Sears Holding: A Case Study in Valuing Collateral in Chapter 11

Valuation is a critical and indispensable part of the bankruptcy process. How collateral and other estate assets (and even creditor claims) are valued determines a wide range of issues, from a secured creditor's right to adequate protection, postpetition interest, or relief from the automatic stay to a proposed chapter 11 plan's satisfaction of the "best interests" test or whether a "cramdown" plan can be confirmed despite the objections of dissenting creditors. Depending on the context, bankruptcy courts rely on numerous different standards to value estate assets, including book, retail, wholesale, liquidation, forced-sale, going-concern, and reorganization value.

The U.S. Court of Appeals for the Second Circuit recently examined collateral valuation in a chapter 11 case for the purpose of determining whether junior secured creditors were entitled to "super-priority" administrative claims to compensate them for alleged diminution in the value of their collateral after the petition date and before the bankruptcy court approved a sale of the debtors' business as a going concern. In ESL Investments, Inc. v. Sears Holdings Corp. (In re Sears Holdings Corp.), 51 F.4th 53 (2d Cir. 2022), cert. denied sub nom. Cyrus Capital Partners, L.P. v. Sears Holdings Corp., No. 22-765 (U.S. Mar. 20, 2023), the Second Circuit held that, given the uncertainty surrounding the retail debtors' fate at the time they filed for bankruptcy, the bankruptcy court did not err in valuing inventory collateral at its "net orderly liquidation value," rather than book value, going-out-of-business sale value, or forced liquidation value. The Second Circuit also found no fault with the bankruptcy court's decision to value non-borrowing base inventory at zero and to ascribe full face value to undrawn letters of credit where, among other things, the junior lenders failed to meet their evidentiary burden of suggesting a reasonable alternative.

Valuation of Collateral in Bankruptcy

Whether a claim is secured or unsecured is determined in accordance with section 506(a) of the Bankruptcy Code. Section 506(a)(1) provides that a secured creditor's claim is "a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property … and is an unsecured claim to the extent that the value of such creditor's interest … is less than the amount of such allowed claim." The provision goes on to mandate that "[s]uch value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property."

The extent to which a claim is secured, therefore, turns on the valuation of the collateral. Section 506(a) is silent, however, as to the specific valuation method that a court should employ. As noted by the U.S. Court of Appeals for the Third Circuit in In re Heritage Highgate, Inc., 679 F.3d 132 (3d Cir. 2012), the legislative history of section 506(a) suggests that Congress's silence on this point was intentional, to enable bankruptcy courts to "choose the standard that best fits the circumstances of a particular case." Id. at 141 (citing H.R. Rep. No. 95–595, at 356 (1977)). Even so, the court wrote, the valuation method should be chosen in light of the proposed disposition or use of the collateral, as set forth in section 506(a)(1) in language that is "of paramount importance to the valuation question." Id. (citation and internal quotation marks omitted).

In Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997), the U.S. Supreme Court provided some guidance on this issue. In Rash, chapter 13 debtors proposed a plan under which they sought to retain the use of a vehicle encumbered by a lender's security interest instead of surrendering the vehicle to the creditor. Because the secured creditor did not consent to the proposed treatment of its secured claim, section 1325(a)(5) of the Bankruptcy Code obligated the debtors to make payments to the secured creditor under their chapter 13 plan equal to at least the present value of the amount of the creditor's secured claim. Thus, the value of the collateral had to be determined so that the debtors could confirm their cramdown plan and retain the use and possession of the vehicle.

The debtors argued that the lower foreclosure value (i.e., the amount the secured creditor would realize if it repossessed the truck and sold it at public auction) should apply, whereas the secured creditor argued for the higher replacement value—what it would cost the debtors to replace the vehicle in the open market. The bankruptcy court, the district court, and the Fifth Circuit (on rehearing en banc) sided with the debtors.

The Supreme Court reversed. The 8–1 majority explained that section 506(a) of the Bankruptcy Code mandates that the value of collateral "be determined in light of the purpose of the valuation and of the proposed disposition or use of such property." Rash, 520 U.S. at 961-62 (emphasis added). In this case, the Court noted, the proposed "disposition or use" of the collateral was the debtors' continued retention and use of the vehicle in order to generate an income stream. For this reason, the Court faulted the courts' conclusion below that the appropriate standard was foreclosure value:

Of prime significance, the replacement-value standard accurately gauges the debtor's "use" of the property. It values "the creditor's interest in the collateral in light of the proposed [repayment plan] reality: no foreclosure sale and economic benefit for the debtor derived from the collateral equal to … its [replacement] value." … The debtor in this case elected to use the collateral to generate an income stream. That actual use, rather than a foreclosure sale that will not take place, is the proper guide under a prescription hinged to the property's "disposition or use."

