Delaware Bankruptcy Court Dismisses Committee’s Complaint Challenging Portion of Credit Bid

The Bottom Line

Recently, in Official Comm. of Unsecured Creditors v. Victory Park Capital Advisors, LLC (In re Katy Indus., Inc.), Case No. 17-50937 (Bankr. D. Del. July 6, 2018), the Bankruptcy Court for the District of Delaware dismissed the Official Committee of Unsecured Creditors’ (the Committee) complaint, which sought to recharacterize, or alternatively subordinate, a portion of the successful bidder’s credit bid for the Debtors’ assets in a Section 363 sale. The court found that neither recharacterization nor subordination would increase the potential distribution to creditors, and that even if the court did disqualify that portion of the credit bid, it would have remained the successful bid due to the lack of alternative bidders.

What Happened?

Katy Industries Inc. (Debtors) manufactured, imported and distributed commercial cleaning and consumer storage products. In 2015, Victory Park provided a second-lien secured loan (the Second Lien Agreement) to the Debtors. In mid-2016, the Debtors defaulted on their obligations on the Second Lien Agreement and under a secured credit facility with BMO Harris Bank N.A. (BMO). The Debtors subsequently entered into a multistep transaction, pursuant to which, inter alia, Victory Park advanced $6.5 million directly to BMO, and the parties amended the Second Lien Agreement. In July 2016, Victory Park and the Debtors executed a third amendment to the Second Lien Agreement, under which Victory Park advanced an additional $750,000. In August 2016, they entered into a fourth amendment, under which Victory Park advanced $5.75 million. Also at this time, the CEO appointed Charles Asfour (who at the time the complaint was filed was a partner at Victory Park Capital Advisors LLC) as a director. In November 2016, the Debtors refinanced their BMO credit facility and again amended the Second Lien Agreement.

In March 2017, the Debtors retained Lincoln International Inc. (Lincoln) to initiate a marketing and sale process. In April 2017, Victory Park advanced an additional $1 million to the Debtors pursuant to a sixth amendment. Also in April, Highview Capital LLC (Highview) contacted Lincoln regarding the Debtors’ asset sale. The complaint alleges that Mr. Asfour provided sensitive financial and operational information to Highview in an attempt to induce Highview to enter into a joint venture with Victory Park. Victory Park and Highview did form a joint venture (Jansan) wherein Highview would provide a $6.5 million DIP loan to the Debtors in exchange for equity in Jansan, and Victory Park would contribute $38.046 million in second-lien debt in exchange for equity in Jansan, which was memorialized in a letter of intent submitted by Jansan to the Debtors. 

On May 14, 2017, the Debtors filed for Chapter 11, with Jansan’s stalking horse bid and DIP financing package. The final DIP order provided that it would be binding on the Committee unless the Committee “timely commenced a contested matter or adversary proceeding . . . (a) challenging the amount, validity or enforceability of the Prepetition Second Lien Obligations, (b) challenging the perfection or priority of the Prepetition Second Liens, (c) challenging the existence of any DIP Collateral, or (d) otherwise asserting any objections, claims or causes of action . . . against the Prepetition Second Lien Lenders relating to the Prepetition Second Liens or the Prepetition Second Lien Obligations.”  Final DIP Order ¶ 26. Jansan was approved as the stalking-horse bidder, and its bid was the only qualified bid received by the deadline. Accordingly, no auction was held. The order approving the sale preserved “the rights or remedies of the Debtors’ estates or the Committee with respect to any ‘Challenge’ as described in paragraph 26 of the Final DIP Order.” Sale Order ¶ 48.

The Committee’s complaint named Victory Park, Jansan and Mr. Asfour as defendants. The complaint sought to recharacterize as equity investments, or alternatively subordinate, the advances made by Victory Park, based on 11 U.S.C. §§ 105(a) and 502(b)(1), and 11 U.S.C. § 510(c), respectively. The Committee also sought to avoid the advances pursuant to 11 U.S.C. § 544(a), the Uniform Fraudulent Transfer Act, and 11 U.S.C. § 549(a), and to recover the avoided transfers pursuant to 11 U.S.C. § 550(a). Finally, the complaint alleged that Mr. Asfour breached his fiduciary duty of loyalty.  The Defendants moved to dismiss the complaint.

The court considered the preliminary issue of whether the Committee had successfully preserved its ability to assert claims for recharacterization and subordination. The court found that the Committee’s preservation of such claims “must be discernible within the four corners of the Sale Order.” The court concluded that even assuming the Committee had a right to bring the claims, neither recharacterization nor subordination would enhance any potential distribution to creditors. Jansan’s bid was the only qualified bid received by the deadline, with a purchase price of $63 million. Even if $7.5 million (the amount of the advances) of its credit bid were disqualified, Jansan would merely have reduced its total credit bid from $36.7 million to $29.2 million, and its total bid from $63 million to $55.5 million. Given the lack of other qualified bidders, Jansan would still have been the successful bidder. Thus, the court found that “reshaping the economics of the deal” would have no tangible effect for the Committee and that it could not fashion an appropriate remedy absent upsetting the entirety of the transaction.

The court dismissed the remaining counts as well. First, Section 544 applies only to prepetition transfers of property, whereas the disputed transfer of property here — the credit bid of the advances — occurred postpetition. Second, Section 549 applies only to postpetition transfers that are not authorized by the court, but here, the sale order specifically authorized credit bidding of the advances. Finally, the court dismissed the count based on Section 550(a), as it was contingent on the success of the prior claims. 

The court also dismissed the Committee’s claim against Mr. Asfour for breach of the fiduciary duty of loyalty. The court found that the complaint did little more than provide blanket statements that Mr. Asfour benefited personally from his conduct and that the Debtors were substantially harmed. In any event, the court found that the complaint failed to allege that Mr. Asfour violated the corporate opportunity doctrine. Finally, the court found no breach of fiduciary duty based on Mr. Asfour’s failure to disclose Victory Park’s intention to oppose any alternative to the Jansan DIP proposal, which the Committee alleged caused the Debtors to incur needless expense and delay. The court found that the complaint did not allege that the DIP process was any more expensive or protracted than it would have been had Mr. Asfour disclosed Victory Park’s intention.

Why This Case Is Interesting

In this opinion, the court affirmed the need for finality in Section 363 sales, noting that it could not fashion an appropriate remedy without upsetting the entirety of the transaction. While the question was not raised by the parties in this case, the court noted in a footnote that it is possible that the Committee’s claims for recharacterization or subordination were moot under the prudential mootness theory. Thus, that may be an argument available to creditors in future cases where the committee seeks similar relief. Also, the court concluded that it did not need to determine whether the Committee had preserved its ability to bring claims for recharacterization and subordination or adjudicate the merits because, even if it had, there would be “no tangible, ameliorative effect for the Committee,” since no other bidder emerged. Nevertheless, the opinion underscores the importance of savings clause language in DIP orders and sale orders. Debtors and committees should require such language and review it carefully to ensure that any possible challenges they may bring are preserved.