured debt, including about $1.15 billion in second-lien debt. The bankruptcy filing prevented the second-lien creditors from foreclosing while allowing the debtors to continue using the collateral. The final debtor-in-possession financing order provided the creditors with possible superpriority claims under 11 U.S.C. § 507(b) if the collateral’s value declined despite the protection provided.

The debtors ultimately sold substantially all of their assets to Transform Holdco LLC, an ESL entity, for approximately $5.2 billion in cash and non-cash consideration. The purchase price included a $433.45 million credit bid that reduced debt owed to the second-lien creditors. After the sale, the creditors asserted Section 507(b) claims and argued that approximately $718 million remained outstanding after accounting for the credit bid.

The bankruptcy court held a two-day evidentiary hearing. The second-lien creditors’ experts offered higher valuations of the collateral and calculated substantial diminution in value. The debtors’ fact witness offered a lower valuation. Judge Robert D. Drain rejected or discounted the competing valuations, performed his own valuation, and determined that the second-lien creditors had not proved a decline in the collateral’s value after the petition date. He therefore ruled that they were not entitled to Section 507(b) superpriority claims. He also interpreted the asset purchase agreement as capping ESL’s recovery on any Section 507(b) claims at $50 million.

Issues on Appeal

The second-lien creditors argued that the bankruptcy court:

- used an improper method to value the inventory; - wrongly deducted undrawn letters of credit, post-petition interest, overhead and professional costs, and other senior obligations; - improperly excluded cash, ineligible inventory, and pharmacy prescriptions from the collateral valuation; and - incorrectly interpreted the asset purchase agreement’s $50 million limit on ESL’s Section 507(b) recovery.

Court’s Analysis

The district court held that the second-lien creditors bore the burden of proving the amount of any diminution in collateral value. It agreed that their failure to meet that burden was independently sufficient to deny the Section 507(b) claims.

The court nevertheless reviewed the bankruptcy court’s valuation. It held that the bankruptcy court did not have to use the retail or book value of the inventory under the Supreme Court’s decision in Associates Commercial Corp. v. Rash. That decision requires valuation to account for the purpose of the proposed use or disposition of the collateral. Here, the collateral was inventory that would be sold through a going-concern transaction or liquidation, rather than property retained for continued use in a reorganized business. The bankruptcy court’s use of a net orderly liquidation value, with adjustments based on the evidence, was not clearly erroneous.

The district court also upheld the valuation reductions. It agreed that the bankruptcy court could count undrawn letters of credit as senior obligations because the creditors had not offered an alternative valuation for them. It upheld the deduction for post-petition interest because the first-lien creditors were over-secured under the orderly-liquidation framework. It also approved the deduction for anticipated overhead and professional costs associated with the liquidation, distinguishing those valuation costs from the separate request to surcharge the collateral for substantially all bankruptcy expenses under Section 506(c).

The court upheld the use of $46.6 million for credit-card receivables and the exclusion of ineligible and in-transit inventory because the creditors had not established their value for purposes of the collateral calculation. It also upheld the exclusion of pharmacy prescriptions because the second-lien security agreement did not contain the language covering prescription lists found in the first-lien creditors’ agreement. Cash was properly excluded because the creditors did not prove that it was traceable to proceeds of the second-lien collateral.

Finally, applying Delaware contract law, the district court held that the asset purchase agreement’s plain language capped ESL’s recovery on Section 507(b) claims at $50 million. The agreement broadly defined “Claims,” and the court rejected ESL’s argument that the cap applied only to proceeds from litigation claims or other legal proceedings.

Disposition

The district court affirmed the bankruptcy court’s July 31, 2019, and August 5, 2019, orders. The Clerk was instructed to terminate the pending appeals and close the cases identified in the order: 19 Civ. 7660, 19 Civ. 7697, and 19 Civ. 7782. The court separately directed the debtors to advise by September 15, 2020, how they wished to proceed with appeals concerning the Section 506(c) cost-surcharge issue.