Orchard Supply Case Study… A Lesson in the Creative Use of DIP Financing
The intricacies involved in the Orchard Supply bankruptcy provide guidance to debtors and creditors about the need to balance the competing interest of lenders, purchasers and stakeholders when it comes to debtor-in-possession financing.
In virtually every Chapter 11 proceeding, post-filing or debtor-in-possession (DIP), financing is essential. DIP financing serves myriad purposes, including most critically to allow the debtor to operate while in Chapter 11 and bridge toward either a sale of assets or the reorganization of the business under a plan of confirmation. DIP financing can also provide the existing pre-petition lenders with further protection for its outstanding debt. And, in the increasingly rare situation where lenders are able to locate previously unencumbered collateral, creative DIP lenders can obtain replacement liens on such assets, which will dramatically increase their position, often to the detriment of general unsecured creditors. These issues recently played out in the early days of In re Orchard Supply Hardware Stores Corporation et al., Case No. 13-11565 (CSS) in the United States Bankruptcy Court for the District of Delaware. And while the circumstances of Orchard Supply are obviously unique, they highlight the significant impact these issues can have for all participants in the bankruptcy process.
On June 17, 2013, Orchard Supply Hardware Stores Corporation, a venerable West Coast retailer which owned and operated 91 hardware and garden retail stores, filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. The underlying facts are relatively straightforward. The jointly administered filing involved three separate debtor entities: Orchard Supply Hardware Stores Corporation, Orchard Supply Hardware LLC and OSH Properties LLC.
Prior to the bankruptcy filing, the debtors were obligors on two credit facilities: a first lien revolving credit and asset-backed loan facility with Wells Fargo Bank as agent, under which approximately $118 million was outstanding; and a term loan facility, under which approximately $129 million was outstanding.
Significantly, the ABL facility had a first lien on substantially all of the assets of two debtors, Orchard Supply Hardware Stores Corporation and Orchard Supply Hardware LLC, with the term loan facility having a junior lien on this collateral and a first lien on the company’s furniture, fixtures and equipment. The third entity, OSH Properties LLC, was unencumbered at the time of the bankruptcy filing, and held certain assets including equipment, real property and related general intangibles, which had substantial value and, if separately monetized, could provide unsecured creditors a significant recovery in the bankruptcy cases.
The intricacies involved in Orchard Supply began with lenders under the term loan facility expressing a strong desire to acquire the company’s assets under a sale pursuant to section §363 of the Bankruptcy Code. These lenders could only effectuate the purchase by “credit bidding” their secured debt under §363(k) of the Bankruptcy Code. The problem presented was the term loan lenders only had senior security interest in less than $5 million of furniture, fixtures and equipment. Thus, for these lenders to have any meaningful opportunity to credit bid, they would need to not only obtain the consent of the ABL facility to stand in their shoes, but similarly obtain a lien on the unencumbered collateral. And while a DIP facility was a viable alternative, this was further complicated by two significant developments. First, the company was highly desirous of obtaining a full roll-up DIP facility from the ABL facility so as to provide its skittish customers and vendors with ample liquidity to survive the uncertainties of Chapter 11. Second, the company strongly preferred selling its assets to a strategic buyer rather than its lenders.
Thus, in the days prior to the commencement of Chapter 11 these multiple interests were satisfied by the company entering a stalking horse agreement to sell all of their assets pursuant to §363 of the Bankruptcy Code to an affiliate of Lowe’s Home Improvement Stores LLC. This sale, which was widely applauded by the debtors, the creditors’ committee and the lenders, would provide a $205 million purchase price and pay substantially all of the debtors’ pre-petition trade liabilities, which was a key to a successful going-concern sale. To satisfy the concerns of Lowe’s and the lenders, a plan support agreement was executed on the day of the bankruptcy filing, which required, among other terms, for the term loan lenders to provide $12 million in supplemental post-petition DIP financing, for these same lenders to agree to support the Lowe’s sale and not submit a competing credit bid and for the term loan lenders to consent to the debtors obtaining almost $165 million post-petition DIP financing from the ABL facility lenders, a consent right they held under an intercreditor agreement. While on the one hand the company entered the uncertain world of Chapter 11 with a well-capitalized buyer and more than $170 million in DIP financing, the entanglement of these factors led to Judge Sontchi describing a perfect storm situation to ultimately approve the terms of the DIP financing.
