john g. hutchinson james p. seery, jr. paul s. caruso john ...€¦ · blockbuster inc., et al.,1...
TRANSCRIPT
Hearing Date: March 10, 2011 at 10:00 a.m. (Eastern Time)
John G. Hutchinson James P. Seery, Jr. Paul S. Caruso John J. Lavelle Alex R. Rovira SIDLEY AUSTIN LLP787 Seventh Avenue New York, New York 10019(212) 839-5300 (tel) (212) 839-5599 (fax)
Attorneys for the Steering Group, and Special Counsel to the Senior Indenture Trustee,in connection with reclamation issue
UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF NEW YORK --------------------------------------------------------------- X
Chapter 11
Case No. 10-14997 (BRL)
(Jointly Administered)
In re:
Blockbuster Inc., et al.,1
Debtors.
:::::::
--------------------------------------------------------------- X
THE STEERING GROUP’S REPLY MEMORANDUM IN SUPPORT OF DEBTORS’ SALE MOTION AND IN OPPOSITION TO VARIOUS SALE OBJECTIONS AND TO
MOTIONS SEEKING TO CONVERT THE DEBTORS’ CHAPTER 11 CASES TO CASES UNDER CHAPTER 7 OF THE BANKRUPTCY CODE
1 The Debtors, together with the last four digits of each Debtor’s federal tax identification number, are: Blockbuster Inc. (5102); Blockbuster Canada Inc. (1269); Blockbuster Digital Technologies Inc. (9222); Blockbuster Distribution, Inc. (0610); Blockbuster Gift Card, Inc. (1855); Blockbuster Global Services Inc. (3019); Blockbuster International Spain Inc. (7615); Blockbuster Investments LLC (6313); Blockbuster Procurement LP (2546); Blockbuster Video Italy, Inc (5068); Movielink, LLC (5575); Trading Zone Inc. (8588); and B2 LLC (5219).
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TABLE OF CONTENTS
Page
TABLE OF AUTHORITIES ......................................................................................................... iii
PRELIMINARY STATEMENT .....................................................................................................1
RELEVANT BACKGROUND .......................................................................................................5
ARGUMENT .................................................................................................................................11
I. THE SENIOR SECURED NOTEHOLDERS AND DIP LENDERS ACTED IN GOOD FAITH THROUGHOUT THESE CHAPTER 11 CASES ..............................11
A. The DIP Facility was Negotiated in Good Faith with Fair and Reasonable Lender Protections ............................................................................. 11
B. The DIP Lenders Acted In Good Faith by Approving Budgets, Authorizing Increased Advertising Spending, and Extending Milestones ............................................................................................................. 15
C. The Debtors Failed to Provide a Viable Business Plan ........................................ 17
D. The Debtors Propose A Sale Under Section 363 of the Bankruptcy Code ...................................................................................................................... 20
E. The DIP Lenders and Senior Secured Noteholders Honored All of Their Obligations .................................................................................................. 22
F. The Creditors’ Committee Fails to Assert Any Legal Basis to Undo this Court’s Final DIP Order Approving the Roll-Up Notes ....................................... 24
G. The Roll-Up is Appropriate as Approved by this Court ....................................... 25
II. THE SALE MOTION IS THE BEST OPTION TO MAXIMIZE THE VALUE OF THE DEBTORS’ ASSETS AND IS IN THE BEST INTERESTS OF THE DEBTORS AND THEIR ESTATES .................................................................................26
A. The Debtors’ Rehabilitation Is Largely Dependent On A Successful Sale Process and It Is Premature To Assume That Rehabilitation is Unlikely................................................................................................................. 28
B. Because the Debtors Could Propose A Chapter 11 Plan of Liquidation, it is Premature to Determine Whether or Not the Debtors Will Be Able To Effectuate The Confirmation of A Plan ........................................................... 31
ii
C. Conversion to Chapter 7 at This Time is Not in the Best Interests of the Creditors of the Estate ........................................................................................... 32
III. SUMMIT’S ALLEGED RECLAMATION RIGHTS ARE SUBORDINATED TO THE RIGHTS OF THE SENIOR SECURED NOTEHOLDERS AND DIP LENDERS..........................................................................................................................34
A. Any Reclamation Rights Summit May Have Are Clearly Subject to the Liens of the Senior Secured Lenders and DIP Lenders ........................................ 35
IV. THE DEBTORS’ UNIVERSAL TITLES SHOULD BE SOLD AS PART OF THE 363 SALE ..................................................................................................................39
A. The Revenue Sharing Agreement is not a “Lease” ............................................... 41
1. Bright Line Test. ....................................................................................... 42
2. Economic Reality Test. ............................................................................. 43
B. Aggregate Payments ............................................................................................. 45
C. Universal has no Expectation that the Discs will be Returned at the End of the Revenue Share Period ................................................................................. 45
D. Universal May Have an Unsecured Claim Against the Debtors for Breach of Contract ................................................................................................ 46
iii
TABLE OF AUTHORITIES
Page(s)CASES
In re The 1031 Tax Group, LLC,374 B.R. 78 (Bankr. S.D.N.Y. 2007) ...........................................................................27, 28, 32
In re 15375 Memorial Corp.,382 B.R. 652 (Bankr. D. Del. 2008), rev’d on other grounds,400 B.R. 420 (D. Del. 2009) ....................................................................................................28
In re Advanced Mktg. Servs., Inc., 360 B.R. 421 (Bankr. D. Del. 2007) ........................................................................................38
In re All Am. of Ashburn, Inc.,40 B.R. 104 (Bankr. N.D. Ga. 1984) .......................................................................................33
In re Alves Serv. Inc.,6 B.R. 690 (Bankr. D. Mass. 1980) ...................................................................................28, 34
In re Arlco Inc.,239 B.R. 261 (Bankr. S.D.N.Y. 1999) ...............................................................................36, 38
In re Braniff, Inc.,113 B.R. 745 (Bankr. M.D. Fla. 1990) ....................................................................................36
In re Chameleon Sys. Inc.,306 B.R. 666 (Bankr. N.D. Cal. 2004) ....................................................................................31
In re Circuit City Stores Inc., et al.,Case No. 0835653 (KRH) (Bankr. E.D.Va. Sept. 14, 2010) ...................................................31
In re Dairy Mart Convenience Stores, Inc.,302 B.R. 128 (Bankr. S.D.N.Y. 2003) .....................................................................................38
In re Dana Corp.,367 B.R. 409 (Bankr. S.D.N.Y. 2007) ..............................................................................36, 38
In re Deer Park, Inc.,136 B.R. 815 (B.A.P. 9th Cir. 1992)........................................................................................33
In re Edison Bros. Stores,207 B.R. 801 (Bankr. D. Del. 1997) ..................................................................................43, 45
In re Finlay Enterprises, Inc. et al.,Case No. 09-14873 (JMP) (Bankr. S.D.N.Y. June 29, 2010) ..................................................32
iv
In re Fortunoff Holdings, LLC et al.,Case No. 09-10497 (RDD) (S.D.N.Y. Oct. 1, 2009) ...............................................................30
In re GPA Technical Consultants, Inc.,106 B.R. 139 (Bankr. S.D. Ohio 1989) ....................................................................................31
In re Grubbs Constr. Co.,319 B.R. 698 (Bankr. M.D. Fla. 2005) ....................................................................................41
In re Linens Holdings Co. et al.,Case No. 08-10832 (CSS) (Bankr. D. Del. Feb. 24, 2010) ......................................................30
In re Lizeric Realty Corp.,188 B.R. 499 (Bankr. S.D.N.Y. 1995) .....................................................................................27
In re Mervyn’s Holdings, LLC, et al.,Case No. 08-11586 (KG) (Bankr. D. Del. 2008) .....................................................................30
In re Midway Games Inc., et al.,Case No. 09-10465 (KG) (Bankr. D. Del. May 21, 2010) .......................................................31
In re Movie Gallery Inc. et al.,Case No. 10-30696 (DOT) (Bankr. E.D.Va. Oct. 29, 2010) ...................................................31
In re Murray,191 B.R. 309 (Bankr. E.D. Pa. 1996) ......................................................................................42
In re New Rochelle Tel. Corp.,397 B.R. 633 (Bankr. E.D.N.Y. 2008) .....................................................................................29
In re Pillowtex, Inc.,349 F.3d 711 (3d Cir. 2003)...................................................................................41, 42, 43, 46
In re Pittsburgh-Canfield Corp.,309 B.R. 277 (B.A.P. 6th Cir. 2004)........................................................................................38
In re PLVTZ Inc.,Case No. 07-13532 (REG) (S.D.N.Y. Oct. 27, 2008)..............................................................30
In re QDS Components, Inc.,292 B.R. 313 (Bankr. S.D. Ohio 2002) ....................................................................................41
In re The SCO Group, Inc.,No. 07-11337, 2009 WL 2425755 (Bankr. D. Del. Aug. 5, 2009) ..........................................32
In re Sydnor,431 B.R. 584 (Bankr. D. Md. 2010) ..................................................................................27, 32
v
In re Taylor,209 B.R. 482 (Bankr. S.D. Ill. 1997) .......................................................................................42
In re Tillary,571 F.2d 1361 (5th Cir. 1978) .................................................................................................41
In re Value City Holdings, Inc. et al.,Case No. 08-14197 (JMP) (Bankr. S.D.N.Y. May 17, 2010) ..................................................31
In re Victory Mkts.,212 B.R. 738 (Bankr. N.D.N.Y. 1997) ....................................................................................36
Pactel Fin. v. D.C. Marine Serv. Corp.,518 N.Y.S.2d 317 (N.Y. Sup. Ct. 1987) ..................................................................................43
Specialty Beverages, L.L.C. v. Pabst Brewing Co.,537 F.3d 1165 (10th Cir. 2008) ...............................................................................................41
STATUTES
11 U.S.C. § 546 (c) ...........................................................................................................34, 35, 36
11 U.S.C. § 546(c)(1) ...............................................................................................................35, 36
11 U.S.C. § 552(a) ........................................................................................................................37
11 U.S.C. § 1112(b)(1) ..................................................................................................................32
11 U.S.C. § 1112(b)(4) ..................................................................................................................27
N.Y.U.C.C. § 1-201(37).................................................................................................................42
N.Y.U.C.C. § 1-201(37)(a) ............................................................................................................42
N.Y.U.C.C. § 2-702(2) ............................................................................................................34, 36
U.C.C. § 1-203, cmt. 2 (2004) .......................................................................................................42
OTHER AUTHORITIES
7 COLLIER ON BANKRUPTCY ¶ 1112.05[1] ...........................................................................27
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TO THE HONORABLE BURTON R. LIFLAND, UNITED STATES BANKRUPTCY JUDGE:
The Steering Group of Senior Secured Noteholders (defined herein) who are also DIP
Lenders (defined herein) – such beneficial holders are managed by Icahn Capital LP, Monarch
Alternative Capital LP, Owl Creek Asset Management, L.P., Stonehill Capital Management
LLC, and Värde Partners, Inc. (collectively, the “Steering Group”) – submits this reply
memorandum (“Reply in Support of Sale Motion”) (1) in support of the Debtors’ Sale Motion
(defined herein) and (2) in opposition to the Committee’s Objection (defined herein), the
Trustee’s Objection and Conversion Motion (defined herein), the Summit Objection (defined
herein) and Universal Objection (defined herein).2 The facts and circumstances supporting this
Reply in Support of Sale Motion are set forth in further detail in the concurrently filed
Declaration of Michael Henkin in Support of the Reply in Support of the Sale Motion (the
“Henkin Declaration” or “Henkin Decl.”). The Steering Group respectfully represents as
follows:
PRELIMINARY STATEMENT
1. Since the commencement of these Chapter 11 Cases, the Debtors have made
payments of over $854 million to their administrative trade and non-trade vendors. (Henkin
Decl. ¶ 74 & Ex. I.) Those payments have consumed cash from the DIP Facility and the DIP
Lenders’ Cash Collateral for the benefit of virtually every other constituency in these cases
except the Senior Secured Noteholders themselves, including payments of over $174 million to
the movie studios, $76 million to game and merchandise vendors, $151 million to landlords, and
2 Capitalized terms not otherwise defined herein shall have the meaning ascribed to them in the Final DIP Order (defined herein).
2
$146 million to Blockbuster’s employees. (Id.) And if the Sale Motion is granted – as it should
be – the Debtors will pay another $285 million in total operating disbursements from the Cash
Collateral for the benefit of those and other constituencies throughout the sale period. (Id. ¶ 58.)
2. By contrast, the Senior Secured Noteholders have suffered the most adverse
consequences from the Debtors’ cash burn and unexpectedly poor financial performance. Since
the Petition Date, the Senior Secured Noteholders have received NO payments of interest,
principal, or fees on account of their Senior Secured Notes, including the Roll-Up Notes,
notwithstanding that their collateral has been or will be sold in connection with the closing and
liquidation of over 900 hundred stores. (Id. ¶ 80.) The proceeds from those sales have been used
to subsidize the operating losses and administrative expenses of the estates, including significant
payments to movie studios on account of inventory delivered to the Debtors prepetition. The
Senior Secured Notes received nothing from this liquidation of their collateral. (Id.) Nothing.
3. Yet despite the Steering Group’s cooperation with the Debtors, and its agreement to
permit the consensual use of its Cash Collateral to try to preserve the enterprise value of the
business and to pay Blockbuster’s administrative expense creditors, the Creditors’ Committee
filed an objection to the Sale Motion that is littered with offensive and unfounded assertions that
question the actions of the bidders and the DIP Lenders. The Creditors’ Committee claims that
the DIP Lenders caused the Debtors to default under the DIP Facility and Plan Support
Agreement by refusing to approve the Debtors’ proposed business plans, (Committee’s
Objection ¶ 31), even though those unrealistic business plans never addressed the rapidly
deteriorating reality of the Debtors’ financial performance. The Creditors’ Committee claims
that the DIP Lenders issued an “illusory DIP Facility,” (id. ¶ 30), even though the Debtors drew
more than $53 million over the life of the DIP Facility and were permitted to use more than $850
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million of Cash Collateral to finance their business. (Henkin Decl. ¶ 74.) And the Creditors’
Committee claims that the DIP Lenders will receive an “undeserved windfall” from the Roll-Up
Notes under the Final DIP Order, (Committee’s Objection ¶ 29), even though those heavily
negotiated provisions provided reasonable consideration to compensate the DIP Lenders for the
additional risk of financing these Debtors. (Henkin Decl. ¶ 19.)
