A collection of Karmaloop’s creditors filed an objection in bankruptcy court to its proposed auction on Thursday, May14th. The objection was made as the Karmaloop auction was approaching, in which the company’s assets would be sold. This Official Committee of Unsecured Creditors felt that the sale, as proposed, would have allowed Karmaloop’s secured creditors to take the estate property and essentially leave other creditors with nothing. If the objection had been successful, Karmaloop would have been required to spread around the auction proceeds, providing benefit to the junior creditors. The objection posed an interesting legal question with respect to the rights of unsecured creditors in cases in which the debtor is over-levered. Due to Karmaloop’s specific circumstances, however, no specific ruling clarifying that legal question was handed down.
The creditor’s committee, a group of leading unsecured creditors who more generally represent the entire unsecured creditor body, claimed that the more senior creditors, led by Comvest Partners, had taken an unwarranted position of power in the sale process. Karmaloop currently has somewhere between 100-500 million in liabilities. The 30 largest unsecured creditors—the parties who make up this committee—alone have 33.5 million in unsecured claims. According to the objection, “Comvest Capital II, L.P. (‘Comvest’ or ‘Lenders’) retains several critical roles in these cases, such as serving as the agent for both the Prepetition Lenders and the Postpetition Lenders, in addition to also serving as a Postpetition Lender. Its various positions within the Debtors’ financial structure enabled Comvest considerable influence in these cases.” 
The Committee felt that due to this extraordinary power, the senior creditors would be getting all of the benefit from the sale, at the expense of the more junior creditors, including unliquidated receivables from pending or potential lawsuits and other proceedings. They were “concerned that the current form of Purchase Agreement, which, for example, provides that the Lenders will receive the benefit of nearly all of the estates’ causes of action, including those under Chapter 5 of the Bankruptcy Code, for no consideration.” Indeed, the Committee believes that “[t]hese claims should inure for the sole benefit of unsecured creditors.”
The objection asserted that Comvest used this position to its advantage and had been actively working to set up a rigged game. Some of the tactics mentioned include how Comvest “forced the Debtors” to accept its low-ball initial bid for the auction “while simultaneously threatening to reduce their liquidity by limiting their ability to borrow funds under the prepetition credit facility and denying use of cash collateral.” Moreover, under the proposed procedure the Lenders appeared to be trying to grant themselves a massive spread on the auction by offering to pay only $13 million but reserving the right to go up to the full $30 million of their outstanding loan, should other bidders drive the price up.
The Committee believed they were being strong-armed by the more senior creditors, and requested that the court take action to ensure that the unsecured claimants got a “reasonable” cut of the money from the auction. They asserted that they needed to know what they would receive, with some reasonable certainty, before they could agree to the sale. They argued that “The Lenders must not be permitted to liquidate their collateral in a chapter 11 process without being required to make a commitment to fund a confirmable and feasible plan that provides for payment of administrative expenses and priority claims along with providing a reasonable return to holders of unsecured claims.“
The argument was not without merit, but the issue was by no means black and white. For creditors to agree to a chapter 11 sale, it is generally found to be necessary to provide two categories of “carve outs,” i.e., pieces of the proceeds dedicated to certain purposes. Bankruptcy expert Jonathan Friedland explained these in Commercial Bankruptcy Litigation, 2d Edition Chapter 23: “(i), a carve out for professional fees, and (ii), a carve out for the benefit of the unsecured creditors. The former is usually required as a matter of course. While the latter is commonly provided as a matter of course, it is not specifically required by bankruptcy law, and a substantial question exists regarding whether the latter toll charge must be paid in order for a case to remain in chapter 11.” 
Friedland further explains that “Nothing in the Bankruptcy Code specifically obliges a secured creditor, as a rule, to pay off unsecured creditors in a chapter 11, particularly when no creditor’s interests are being prejudiced absent the payoff.” Oftentimes, senior claimants only provide a small, nominal amount to the unsecured creditors (without which they would end up getting nothing). This may be the practical way “toward an expeditious section 363 sale of assets, and the eventual resolution of the chapter 11 case with the cooperation of the major constituents.” The threat of obstruction or delay “can be a powerful sword for a creditors committee or other party to wield in extracting a carve out agreement for its constituents from the secured investors.”
Different courts have ruled differently with respect to the carve outs. In its objection, the Committee pointed to rulings such as that of In re Fremont Battery Co., in which the sale process was not permitted to be ramrodded through because “no business reason justified a proposed 363 sale that, at best, benefited one creditor and did ‘not create proceeds which would inure to the benefit of the unsecured creditors.’ In re Fremont Battery Co., 73 B.R. 277, 279 (Bankr. W.D. Ohio 1987).” Thus, there must be a reason for the sale to be pursued other than the limited interests of one of the major creditors. The Committee argued that no such reason existed for the proposed Karmaloop sale.
In response to the objection, the debtor could well have pointed to other cases like In re GPA Technical Consultants, Inc. (“GPA”), which can be interpreted to yield a different conclusion. In GPA, the company was already in chapter 11, but the United States Trustee wanted to convert to a chapter 7 liquidation because there was no longer a hope of an ongoing business concern and the secured creditor would not benefit from liquidating under a chapter 11. The secured and unsecured creditors both objected, noting that the secured creditors would be absorbing all of the wind-down costs of payroll and operating expenses, as well as legal fees and expenses, which were more than offset by recoveries from asset sales, liquidations and collections. The GPA court “noted that unsecured creditors stood to gain or lose nothing, regardless of whether the estate was liquidated in a chapter 11 or chapter 7, or for that matter, pursuant to applicable state law because the secured claim was greater than any realistic recoveries.” It denied the U.S. Trustee’s motion to convert to chapter 7 and, significantly, stated that the test of whether something is in the “best interest of the creditors and the estate”–a crucial litmus test for all sorts of issues in bankruptcy cases–can in situations like this refer merely to the best interest of the senior secured creditors. Unsecured creditors need not receive any benefit necessarily in order for a debtor’s actions to pass the “best interest of creditors” test.
Thus, there are divergent views regarding the crux of the Committee’s objection. One might have expected a possible carve out by the Karmaloop secured creditors for the unsecureds, just to expedite the sale process, even though they would clearly take the position that they were not legally required to do so. As it turns out, no auction bids other than Comvest’s were ever received, and the Committee’s objection became fairly moot. The $13 million bid by Comvest became a de facto reasonable market value bid. We don’t know how the court would have ruled had the situation become more complicated through the price being drive up by multiple other bidders–but all objections to the sale were overruled, withdrawn or resolved and the sale order was entered on May 21, shortly after the hearing. However, the sale does not constitute a Chapter 11 plan of reorganization, so we shall keep an eye out for the filing of such a proposed plan to see if the unsecured creditors are offered anything more than originally contemplated. “Official Committee of Unsecured Creditors’ (I) Objection to the Debtor’s Motion for Entry of an Order Approving and Authorizing the Sale of the Debtors’ Assets Free and Clear of all Liens, Claims and Encumbrances and Granting Related Relief and (II) Lien Challenge,” In Re Karmaloop, Chapter 11 Case No. 15-100635, Docket #266, filed 5/4/15.  Commercial Bankruptcy Litigation, 2d Edition Chapter 23 (Jonathan P. Friedland, Elizabeth B. Vandesteeg & Christopher M. Cahill eds, 2015).  Ibid.
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