In re Aéropostale, Inc.: Bankruptcy Court Finds No Inequitable Conduct and Rejects Motion to Equitably Subordinate Claim and Deny Credit Bidding Rights

Practical Law Legal Update w-003-2921 (Approx. 7 pages)

In re Aéropostale, Inc.: Bankruptcy Court Finds No Inequitable Conduct and Rejects Motion to Equitably Subordinate Claim and Deny Credit Bidding Rights

by Practical Law Bankruptcy & Restructuring

Background

Aéropostale, Inc. and its debtor affiliates (Aéropostale or Debtors) are retailers of casual apparel and accessories, with stores in every US state, Puerto Rico, and Canada. On February 24, 2016, MGF Sourcing US LLC (MGF), a major supplier for Aéropostale and a direct subsidiary of one of the Debtors' term lenders and an affiliate of the other term lender, notified Aéropostale that MGF had declared a credit review period and required cash in advance terms on Aéropostale's pending and future orders.

Aéropostale had been suffering liquidity problems since 2013 as a result of declining mall traffic, increased retail competition, a decline in customer demand for apparel, and an increase in technology and personal experiences. In the summer and fall of 2013, a Sycamore subsidiary acquired approximately 8% of Aéropostale's common stock. In 2014, Aéropostale reached a financing agreement with two affiliates of Sycamore (Sycamore Lenders) for a $150 million term loan that included a sourcing agreement with MGF. One of the Sycamore Lenders is the majority owner of MGF, and has the power to elect the MGF board.

The sourcing agreement between MGF and Aéropostale included a provision that gave MGF the right to declare a credit review period if Aéropostale's liquidity dropped below $150 million, which, MGF argued, gave them the right to adjust the terms of payment to require cash in advance of an order. In late February 2016, MGF and Aéropostale began to dispute the facts of whether Aéropostale had dropped below the $150 million liquidity threshold, triggering the credit review period, and whether the changed supply and payment terms were justified. On February 29, 2016, MGF halted the delivery of pending orders, but certain shipments were resumed through interim agreements between April 1, 2016, and April 8, 2016, though legal disputes over the supply terms persisted until early in the bankruptcy proceedings. On May 4, 2016, Aéropostale filed Chapter 11 petitions, and the supply disputes were resolved under a bankruptcy court approved settlement agreement on May 24, 2016. The Debtors subsequently recognized that they had made an accounting error in calculating their liquidity, and that they had dropped below the $150 million liquidity threshold by the last day in February of 2016.

Following these events, the Debtors filed a motion with the bankruptcy court seeking to:

Equitably subordinate the Sycamore Lenders' claims.
Disqualify the Sycamore Lenders from credit bidding in a sale of Debtors' assets.
Recharacterize the Sycamore Lenders' claims under section 105 of the Bankruptcy Code.

Outcome

The Lenders' Conduct Was Not Inequitable

The bankruptcy court held that the Sycamore Lenders' conduct was not inequitable and denied the Debtors' motion to equitably subordinate their claims. The bankruptcy court relied on the Mobile Steel pre-Bankruptcy Code test for equitable subordination (Benjamin v. Diamond (In re Mobile Steel Corp.), 563 F.2d 692 (5th Cir. 1977). The Mobile Steel factors are:

The claimant must have engaged in some type of inequitable conduct.
The misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant.
Equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act.

The bankruptcy court rejected the Debtors' three arguments that the Sycamore Lenders' conduct was inequitable. The Debtors' arguments were:

MGF breached the sourcing agreement when it changed the payment terms.
The Sycamore parties' overall conduct was a secret plan to force Aéropostale into bankruptcy and allow Sycamore to buy Aéropostale at a discount.
The Sycamore parties improperly traded stock while in possession of non-public Aéropostale information.

MGF Did Not Breach the Sourcing Agreement

Since the Debtors no longer disputed that they were below the $150 million liquidity trigger at the end of February 2016, the bankruptcy court focused its analysis on whether MGF breached the sourcing agreement when it changed the payment terms. Based on New York state law and looking within the "four corners" of the document, the bankruptcy court determined that MGF was within the scope of rights under the sourcing agreement to change payment terms during a credit review period, and rejected the Debtors' arguments that:

The terms imposed by MGF were unreasonable.
MGF breached the sourcing agreement by retroactively applying the new payment terms to orders that were placed before the credit review period began.

The bankruptcy court determined that MGF was reasonable in changing the terms of payment because the sourcing agreement allowed MGF to impose "upfront terms… in the exercise of it[s] reasonable credit judgment." The bankruptcy court noted "it[s] reasonable credit judgment" is not an objective reasonableness standard, but gives MGF the right to apply its reasonable credit judgment to determine what was prudent for its business.

The bankruptcy court determined that the sourcing agreement allowed MGF to apply the changed payment terms retroactively to orders that were pending because the agreement applies to "an Order created under this Agreement" and does not limit its application to future orders. Therefore, an order remains open until delivery and is subject to the conditions permitted by the sourcing agreement.

No Evidence of a Secret Plan to Force the Debtors into Bankruptcy

The bankruptcy court held there was no evidence of a secret plan by the Sycamore parties to force Aéreopostale into bankruptcy. Rather, the evidence showed that the Sycamore parties had much at stake in the success of Aéropostale. The Sycamore parties' investments included:

8% of Aéropostale common stock which was, at the time, worth $54 million.
The $150 million term loan.
Another 5% of Aéropostale's common stock purchased in connection with the term loan on May 23, 2014.
The sourcing agreement with MGF, which was a long term proposition involving more than one quarter of a billion dollars.

The bankruptcy court noted that all of these investments were worth much less if Aéropostale failed, and the evidence demonstrated that the Sycamore parties only took actions to protect their interests.