4. The Committee’s deliberately misleading allegations have no basis in reality and
should not prevent this Court’s approval of the Sale Motion nor compel entry of the other relief
the objectors seek. As the factual record overwhelmingly demonstrates, the DIP Lenders
extended credit and acted in good faith throughout these Chapter 11 Cases.
5. It is the Debtors that defaulted under the terms of the Plan Support Agreement and
the DIP Credit Agreement by missing numerous milestones under those agreements which the
Steering Group in good faith extended several times. (Id. ¶ 11.) It is the Debtors that failed to
deliver a realistic business plan that addressed Blockbuster’s precipitously deteriorating financial
performance. (Id. ¶¶ 23-28, 36-37.) It is the performance of the Debtors’ businesses and not the
actions of the DIP Lenders or Senior Secured Noteholders that led to this disappointing yet
necessary sale under section 363 of title 11 of the United States Code (the “Bankruptcy Code”).
6. The DIP Lenders never agreed to “backstop” the entire reorganization process or
guarantee payment of all of the Debtors’ administrative and other creditors without limitations,
as the Creditors’ Committee erroneously contends. (Committee’s Objection at 3.) As “Backstop
Lenders,” the Steering Group committed to fund the entire DIP Facility if there were not enough
Senior Secured Noteholders subscribing to the facility. (Henkin Decl. ¶ 76.) They agreed to
provide a revolving credit facility on very specific terms that were negotiated and agreed to by
the Creditors’ Committee and approved by a final order of this Court. (Id. ¶ 15.)
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7. The Steering Group therefore supports the Debtors’ Sale Motion, and opposes the
various objectors’ premature motions to convert these Chapter 11 Cases, because the auction and
sale process is now the best way to preserve and maximize Blockbuster’s value as a going
concern business. (Id. ¶ 51.) As detailed below and in the accompanying declaration of Michael
Henkin of Jeffries & Company, Inc., the Steering Group’s financial advisor, the Steering Group
has worked in good faith and cooperation with the Debtors to maintain that enterprise value
throughout the restructuring process. The proposed auction process under section 363 of the
Bankruptcy Code has the greatest potential to generate overbids from interested purchasers for
the benefit of all constituents. A going-concern bidder may also assume significant
administrative expenses to the benefit of many constituents. Indeed, according to the Debtors’
financial advisor, at least five or six potential purchasers have conducted due diligence and
expressed serious interest in submitting a bid at the auction.
8. The premature conversion to a chapter 7 liquidation at this stage would be a
disaster for all constituents, causing further harm to the Debtors’ businesses and deterioration to
the value of the Debtors’ assets. With the DIP Lenders’ consent and cooperation, Blockbuster
has tried to stem the decimation of its enterprise value and worked to maintain significant trade
vendor relationships by spending the Senior Secured Noteholders’ Cash Collateral. But that
value could be depleted significantly in a chapter 7 liquidation. And in a conversion, it is highly
unlikely that any other constituent will receive any consideration because the Senior Secured
Noteholders have valid secured liens of approximately $630 million in substantially all of the
Debtors’ property.
9. Under the proposed sale budget, by contrast, the Debtors are slated to use the
Senior Secured Noteholders’ Cash Collateral generated through the operation of the Debtors’
5
business and the ongoing liquidation of inventory at closed stores to pay over $285 million in
total operating expenses to administrative claimants from February 27, 2011 through April 17,
2011, the estimated closing date of the sale. (Henkin Decl. ¶ 58.)
10. Indeed, the $285 million proposed budget – subject to the Sale Motion being
approved and agreement reached with constituents – for the sale process allocates payments of
approximately $65 million to movie studios, game providers, and general merchandise providers,
approximately $68 million to landlords, utilities, and maintenance, approximately $80 million for
rank-and-file employee compensation and benefits, approximately $25 million for taxes, and
approximately $40 million for other operating expenses such as insurance, information
technology, and freight/postage. (Id. ¶ 59.) Of course, all of these payments are to be made
from the Senior Secured Noteholders’ Cash Collateral with NOTHING being paid to the Senior
Secured Noteholders. (Id.) Granting the Sale Motion and implementing the auction process
unquestionably will result in a better economic outcome for administrative claimants compared
to converting these cases to chapter 7.
11. For all of these reasons and as detailed below, the Sale Motion should be granted,
and the various objections and motions to convert these Chapter 11 Cases to a liquidation under
chapter 7 should be denied.
RELEVANT BACKGROUND
12. The commencement of these Chapter 11 Cases resulted from a months-long
negotiation process between the Debtors and the Steering Group, whose members hold in excess
of 80% in face amount of Blockbuster’s Senior Secured Notes. (Id. ¶ 9.) Prior to the Petition
Date, Blockbuster and the Steering Group entered into a plan support agreement dated as of
September 22, 2010 (the “Plan Support Agreement”) in which they agreed to the material
terms of a chapter 11 plan of reorganization and proposed exit financing. (Id.) The Plan Support
6
Agreement contemplated a recapitalization of the Debtors whereby the approximately $630
million of Senior Secured Notes would be exchanged for 100% of the equity interests in a
reorganized Blockbuster. (Id. ¶ 10.)
13. On September 23, 2010 (the “Petition Date”), each of the above captioned debtors
(the “Debtors”) commenced these chapter 11 cases (the “Chapter 11 Cases”) by filing a
voluntary petition under chapter 11 the Bankruptcy Code.
14. On October 1, 2010, the Office of the United States Trustee for the Southern
District of New York (the “Trustee”) appointed an official committee of unsecured creditors
(the “Creditors’ Committee”) to represent the interests of the unsecured creditors in these
Chapter 11 Cases.
15. In connection with the Plan Support Agreement, the Steering Group also agreed to
provide debtor in possession financing so that Blockbuster would have sufficient liquidity to
conduct ordinary course business operations during the restructuring. (Henkin Decl. ¶ 12.)
Accordingly, on the Petition Date, the Debtors filed their Motion for Entry of an Order, on an
Interim and Final Basis, (I) Authorizing the Debtors to Obtain Post-Petition Superpriority
Financing (the “DIP Facility”) Pursuant to 11 U.S.C. §§ 105, 361, 362, 364(c), 364(d)(1), and
364(e), (II) Authorizing Debtors' Use of Cash Collateral Pursuant to 11 U.S.C. § 363, (III)
Granting Liens and Superpriority Claims to DIP Lenders Pursuant to 11 U.S.C. § 364, (IV)
Providing Adequate Protection Pursuant to 11 U.S.C. §§ 361, 362, 363 and 364, and (V)
Scheduling a Final Hearing Pursuant to Bankruptcy Rules 2002, 4001(b), 4001(c), and 6004 (the
“DIP Motion”).
16. On October 27, 2010, this Court entered a final order (the “Final DIP Order”) (i)
authorizing the Debtors to obtain post-petition super-priority secured financing (the “DIP
7
Financing”) from those lenders (the “DIP Lenders”) party to that certain Senior Secured,
Super-Priority Debtor-in-Possession Revolving Credit Agreement dated as of September 23,
2010 (the “DIP Credit Agreement”), (ii) authorizing the Debtors’ post-petition use of Cash
Collateral of the DIP Lenders, the Roll-Up Noteholders, and the Senior Secured Noteholders
(defined in the Final DIP Order, the “Cash Collateral”), and (iii) granting adequate protection to
the beneficial holders (“Senior Secured Noteholders”) of the 11.75% Senior Secured Notes due
2014 (the “Senior Secured Notes”) and U.S. Bank National Association, as trustee and
collateral agent.
17. As security for the DIP Obligations (including the Roll-Up Notes), the Final DIP
Order provided that the Debtors granted to the DIP Agent, for the benefit of itself and the DIP
Lenders and the Roll-Up Noteholders, the DIP Lenders and the Roll-Up Noteholders valid,
enforceable, non-avoidable, and fully perfected first priority liens on and security interests in the
DIP Collateral (defined in the Final DIP Order), which included first priority liens on and
security interests in the Debtors’ unencumbered assets. (Henkin Decl. ¶ 18.) The Debtors’ only
material unencumbered assets were one-third of the equity interests of the Debtors’ foreign
assets, which had not been pledged to the Senior Secured Noteholders for tax purposes, a Danish
subsidiary, and the Avoidance Actions (defined in the DIP Order). (Id. ¶ 19.)
18. In addition, the Senior Indenture Trustee received, on behalf of the Senior Secured
Noteholders, adequate protection of their interests in their Prepetition Collateral (defined in the
Final DIP Order), including Cash Collateral, for and equal in amount to the aggregate diminution
in value of the DIP Lenders’ security interests in the Prepetition Collateral as a result of, among
other things, the Debtors’ sale, lease, or use of cash collateral and any other Prepetition
Collateral, and the priming of the Senior Secured Noteholders’ security interest and liens in the
8
Prepetition Collateral. Such adequate protection included replacement security interests in and
liens upon all DIP Collateral and superpriority administrative expense claims. (Henkin Decl. ¶
18.) The Final DIP Order also found that the DIP Lenders acted in good faith in negotiating the
DIP Credit Agreement, including the Roll-Up Notes. (See Final DIP Order at 12-13, ¶ 6(h).)
19. The revolving DIP Facility has drawn as much as $53 million. (Henkin Decl. ¶
74.) Those draws have been repaid and the DIP Facility was terminated.3
20. During the Chapter 11 Cases, no amounts, whether principal, interest, or fees have
been paid on the Senior Secured Notes, including the Roll-Up Notes. (Id. ¶ 80.)
21. On February 21, 2011, the Debtors’ filed their Motion, Pursuant To 11 U.S.C. §§
105, 363, 364, and Fed. R. Bankr. P. 2002, 4001, 6004, 6006, 9008, and 9014, for Entry of: (I) an
Order Approving (a) Bid Procedures, (b) Stalking Horse Expense Reimbursement, (c) Notice of
Sale, Auction, and Sale Hearing, (d) Assumption Procedures and Related Notices, (e) Incurrence
of Sale-Related Administrative Priority Claims and Related Liens, and (f) Imposition of an
Administrative Stay; and (II) an Order Approving the Sale of Substantially All of the Debtors’
Assets (the “Sale Motion”) [Docket No. 947].
22. On February 3, 2011, Summit Distribution, LLC (“Summit”) filed that certain
Motion for Entry of an Order (I) Compelling Immediate Payment of its Administrative Expense
3 On February 25, 2011, the DIP Agent notified the Debtors of the occurrence of and continuation of certain Events of Default under the DIP Credit Agreement, exercised its rights to terminate the DIP Credit Agreement, and declared all obligations under the DIP Facility due and payable. On February 25, 2011, the Requisite Consenting Noteholders notified the Debtors of the occurrence of and continuation of certain Termination Events under the Plan Support Agreement, and exercised their rights to terminate the Plan Support Agreement. Also on February 25, 2011, the DIP Agent, as directed by the Requisite Lenders, delivered to the Debtors, United States Trustee, and the Creditors’ Committee the Carve-Out Trigger Notice (defined under the Final DIP Order) notifying each of a Termination Event under the Final DIP Order, that all obligations under the DIP Facility had been accelerated, that the Post Carve-Out Trigger Cap had been invoked, and that the delivery of the Carve-Out Trigger Notice constituted a Roll-Up Event (defined under the Final DIP Order). Importantly, the DIP Lenders have consented to the Debtors’ use of Cash Collateral throughout the sale process, if approved.
9
Claim or, in the Alternative, (II) Granting it Relief from the Automatic Stay to Permit
Reclamation of its Goods and Converting the Chapter 11 Cases to Cases Under Chapter 7 for
Cause (the “Summit Motion”) [Docket No. 907]. The Summit Motion asked the Court to
compel the immediate payment of its administrative expense claims (Summit Motion, ¶ 10-13),
or, in the alternative, grant it relief from the automatic stay to permit the enforcement of its
reclamation rights (id. ¶ 14-16), and convert these cases to chapter 7 (id. ¶ 17-19).
23. On February 22, 2011, Universal Studios Home Entertainment (“Universal”) filed
that certain Motion for Entry of an Order (I) Compelling Immediate Payment of its
Administrative Expense Claim or, (II) Granting Adequate Protection or, (III) Ordering Recall of
Goods Pursuant to 11 U.S.C. 105(a) and 362(d) to the Extent Necessary and Applicable or, (IV)
Granting it Relief from the Automatic Stay to Permit Reclamation of its Goods, Including
Memorandum of Law in Support of Motion [Docket No. 951] (the “Universal Motion”). The
Universal Motion seeks the immediate payment of its administrative expense claims (Universal
Motion ¶ 21-24), adequate protection for the declining value of Universal titles (id. ¶ 25-34), and
relief from the automatic stay to permit the enforcement of its reclamation rights (id. ¶35-41).
24. On or about February 28, 2011, the Creditors’ Committee filed an objection to the
Sale Motion and a cross-motion seeking to convert the Debtors’ Chapter 11 Cases to cases under
chapter 7 of the Bankruptcy Code (the “Committee’s Objection”). The Committee’s Objection
alleges that the DIP Lenders acted in bad faith by providing an “illusory” $125 million DIP
Facility. (Committee’s Objection at 3.) The Committee’s Objection asserts that the DIP Lenders
never intended for the DIP Facility to backstop the substantial post-petition credit that was
necessary to fund the Chapter 11 Cases and that the DIP Lenders broke their commitment to
backstop the Debtors’ reorganization process. (Id.) With no evidentiary support whatsoever,
10
and based on clearly incorrect allegations, the Creditors’ Committee requests that this Court,
among other things, (i) find that the DIP Lenders acted in bad faith, (id. ¶¶ 14-18), (ii) reverse its
prior order and limit the benefits granted by this Court to the DIP Lenders under the Roll-Up
Notes, (id. ¶¶ 19-32), and (iii) order the DIP Lenders to guarantee payment of post-sale
administrative expense claims (id. ¶¶ 38-40).
