Valuing Collateral in Bankruptcy

In In re Sears Holdings Corporation, the U.S. Court of Appeals for the Second Circuit provides a primer on valuing collateral for bankruptcy purposes. The case involved claims by three “second-lien” secured creditors that the value of their collateral (largely consisting of the debtors’ inventory) had diminished after the petition date. If their claims were successful, they’d be entitled to administrative “super-priority” — that is, the right to be paid ahead of all other creditors up to the collateral value they lost.

Court-Approved Asset Sale

The bankruptcy court approved the purchase of substantially all the debtors’ assets by one of the second-lien holders. The other second-lien holders weren’t parties to the transaction. But they were obligated to participate in a $433.5 million “credit bid,” under which the second-lien holders essentially forgave debt in exchange for a dollar-for-dollar reduction in the purchase price.

The second-lien holders claimed that the credit bid fell short of their collateral’s value on the petition date, effectively entitling them to super-priority treatment to the extent of the shortfall. To establish whether the collateral’s value had decreased, it was necessary to determine its value as of the petition date and then subtract the amounts owed to the first-lien holders as of the petition date. The second-lien holders would have a viable super-priority claim if this amount exceeded the $433.5 million credit bid.

Collateral Value

To value the debtors’ inventory, the bankruptcy court considered several approaches:

• Full retail price,
• A depressed liquidation price, or
• Net orderly liquidation value (NOLV).

NOLV refers to an orderly companywide going-out-of-business sale that would yield more than liquidation value but less than full retail value. The bankruptcy court adopted the NOLV approach for most of the inventory, finding that a complete liquidation of the debtors’ assets was a genuine possibility.

The court also assigned zero value to certain non-borrowing-base (NBB) inventory and deducted the face value of certain letters of credit from the collateral value. This was done under the assumption that the letters of credit would be drawn, and those creditors would have priority over the second-lien holders. The court valued the collateral on the petition date at $2.147 billion. Subtracting $1.96 billion of first-lien holders’ claims, the second-lien holders were left with $187 million. Because this amount was less than they had already realized from the $433.5 million credit bid, the second-lien holders weren’t entitled to any super-priority claims.

Failed Appeal

On appeal, the second-lien holders argued that the debtors “retained and used” the inventory, so it should be valued at replacement or retail value. The Second Circuit disagreed: The expectation was that the inventory would be disposed of. How it would be disposed of wasn’t certain on the petition date, but the bankruptcy court “reasonably recognized that there were two ‘realistic scenarios’ — a going-concern sale or a forced liquidation.”

The bankruptcy court valued the collateral somewhere between a forced liquidation and full retail price — an approach the appellate court found sensible. The second-lien holders argued that retail value was appropriate because the debtors didn’t liquidate. Instead, they operated many stores for months and then sold the remaining business as a going concern. The Second Circuit rejected this argument, explaining that the relevant inquiry was the collateral’s value on the petition date, not how the collateral was ultimately used.

The Second Circuit upheld the bankruptcy court’s decision to assign zero value to the NBB inventory because “the second-lien holders failed to offer a reasonable valuation method” for those assets. It also ruled that the bankruptcy court reasonably deducted face value of the letters of credit from the collateral value. Although it may have been possible to discount their value based on the probability they would be drawn, “the second-lien holders never offered any such analysis.”

Be Prepared

As Sears Holdings illustrates, bankruptcy courts have a great deal of leeway in valuing collateral. For this reason, among others, parties should be prepared to offer reasonable, well-supported valuation analyses and methods.