Roll-up DIPs: The other “shoe” drops
On April 20, 2017, in Payless Holdings Inc. LLC, Re,[i] Justice Morawetz refused to recognize the debtor-in-possession financing facility (the “DIP Facility”) granted in Payless’ (as defined below) proceedings pursuant to Chapter 11 of the U.S. Bankruptcy Code (the “Chapter 11 Proceedings”). The Court held that it was not reasonable to do so as the DIP Facility encumbered assets of the Payless Canada Group (as defined below), where such entities were not borrowers under the DIP Facility and were neither borrowers nor guarantors under the pre-filing facility with the DIP lender (the “Pre-Filing Credit Facility”). This decision demonstrates that the Court will not necessarily tolerate prejudicial treatment, even in the interest of international comity or pending liquidity needs, if such treatment is not necessary or fair in the circumstances.
Payless Holdings LLC, an American footwear retailer, and its affiliated companies (including its Canadian subsidiaries, the “Payless Canada Group”) (collectively “Payless”) commenced the Chapter 11 Proceedings on April 4, 2017. On April 7, 2017, Payless applied for Orders under Part IV of the Companies’ Creditors Arrangement Act,[ii] including, inter alia, recognizing the DIP Facility and granting a first-ranking charge in favour of the DIP lender to secure the obligations of Payless under the DIP Facility (the “DIP Charge”).
The Payless Canada Group operated 258 leased stores in Canada and had approximately 2,100 employees. The operations of the Payless Canada Group were fully integrated in the operations of the U.S. Payless debtors (the “U.S. Debtors”). The Payless Canada Group would unlikely be able to continue to operate if the U.S. Debtors ceased to operate.
Prior to the Chapter 11 Proceedings, the U.S. Debtors had entered into the Pre-Filing Credit Facility. None of the entities that form the Payless Canada Group were a borrower or guarantor under the Pre-Filing Credit Facility.
Payless had insufficient liquidity to maintain normal course operations and, accordingly, required interim financing. The Payless Canada Group was cash solvent, but would be unable to operate without the U.S. Debtors. Accordingly, Payless negotiated the DIP Facility to provide interim financing. The DIP Facility was to be secured by the DIP Charge. The DIP Facility was approved in the Chapter 11 Proceedings pursuant to an interim order (the “Interim DIP Order”). Certain of the U.S. Debtors were borrowers under the DIP Facility. The Payless Canada Group, although not borrowers under the DIP Facility, were obligated to guarantee the DIP Facility and to grant security over their assets as collateral for the indebtedness under the DIP Facility.
The DIP Facility contemplated a “roll up”[iii] of the Pre-Filing Credit Facility, which would have the effect of making the Payless Canada Group jointly liable with the U.S. Debtors for the obligations incurred under both the Pre-Filing Credit Facility and the DIP Facility. In simple terms, this would cause the Payless Canada Group (and more accurately, its creditors to the extent of their interest in the estates of the Payless Canada Group) to be liable for the pre-filing obligations of the U.S. Debtors.
The Court was asked to recognize the DIP Facility and grant the DIP Charge. Such relief was opposed by a group of unsecured landlords that owned several of the Payless Canada Group’s leased locations (the “Landlords”).
Payless submitted that the DIP Facility and DIP Charge, although encumbering Canadian assets, was in the best interests of the entire Payless organization and its stakeholders. Without immediate access to the DIP Facility, the U.S. Debtors would be unable to fund their operations, which would have a disastrous effect on the entire Payless group, including the Payless Canada Group. Further, the DIP Lender would not agree to provide additional financing if the Payless Canada Group did not guarantee the DIP Facility and provide collateral to secure such guarantee.