25. The Committee’s Objection also seeks to convert the Chapter 11 Cases if the
stalking horse bidders do not make certain changes to the proposed sale process and their
stalking horse bid. (Id. ¶ 41.) Again with no evidentiary support whatsoever and based on mere
assumptions, the Creditors’ Committee argues that their cross-motion for conversion should be
granted because there is (i) a continuing loss to or diminution of the estate and the absence of a
reasonable likelihood of rehabilitation, (id. ¶¶ 46-49), or (ii) an inability to effectuate substantial
consummation of a confirmed plan, (id. ¶¶ 50-51).
26. On February 28, 2011, the Trustee filed that certain Objection to Order Authorizing
the Incurrence of Sale-Related Administrative Priority Claims (the “Trustee Objection”)
[Docket No. 986]. In the Trustee Objection, the Trustee opposed the Debtors’ proposal to grant
super-priority status to certain administrative claims, (Trustee Objection ¶¶ 22-27), requesting
clarification as to which administrative creditors would receive super-priority treatment and
which would not (id. ¶¶ 28-30).
27. On February 28, 2011, Universal filed an Objection to the Sale Motion (the
“Universal Objection”) [Docket No. 1024]. The Universal Objection asserted Universal’s
rights to Universal titles in the Debtors’ possession, arguing that those titles were leases to the
Debtors (Universal Motion ¶ 4). Universal also objected to the Debtors’ request for the
imposition of the Administrative Stay. (Id. ¶ 5).
11
28. On February 28, 2011, Summit filed an Objection to the Sale Motion (the “Summit
Objection”) [Docket No. 989]. Summit objected to the Debtors’ proposed payment of certain
administrative expense claims on a super-priority basis (Summit Objection ¶¶ 6-8), and again
asserted their right to reclaim their goods from the Debtors (id. ¶¶ 9-12). Summit also moved
for conversion of these cases to chapter 7 (id. ¶¶ 13-17), and described the Sale Motion as a sub
rosa plan of reorganization that was not fair or reasonable (id. ¶¶ 18-19, 20-26).
29. On March 4, 2011, the Trustee filed that certain Motion to Shorten the Notice
Period and Covert these Chapter 11 Cases to Cases Under Chapter 7 (the “Trustee Conversion
Motion”) [Docket No. 1075]. The Trustee Conversion Motion requested the conversion of these
cases to chapter 7, asserting that the Debtors are administratively insolvent (Trustee Conversion
Motion ¶ 29), and unlikely to present a plan of liquidation (id. ¶ 30). The Trustee further
objected to the Sale Motion’s treatment of chapter 7 administrative expense claims in any
subsequent conversion to chapter 7. (Id. ¶ 42.) The Trustee Conversion Motion alleges that the
Debtors have abandoned any meaningful reorganization activity, and that the Debtors’
administrative insolvency makes it highly unlikely that a plan can be confirmed. (Id. ¶ 44.)
ARGUMENT
I. THE SENIOR SECURED NOTEHOLDERS AND DIP LENDERS ACTED IN GOOD FAITH THROUGHOUT THESE CHAPTER 11 CASES
A. The DIP Facility was Negotiated in Good Faith with Fair and Reasonable Lender Protections
30. Without any factual evidence whatsoever, the Committee’s Objection attacks the
bona fides of the DIP Credit Agreement, the lender protections provided therein and granted by
this Court in the Final DIP Order, and the actions of the DIP Lenders thereunder.
31. As this Court has already found when it entered the Final DIP Order, the terms and
conditions of the DIP Credit Agreement and the consensual use of cash collateral were
12
negotiated between the Debtors, the DIP Lenders, and the Creditors’ Committee through
extensive good-faith arm’s length negotiations. (See Final DIP Order at 12-13, ¶ 6(h).)
32. Given Blockbuster’s continued downward trending revenues and the increasing
obsolescence of Blockbuster’s “brick and mortar” distribution platform (as evidenced in the quite
recent liquidation of Movie Gallery, a former Blockbuster competitor), the Steering Group was
highly concerned about loans that would be made to Blockbuster under the DIP Credit
Agreement. (See Henkin Decl. ¶ 14.) Indeed, the rapid decline of Blockbuster’s business is
reflected in the significant decrease in Blockbuster’s total revenues and EBITDA over the
preceding three years. For the year fiscal year ending December 31, 2008, Blockbuster’s total
revenues were approximately $5 billion with EBITDA of approximately $277 million. For the
fiscal year ending 2009, Blockbuster’s total revenues were approximately $4 billion with
EBITDA of approximately $162 million. By the fiscal year ending 2010, Blockbuster’s
revenues were approximately $3 billion and its EBITDA had shrunk to an adjusted $78 million
(a 52% decrease year-over-year). (See id. ¶ 5 & Ex. A.)
33. The net rental revenue from Blockbuster’s sales at domestic retail stores that have
been open for a year or more (i.e., comparative store sales, or “comp store sales”) has trended
significantly downward from a high of approximately 8.4% in the second quarter of 2008, to as
low as approximately 18% down for the fourth quarter of 2010. (Id. ¶ 7 & Ex. B.) For example,
the average comp store sales for the year ending 2008 was down 1.2%, for the year ending 2009
was down 14.6%, and for the year ending 2010 was down another 10.4%. (Id. & Ex. B.) The
week over week decline is even more dramatic. (See id. ¶ 24 & Ex. C.)
34. In light of these risks, the DIP Lenders negotiated a structure and conditions to
protect their potential exposure on the new money loans. The Creditors’ Committee reviewed
13
the structure and conditions of the DIP Facility, including the budget. It objected to provisions
of the DIP Facility; it negotiated with the DIP Lenders with respect to those terms; and it reached
agreement with the Debtors and the DIP Lenders and consented to the Final DIP Order after full
and arm’s length negotiations. (Id. ¶¶ 12-21.)
35. The final, negotiated DIP Facility was structured as a revolving loan facility subject
to an approved budget to fund Blockbuster’s day-to-day operations. (Id. ¶ 15.) Under the DIP
Credit Agreement, Blockbuster was required each month to submit a proposed budget to the DIP
Lenders for approval. The initial 13-week budget submitted to this Court demonstrated that,
from the beginning of these Chapter 11 Cases through the week commencing January 9, 2011,
the largest balance of the DIP Facility was estimated at $69.2 million, with no draw being greater
than $23 million. (See id. ¶ 16.) This was so because store closings and liquidation of the
collateral of the Senior Secured Noteholders from those stores would provide additional cash to
fund administrative expenses. As it turned out, much of that cash was also necessary to fund
operating losses.
36. The DIP Credit Agreement was not a blank check. It provided the Debtors with up
to $125 million of revolving loans on very specific terms and conditions precedent and required
the Debtors to meet specific milestones.4 (Id. ¶ 15.)
4 The milestones included (i) obtaining a final order approving the DIP Credit Agreement by October 23, 2010 (extended by the DIP Lenders to November 7, 2010); (ii) obtaining critical vendor orders with respect to Sony Pictures Home Entertainment Inc., Warner Bros. Home Entertainment Inc. and Twentieth Century Fox by October 28, 2010; (iii) filing a plan of reorganization that conformed to the requirements of the Plan Support Agreement in all respects by November 22, 2010 (extended several times and ultimately to February 18, 2011); (iv) obtaining approval by the Requisite DIP Lenders of an updated business plan by November 30, 2010 (extended several times and ultimately to February 18, 2011); (v) obtaining an order approving the disclosure statement of a plan that conforms to the requirements of the Plan Support Agreement in all respects by January 15, 2011 (extended to February 18, 2011); and (vi) obtaining an order confirming a plan that conforms to the requirements of the Plan Support Agreement by March 15, 2011. (Henkin Decl. ¶ 15.)
14
37. The DIP Credit Agreement also required weekly mandatory prepayments if
aggregate treasury cash exceeded $25 million in the month of December, or $20 million dollars
in any other month. (Id. ¶ 17.) The excess was to be used to pay down the then-outstanding
balance on the DIP Facility. (Id.) The Creditors’ Committee reviewed and negotiated or
accepted each of these reasonable protective provisions and understood them to be limitations on
the availability of the DIP Facility. (Id. ¶¶ 14-17.) In addition, the Debtors and the DIP Lenders,
consistent with the terms of the Plan Support Agreement, sought to achieve a quick
reorganization under a new management team and business plan that would de-lever the Debtors
significantly, leaving little to no funded debt on the Company (other than a new $50 million
working capital exit facility which the Debtors had to obtain). (See id. ¶ 10.)
38. Since the entry of the Final DIP Order and throughout these Chapter 11 Cases, the
DIP Lenders have continued to work cooperatively with the Debtors and the Creditors’
Committee. For example, subsequent to the entry of the Final DIP Order, the Creditors’
Committee requested that the Challenge Period (defined in the Final DIP Order) for commencing
actions pursuant to paragraph 28 of the Final DIP Order be extended from the original expiration
date of December 27, 2010. The Requisite Lenders in good faith granted that request and agreed
to extend the Challenge Period to February 1, 2011, and then further extended the Challenge
Period to February 11, 2011. (See id. ¶ 21.)
39. The Creditors’ Committee conducted a thorough investigation of the DIP Financing
and the liens and obligations related to the Senior Secured Notes, and ultimately completed that
15
investigation without taking any action or commencing an adversary proceeding. 5 (See id. ¶ 22.)
The DIP Lenders relied on their deal with the Creditors’ Committee and the Final DIP Order by
making advances and permitting the use of Cash Collateral to fund ongoing business operations.
B. The DIP Lenders Acted In Good Faith by Approving Budgets, Authorizing Increased Advertising Spending, and Extending Milestones
40. Again, with absolutely no factual evidence, the Creditors’ Committee attempts to
mislead this Court into believing that the DIP Lenders have concocted some mischievous plan
“to direct and control a chapter 11 sale process designed for its exclusive benefit and without
regard to the devastation that it previously caused these estates.” (See Committee’s Objection at
3.) Indeed, the Creditors’ Committee carelessly asserts that the DIP Lenders “walked away
unscathed from their commitment to backstop the reorganization they pledged to sponsor.” (Id.)
In fact, these case have been run for the benefit of every constituent but the Senior Secured
Noteholders and DIP Lenders who have been the most “scathed” party as a result of the
uncompensated liquidation of their collateral.
41. From September 23, 2010 through February 24, 2011, the DIP Lenders approved
every proposed budget submitted by the Debtors (in October, November, December, January and
then week-to-week until the budget period ending February 24, 2011, the date on which the
Debtors filed the Sale Motion). (Henkin Decl. ¶ 23.) By approving each of those budgets, the
5 As provided under the Final DIP Order, “[i]f no such adversary proceeding is timely and properly commenced during the Challenge Period then, without further order of the Court, (i) the claims, liens and security interests of the Senior Indenture Trustee and the Senior Secured Noteholders shall be deemed to be finally allowed for all purposes in these Chapter 11 Cases and any subsequent chapter 7 cases of any of the Debtors and shall not be subject to challenge by any party in interest as to validity, priority, extent, perfection or otherwise, and (ii) the Debtors and their estates shall be deemed to have released any and all claims or causes of action against the Senior Indenture Trustee and the Senior Secured Noteholders with respect to the Senior Note Documents or any conduct or transactions related thereto whether prepetition or postpetition.” (See Final DIP Order at 48, ¶ 28(b) (emphasis added).) Upon information and belief, the professionals of the Creditors’ Committee have incurred fees of over $600,000 and the vast majority of such fees were incurred in connection with the investigation and depositions of the DIP Lenders.
16
DIP Lenders authorized Blockbuster to use the DIP Financing and Cash Collateral to fund the
day-to-day operations of the company and to pay administrative expenses that totaled in excess
of $850 million. (Id. ¶¶ 23, 74, 80 & Ex. I.) While the DIP Lenders received some interest and
fees,6 the Senior Secured Noteholders have received NO payments of any kind on account of
their $630 million Senior Secured Notes, including none on the Roll-Up Notes. (See id. ¶ 80.)
42. Although Blockbuster’s financial performance continued to rapidly deteriorate as
set forth in more detail in the Henkin Declaration, the DIP Lenders continued to support the
Debtors’ efforts to turn around the business. For example, in late October, Blockbuster’s
management requested the DIP Lenders’ consent to an additional $20 million advertising spend
for the holiday season (the “Q4 Ad Campaign”). (Id. ¶ 31.) As discussed in more detail in the
Henkin Declaration, the Debtors’ management expected that the Q4 Ad Campaign would drive
an 8.6% increase in net rental revenue comp stores sales and approximately $8 million in gross
margin. (See Id. ¶ 32 & Ex. F.) In a good-faith effort to support increased customer awareness
and reverse or slow Blockbuster’s further financial deterioration, the Steering Group
unanimously approved the Q4 Ad Campaign.7 (Id. ¶ 33.)
6 Total commitment and underwriting fees to the DIP Lenders for the DIP Facility were $4.375 million plus the benefit of the Roll-Up Notes. 7 As another example of the DIP Lenders good faith, the DIP Lenders also agreed, at the Debtors’ request, to amend the definition of EBITDA in the DIP Credit Agreement to allow an add-back of approximately $10 million so that the Debtors would not trip their minimum EBITDA covenant, given the additional advertising spend. Without this add-back, it is doubtful that Blockbuster would have met its year-end minimum EBITDA covenant, and the Debtors could have been defaulted much earlier under the DIP Credit Agreement. In addition to the Q4 Ad Campaign, Blockbuster’s management also requested additional cash then budgeted in order to bid on certain intellectual property being sold in the Movie Gallery bankruptcy cases. Again, the Steering Group approved this non-budgeted amount, although Blockbuster was ultimately unsuccessful in purchasing the Movie Gallery intellectual property. (Henkin Decl. ¶ 33.)
17
43. Throughout the Chapter 11 Cases, the DIP Lenders continued to approve a
significant amount of payments from the Debtors to their trade partners in order to maintain
commercial relations and try to preserve the going concern value of the enterprise. (Id. ¶ 74.)