Upon the bankruptcy filing, the debtors sought to obtain court authority to enter into DIP financing with both the lenders under the ABL facility and term loan facility. In doing so, the debtors sought to provide superpriority DIP liens, junior priority DIP liens or replacement liens on the previously unencumbered assets of OSH Properties LLC. The effect of this cross-collateralization was clear; if approved it would allow the term loan lenders to obtain all of the proceeds of the sale of the company’s assets following the repayment of the DIP facility provided by the ABL facility and the payment of administrative claims. If rejected by the bankruptcy court, the term loan lenders would have to share the proceeds from the sale of the previously unencumbered collateral with the remaining unsecured creditors. Of course, the Official Committee of Unsecured Creditors filed an objection to the entry of a final order approving the entry of the DIP financing order, and also conducted extensive discovery in support of their objection.
On July 15, 2013, following an extensive evidentiary hearing, Bankruptcy Judge Christopher S. Sontchi approved the debtor’s DIP financing, including the cross-collateralization provisions. In doing so, Judge Sontchi stated that he “do[es] think and do[es] find that the sale to a third-party nonlender is the best path forward … [and t]hat sale, to get their required liquidity that the debtor needed, that the debtor was only able to get out of Wells Fargo; Wells Fargo was only willing to provide the liquidity to the extent it was going to get additional collateral, or improve its collateral position; and the term lenders who had that position or had a blocking position were only willing to do so if they could get cross-collateralization in connection with their DIP.” The court noted that to do otherwise would, under the plan support agreement, undermine the Lowe’s transaction, which all parties — including the committee — believed was the appropriate path forward. While the approval of the DIP financing largely eliminated any recovery for the unsecured creditors that remained, Judge Sontchi conceded that he was “very, very, very reluctant to approve that kind of relief” and yet, “in this unique set of circumstances,” he overruled the objections and approved the DIP financing.
Despite the relatively unique set of circumstances that gave rise to the ruling in Orchard Supply, the case presents certain lessons that can be learned for debtors, lenders and creditors alike. The debtors in this situation were most concerned with a prompt sale of its business to an established buyer to protect the nearly 6,000 jobs throughout the Orchard chain and the company’s thousands of trade creditors. Lowe’s was of course interested in acquiring the assets as efficiently as possible without the threat of objection by, or a credit bid from, the term loan lenders. The lenders under the ABL facility were interested in both protecting their position and being repaid in full, while the term loan lenders were most interested in increasing the recovery on their debt position. All of the parties were able to achieve their desired aims, but were only able to do so in a risky series of transactions. The term loan lenders took a sizeable, albeit calculated, risk in presenting the proposed DIP financing terms. Had the bankruptcy court denied the DIP financing relief, the term loan lenders could have withheld their consent to the remaining DIP, thus placing the entire restructuring in serious jeopardy. And of course, with the term loan lender DIP financing, these lenders were free to credit bid, which would have likely resulted in Lowe’s terminating their purchase contract, likely moving the company toward liquidation. It was an emboldened move by the term loan lenders that paid off, and undoubtedly paves the way for lenders to continue to explore the bounds of DIP financing, especially in the context of sale under §363.
In analyzing these complex issues, it is important not to ignore the path chosen by the committee. On the one hand, the committee had no choice but to object to the term loan lender DIP financing, but the litigation strategy certainly presented the all-or-nothing paradox. What made this all the more complex was that fact that if the committee had been successful and the bankruptcy court had rejected the DIP financing, not only could the Lowe’s transaction have cratered, but the company could have spiraled toward liquidation. Needless to say, such a result would not have been in the best, or any interest of the company’s employees and creditors.
Thus, having lost their objection, the committee was left in the difficult position of having to negotiate with the term loan lenders from a position of material weakness. While the committee’s efforts were not only expected but required, with the benefit of hindsight, negotiating a settlement recognizing the exigencies of the Orchard Supply situation would have been in the best interest of all stakeholders and avoided placing the bankruptcy court in such a difficult position, with the company hanging in the balance.
Not only is Judge Sontchi’s decision in the Orchard Supply bankruptcy case highly instructive, but the ruling is of critical importance in the debtor-in-possession financing market. It is a broad lesson to lenders that there is a limit to how far the bankruptcy courts will travel, while at the same time it provides substantial guidance to debtors and creditors alike of the practical guidance they must employ when balancing the competing interest of lenders, purchasers and stakeholders.
Richard A. Chesley is the co-chair of DLA Piper’s restructuring practice, based in the Chicago office. He focuses on corporate restructuring, with an emphasis on bankruptcy transactions both in the United States and internationally.
Daniel Simon is an associate in the finance practice group, concentrating his practice on corporate restructuring and bankruptcy. He is based in Chicago.