Lead into Gold? Sears' Possible Post-Petition Sale of Intracompany Debt

Sears is supposedly considering trying to raise liquidity through the post-petition sale of intracompany debt. The details of the debt and the proposed transaction aren't clear, but as a general matter, the post-petition sale of intracompany debt (or Treasury stock) seems problematic to me as with any lead into gold transaction.  Here's the issue:  if the debt is sold, is it still intracompany debt or does it become general unsecured debt? 

The viability of Sears' strategy depends on the answer to this question.  If it is still intracompany debt post-sale, it's not going to sell for very much; if it is general unsecured debt, it's much more valuable.  (This is putting aside the weird arbitrage with the CDS settlement auction market that gets warped by the CDS volume exceeding the reference debt volume.) 

In most bankruptcies, intracompany obligations between affiliated debtors are either subordinated or cancelled outright.  Nothing in the Bankruptcy Code compels this, but it's pretty standard. It tends to follow from a separate classification of intracompany obligations (again, not compelled by the Code) and from the difficulty in determining net intracompany obligations--deemed consolidation for voting and distribution is standard operating procedure in large bankruptcies. If the leaden intracompany claims can be transformed into golden general unsecured claims, it's a huge siphoning of value away from other general unsecured creditors.  General unsecured creditors are paid pro rata on their claims, so an increase in the size of the general unsecured claim pool dilutes recoveries on the debt.  

So would a sale of intracompany obligations transform them into arms' length obligations?

I don't have a definitive answer about whether the sale transforms the character of the debt.  Perhaps it relates to the form of the debt (formal notes, rather than accounts receivable), but I don't think it should, even if one might conceive of intracompany notes as part of an internal capital market.  The issue seems akin to the question of whether disallowance or equitable subordination travels with a claim, something I wrote about at the beginning of my academic career (here and here), and which has never been clearly resolved by the courts. In the claims trading, context, there are at least workarounds with contractual warranties, however. In the case of a post-petition sale, there's only the sale order.  

Given that there's no inherent subordination of intracompany claims, the case against their transformation seems weak, but the sale of intracompany debt is further complicated because it comes with governance rights, which are subordinated.   11 USC 1129(a)(10) requires that a cram down plan be accepted by at least one impaired class, not counting the votes of insiders (i.e., intracompany votes). Cf. Section 316(a) of the Trust Indenture Act, which also disregards insider votes.  Selling intracompany debt thus changes the bankruptcy electorate.  On the one hand, we might not be concerned because if the debt is held by non-insiders, the issues with insider voting go away.  On the other hand, though, has the clear dilutive effect on general unsecured claimants' voting power. 

All of which is to say that there seems to be some grounds to potentially challenge the sale of intracompany obligations.  Yes, they raise liquidity for the debtor, but if the debtor can't get liquidity through DIP financing or cash collateral, should it really be reorganizing?  If you've got to burn the furniture to heat the apartment, you can't afford the keep operating the apartment.  I suppose a court could always say that the distributional/voting issues raised by a sale of intracompany obligations is an issue to be addressed later with plan objections (good faith perhaps?  Or vote designation or subordination motions?), but it seems to me that it's an issue that the court would do well to resolve upfront as clarifying parties' respective rights will make it easier to negotiate deals without the uncertainty about the deals' enforceability.  Perhaps the solution is a proposed sale order that addresses the issue, and lets the parties have the fight up-front.  Of course, that might be exactly what Sears doesn't want--it wants funding now and to worry about priorities later.  But lack of clear priorities should depress sale values, so there's a trade-off between liquidity and speed that will have to be considered. 

Let me just note, however, that if the sale does transform the quality of the debt from being intracompany to arms' length general unsecured debt, it should be standard operating practice in Chapter 11 as a matter of maximizing the value of the assets of the estate. That fact that it is not suggests that there are real concerns about the ability of a sale to turn lead into gold.  

Comments

[MJ Ferguson]

I understand how inter-company debt is working, but I'm a little confused why Treasury stock is also mentioned. Is treasury stock being spread out and held by subsidiaries of Sears? I thought treasury stock would just be in Sears' name and then could only be sold on the open market to non-Sears parties, and so then it would then go to Common stock on the balance sheet, at then probably a decrease in APIC since it's price is low. Can anyone provide some clarification to help me understand? Thank you.

[Adam]

MJ--the Sears proposal is only about intercompany debt, but I think the same principles would apply to treasury stock. In the hands of any Sears entity, both would be held by an insider and therefore not included in the voting under 1129(a)(10). That's a sort of subordination of governance rights.