The Landlords argued that the DIP Facility would be detrimental to the position of the Landlords as, prior to the Chapter 11 Proceedings, the Payless Canada Group was cash flow solvent. Encumbering their assets pursuant to the DIP Facility and DIP Charge would immediately render each entity in the Payless Canada Group insolvent. The Landlords, potentially one of the largest groups of unsecured creditors, could face a significant reduction in the recoverable amount of their claim if the U.S. Debtors were permitted to roll-up their pre-filing debt into the DIP Facility. Further, Payless did not have an immediate cash need during the initial 13-week stay period.
The Court denied the recognition of the DIP Facility and granting DIP Charge, noting the following factors:
- The Landlords’ position could be detrimentally affected by the Payless Canada Group providing the guarantee and DIP Charge;
- There was no proposed priority mechanism specifying that the DIP lender must first look to the assets of the U.S. Debtors prior to looking to the assets of the Payless Canada Group;
- There was no replacement security or fund established to ensure that all Canadian unsecured creditor groups (including the Landlords) would not be adversely affected by the granting of security;
- The projected cash flow statement did not project an immediate liquidity crisis, which did not support Payless’ immediate need for interim financing; and
- There were no assurances that the Canadian stores would continue to operate, even though that was the intended reorganization proposal.
Based on the above considerations, the Court determined that recognition of the Interim DIP Order and granting the DIP Charge was not necessary to protect the assets and property of the Payless Canada Group and such relief was not reasonable and fair to the unsecured Landlords in the circumstances.
Lessons and Conclusion
This decision highlights the following important lessons and conclusions:
- Insolvency professionals should be aware that, when dealing with cross-border matters, the Court will not permit Canadian creditors to be prejudiced by the decisions and actions of a foreign court, notwithstanding the Court’s inclination towards international comity.
- In particular, when recognizing a financing order granted by a foreign court, the Court will consider whether there would be any material adverse effects to any Canadian stakeholders. The decision in Horsehead Holding Corp., Re.,[iv] demonstrates that such consideration may also be made by the U.S. Court, in addition to the CCAA Court. On February 5, 2016, the Honourable Justice Newbould, who has recently joined Thornton Grout Finnigan LLP, granted an order recognizing the interim financing facility approved in the debtors’ chapter 11 proceedings. In his decision, Newbould J. addressed the decision of the U.S. Court in approving the facility, which required the debtors to re-negotiate the terms of the facility to reduce the obligations of the Canadian debtor thereunder. Satisfied that the Canadian debtor’s liability under the interim financing facility had been properly revised and was proportionate to the benefit the Canadian debtor would receive under the facility, Newbould J. granted the order recognizing the interim financing facility.
- Landlords and unsecured creditors should know that they have rights in an insolvency proceeding and in certain equitable circumstances and with competent representation, their rights may override the wishes of secured creditors.
- When faced with inequitable terms in an interim financing facility, the Court will use its discretion in determining whether such terms are fair and reasonable to all stakeholders in the factual circumstances. In this case, the (i) lack of immediate liquidity crisis; (ii) solvency of the Payless Canada Group; (iii) Payless Canada Group’s lack of involvement in or exposure to the pre-filing debt; and (iii) presence of roll-up provisions, among other factors, all combined to create a formula that the Court could not tolerate.
- Potential DIP lenders should be aware that an interim financing facility with strict requirements may not be granted by the Court, even in the face of threats that the interim financing would not be provided if such requirements were not met, if the interim financing is not necessary or fair in the circumstances.
- Insolvency professionals negotiating the terms of the interim financing facility should be aware that the Court will not determine the contractual terms of interim financing or put forward alternative solutions, as the Court will only approve or reject the proposed financing facility.
- In cross-border retail insolvencies, which are rising in number, the Court takes into account the position and interests of the unsecured landlords, which usually comprise a significant portion of the unsecured liabilities.
[ii] R.S.C. 1985, c. C.36 (the “CCAA”).
[iii] In a roll-up, an interim financing lender advances interim financing which is used to repay a pre-filing facility owing to the same lender. Roll-ups are typically not permitted under the CCAA (subject to certain circumstances), but are permissible in proceedings pursuant to the Chapter 11 of the U.S. Bankruptcy Code.