C. The Debtors Failed to Provide a Viable Business Plan
44. The Creditors’ Committee’s assertion that the DIP Lenders themselves somehow
acted improperly by causing the Debtors to default under the DIP Facility, by refusing to reach
consensus among themselves with respect to the Debtors’ proposed business plans, (Committee’s
Objection ¶ 31), is flat out wrong and simplistic in its failure to understand the significant
decrease in Blockbuster’s total revenues and EBITDA due to the rapid deterioration of the
company’s traditional store-based distribution channel. (See Henkin Decl. ¶¶ 6-7, 36.)
45. Pursuant to the DIP Credit Agreement, the Debtors were required to (i) file a plan
of reorganization that conformed to the requirements of the Plan Support Agreement in all
respects by November 22, 2010 (extended by the Final DIP Order to November 30, 2010) and
(ii) obtain approval by the Requisite Lenders of an updated business plan by November 30, 2010.
In addition to these milestones in the DIP Credit Agreement, the Plan Support Agreement not
only required that the foregoing milestones be achieved but also required that the Debtors
nominate a chief executive officer for reorganized Blockbuster that was acceptable to the
Requisite Lenders. (Id. ¶ 11.)
46. Despite amendments to the DIP Credit Agreement and several extensions of the
milestones under the DIP Credit Agreement and Plan Support Agreement granted in good faith
by the Steering Group, the Debtors were unable to present an economically viable business plan
that the Steering Group could approve, largely because the Debtors’ declining financial
performance accelerated much more rapidly than expected following the Petition Date. Indeed,
since the commencement of these Chapter 11 Cases, Blockbuster’s weekly net rental revenue
18
comp store sales have continued to decline at an accelerated pace, falling from negative 5% on
September 5, 2010 to as low as negative 38% in mid-February 2011. (Id. ¶ 24 & Ex. C.) Since
September 5, 2010, total net revenue comp store sales have declined by 18.1%. (Id.)
47. On or about October 12, 2010, Blockbuster’s management presented the Steering
Group with its first proposed Business Plan (the “October Business Plan”). The Steering Group
believed that the October Business Plan presented an overly optimistic forecast of Blockbuster’s
future. In the October Business Plan, Blockbuster optimistically projected year-end adjusted
EBITDA for 2010 at approximately $88 million (representing a 22% decrease from the July
Business Plan), increasing to $98 million for the year ending 2011, to $142 million for the year
ending 2012, to $168 million for the year ending 2013 and up to $192 million for the year ending
2014. (See Henkin Decl. ¶ 27 & Ex. E.) With respect to domestic store revenues, the October
Business Plan projected revenues of $1.9 billion for 2010, a year-over-year decline of negative
24%. However, domestic store revenues were then projected to stabilize for years two and three
at around $1.6 billion, before falling again to $1.2 billion in 2014 with a year-over-year change
of negative 18%. (See id.)
48. In light of Blockbuster’s actual negative double digit comp store trends over the
prior three years, and the gale force headwinds facing the business, the Steering Group did not
believe the October Business Plan could be achieved. Indeed, if the recent comp store sales
downward trend continued, then based on the Debtors’ own analysis, approximately two-thirds
of the Debtors’ stores will be cash flow negative within 24 months. (See Henkin Decl. ¶ 28 &
Ex. D.)
49. The Steering Group expressed concerns with the October Business Plan, and
Blockbuster indicated that it would revise its forecasts and financial projections to project a more
19
realistic view of the future. During the subsequent weeks, however, Blockbuster’s financial
performance continued to plummet while its competitors continued to increase their market
presence in the rapidly growing and more popular distribution channels. (See Henkin Decl. ¶¶
29-31.)
50. In late November 2010, Blockbuster’s management presented a newly revised
business plan to the Steering Group (the “November Business Plan”, together with the October
Business Plan, the “Proposed Business Plans”). The November Business Plan continued to
forecast optimistic net rental revenue comp store sales that could not be reconciled with the
Debtors’ actual financial performance. Specifically, the plan showed net rental revenue comp
store sales of negative 6% for the year ending 2010, up to negative 1.4% for the year ending
2011, negative 1.9% for the year ending 2012, negative 2.7% for the year ending 2013, and
negative 2.8% for the year ending 2014. (See id. ¶ 36 & Ex. H.) Compared to the significantly
downward historical trend of net rental revenue comp store sales since 2008, with average comp
store sales of negative 14.6% for the year ending 2009 and negative 10.4% for the year ending
2010, (id. & Ex. C), management’s November forecast of very modest 1.4% - 2.8% annual net
negative rental revenue comp store sales was unduly optimistic, (id.)
51. The November Business Plan forecasted that EBITDA would increase over the
subsequent five years, despite the fact that EBITDA had decreased substantially from 2008
through 2010 due to competitive headwinds and rapidly changing industry dynamics. Yet the
November Business Plan forecasted year-end adjusted EBITDA for 2010 at approximately $82
million, then increasing to $86 million for the year ending 2011, up to $129 million for the year
ending 2012, up to $143 million for the year ending 2013, and up to $172 million for the year
ending 2014. (See id. ¶ 37.)
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52. The November Business Plan for the first time also called for a $200 million rights
offering, but failed to explain the uses and potential returns on the new money from the proposed
equity investment. The net $190 million equity investment (after fees) was simply described as
needed to (i) provide liquidity; (ii) underscore the company’s near-term financial viability; (iii)
reserve committed capital for future digital business development; (iv) ensure trade partner
confidence; (v) secure studio exclusive content investments; and (vi) support other strategic
growth opportunities. The Debtors never provided any support for how they intended to use the
proposed $190 million equity investment, nor did they demonstrate how the equity infusion was
expected to generate real return on investment. (See Henkin Decl. ¶ 38.) Neither the Plan
Support Agreement nor the DIP Credit Agreement contemplated an additional investment by the
Steering Group of $200 million, on top of the conversion of more than $600 million worth of
debt into equity, as a condition to a plan of reorganization.
53. The Steering Group engaged in extensive discussions with the Debtors’
professionals to address its concerns about the November Business Plan. The Debtors agreed
that further revisions to their business plan were necessary, and the DIP Credit Agreement was
amended to extend the Third Milestone – the date by which the Debtors were required to file a
Disclosure Statement and Plan with this Court and to obtain approval of a Business Plan – from
November 30, 2010 to December 15, 2010 and then further to January 14, 2011. (See id. ¶¶ 39,
41.)
D. The Debtors Propose A Sale Under Section 363 of the Bankruptcy Code
54. On January 11, 2011, management held a meeting with the Steering Group during
which it presented a financial update to the Steering Group. Management conceded that the
company’s financial performance had deteriorated to a much greater extent than it had forecasted
just weeks earlier, and reported that adjusted EBITDA for the year ending 2010 was
21
approximately $78 million as compared to $200 million for the year ending 2009, a decrease of
approximately 56%. Management also reported that the $17 million Q4 Ad Campaign had not
produced the expected results, and that the Debtors had in fact experienced decreased net rental
revenues against the same period in 2009. (See Henkin Decl. ¶ 42.) At this presentation,
management also recognized that the number and pace of store closings would have to increase
substantially due to the significant downward trend of comp store sales, the decrease in customer
foot traffic, and the flawed assumptions made by Blockbuster in its Proposed Business Plans
regarding its ability to stem the significant declines in year-over-year same store comp sales.
(Id.)
55. Importantly, it was at this meeting it was revealed that the Debtors’ Board of
Directors had authorized management to consider other restructuring alternatives, including a
section 363 sale of substantially all of the Debtors’ assets. (Id. ¶ 43.) Management on behalf of
the Board requested stalking horse bids from lenders in the Steering Group given that those
lenders were fully familiar with Blockbuster’s assets and operations, and would be in the best
position to quickly commence a 363 sale. In addition, at the January 11 meeting, the Debtors’
management and advisors disclosed for the first time that the administrative claims incurred
during these Chapter 11 cases were approximately $285 million – far greater than the Steering
Group had expected based upon the prior information provided to it. (Id. ¶¶ 43-48.)
56. The Steering Group concurred with the Debtors’ conclusion that a 363 auction and
sale process would be the best way to maximize Blockbuster’s value as a going concern. (Id. ¶¶
50-51.) The auction process may lead to overbids from potential bidders, and a bidder may agree
to assume administrative expenses to the benefit of many constituents. Auctions of this type
22
often lead to overbids where potential buyers express serious interests in the company or its
assets. (See id. ¶ 51.)
57. The Steering Group clearly behaved in good faith by continuously extending
milestones and working constructively with the Debtors to try to come up with a realistic and
achievable business plan. The Debtors missed numerous milestones despite multiple extensions
granted by the Steering Group. The Debtors failed to produce a rational business plan that
addressed their precipitously deteriorating comp store sales, failed to develop a plan to rapidly
close underperforming stores, and failed to provide EBITDA projections that reflected the reality
of the competitive and rapidly changing market environment in which Blockbuster struggled to
operate.
58. The Debtors’ decision to investigate a 363 sale and the Senior Secured Lenders’
agreement to participate in the process was born from the unfortunate conditions of the Debtors’
business and not from an attempt to “lin[e] the pockets of the [stalking horse bidder].”8
(Committee’s Obj. at 5.)
E. The DIP Lenders and Senior Secured Noteholders Honored All of Their Obligations
59. The Debtors actually drew over $53 million over the life of the DIP Facility,
including draws as high as $17 million and an outstanding balance as high as $26 million at one
point. (Henkin Decl. ¶ 74.) The Debtors have used those draws under the DIP Facility to fund
the company’s operations, pay administrative expenses, and preserve the enterprise. (Id.) The
DIP Lenders met each and every one of their obligations under the DIP Facility and even
8 It should be noted that the agreed upon bidding procedures to not include typical stalking horse protections and the stalking horse is not proposing a credit bid. It is proposing a cash bid and the procedures are wide open for a higher bid.
23
provided the Debtors with numerous amendments and extensions in support of the reorganization
efforts, all without any consideration. (Id. ¶¶ 11, 15.) The Creditors’ Committee would have
this Court overlook that the Debtors have also been using the DIP Lenders’ Cash Collateral,
including cash proceeds from the liquidation of what will be approximately 900 stores. (Id. ¶
80.) Instead of using the proceeds of collateral liquidations to retire secured debt, the Debtors
used the DIP Facility and other Cash Collateral to fund administrative payments to their trade
partners of over $850 million from September 19, 2010 to February 20, 2011. (Id. ¶ 74.)
60. The DIP Lenders did not commit to backstop the Debtors’ reorganization; they
backstopped a lending facility. The Creditors’ Committee misconstrues the meaning of
“backstop” in the context of the DIP Credit Agreement (Committee Objection at 3.) As
expressly set forth in the Final DIP Order, “back stop” simply refers to the commitment of the
Steering Group – the Backstop Lenders –to commit to the entire $125 million DIP Facility if,
after opening up participation of the DIP Facility to all Senior Secured Noteholders, there were
not enough commitments from those other Senior Secured Noteholders (Henkin Decl. ¶ 76; see
also Final DIP Order at 12, ¶ 6(f).) That is the only commitment the Backstop Lenders agreed to
“back stop.” They did not commit in any way to backstop the entire “reorganization process”
nor guarantee to pay all of the Debtors’ administrative expense payments to all of their vendors
and other creditors. (Henkin Decl. ¶ 76.) Of course, the Creditors’ Committee knows that the
Backstop Lenders and the other DIP Lenders have met all of their obligations as evidenced by
the fact that they cannot cite one provision of the DIP Facility which has been breached by the
DIP Lenders. Instead, they rely on false innuendo and misleading hyperbole in a smear attempt
that should not be countenanced.
24
F. The Creditors’ Committee Fails to Assert Any Legal Basis to Undo this Court’s Final DIP Order Approving the Roll-Up Notes
61. In its objection, the Committee fails to set forth any legal basis for undoing this
Court’s Final DIP Order: (i) authorizing the Roll-Up Notes; (ii) granting the DIP Agent and
Senior Indenture Trustee security interests in all of the DIP Collateral, including any of the
Debtors’ unencumbered property, to secure the DIP Obligations, including the Roll-Up Notes;
(iii) providing that the right of a DIP Lender to receive Roll-Up Notes on the occurrence of a
Roll-Up Event is indefeasible and cannot be revoked, avoided, curtailed, or impaired by the
satisfaction, repayment, termination, or acceleration of the Revolving DIP Loan or the
cancellation, reduction or termination of any commitments with respect thereto; and (iv) finding
that the DIP Facility was negotiated in good faith and at arm’s length. (Final DIP Order ¶ 8(a),
12(a), 8(a)(v), 6(h).)
62. Instead, the Creditors’ Committee makes baseless allegations that the DIP Lenders
somehow acted poorly and induced the landlords, vendors, and service providers to finance the
Debtors’ attempted reorganization with an “illusory” DIP Facility. (See Committee Objection ¶
17.) In reality, the members of the Steering Group, in their capacity as DIP Lenders, cooperated
with the Debtors and acted with the upmost good faith at all times by financing Blockbuster
throughout its attempt at reorganization. (Henkin Decl. ¶¶ 14-39.)
63. The Creditors’ Committee’s overheated allegations of bad faith constitute a gross
distortion of the facts designed to frustrate a valid disposition of the Debtors’ assets in a manner
consistent with the principles of section 363 of the Bankruptcy Code, and consistent with the
serious possibility that a public auction of the Debtors’ assets as a going concern will maximize
the value of the Debtors’ assets. Indeed, the Creditors’ Committee’s unsupported request for
25
relief would effectively negate this Court’s Final DIP Order and the good faith reliance of the
DIP Lenders thereunder.
G. The Roll-Up is Appropriate as Approved by this Court
64. The Final DIP Order granted the DIP Lenders a roll-up of $125 million of their
prepetition Senior Secured Notes (the “Roll-Up Notes”) and superpriority administrative expense
claims on such Roll-Up Notes secured by the superpriority priming liens on the DIP Collateral.
