In December 2014, the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 released its recommendations for amendment to the current Bankruptcy Code. If implemented, these recommendations would deeply impact secured lenders and their borrowers. Secured lenders’ concerns include limitations on, among other things, rolling up prepetition debt, liens on avoidance actions, and milestones in DIP financing agreements. While the bankruptcy bar has provided publications summarizing these concerns at a high level, it is now useful to examine individual recommendations more closely.  This article addresses the effect of one recommendation – the standard to be used in the calculation of adequate protection – on secured lending to retailers. As further explained below, if enacted, the Commission’s recommendation would severely disrupt the secured lending market in general, but may be even more problematic for borrowers in the retail space. Secured lenders would ultimately adapt to the new environment by underwriting loans that offer reduced incremental liquidity, higher pricing, and more restrictive structure.

Background

The ABI Commission’s recommendations include a new standard for calculating adequate protection at the commencement of a bankruptcy case. Specifically, the Commission recommends that the adequate protection required to safeguard a secured creditor’s interest be determined based on the “foreclosure value” of the collateral, defined as the net amount a secured creditor would realize upon a “hypothetical, commercially reasonable foreclosure sale of the secured creditor’s collateral under applicable non-bankruptcy law.” This method of calculation marks a departure from current practice. Although the Bankruptcy Code does not currently provide a specific standard, many courts apply standards such as “going concern value,” “reorganization value,” or “market value.” These standards are generally much higher than “foreclosure value.”

The new “foreclosure value” standard would disrupt the secured credit market, allowing debtors to more easily establish the adequate protection needed to access a secured lender’s cash collateral or to obtain post-petition financing with liens that are pari passu with, or senior to, a secured lender’s existing liens.  The Commission’s other recommendations do not mitigate this risk. For example, the proposal that a secured creditor should ultimately receive “reorganization value” for purposes of distributions would be of little help to a secured lender whose cash collateral and senior liens have already been diluted. After competing liens attach to the same asset, proceeds of the collateral may still be distributed at “reorganization value” – but now this value will be sliced apart and distributed among multiple creditors.

Lending to Retailers

The Commission’s adequate protection framework would be especially troublesome for retailers. These companies often have a capital structure that includes asset-based loans, in which inventory and other assets are pledged as collateral. Lenders carefully structure these loans so that collateral value always exceeds amounts outstanding. In the context of inventory, collateral value generally means “net orderly liquidation value” (NOLV). This value assumes that inventory is sold in a going-out-of-business (GOB) sale overseen by a bankruptcy court, instead of through a foreclosure sale under state law.  GOB sales generate significantly better recoveries than foreclosure sales. In a GOB sale, liquidators seek to maximize recovery by selling as much inventory as possible through the retail channel.  Liquidators are experts at using the retailer’s existing store base to drive sales. Only after the benefits of this channel are exhausted will liquidators look to sell inventory to wholesalers and other potential buyers. In contrast, lenders pursuing a foreclosure remedy would need to seize inventory and sell primarily through alternate channels.  While this framework may be sufficient for wholesalers, it ignores the obvious channel for liquidating a retailer’s inventory. A market for appraisals of retail inventory at “foreclosure value” does not even exist.  For these reasons, a world in which adequate protection is calculated at “foreclosure value” would be disruptive to secured lenders and the retailers who borrower from them.

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