No Evidence of Improper Trading of Stock

The bankruptcy court held that, while it was true that the Sycamore parties were in possession of information the public did not have, there was no evidence of improper trading. The bankruptcy court noted that there was no evidence to satisfy the equitable subordination requirements, as the trades neither harmed the Debtors or other creditors, nor gave the Sycamore parties an unfair advantage. The Sycamore affiliated equity investor sold its shares between February 3 and February 8, 2016, at a loss of approximately $53 million, and the evidence showed that the Debtors' stock price remained the same from February 2016 to April 2016.

The Lenders' Credit Bidding Would Not Chill a Sale of the Debtors' Assets and Could Not Be Limited Absent Inequitable Conduct

The bankruptcy court held that the Sycamore Lenders' conduct was not inequitable and their credit bid would not chill a sale of the Debtors' assets which factor could not alone support denial of the right to credit bid. On these bases, the bankruptcy court upheld the Sycamore Lenders' right to credit bid.

Under section 363(k) of the Bankruptcy Code, a party may credit bid unless the court determines there is cause otherwise. The bankruptcy court relied on Free Lance-Star Publishing, where a secured creditor's right to credit bid was denied due to inequitable conduct (In re Free Lance-Star Publishing Co. of Fredericksburg, VA, 512 B.R. 798, 804-06 (Bankr. E.D. Va. 2014); see Legal Update, In re Free Lance-Star Publishing Co: Court Follows Fisker and Caps Credit Bidding Rights "For Cause").

The bankruptcy court found two problems with the Debtors' arguments that the Sycamore Lenders' credit bidding should be disallowed. The problems were that:

The case law did not support denying or limiting the Sycamore Lenders' credit bid. The bankruptcy court noted that some courts refer to a credit bid's chilling effect on the bidding process as a factor in their determination to deny or limit credit bidding, but these courts invariably require other circumstances that support limiting a creditor's right to credit bid. These circumstances can include a creditor insisting on an unfair sales process or pressuring the debtors to shorten the marketing period. The bankruptcy court held that there were no such conditions that supported limiting or denying the Sycamore Lenders' credit bid.
The factual record did not support limiting or denying the Sycamore Lenders' credit bid. The bankruptcy court noted that there was active interest in the Debtors' assets as a going concern, liquidating their assets, purchasing their assets, negotiations for a party acting as stalking horse bidder, and submitting bids in an auction.

The bankruptcy court noted in a footnote that in Philadelphia Newspapers, the US Court of Appeals for the Third Circuit rejected inequitable conduct as a requirement for a court to limit credit bidding for cause (In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3rd Cir. 2010)). But the Aéropostale bankruptcy court noted that the US Supreme Court has since ruled in Radlax that "the pros and cons of credit bidding are for the consideration of Congress, not the courts" (Radlax Gateway Hotel, LLC V Amalgamated Bank, 132 S.Ct. 2065, 2073 (2012); see Legal Update, Supreme Court Finds Debtors Must Allow Credit Bidding) suggesting that the Third Circuit may be less restrictive of credit bidding in the future.

Term Loan Not Recharacterized as Equity

Relying on the AutoStyle factors, the bankruptcy court held that the term loan between the Sycamore Lenders and Aéropostale would not be recharacterized as equity (see Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726, 750 (6th Cir. 2001)). The bankruptcy court found that the vast majority of the AutoStyle factors weighed against recharacterization. The bankruptcy court held that the Debtors did establish the third factor, the presence of a fixed rate of interest and interest payments, but this was not dispositive and noted that the evidence established that the loan was structured to create economic returns and repayment through the sourcing agreement. The Debtors argued that the fifth factor, adequacy or inadequacy of capitalization, weighed in favor of recharacterization, but the bankruptcy court noted this factor is given only modest weight because all companies in bankruptcy are financially distressed. The court concluded that it would be wrong to penalize the Sycamore Lenders for lending to a distressed company when it was the Debtors who sought them out to finance their turnaround.

Sycamore Lenders Were Not Alter Egos of Sycamore and Its Affiliates

The bankruptcy court also rejected the Debtors' arguments that the Sycamore Lenders were liable as alter egos of Sycamore and its affiliates. The bankruptcy court, relying on Sunbeam, held that to pierce the corporate veil and be treated as an alter ego of the Sycamore Lenders, the Sycamore affiliates must have exerted complete domination and control over the Sycamore Lenders so that they are a mere shell of the Sycamore parties (see Official Comm. of Unsecured Creditors of Sunbeam Corp. v. Morgan Stanley & Co. (In re Sunbeam Corp.), 284 B. R. 355 (Bankr. S.D.N.Y. 2002)). The bankruptcy court noted that MGF had its own staff, financing in its own name, offices, phone numbers, technology systems, bank accounts, and email addresses, separate from Sycamore and the Sycamore Lenders. For the Sycamore equity investor affiliate, the bankruptcy court noted that this was a closer question, but it did not need to resolve this question because of the bankruptcy court's rulings on equitable subordination and credit bidding.

Practical Implications

This decision demonstrates the reluctance of courts to equitably subordinate claims or recharacterize debt as a basis for limiting or denying credit bidding rights following Radlax. Without clear evidence of inequitable conduct, courts are not likely to grant these motions (see Legal Updates, In re RML Development, Inc.: Court Holds Mere Bid "Chilling" is Not Sufficient Cause to Limit Credit Bidding Rights, and In re Sentinel Management: Seventh Circuit Provides Guidance on Inquiry Notice and Equitable Subordination).

In re Aéropostale, Inc.: Bankruptcy Court Finds No Inequitable Conduct and Rejects Motion to Equitably Subordinate Claim and Deny Credit Bidding Rights | Practical Law