(Henkin Decl. ¶ 19.) It should be noted that the Roll-Up Notes did not inure solely to the benefit
of the members of the Steering Group, but to all DIP Lenders which are holders of
approximately 97% of the Senior Secured Notes. The Roll-Up Notes were intended to be a form
of consideration to compensate the DIP Lenders for the risk of providing the DIP Facility. (Id. ¶
19.) One of the concessions that the Steering Group made to the Creditors’ Committee in
negotiating the Final DIP Order was that any Superpriority Claims (defined in the Final DIP
Order) on account of the Roll-Up Notes would not be paid or satisfied from the Avoidance
Actions Proceeds (defined in the Final DIP Order). (Id.)
65. The Committee’s Objection also asserts that the Senior Secured Noteholders
received an “undeserved windfall” through the issuance of the Roll-Up Notes and the priority of
distribution from the DIP Collateral afforded to those notes under the Final DIP Order.
(Committee’s Objection ¶¶ 27-29.) As stated above, prior to the Petition Date, the Senior
Secured Noteholders held valid perfected liens on substantially all of the Debtors’ assets. The
discrete portion of the Debtors’ assets in which the Senior Secured Noteholders did not have
valid liens was a Danish subsidiary and one-third interest in the equity of certain of the Debtors’
foreign subsidiaries. (Henkin Decl. ¶ 72.) The Final DIP Order granted valid, enforceable, non-
avoidable, and fully perfected first priority liens on the DIP Collateral (defined in the Final DIP
Order), which included liens on the Debtors’ limited unencumbered assets. Based upon the
26
risks associated with making the DIP Loans, including the potential material diminution of the
collateral during the pendency of these cases, it was reasonable and appropriate for the DIP
Lenders to take this limited additional collateral to further secure the Senior Secured Notes.
(Henkin Decl. ¶¶ 72-73.)
66. Thus, although the DIP Liens secure both the DIP Loans and the Roll-Up Notes,
the Roll-Up Notes do not benefit from $125 million of previously unencumbered assets as
asserted by the Creditors’ Committee. Rather, the incremental collateral granted under the Final
DIP Order is limited to the value of one-third of the equity interests in certain of the Debtors’
foreign subsidiaries and the stock of the Danish subsidiary. (Id. ¶ 72.) Two-thirds of the foreign
subsidiary stock (other than the Danish subsidiary) was pledged to and perfected by the Senior
Secured Noteholders prepetition.
67. And even if the collateral securing payment of the Roll-Up Notes were limited to
the pre-petition collateral securing the Senior Secured Notes, any administrative claims asserted
by vendors or other unsecured creditors in these cases would be subject to both the Superpriority
Claims granted to the Roll-Up Notes under the Final DIP Order and the Adequate Protection
Superpriority Claims and replacement liens granted to the Adequate Protection Parties (each
defined in the Final DIP Order) under the Final DIP Order for the considerable diminution of the
value of the prepetition collateral during these cases.
II. THE SALE MOTION IS THE BEST OPTION TO MAXIMIZE THE VALUE OF THE DEBTORS’ ASSETS AND IS IN THE BEST INTERESTS OF THE DEBTORS AND THEIR ESTATES
68. The United States Trustee, the Creditors’ Committee, and Summit, have objected to
the Sale Motion and have asserted that pursuing a section 363 sale process will not produce a
better outcome for creditors than converting these cases to cases under chapter 7 of the
Bankruptcy Code. (See Trustee Objection ¶¶ 22-41; Trustee Conversion Motion ¶¶ 29-49;
27
Creditors’ Committee’s Objection ¶¶ 41-55; Summit Objection ¶¶ 13-19 (collectively, for the
purposes of this Section only, the “Conversion Arguments”).) A court can only convert a
chapter 11 case to a chapter 7 case for “cause.” 11 U.S.C. § 1112(b)(4).
69. The principal grounds for purported “cause” alleged in the Conversion Arguments
are (i) a continuing loss to or diminution of the estate and the unlikelihood of the Debtors’
rehabilitation, and (ii) the Debtors’ inability to effectuate substantial consummation of a
confirmed plan. Although these are both possible results if the Debtors continue in chapter 11,
they are not yet realities and do not constitute cause for conversion to chapter 7 at this stage of
the Chapter 11 Cases. In fact, there are strong indications that through the contemplated 363
sale, the Debtors can avoid these fates, and maximize the value of the company for the benefit of
all stakeholders.
70. The burden of showing “cause” for conversion lies with the moving party. In re
Lizeric Realty Corp., 188 B.R. 499, 503 (Bankr. S.D.N.Y. 1995); 7 COLLIER ON
BANKRUPTCY ¶ 1112.05[1]. Although the Conversion Arguments suggest that this Court is
absolutely bound to convert these cases by the language of the Bankruptcy Code if any of the
statutory grounds for “cause” is established, the bankruptcy court in fact “has wide discretion to
determine if cause [for conversion] exists and how to ultimately adjudicate the case,” and “even
if there is a finding of cause[,] a court is not obligated to convert the case.” In re The 1031 Tax
Group, LLC, 374 B.R. 78, 93 (Bankr. S.D.N.Y. 2007); see also In re Sydnor, 431 B.R. 584, 591
(Bankr. D. Md. 2010) (even if cause has been established, the court shall not act if conversion
would not be in the best interest of the creditors and estate).
71. The conversion motions should be denied here because the requested relief is not in
the best interests of either the creditors or the estate, but the 363 sale presents the only
28
opportunity for all stakeholders to preserve and maximize the going concern value of the estate
and attempt to avoid liquidation. In fact, the financial advisors to the Debtors have indicated that
at least five entities have expressed substantial interest in the sale process and have been
conducting due diligence, thereby increasing the potential for one or more overbids that may
further maximize the value of the estates to the benefit of all stakeholders. (Henkin Decl. ¶ 51.)
As such, conversion to chapter 7 is premature, and the Court should allow these cases to proceed
under chapter 11 until the 363 sale realities are fully explored or it becomes evident that the 363
sale will not be in the best interest of the creditors and the estate. See In re 15375 Memorial
Corp., 382 B.R. 652, 682 (Bankr. D. Del. 2008), rev’d on other grounds, 400 B.R. 420 (D. Del.
2009) (courts should not “precipitously sound the death knell for a chapter 11 debtor by
prematurely converting or dismissing the case”).
A. The Debtors’ Rehabilitation Is Largely Dependent On A Successful Sale Process and It Is Premature To Assume That Rehabilitation is Unlikely
72. The first purported ground for “cause” alleged in the Conversion Arguments is that
the Debtors are suffering substantial or continuing losses to or diminution of the estate and the
absence of a reasonable likelihood of rehabilitation. (Committee’s Objection ¶ 45; Trustee
Objection ¶ 34; Trustee Conversion Motion ¶¶ 39, 42; Summit Objection ¶ 16.) While it is clear
that the Debtors’ businesses have continued to deteriorate significantly (and the party suffering
the most from that deterioration is the Senior Secured Noteholders), losses to the estate only
compel “cause” for conversion if those losses ensure that rehabilitation is unlikely. See 1031 Tax
Group, 374 B.R. at 93 (“The fact that there is a continuing loss to the estate … is insufficient to
establish ‘cause’ within the meaning of § 1112(b).”); see also In re Alves Serv. Inc., 6 B.R. 690,
693 (Bankr. D. Mass. 1980) (“the inability to rehabilitate must be accompanied by continuing
loss to or diminution of the estate to constitute cause”). Here, however, it is premature to assume
29
that the diminution of the Debtors’ estates has created or contributed to the “absence of a
likelihood of rehabilitation,” and conversion under this theory would be a classic example of
putting the cart before the horse.
73. Despite the conjecture in the Conversion Arguments, the Sale Motion does not
dictate the conclusion of these Chapter 11 Cases. Rather, it establishes a process by which
various parties can bid on the Debtors’ assets at auction, a process which, by definition, is
predicated on the uncertainty of the ultimate outcome. Therefore, at this stage, it is impossible to
declare that there is no hope for rehabilitation of the Debtors’ estates. It is further disingenuous
to, on the one hand, bemoan the “absence of a reasonable likelihood of rehabilitation,” while at
the same time attempting to block the Debtors’ attempt to conduct what all parties hope will be a
competitive auction that will, at a minimum, generate value for the estate that is greater than
what could be obtained in a chapter 7 liquidation.
74. In theory, the 363 sale process proposed by the Debtors in the Sale Motion could be
the mechanism by which the Debtors achieve rehabilitation of the business. The stalking horse
bid establishes a floor price for the sale of the Debtors’ assets, not a ceiling, and the proposed
auction could yield a greater value for the estate than what could be obtained in a chapter 7
liquidation. This possibility is made promising by the fact that numerous entities have already
approached the Debtors to conduct due diligence and have expressed serious interest in bidding
on the Debtors’ assets. These circumstances increase the likelihood that one of these seriously
interested parties will submit an overbid. (Henkin Decl. ¶ 51.) See In re New Rochelle Tel.
Corp., 397 B.R. 633 (Bankr. E.D.N.Y. 2008) (denying motion to convert and reasoning that
debtor’s ongoing negotiations with and receipt of firm bids from potential buyers created
reasonable likelihood of rehabilitation).
30
75. This fact alone confirms that it is impossible for anyone – the Debtors, the Steering
Group, the United States Trustee, the Creditor’s Committee, Summit, or any other party in
interest – to declare at this early stage that the auction process proposed by the Sale Motion will
fail to rehabilitate these struggling estates. Such a determination can only be made once the
value of the estates is determined through the bidding process. It is not in the best interests of the
Debtors or their various creditor constituencies at this stage to cut the Debtors’ legs out from
under them by blocking their attempt to conduct what could be a very competitive auction
process that maximizes the value of the estates.
76. Courts routinely permit conversion only after the estate’s assets have already been
sold and the debtors are able to evaluate their financial situation. For example, in In re Mervyn’s
Holdings, LLC, et al., Case No. 08-11586 (KG) (Bankr. D. Del. 2008), the debtors’ attempt to
sell their assets was met with a motion for conversion by unsecured creditors based on grounds
similar to the Conversion Arguments asserted here. Both the debtors and their secured lenders
objected to the conversion, arguing that it was premature to force a chapter 7 liquidation as the
Debtors were preparing to institute a 363 sale process. Instead of converting the case, the Court
allowed the sale to proceed, and the debtor’s liquidation efforts remained ongoing.9 As this
authority illustrates, permitting the sale to proceed will not prohibit the Court from converting
the cases at a more appropriate time if it becomes apparent that rehabilitation is not possible. As
9 See also In re PLVTZ Inc., Case No. 07-13532 (REG) (S.D.N.Y. Oct. 27, 2008) (ordering conversion to chapter 7 only after the majority of the debtor’s assets had been sold and the period of exclusivity for filing a chapter 11 plan had expired); In re Linens Holdings Co. et al., Case No. 08-10832 (CSS) (Bankr. D. Del. Feb. 24, 2010) (ordering conversion to chapter 7 only after the debtor had liquidated most of its assets and failed to confirm a proposed plan); In re Fortunoff Holdings, LLC et al., Case No. 09-10497 (RDD) (S.D.N.Y. Oct. 1, 2009) (ordering conversion to chapter 7 only after the debtors sold off their assets, despite a motion to convert the case before the sale).
31
such, the Court should not find cause for conversion based on “the unlikelihood of the Debtors’
rehabilitation.”
B. Because the Debtors Could Propose A Chapter 11 Plan of Liquidation, it isPremature to Determine Whether or Not the Debtors Will Be Able To Effectuate The Confirmation of A Plan
77. The Creditors’ Committee further asserts that cause for conversion to chapter 7 also
exists because the Debtors will be unable to effectuate the confirmation of a chapter 11
confirmed plan for a successful sale of substantially all of their assets. (Committee’s Objection ¶
50.) This claim assumes that the Debtors are bound to effectuate a plan of reorganization, and
fails to consider the Debtors’ ability to propose and confirm a plan of liquidation under chapter
11. See In re Chameleon Sys. Inc., 306 B.R. 666, 670 (Bankr. N.D. Cal. 2004) (the Bankruptcy
Code allows for the liquidation of a debtor’s assets in the Chapter 11 context); see also In re
GPA Technical Consultants, Inc., 106 B.R. 139, 141 (Bankr. S.D. Ohio 1989) (finding that
probability of the filing of a chapter 11 plan of liquidation does not serve as ground for
conversion).
78. Moreover, a liquidation plan, pursuant to chapter 11, often allows for a less
expensive, more expeditious, and more orderly disposition of assets than if undertaken by a
trustee pursuant to chapter 7, who would be unfamiliar with the estate and its assets. For these
reasons, it is not uncommon for debtors to liquidate their assets through a 363 sale in the context
of chapter 11, which is exactly what the Debtors have proposed here. See, e.g., In re Movie
Gallery Inc. et al., Case No. 10-30696 (DOT) (Bankr. E.D.Va. Oct. 29, 2010); In re Circuit City
Stores Inc., et al., Case No. 0835653 (KRH) (Bankr. E.D.Va. Sept. 14, 2010); In re Finlay
Enterprises, Inc. et al., Case No. 09-14873 (JMP) (Bankr. S.D.N.Y. June 29, 2010); In re
Midway Games Inc., et al., Case No. 09-10465 (KG) (Bankr. D. Del. May 21, 2010); In re Value
City Holdings, Inc. et al., Case No. 08-14197 (JMP) (Bankr. S.D.N.Y. May 17, 2010). As such,
32
the contention that the Debtors are unable to effectuate a plan in a chapter 11 context is
premature and, accordingly, without merit at this stage. The Court should find no cause for
conversion based on “the Debtors’ inability to effectuate the confirmation of a plan.”
C. Conversion to Chapter 7 at This Time is Not in the Best Interests of the Creditors of the Estate
79. Even if the Court were to find the existence of “cause” for conversion under section
1112 of the Bankruptcy Code at this premature stage – and none of the purported grounds for
cause asserted in the Conversion Arguments in fact exists – the “court is not obligated to convert
the case” if it is not in the best interest of the debtor’s estate. 1031 Tax Group, 374 B.R. at 93;
Sydnor, 431 B.R. at 591. This is especially so when unusual circumstances dictate that the
requested conversion is not in the best interests of creditors and the estate. 11 U.S.C. §
1112(b)(1); see, e.g., In re The SCO Group, Inc., No. 07-11337, 2009 WL 2425755 (Bankr. D.
