Restructuring

Introduction

In re Katy Indus., Inc., 590 B.R. 628 (Bankr. D. Del. 2018) presented an interesting question: If a stalking horse bidder’s successful bid to purchase a company in chapter 11 was partially predicated upon a credit bid, and a portion of that credit bid was challenged after the sale closed, what would be the result for the bidder’s overall successful bid if that portion of the credit bid was eliminated?

Background

Katy Industries, Inc. (“Katy”) was a manufacturer of consumer cleaning and storage products that were distributed across the United States and Canada for more than 50 years. In 2015, Victory Park Capital Advisors, LLC (“Victory Park”) provided secured second lien financing to Katy, which Katy later defaulted on in mid-2016. Pursuant to a restructuring transaction, Victory Park provided an additional $6.5 million in financing, which was later supplemented by additional advances of financing for $750,000, $5.75 million and $1 million. These advances were made pursuant to amendments to the second lien agreement under which Victory Park had provided secured acquisition financing to Katy. Such amendments and advances were consummated in order to facilitate Katy working through a significant liquidity crisis. Victory Park also purchased all of Katy’s outstanding preferred stock and replaced a majority of Katy’s board of directors.

Continuing to face liquidity issues, Katy filed for chapter 11 relief in 2017 with a plan to sell itself. Victory Park served as Katy’s stalking horse bidder and, pursuant to its approved bidding procedures, no other qualified bids were submitted. The bankruptcy court ultimately approved Victory Park’s bid of approximately $63 million, which included a $36.7 million credit bid, resulting from all of the secured financing previously provided to Katy by Victory Park, including the advances made in 2016 and 2017. The official committee of unsecured creditors (the “Committee”) filed an adversary proceeding, arguing, among other things, that a portion of the credit bid, $7.5 million, should be reclassified as equity investments in Katy, or that the advances made should be avoided pursuant to either section 544(a) of the Bankruptcy Code or section 549(a) of the Bankruptcy Code, that the avoided transfers should be recoverable pursuant to section 550(a) of the Bankruptcy Code, and that there was a breach of the fiduciary duty of loyalty owed to Katy and the Debtors.

Analysis

By arguing that the $7.5 million portion of the credit bid should be reclassified as equity investments, or subordinated or avoided in the alternative, the Committee was seeking to prevent that amount from being able to be credit bid toward the overall purchase amount by Victory Park. The $7.5 million represented the amount of the advances made in 2016 and 2017, and constituted 20.4% of the total credit bid and 11.9% of the original total purchase price. The Committee argued that the additional amount inflated the total bid, resulting in a chilling effect on overall bidding, thereby dissuading other potential bidders from submitting qualified bids.

As an initial matter, the bankruptcy court was confronted with the question of whether the Committee had properly preserved its right to challenge the successful bid under the sale order by including a “saving clause” relating to lien challenges in the DIP order. However, the bankruptcy court reasoned that it need not address that issue because the bankruptcy court found that there was no practical, useful remedy that could result from the Committee’s challenge that would increase the distribution to creditors.

Notably, the bankruptcy court pointed out the practical reality that even if the Committee was successful in reclassifying or subordinating the $7.5 million portion of the credit bid at issue, Victory Park’s bid would still have been a qualified bid, which still would have been the only bid that Katy received pursuant to its bidding procedures. Accordingly, Katy’s bid would have been the successful bid by default. The only difference would have been that Victory Park’s winning bid would have been for $55.5 million, including $29.2 million of credit bidding, instead of a $63 million bid with $36.7 million of credit bidding. Thus, the bankruptcy court concluded that since Victory Park “would still have been the successful bid,” that “reshaping the economics of the deal to reflect a hypothetical reduction of $7.5 million in § 363(k) currency would have no tangible, ameliorative effect for the Committee.” Katy, 590 B.R. at 638.

The bankruptcy court also discredited the Committee’s argument that Victory Park’s inflated bid chilled the bidding process, noting that there had been no evidence whatsoever provided throughout the case that supported such a contention. The bankruptcy court thereby concluded that no relief could be granted absent the unwinding of the entire sale transaction, and so held that the Committee had failed to state a claim upon which relief could be granted. The bankruptcy court thereby granted the motion to dismiss the Committee’s complaint with prejudice.

Conclusion

In the end, although the absence of any additional qualifying bids or evidence that bidding had been chilled short-circuited the bankruptcy court’s analysis, one can certainly contemplate analogous situations that could arise in the future where this issue is raised and there are competing bidders, or where the disqualification of a portion of a credit bid would lead to such bid no longer constituting a qualified bid under the bidding procedures of that case. In this situation, the potential for a challenge leading to the elimination of a portion of a credit bid could dramatically impact the outcome of such a case, with another bidder potentially being named the successful bidder, or with no bid succeeding at all. However, this was not that case, and the dearth of competition here means that how this situation will turn when it arises again with competing bidders at play must be decided another day.