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

• Jurisdiction: United States,Federal
• Law Firm: Jones Day
• Subject Matter: Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy
• Author: Mr Mark Douglas and Oliver Zeltner
• Published date: 01 February 2023

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), 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...