Del, Aug. 5, 2009) (denying multiple motions for conversion, finding that unusual circumstances
existed and that conversion is therefore not in the best interest of the creditors and the estate).
80. Here, a chapter 7 liquidation manifestly is not in the best interests of any
stakeholder. The conversion would further disrupt the Debtors’ businesses and likely will have a
significant negative effect on the value of the Debtors’ assets. (Henkin Decl. ¶ 50.) In a chapter
7 liquidation, not only would the value of the Debtors’ assets likely decrease significantly, but
Blockbuster’s enterprise value and significant trade vendor relationships – which Blockbuster
had continued to maintain and develop throughout the Chapter 11 Cases – likely would suffer
significantly or be wiped out completely. (Id.)
81. In addition to the straightforward harm that a chapter 7 liquidation would cause to
the estate, “unusual circumstances” are present here which further confirm that conversion to
chapter 7 is not in the best interests of creditors and the estate. 11 U.S.C. § 1112(b)(1).
33
Specifically, as of the Petition Date, the Senior Secured Noteholders had valid secured claims of
approximately $630 million. (Henkin Decl. ¶¶ 69-70.) Thus, notwithstanding any distribution to
be made on account of the Roll-Up Notes, under a chapter 7 liquidation of the Debtors’ assets,
general unsecured claims and chapter 11 administrative expense claims would be subject to
approximately $630 million of senior secured claims and likely would receive no recovery. (Id.
¶ 70.) In contrast, administrative claimants have been paid approximately $854 million during
these chapter 11 cases (id. ¶ 74), and will continue to be paid approximately $285 in additional
payments from these estates during the 363 sale process (id. ¶ 59). For these reasons, the sale
process will produce a better economic outcome for administrative claimants compared to
converting these cases to chapter 7. (Id. ¶ 70.)
82. Even assuming, that liquidation is imminent, there are significant benefits to
allowing liquidation in a chapter 11 context as opposed to under chapter 7. For example,
“liquidation under Chapter 11 allows the debtor in possession, one who is presumably more
familiar with the assets of the debtor's organization and its respective values, the ability to plan
for an orderly divestiture of the assets over time as opposed to a Chapter 7 trustee, who is
generally less familiar with the debtor's assets.” In re Deer Park, Inc., 136 B.R. 815, 818
(B.A.P. 9th Cir. 1992). Additionally, “[a] liquidating plan is desirable when the debtor in
possession can bring about a greater recovery for the creditors than would a straight liquidation
under Chapter 7.” Id. Likewise, courts have denied motions to convert in part because of the
“acquired expertise” by the parties’ professionals, such that costs would not be “much greater
than would occur in a proceeding under Chapter 7.” In re All Am. of Ashburn, Inc., 40 B.R. 104,
109 (Bankr. N.D. Ga. 1984). Courts have also denied conversion where “the purported savings
34
derived from a conversion would not offset the additional replacement costs.” Alves Photo Serv.,
6 B.R. at 694.
83. The sale and possible liquidation of the Debtors’ assets in a chapter 11 context
avoids the inevitable waste of time that would result from the appointment of a chapter 7 trustee
possessing no underlying familiarity with the claims against, and assets of, the Debtors or of the
complicated history of these cases. Ultimately, by remaining in chapter 11 and proceeding with
the requested 363 sale, the Debtors can maximize the going concern value of the company for
the benefit of all stakeholders. As such, conversion to chapter 7 is entirely premature, and the
Court should deny the conversion motions and permit the cases to proceed under chapter 11 until
the 363 sale realities are fully explored, or until it becomes evident that the 363 sale will not be
in the best interests of the creditors and the estate.
III. SUMMIT’S ALLEGED RECLAMATION RIGHTS ARE SUBORDINATED TO THE RIGHTS OF THE SENIOR SECURED NOTEHOLDERS AND DIP LENDERS10
84. Summit’s request for reclamation pursuant to Section 2-702 of the New York
Uniform Commercial Code (“UCC”) should be denied because, even if Summit had timely
asserted any reclamation rights to the goods in question,11 Summit’s reclamation right is subject
to the prior perfected liens held by the Senior Secured Noteholders and DIP Lenders, which
10 The Senior Indentured Trustee, on behalf of the Senior Secured Noteholders, joins in support of Section III of this reply memorandum.
11 Summit filed the Summit Motion on February 3, 2011, asserting, among other things, that it had been misled into believing the Debtors were solvent and is therefore entitled to the reclamation of those Summit titles it had shipped to the Debtors. The Debtors, in their Objection to the Summit Motion [Dkt. No. 938], demonstrated that Summit failed to carry its burden under Section 546(c) of the Bankruptcy Code, and Section 2-702(2) of the UCC, because the Debtors never misrepresented their solvency to Summit. The Debtors have established that, in the absence of any evidence that the Debtors misrepresented their solvency to Summit – indeed, the Debtors have been publicly insolvent since the outset of these cases – Summit’s reclamation claim fails as a matter of law.
35
secure claims totaling more than $630 million – an amount well in excess of the value of the
collateral securing such obligations. Summit nevertheless claims that it should be permitted “to
immediately repossess its goods” as “a matter of equity” because the Debtors made
“misrepresentations” and are “trying to ‘game the system’ and discriminate” against
administrative creditors. (Summit Objection at 8, 9, 11 n. 11, 12 n. 12.) These “equitable”
complaints about the Debtors do not support reclamation of the collateral of the Senior Secured
Noteholders and DIP Lenders because, as lien creditors, both the Senior Secured Noteholders
and DIP Lenders are considered good faith purchasers (under the applicable provisions of the
Uniform Commercial Code) of the goods Summit seeks to reclaim. In addition, the Final DIP
Order entered by this Court found that the DIP Lenders acted in good faith in negotiating the DIP
Credit Agreement, including the Roll-Up Notes. (See Final DIP Order ¶¶ 12, 13, ¶ 6(h).)
A. Any Reclamation Rights Summit May Have Are Clearly Subject to the Liens of the Senior Secured Lenders and DIP Lenders
85. Section 546(c) of the Bankruptcy Code addresses a seller’s right of reclamation and
explicitly provides that a seller’s right to reclaim goods is “subject to the prior rights of a holder
of a security interest in such goods or the proceeds thereof.”12 While section 546(c) of the
12 Section 546(c) provides, in relevant part, that:
Except as provided in subsection (d) of this section and in section 507(c), and subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof, the rights and powers of the trustee under sections 544(a), 545, 547, and 549 are subject to the right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller’s business, to reclaim such goods if the debtor has received such goods while insolvent, within 45 days before the date of the commencement of a case under this title, but such a seller may not reclaim such goods unless such seller demands in writing reclamation of such goods –
(A) not later than 45 days after the date of receipt of such goods by the debtor; or
(B) not later than 20 days after the date of commencement of the case, if the 45-day period expires after the commencement of the case.
(Footnote continued)
36
Bankruptcy Code recognizes a creditor’s right of reclamation, it is generally understood that
Section 546(c) does not grant an “independent federal right of reclamation nor does it create a
coherent comprehensive federal scheme for reclamation.” In re Dana Corp., 367 B.R. 409, 416
(Bankr. S.D.N.Y. 2007) (Lifland, J.).
86. The New York UCC generally provides a right of reclamation when “the seller
discovers that the buyer has received goods on credit while insolvent,” N.Y. U.C.C. § 2-702(2),
but the seller’s rights under Section 2-702(2) are subject to the “rights of a buyer in the ordinary
course or other good faith purchaser,” id. § 2-702(3). It is well settled that a secured creditor
with a lien on the goods subject to a reclamation demand qualifies as a “good faith purchaser for
value” of those goods for purposes of Section 2-702(2). In re Arlco Inc., 239 B.R. 261, 267-68
(Bankr. S.D.N.Y. 1999). In fact, “[m]ost courts have treated a holder of a prior perfected,
floating lien on inventory … as a good faith purchaser with rights superior to those of a
reclaiming seller.” Id.; see also In re Victory Mkts., 212 B.R. 738, 742 (Bankr. N.D.N.Y. 1997).
The seller bears the burden to prove the elements set forth in section 546(c) of the Bankruptcy
Code by a preponderance of the evidence. See, e.g., Victory Markets, 212 B.R. at 741; In re
Braniff, Inc., 113 B.R. 745, 751 (Bankr. M.D. Fla. 1990).
87. Summit cannot meet its burden here because any reclamation rights in the Summit
goods are subject to a host of liens held by the Senior Secured Noteholders and DIP Lenders on
virtually all of the Debtors’ property (id. ¶ 18), including the goods Summit seeks to reclaim, and
the value of the senior secured claims secured by such liens vastly exceeds the value of the
11 U.S.C. § 546(c)(1).
37
collateral. Putting aside the liens and secured claims under the DIP Facility, on the Petition
Date, the Debtors owed approximately $630 million to the Senior Secured Noteholders, with all
such obligations secured by liens on substantially all of the Debtors assets, including liens on the
goods Summit seeks to reclaim here. (Id. ¶ 70.) Summit does not and cannot dispute that the
Senior Secured Noteholders acquired their rights to those liens as good faith purchasers.13
88. The Creditors’ Committee has completed its investigation of the prepetition liens
securing the Senior Secured Noteholder claims and no adversary proceeding has been filed. (Id.
¶ 22.) Pursuant to the Final DIP Order, therefore, “the claims, liens and security interests of the
Senior Indenture Trustee and the Senior Secured Noteholders” have been “deemed to be finally
allowed for all purposes in these Chapter 11 Cases and any subsequent chapter 7 cases of any of
the Debtors,” and are not “subject to challenge by any party in interest as to validity, priority,
extent, perfection or otherwise.” (See Final DIP Order at 48, ¶ 28(b).)
89. The Final DIP Order also provides that all prepetition liens granted to the
prepetition lenders are preserved in favor of the postpetition DIP Lenders. Final DIP Order at
51, ¶ 31. The claims arising under the DIP Facility are likewise secured by substantially
identical liens on the Debtors’ assets, including liens on the goods that Summit seeks to reclaim.
In addition, in the Final DIP Order, this Court found that the DIP Lenders acted in good faith in
negotiating the DIP Credit Agreement, including the Roll-Up Notes. (See id. at 12-13, ¶ 6(h).)
90. Because the amount of indebtedness owed to the DIP Lenders pursuant to these
liens – $630 million – overwhelmingly exceeds the value of the goods Summit is seeking to
13 Pursuant to § 552(a) of the Bankruptcy Code, the liens granted to the Senior Secured Noteholders extend to the proceeds, products, offspring, or profits acquired by the estate after the Petition Date – including the goods Summit seeks to reclaim.
38
reclaim, that claim is effectively rendered “valueless.” Dana Corp., 367 B.R. at 419
(“Reclamation is an in rem remedy, and reclaiming sellers have no right to compel a lienholder
to satisfy its claim from other collateral.”). It is well settled that a “‘reclaiming seller is entitled
to a lien or administrative expense claim only to the extent that the value of the specific
inventory in which the reclaiming seller asserts an interest exceeds the amount of the floating
lien in the debtor’s inventory.’” Id. (citation omitted).
91. This Court applied this “prior lien defense” in In re Dana Corp., for example,
holding that the seller’s reclamation claims were “valueless” where, as here, the goods at issue
were collateral covered both by a prepetition lien as well as a DIP lien, which also “provided a
security interest in, and lien upon, all of the collateral constituting the prepetition collateral.”
367 B.R. at 420-21. The $381 million prepetition lien greatly exceeded the largest reclamation
claim of $9.6 million, id. at 419, and the “grant of the DIP Lien was a necessary condition of the
DIP Lenders’ agreement to enter into the DIP Facility,” id. at 421. Because any proceeds from
the disposition of the reclaimed goods would be applied entirely to satisfy the secured creditors’
claims, this Court found that the reclamation claims were “valueless[,] as the goods remained
subject to the Prior Lien Defense.” Id.; see also In re Dairy Mart Convenience Stores, Inc., 302
B.R. 128, 134 (Bankr. S.D.N.Y. 2003) (holding that reclamation claims were valueless in light of
secured lender’s prior existing lien on debtor’s inventory); Arlco Inc., 239 B.R. at 267-68
(finding that rights of holders of prior perfected liens on inventory were superior to rights of any
reclaiming sellers).14
14 See also In re Advanced Mktg. Servs., Inc., 360 B.R. 421, 426 (Bankr. D. Del. 2007) (“[T]he Senior Lenders’ pre-petition and post-petition liens on the Debtors’ inventory are superior to [the sellers’] reclamation claim.”); In re Pittsburgh-Canfield Corp., 309 B.R. 277 (B.A.P. 6th Cir. 2004) (reclaiming that seller was entitled to administrative
(Footnote continued)
39
92. The goods Summit seeks to reclaim are subject to the existing liens securing over
$630 million in claims of the Senior Secured Noteholders, plus the claims of the DIP Lenders.
Because the sum total of the value of all the collateral does not exceed the claims of the Senior
Secured Noteholders and the DIP Lenders, Summit may not reclaim its goods and its reclamation
claim is “valueless.”