Id. at 963.

Rash involved confirmation of a cramdown chapter 13 plan. The impact of Rash on collateral valuations in other contexts is unclear. Many, but not all, courts have concluded that its rationale extends beyond chapter 13 to include valuations in chapter 11 cases. See, e.g., Matter of Houston Reg'l Sports Network, L.P., 886 F.3d 523, 529 (5th Cir. 2018) ("Though the [Rash] court was considering whether foreclosure value or replacement value was appropriate in the Chapter 13 cram-down context, … the language provides guidance on the proper interpretation of § 506(a) as applied to plan-confirmation valuations when the debtor proposes to retain property [under a chapter 11 plan]."); In re Nat'l Truck Funding LLC, 588 B.R. 175, 180 (Bankr. S.D. Miss. 2018) ("Although Rash was decided in the context of chapter 13, its emphasis on 'actual use' of the property as the guide to valuation also applies in chapter 11."); In re Motors Liquidation Co., 576 B.R. 325, 424 (Bankr. S.D.N.Y. 2017) ("Although Rash was decided in the context of a chapter 13 plan, the Court finds that the Supreme Court's emphasis on the actual disposition of the property, rather than a hypothetical outcome, applicable [for purposes of avoidance litigation requiring valuation of collateral]."); In re Castleton Plaza, LP, 2011 WL 4621123, *3 (Bankr. S.D. Ind. Sept. 30, 2011) ("Though Rash was not decided in the context of Chapter 11, it is routinely applied to cases arising under its provisions.") (citing HSBC Bank USA v. UAL Corp., 351 B.R. 916 (Bankr. N.D. Ill. 2006)). But see In re Sugarleaf Timber, LLC, 529 B.R. 317, 329 n.14 (M.D. Fla. 2015) ("Rash's narrow holding is inapplicable in the 'dirt-for-debt' context under Chapter 11, where the Debtor proposes to surrender property, not to retain it."). 

The Automatic Stay, Adequate Protection, and Super-Priority Administrative Expense Claims

The filing of a bankruptcy petition triggers an automatic stay that precludes most actions against the debtor or its property to collect on prepetition debts. This includes "any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate." 11 U.S.C. § 362(a)(3). Because a lender is prevented by the automatic stay from foreclosing on its collateral after the borrower files for bankruptcy, the creditor is entitled to "adequate protection" of its interest in the collateral, which commonly takes the form of a cash payment or an additional or replacement lien to compensate the secured creditor for diminution in the value of its collateral during the bankruptcy case.11 U.S.C. § 361(1)-(2).

If the adequate protection provided fails to preserve the value of the collateral during the bankruptcy case, the secured creditor is entitled as compensation to a "super-priority" administrative expense claim that must be paid before the payment from the bankruptcy estate of other administrative expense claims. 11 U.S.C. §§ 507(a)(2), (b); In re Blackwood Assocs., L.P., 153 F.3d 61, 68 (2d Cir. 1998).

Sears Holdings

Iconic retailer Sears Holdings Corporation and its affiliates (collectively, "Sears") filed for chapter 11 protection in the Southern District of New York in October 2018. 

When Sears filed for bankruptcy, its secured debt totaled approximately $2.68 billion, consisting of approximately $1.53 billion in first-lien debt secured by inventory, receivables, and certain other assets, and approximately $1.15 billion in second-lien debt secured on a junior basis by substantially the same collateral. The collateral securing both tranches of debt consisted of $2.39 billion in book value of borrowing-base inventory (referred to as "eligible" inventory), and approximately $300 million in book value of "non-borrowing-base" ("NBB") inventory that was excluded from the borrowing base against which asset-based lenders would loan money to Sears. The first-lien lenders had also issued $395 million in letters of credit ("LCs") guaranteeing various Sears obligations, such as workers' compensation claims. Although none of the LCs had been drawn on the petition date, approximately $9 million were drawn during the bankruptcy case.

Sears's largest secured creditor was ESL Investments, Inc. ("ESL"), a hedge fund owned by Edward Lampert, the CEO of Sears and chairman of its board of directors. ESL held approximately 79% of the second-lien debt. 

As part of a debtor-in-possession financing package approved by the bankruptcy court early in Sears's chapter 11 case, the bankruptcy court granted adequate protection to both the first- and second-lien lenders for the use of their collateral in the form of replacement liens and super-priority claims under section 507(b) to compensate for any decline in the value of their collateral during the bankruptcy case.