IV. THE DEBTORS’ UNIVERSAL TITLES SHOULD BE SOLD AS PART OF THE 363 SALE
93. Universal objects to the extent that the Debtors “purport to sell any of USHE leased
titles to the Purchaser,” and argues that the Debtors “should be prohibited from selling property
which does not belong to them … unless the Debtors sequesters any revenue from such sales
sufficient to pay USHE the amount it is due under the applicable agreement under which such
titles were delivered to the Debtors.” (Universal Objection ¶ 4.) Universal’s position mistakenly
assumes that Universal has a superior claim to the discs in the Debtors’ possession as well as the
revenue generated from the sale and/or rental of such discs. To advance this position, Universal
asserts that its discs are “leased” to the Debtors.15 While the Revenue Share Agreement uses the
term “lease” in certain provisions, it is clear under the facts and circumstances, as well as the
economic realities surrounding the Revenue Share Agreement, that the discs in fact are sold to
and not “leased” by the Debtors. The Revenue Sharing Agreement (i) does not provide that
Universal retains title or any interest in the discs; (ii) does not require that the Debtors return
expense claim pursuant to valid reclamation rights, but only to the extent surplus proceeds remained after perfected security interest of secured creditor had been satisfied or released). 15 A similar position was raised by Twentieth Century Fox Home Entertainment LLC (“Fox”) in its Motion for Adequate Protection pursuant to 11 U.S.C. §§ 361 and 363(e) (the “Fox Motion”). The Fox Motion is scheduled to be heard at the March 17, 2011 hearing and, as a result, this Reply does not directly address the arguments advanced therein, however, for the same reasons advanced herein (and certain additional reasons unique to the Debtors’ agreements with Fox) the Steering Group does not believe that the agreements with Fox are leases.
40
discs received thereunder to Universal at the end of the revenue share period; and (iii) subject to
certain limitations, already permits the Debtors to sell the discs at their retail locations.
94. The Revenue Sharing Agreement imposes certain obligations upon the Debtors
which gives rise to a claim by Universal against the Debtors, but such claim is an unsecured
claim against the Debtors estates. For example, the Revenue Sharing Agreement requires the
Debtors to pay Universal an upfront fee and a share of the rental and/or sale revenue, subject to a
minimum payment in order to acquire the discs. If the Debtors fail to make any of those
payments, or fail to destroy the minimum number of discs required by the Revenue Sharing
Agreement, Universal simply has a claim against the Debtors. Because Universal did not secure
the Debtors’ obligations under the Revenue Sharing Agreement by taking a security interest in
the proceeds of the discs (or any other asset of the Debtors, including the discs themselves), its
claim is unsecured.
95. The arrangement between the Debtors and Universal dictates this conclusion, a
result that is further confirmed when the Revenue Sharing Agreement is compared with an
amendment thereto covering only one movie title (the “Amendment”). For that one title,
Universal included the following language in the Amendment:
If Blockbuster’s account is in good standing, title in and to the units of the Picture shall pass to Blockbuster upon receipt of notice from USHE. If Blockbuster’s account is not in good standing, Blockbuster shall promptly return all units of the Picture at its sole cost and expense via a carrier approved by USHE, not to be unreasonably withheld.
- and –
In order to secure Blockbuster’s obligations hereunder, including, without limitation, its obligation to pay USHE, Blockbuster hereby grants to USHE a first priority security interest in its receivables and in all rights granted by USHE to Blockbuster in connection with units of the Picture shipped to Blockbuster hereunder including any receivables derived therefrom, until title in and to such units of the Picture passes to Blockbuster.
41
The Revenue Sharing Agreement does not contain similar language, and had that agreement
operated the way Universal now contends that it does (as a lease), there would be no need to
have included the above-quoted language into the Amendment for a single title.
A. The Revenue Sharing Agreement is not a “Lease”
96. It is well-settled law that merely using the term “lease” in an agreement is not
dispositive of such agreement’s true characterization, and a court must look beyond the specific
language and examine all provisions in order to determine the true nature of the agreement. In re
Pillowtex, Inc., 349 F.3d 711, 722 (3d Cir. 2003) (court was “persuaded by the clear weight of
authority that the intent of the parties, no matter how clearly spelled out in the parties’
representations within the agreement, can not control the issue of whether the agreement
constitutes a true lease or a security agreement”) (quoting In re Homeplace Stores, 228 B.R. 88,
94 (Bankr. D. Del. 1998)); In re Tillary, 571 F.2d 1361, 1364-65 (5th Cir. 1978) (court is “not
bound by the denomination of the parties as ‘lessor’ or ‘lessee’ or the agreement as a ‘lease’; but
must look beyond the language used to determine the rights and obligations of the parties”); see
also In re Grubbs Constr. Co., 319 B.R. 698, 711-2 (Bankr. M.D. Fla. 2005)16 (“The distinction
between a true lease and a financing transaction is based upon the economic substance of the
16 It is a well-accepted practice for courts faced with the true lease versus financing arrangement issue to look to relevant decisions from other jurisdictions, since the Uniform Commercial Code has been adopted in all 50 states, and its purpose is to achieve uniformity. Pillowtex, 349 F.3d at 718 n.8 (“Because N.Y. U.C.C. § 1-201(37) is based on the Uniform Commercial Code, decisions from other jurisdictions interpreting this same uniform statute are instructive.”); Specialty Beverages, L.L.C. v. Pabst Brewing Co., 537 F.3d 1165, 1175 n.7 (10th Cir. 2008) (“In the UCC context, decisions from other jurisdictions are particularly persuasive due to the uniform nature of the UCC”); Grubbs Constr. Co., 319 B.R. at 712 (“[C]ourts dealing with the lease versus security agreement issue generally look at cases from various jurisdictions”); In re QDS Components, Inc., 292 B.R. 313, 321 n.3 (Bankr. S.D. Ohio 2002) (“Because the UCC is a uniform law, decisions from other state and federal courts interpreting § 1-201(37) also may be considered.”).
42
transaction and not, for example, upon the locus of the title, the form of the transaction or the
fact that the transaction is denominated as a ‘lease.’”).
97. The determination of whether a transaction is a lease or a financing arrangement is
subject to two tests: (i) the “bright-line” test set forth in § 1-207(37) of the UCC, as adopted by
N.Y.U.C.C. § 1-207(37); and (ii) a review of the totality of the circumstances in the case to
determine whether the economic realities of the transaction suggest that it is a financing
arrangement rather than a lease. Pillowtex, 349 F.3d at 717; In re Taylor, 209 B.R. 482, 484
(Bankr. S.D. Ill. 1997); In re Murray, 191 B.R. 309, 315 (Bankr. E.D. Pa. 1996).
1. Bright Line Test
98. Under the “bright-line” test an agreement is not considered a lease where the
consideration paid by the “purchaser” is an obligation for the term of the agreement not subject
to termination by the lessee and at least one of the other four enumerated conditions is satisfied.17
Pillowtex, 349 F.3d at 717; see also U.C.C. § 1-203, cmt. 2 (2004) (“[s]ubsection (b) further
provides that a transaction creates a security interest if the lessee has an obligation to continue
paying consideration for the term of the lease, if the obligation is not terminable by the lessee …
and if one of four additional tests is met”). Under the “bright-line” test, the Revenue Sharing
Agreement would not be considered a “lease” – the Debtors lack the ability to terminate the
17 Under N.Y.U.C.C. § 1-201(37)(a), the four residual conditions are:
(i) the original term of the lease is equal to or greater than the remaining economic life of the goods, (ii) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods, (iii) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement, or (iv) the lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease arrangement.
43
Revenue Sharing Agreement without paying Universal at least the minimum guaranteed
consideration. In addition, the Debtors satisfy at least one of the other enumerated conditions
because they have the ability to take ownership of the discs for nominal consideration –
specifically, $1.00.
2. Economic Reality Test
99. Alternatively, courts may consider the economic reality of a transaction to
determine, based on “the particular facts of the case, whether the transaction is more fairly
characterized as a lease or a secured financing arrangement.” Pillowtex, 349 F.3d at 719. To do
so, courts will look to various factors in evaluating the “economic reality of the transaction . . . in
determining whether there has been a sale or a true lease.” Pactel Fin. v. D.C. Marine Serv.
Corp., 518 N.Y.S.2d 317, 318 (N.Y. Sup. Ct. 1987). These factors include whether the purchase
option is nominal; whether the lessee is required to make aggregate payments having a present
value equaling or exceeding the original cost of the leased property; and whether the lease term
covers the total useful life of the equipment. In re Edison Bros. Stores, 207 B.R. 801, 809-10
(Bankr. D. Del. 1997).
100. The facts and circumstances here also suggest that the Revenue Sharing Agreement
is not a lease. At bottom, the Revenue Sharing Agreement is a financing arrangement whereby
Universal reduces the Debtors’ up-front acquisition costs in exchange for a “sharing” of the
revenues received by the Debtors from the rental and sale of titles acquired under the revenue
sharing agreement. Unlike traditional retailers such as Best Buy or Wal-Mart, which obtain
movie titles for resale at retail prices, the Debtors finance the acquisition of titles for a
combination of rental and retail transactions. Needless to say, Blockbuster – a name
synonymous with video rental – generates more rental transactions than retail transactions. The
Debtors’ rental transactions generate less immediate revenue than a retail transaction. The
44
Debtors’ business model and capital structure cannot sustain the same “up front” acquisition cost
as a traditional retailer. Recognizing this fact, the Debtors and Universal (among other studios)
entered into revenue sharing financing arrangements which establish a lower “up-front” payment
and a minimum “guaranteed” payment, but allow the Debtors to pay for the discs over time from
the rental and sale revenues during the revenue share period. In this regard, the Revenue
Sharing Agreement is merely a financing (or deferral) of the cost of the discs.
101. Moreover, after the Debtors obtain copies of the movie titles pursuant to the
revenue sharing arrangement they can freely rent the movie titles and are generally free to sell
the titles after a 28-day “blackout” period. During the 26-week period following the release of
the title, the revenue sharing arrangement requires the Debtors to share a portion of the revenue
from the sale and/or rental of a disc. At the end of the 26-week period, the arrangement requires
that the Debtors have paid a certain minimum amount per disc, and requires the Debtors to
destroy a certain minimum number of discs (which number could be increased to up to 100% in
the Debtors’ discretion). The Debtors must pay $1.00 for the remaining discs that are not
destroyed, but are no longer required to share rental and/or sale revenues with Universal on
account of such discs.
102. In sum, the Debtors buy discs from Universal for a smaller up front payment than
other retailers, pay Universal a portion of the proceeds from the Debtors’ rental of the discs
during a limited revenue share period, and then after limited destruction requirements, can
continue to rent or sell the inventory for as long or as little as they like after paying Universal
$1.00. They can even destroy all the inventory. Clearly, the Debtors have the benefits and
burdens of ownership on the inventory sold to them by Universal.
45
B. Aggregate Payments
103. Courts will also look to whether the aggregate payments made over the term of the
agreement equal or exceed the original cost of the property. Edison Bros., 207 B.R. at 814. “[I]f
the alleged lessee is obligated to pay the lessor a sum equal to or greater than the full purchase
price of the leased goods plus an interest charge over the term of the alleged lease agreement, a
sale is likely to have been intended since what the lessor will receive is more than a payment for
the use of the leased goods and loss of their value; the lessor will received a consideration that
would amount to a return on its investment.” Id. at 814.
104. As stated above, the revenue share structure is intended to defer the Debtors’ “up-
front” cost of obtaining titles from the studios. The arrangement does not, however, reduce or
eliminate the cost that would ordinarily be paid by the Debtors – it merely stretches out the
payments and in exchange for such terms, Universal gets a potential financing premium by way
of a share of the rental and sale revenues. If, at the end of the revenue share period, the revenue
sharing did not meet the minimum required payment, the Debtors must pay the difference.
C. Universal has no Expectation that the Discs will be Returned at the End of the Revenue Share Period
105. Courts also consider whether the useful life of the property is shorter than the term
of the agreement. Edison Bros., 207 B.R. at 816. The reasoning behind this factor is that “[a]n
essential characteristic of a true lease is that there be something of value to return to the lessor
after the term.” Id. This is because “[w]here the term of the lease is substantially equal to the
life of the lease property such that there will be nothing of value to return at the end of the lease,
the transaction is in essence a sale,” and “if the lessor expected a remaining useful life after the
expiration of the lease term, it can be reasonably inferred that it expected to retain substantial
46
residual value in the leased property at the end of the lease term and that it therefore intended to
create a true lease.” Id.
106. Especially relevant to the revenue sharing arrangement between Universal and the
Debtors is that courts have noted that even where transferred goods have a useful life extending
beyond the term of the agreement, which could reveal a transferor’s expectation of retaining
some residual value in those goods, such an inference would only be proper “where the evidence
showed a plausible intent by the transferor to repossess the goods.” Pillowtex, 349 F.3d at 720.
By giving the Debtors the discretion to destroy all discs at the end of the 26-week revenue share
period, Universal has no expectation that it will retake possession of the discs. Such a fact
clearly creates a strong inference that Universal does not believe that there is much more than
nominal value in the discs at the end of the revenue share period.
D. Universal May Have an Unsecured Claim Against the Debtors for Breach of Contract
107. As stated above, to the extent that the sale results in the Debtors breaching certain
provisions under the Revenue Sharing Agreement, Universal may have a claim for damages;
however, such damage claim is an unsecured claim that can be asserted against the Debtors’
estates and none of the Revenue Sharing Agreement, Bankruptcy Code or other applicable law
requires the Universal titles to be carved out of the sale or gives Universal a superior claim to the
proceeds of the Universal inventory sold to the Debtors.
47
WHEREFORE, for all the foregoing reasons, the Steering Group respectfully
requests that the Court grant the Sale Motion, and award such other and further relief as the
Court deems appropriate.