At the time it filed for chapter 11, neither Sears nor its creditors knew whether Sears would be sold as a going concern or liquidated. In February 2019, after several rounds of failed negotiations, the bankruptcy court approved the sale of substantially all of Sears's assets for $5.2 billion to Transform Holdco LLC, an ESL affiliate controlled by Lampert and several other former Sears executives. The purchase price included more than $1.4 billion in cash, but consisted largely of non-cash consideration, including a $433.5 million credit bid organized by ESL, in which all of the second-lien lenders were obligated to participate under the terms of the credit documents. 

The second-lien lenders claimed that the value of the collateral on the petition date was more than adequate to pay the first-lien and second-lien debt in full, but it had plummeted by the time of the sale due to Sears's use of its collateral by, among other things, selling the inventory to retail customers, collecting (and spending) old and new accounts receivable and cash, and funding the administrative costs of the chapter 11 case. This diminution, the second-lien lenders asserted, left them with $718 million in unpaid debt after the first-lien lenders were paid from the proceeds of the sale. The second-lien lenders also argued that, because the $433.5 million credit bid fell far short of the value of the collateral as of the petition date, they were entitled to section 507(b) super-priority claims to compensate for the diminution of the value of the collateral during the course of the bankruptcy case.

Thus, the bankruptcy court was asked to value the collateral as of the petition date and to determine whether that value had decreased by the time of the sale. To make that determination, the court had to calculate the petition-date value of the collateral and then subtract from that amount the obligations owed to the first-lien lenders on the petition date. The second-lien lenders would have viable section 507(b) super-priority claims only if that figure exceeded the $433.5 million credit bid the second-lien lenders had already recouped as part of the sale. 

The second-lien lenders urged the bankruptcy court to apply a book value or replacement value standard in valuing the inventory collateral as of the petition date, which approach, they argued, was mandated by the Supreme Court's decision in Rash. The debtors argued that, as of the petition date, the inventory collateral was worth significantly less than its book value in light of the uncertainty regarding whether Sears would be sold or liquidated in chapter 11.

After holding a hearing and considering expert testimony, the bankruptcy court found that neither of the methodologies proposed by the second-lien lenders and the debtors appropriately measured the value of the collateral as of the petition date. Rather, the bankruptcy court determined that it would value the bulk of the collateral at its "net orderly liquidation value" ("NOLV")—the value Sears could have realized on the petition date for its assets in an orderly, company-wide going-out-of-business ("GOB") sale. This metric resulted in a valuation that was higher than the assets' liquidation value, but less than the full retail price of the inventory collateral. The bankruptcy court determined that a NOLV analysis, rather than full retail price or a depressed GOB sale or liquidation price, was appropriate because, although the Sears assets ultimately were sold as a going concern, that outcome was far from certain as of the petition date, when a material risk of liquidation still existed.

Applying the NOLV approach, the bankruptcy court found that the NOLV of the inventory collateral—after subtracting estimated overhead costs and legal fees, was 87.4% of its $2.69 billion book value, or $2.147 billion. It valued Sears's NBB inventory at zero because the second-lien lenders failed to offer a reasonable valuation method for those assets. Finally, the bankruptcy court decided that, because the LCs were undrawn as of the petition date, but at that time reasonably could have been expected to be drawn due to the exigent circumstances of the case, the full $395 million face value of the LCs should be deducted from the petition-date value of the collateral. In so ruling, the court rejected the second-lien lenders' argument that the LCs should be valued in accordance with how they were subsequently drawn during the case (to the extent of $9 million) and noted that the second-lien lenders failed to offer any reasonable method of discounting the value of the LCs as of the petition date.

After subtracting the first-lien lenders' $1.96 billion in claims from the $2.147 billion value of the collateral, the bankruptcy court determined that $187 million in collateral value remained for the second-lien lenders. However, because the second-lien lenders had already realized a greater amount from their $433.5 million credit bid, the court held that they were not entitled to any additional recovery in the form of section 507(b) super-priority claims.

The district court affirmed on appeal, and the second-lien lenders appealed to the Second Circuit.

The Second Circuit's Ruling

A three-judge panel of the Second Circuit affirmed.

Writing for the panel, U.S. Circuit Judge Richard J. Sullivan explained that "[t]he key question in this case is the value of the second-lien holders' collateral on the Petition Date, which, as the second-lien holders agree, is the value that controls for purposes of adequate protection and section 507(b) administrative super-priority claims." Sears Holdings, 51 F.4th at 61.

According to the Second Circuit, the bankruptcy court did not err in valuing Sears's inventory at NOLV, rather than book or replacement value. In Rash, Judge Sullivan noted, the Supreme Court never had to address whether the sale of collateral is properly characterized as a "disposition or use" within the meaning of section 506(a). Id. at 62. Even so, he concluded that, in accordance with the ordinary meaning of the word "disposition," a sale of inventory is properly characterized as a disposition. Id.

Looking to Rash for guidance, the Second Circuit observed that "Rash contemplated that one particular use or disposition must be proposed, and that this proposal must guide the valuation exercise." Id. at 63. According to Judge Sullivan, because neither Sears nor the second-lien lenders knew exactly how the collateral would be sold when Sears filed for bankruptcy, "the bankruptcy court reasonably decided to assess the value of the second-lien holders' collateral in light of what the Debtors would likely be able to recoup from the collateral somewhere between a forced liquidation and its full retail price." Id.

The Second Circuit rejected the second-lien lenders' argument that the bankruptcy court should have valued the collateral at its retail value, instead of NOLV, because Sears did not ultimately liquidate but continued operating for several months before selling its business as a going concern. "[T]he valuation process in this case," Judge Sullivan wrote, "turned on the value of the collateral on the Petition Date, without inquiring into how the collateral was ultimately used." Id. 

Next, the Second Circuit found no error in the bankruptcy court's NOLV analysis, noting that "a distressed-asset sale was regarded as a reasonably high-probability outcome" as of the petition date. The bankruptcy court's decision to use NOLV, Judge Sullivan wrote, "was consistent with section 506(a), Rash, and the facts of this case." Id. at 65. 

In addition, given the second-lien lenders' "unsatisfactory" argument that that the NBB inventory should be valued in the same manner as the rest of the inventory collateral, the Second Circuit agreed with the bankruptcy court that the second-lien lenders failed to satisfy their evidentiary burden "to present the bankruptcy court with a credible method to value their [NBB] collateral as of the Petition Date." Observing that "the bankruptcy court was not obliged to manufacture an alternative valuation method for them," the Second Circuit found no fault with the bankruptcy court's decision to value the NBB inventory at zero. Id. at 66.

Finally the Second Circuit found no error in the bankruptcy court's decision to assign no value to the LCs as of the petition date. According to Judge Sullivan, the bankruptcy court acknowledged that it could value the LCs "based on a probabilistic formula, discounting their face value by some probability that they would actually be drawn," but the second-lien lenders never offered any such analysis below (or on appeal). Thus, he explained, the bankruptcy court, in assessing the value of those contingent liabilities, reasonably rejected the second-lien lenders' argument that the LCs should be valued at either: (i) zero as of the petition date, because it "ignored the 'realistic context of this case,' including 'the very real backdrop of a potential liquidation,' and the resulting need to tap available sources of capital"; or (ii) $9 million, because this "after-the-fact valuation methodology" was irrelevant in assessing the "likelihood of the contingency on the Petition Date." Id. at 67.

Outlook

There are several key takeaways from the Second Circuit's ruling in Sears Holding.

First, valuation in bankruptcy is a fact-specific inquiry, and the selection of an appropriate valuation method, guided by section 506(a), is committed to the sound discretion of the Bankruptcy Court. The Second Circuit concluded that, based on the circumstances of the case, the bankruptcy court reasonably determined that the second-lien lenders' collateral should be valued at net orderly liquidation value in examining whether it had decreased in value after the petition date. In another context—e.g., determining whether the second-lien lenders' claims could be crammed down under a chapter 11 plan—the court likely would have chosen a different valuation method recognizing what actually happened during the course of the bankruptcy case.

Second, Sears Holding is a testament to the consequences of failing to satisfy evidentiary burdens. The Second Circuit found no error in the bankruptcy court's decision to ascribe no value to NBB inventory and to discount to zero the full face value of undrawn letters of credit because the second-lien lenders had the burden of proposing a reasonable alternative but repeatedly failed to do so.

Third, the Second Circuit reaffirmed in Sears Holding that Rash casts a wider net than the specific facts in that case. In Sears Holding, the Second Circuit interpreted Rash to require a bankruptcy court in a chapter 11 case to be guided in its valuation by the use or disposition likely for the subject collateral, rather than some hypothetical use or disposition.

Because Sears Holdings was heavily fact-dependent, it remains to be seen what impact the decision will have on valuations in other chapter 11 cases.

The Supreme Court denied the junior lenders' petition for review of the Second Circuit’s decision on March 20, 2023.