Dated: New York, New York March 9, 2011 Respectfully submitted,
SIDLEY AUSTIN LLP
By: /s/ John G. HutchinsonJohn G. Hutchinson James P. Seery Jr. Paul S. Caruso John J. Lavelle Alex R. Rovira 787 Seventh Avenue New York, New York 10019 Tel: 212-839-5300 Fax: 212-839-5599 [email protected]@[email protected]@sidley.com [email protected]
Attorneys for the Steering Group, and Special Counsel to the Senior Indenture Trustee,in connection with reclamation issue
EXHIBIT 1
1
UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF NEW YORK ---------------------------------------------------------------x : In re : Chapter 11 : BLOCKBUSTER INC., et al., : Case No. 10-14997 (BRL) : : (Jointly Administered) Debtors. : ---------------------------------------------------------------x
DECLARATION OF MICHAEL HENKIN IN SUPPORT OF THE STEERING GROUPS’ REPLY MEMORANDUM IN SUPPORT OF DEBTORS’ SALE MOTION
AND IN OPPOSITION TO VARIOUS SALE OBJECTIONS AND TO MOTIONS SEEKING TO CONVERT THE DEBTORS’ CHAPTER 11 CASES TO CASES UNDER
CHAPTER 7 OF THE BANKRUPTCY CODE
I, Michael Henkin, hereby declare under penalty of perjury of law as follows:
1. I am a Managing Director of Jefferies & Company, Inc. (“Jefferies”), Co-
Head of the firm’s Recapitalization and Restructuring Group, and am duly authorized to make
this declaration in connection with the Reply Memorandum (the “Memorandum”) of the Steering
Group of Senior Secured Noteholders (as defined hereafter) who are also DIP Lenders (as
defined hereafter) (the “Steering Group”), submitted in support of the Debtors’ motion for entry
of: (I) an Order Approving (A) Bid Procedures, (B) Stalking Horse Expense Reimbursement,
(C) Notice of Sale, Auction, and Sale Hearing, (D) Assumption Procedures and Related Notices,
(E) Incurrence of Sale-Related Administrative Priority Claims, and (F) Imposition of an
Administrative Stay; and (II) an Order Approving the Sale of Substantially All of the Debtors’
Assets (collectively, the “Sale Motion”), and in opposition to the various objections to the Sale
Motion and certain objectors’ motions for an order to convert the Debtors’ Chapter 11 Cases into
cases under chapter 7 of the Bankruptcy Code. Except as otherwise indicated, all of the facts set
forth herein are based upon my personal knowledge, my discussions with the Debtors and their
2
advisors, and my review of relevant documents, including the objections to the Sale Motion, or
upon information provided to me by professionals of Jefferies.
2. I have principal responsibilities for managing the ongoing financial
advisory services that Jefferies is performing on the Steering Group’s behalf, and I have
significant expertise in restructuring advisory assignments involving distressed companies,
representing both companies and creditors in a wide range of industries – including
communications, technology, manufacturing, retail, automotive, services, and consumer. I have
executed over 70 transactions, including more than 25 chapter 11 cases (and foreign
equivalents), auctions and sales under Section 363 of the Bankruptcy Code, and numerous public
/ private financings, M&A and other advisory assignments, with over $90 billion in aggregate
transaction value. I have also testified as an expert via trial, deposition, and expert reports in
connection with multiple restructurings and chapter 11 proceedings, including Adelphia
Communications, Allied Holdings, Calpine, DBSD, Extended Stay, Federal-Mogul, Loral Space
& Communications, Newcomm Wireless Services, Philip Services, and Union Power.
3. Jefferies is a global investment banking firm with its principal office
located at 520 Madison Avenue, 12th Floor, New York, New York 10022. Jefferies provides a
broad range of corporate advisory services to its clients including, without limitation, services
relating to: (a) general financial advice; (b) corporate restructurings; (c) mergers, acquisitions
and divestitures; (d) special committee assignments; and (e) capital raising. Jefferies and its
senior professionals have extensive experience in the reorganization and restructuring of troubled
companies, both out-of-court and in chapter 11 proceedings. The employees of Jefferies have
advised debtors, creditors, equity constituencies, and purchasers in many reorganizations,
3
including in connection with debtor in possession financings and Section 363 auctions and sales
processes.
4. As of September 24, 2010, Jefferies was retained to act as the financial
advisor to Sidley Austin LLP (“Sidley”), as counsel to the Steering Group, comprised of certain
beneficial holders (the “Senior Secured Noteholders”) of the 11.75% Senior Secured Notes due
2014 (the “Senior Secured Notes”) of Blockbuster, Inc. (together with its subsidiaries and
affiliates, “Blockbuster” or the “Debtors”). Since the commencement of this engagement,
Jefferies has provided financial advisory services on behalf of the Steering Group related to the
Debtors’ Chapter 11 Cases. In such capacity, Jefferies has become familiar with the Debtors’
business operations, capital structure, financing documents, and other material information.
I. The Deteriorating Performance of Blockbuster’s Business
5. The rapid decline of Blockbuster’s traditional “brick and mortar” retail
store-based customer business which precipitated these bankruptcy proceedings, is reflected in
the significant decrease in Blockbuster’s total revenues and EBITDA over the preceding three
years. For the year fiscal year ending December 31, 2008, Blockbuster’s total revenues were
approximately $5 billion with adjusted EBITDA of approximately $304 million. For the fiscal
year ending 2009, Blockbuster’s total revenues were approximately $4 billion with adjusted
EBITDA of approximately $201 million. By the fiscal year ending 2010, Blockbuster’s
revenues were approximately $3 billion and its adjusted EBITDA had shrunk to an adjusted $78
million (a 61% decrease year-over-year). (See Exhibit A attached hereto.)
6. The driving force behind Blockbuster’s poor financial performance has
been the deterioration of the company’s traditional store-based distribution channel caused by
competition from new market participants leveraging more cost effective, convenient, and
technology-driven distribution methods and channels. The alternative distribution channels –
4
including direct delivery media entertainment through direct broadcast satellite, cable television
(particularly on-demand and pay-per-view offerings), broadband Internet access, DVR-based
services such as TiVo, and digital video offerings from companies such as Apple, Amazon, and
Google – have eroded the market for the rental and sale of physical video discs.
7. As a result, the net rental revenue from Blockbuster’s sales at its domestic
retail stores that have been open for a year or more (i.e., comparative store sales, or “comp store
sales”) has trended significantly downward from a high of approximately 8.4% in the second
quarter of 2008, to as low as approximately 18% down for the fourth quarter of 2010. (See
Exhibit B attached hereto.) For example, the average comp store sales for the year ending 2008
were down 1.2%, for the year ending 2009 were down 14.6%, and for the year ending 2010 was
down another 10.4%, and that 10.4% decline were aided by the closing of a number of the worst
performing stores. (Id.) Without the closing of the worst stores and the use of the liquidation
proceeds in the business, Blockbuster’s financial performance would have been even worse.
8. Compounding the eroding margins generated by the Debtors’ retail
locations, Blockbuster also has failed to establish and maintain significant market share in the
By-Mail distribution channel (where NetFlix is the market leader), and its participation in the
Vending channel (where Redbox is the market leader) suffers from limitations under
Blockbuster’s current contractual arrangement with NCR Corporation.
II. The Plan Support Agreement
9. In this competitive and rapidly changing environment, in mid-2010,
Blockbuster recognized that its financial situation and capital structure were unsustainable. The
commencement of these chapter 11 cases (the “Chapter 11 Cases”) resulted from a months-long
negotiation process between the Debtors and the Steering Group, whose members hold in excess
of 80% in face amount of Blockbuster’s Senior Secured Notes. Prior to the commencement of
5
these Chapter 11 Cases, Blockbuster and the Steering Group entered into a plan support
agreement dated as of September 22, 2010 (the “Plan Support Agreement”) in which they agreed
to the material terms of a chapter 11 plan of reorganization and proposed exit financing.
Although the Plan Support Agreement was largely negotiated before Jefferies was engaged by
Sidley, I am generally familiar with its terms and the Plan Term Sheet which was attached
thereto.
10. The Plan Support Agreement contemplated a recapitalization of
Blockbuster whereby the approximately $630 million of Senior Secured Notes would be
exchanged for 100% of the equity interests of a reorganized Blockbuster. The recapitalization
was designed to try to provide reorganized Blockbuster with a de-levered capital structure and
the financial flexibility needed to navigate the rapidly transitioning movie content distribution
business, develop new distribution channels, and implement a viable long-term strategy. In
pursuing that strategy, Blockbuster sought to differentiate itself as the only provider of content
access across multiple delivery channels, offering convenience, service, and value to its multi-
channel customers. The Plan Support Agreement contemplated that the DIP Facility (as defined
below) would be largely undrawn at exit and that there would only be a $50 million first lien exit
revolver for the purpose of providing funding for ongoing working capital needs.
11. Given the challenging and evolving competitive environment, it was
important to the Steering Group that Blockbuster reorganize as quickly as possible to minimize
business disruption, ensure that Blockbuster maintain relevance on digital platforms (e.g., obtain
a “seat at the digital table”), and exit bankruptcy with virtually no debt. Because the key to a
successful reorganization would be a brief stay in chapter 11, and to prevent the dissipation of
assets that would result from a protracted proceeding, the Plan Support Agreement provided
6
specific milestones that the Debtors had to achieve to maintain the support of those Senior
Secured Noteholders who were parties to the Plan Support Agreement (the “Consenting
Noteholders”). The Plan Support Agreement required the Debtors, among other things, to (i) file
their Plan and Disclosure Statement by November 22, 2010 (later extended to November 30,
2010 and further extended several times and ultimately to February 18, 2011); (ii) obtain
approval of their business plan from 75% of the Consenting Noteholders (the “Supermajority of
Consenting Noteholders”) by November 30, 2010 (extended several times and ultimately to
February 18, 2011); (iii) obtain approval of the Debtors’ selection for chief executive officer of
reorganized Blockbuster from the Supermajority of Consenting Noteholders by December 31,
2010 (extended several times and ultimately to February 18, 2011); (iv) obtain an order
approving the adequacy of their disclosure statement by January 15, 2011; and (v) obtain an
order confirming the proposed plan of reorganization by March 15, 2011. The Plan Support
Agreement expressly provided that, if the Debtors failed to meet any of these milestones, the
Steering Group could terminate the Plan Support Agreement, with no further obligation to
support the plan of reorganization contemplated therein. As described below, the Debtors were
unable to meet several milestones, although the Steering Group in good faith agreed to extend
the first three milestones several times to accommodate Blockbuster and its reorganization
efforts.
III. Terms of the DIP Credit Agreement and DIP Order
12. In connection with the Plan Support Agreement and the Debtors’ proposed
restructuring, the Steering Group also agreed to allow for the consensual use of Cash Collateral
and provide debtor in possession financing so that Blockbuster would have sufficient liquidity to
conduct ordinary course business operations during the pendency of the restructuring. On
September 23, 2011 (the “Petition Date”), the Debtors filed their Motion for Entry of an Order,
7
on an Interim and Final Basis, (I) Authorizing the Debtors to Obtain Post-petition Superpriority
Financing (the “DIP Facility”) Pursuant to 11 U.S.C. §§ 105, 361, 362, 364(c), 364(d)(1), and
364(e), (II) Authorizing Debtors' Use of Cash Collateral Pursuant to 11 U.S.C. § 363, (III)
Granting Liens and Superpriority Claims to DIP Lenders Pursuant to 11 U.S.C. § 364, (IV)
Providing Adequate Protection Pursuant to 11 U.S.C. §§ 361, 362, 363, and 364, and (V)
Scheduling a Final Hearing Pursuant to Bankruptcy Rules 2002, 4001(b), 4001(c), and 6004 (the
“DIP Motion”).
13. On October 27, 2010, this Court entered a final order [Docket No. 432]
(the “Final DIP Order”) (i) authorizing the Debtors to obtain post-petition super-priority secured
financing (the “DIP Financing”) from those lenders (the “DIP Lenders”) party to the DIP Credit
Agreement, (ii) authorizing the Debtors’ post-petition use of Cash Collateral of the DIP Lenders,
the Roll-Up Noteholders (as defined in the Final DIP Order) and the Senior Secured Noteholders
(collectively, and as defined in the Final DIP Order, the “Cash Collateral”), and (iii) granting
adequate protection to the Senior Secured Noteholders and U.S. Bank National Association, as
trustee and collateral agent. Jefferies advised the Steering Group in connection with the
negotiations finalizing the use of Cash Collateral and the Senior Secured, Super-Priority Debtor-
in-Possession Revolving Credit Agreement (the “DIP Credit Agreement”). Accordingly, I am
familiar with the principal terms of the DIP Financing.
14. Since the date of Jeffries’ retention, I have observed the Steering Group
engage in extensive, good-faith, arm’s-length negotiations with the Debtors concerning terms
and provisions of the DIP Financing and the use of Cash Collateral. Given Blockbuster’s
continued downward trending revenues and the increasing obsolescence of Blockbuster’s “brick
and mortar” distribution platform (as evidenced in the quite recent liquidation of Movie Gallery,
8
a former Blockbuster competitor), the Steering Group was very concerned about its pre-petition
exposure as well as the loans that would be made to Blockbuster under the DIP Credit
Agreement. These concerns were particularly acute in light of the likely diminution of the
collateral securing the DIP Financing and the Senior Secured Notes through the closing of stores
and the dissipation of the liquidation proceeds in the business.
15. The Steering Group therefore structured the DIP Facility and negotiated
DIP covenants and other terms to protect the DIP Lenders’ exposure on new money loans to be
made to Blockbuster. For example, the DIP Facility was structured as a revolving loan facility
subject to an approved budget. Like many out of court revolving credit facilities, the structure
limited the Debtors’ ability to draw the loans to compliance with an approved budget and
satisfaction of conditions precedent. The revolving facility also required immediate repayment
from cash above an agreed upon maximum. In addition, like the Plan Support Agreement, the
DIP Credit Agreement required the Debtors to meet specific milestones by certain dates.
Specifically, the Debtors were required to (i) obtain a final order approving the DIP Credit
Agreement by October 23, 2010 (extended by the DIP Lenders to November 7, 2010); (ii) obtain
critical vendor orders with respect to Sony Pictures Home Entertainment Inc., Warner Bros.
Home Entertainment Inc., and Twentieth Century Fox by October 28, 2010; (iii) file a plan of
reorganization that conformed to the requirements of the Plan Support Agreement in all respects
by November 22, 2010 (later extended to November 30, 2010 and further extended several times
and ultimately to February 18, 2011); (iv) obtain approval by the Requisite DIP Lenders of an
updated business plan by November 30, 2010 (extended several times and ultimately to February
18, 2011); (v) obtain an order approving the disclosure statement of a plan that conforms to the
requirements of the Plan Support Agreement in all respects by January 15, 2011 (extended to
9
February 18, 2011); and (vi) obtain an order confirming a plan that conforms to the requirements
of the Plan Support Agreement by March 15, 2011. The Debtors’ failure to meet any of these
milestones would constitute an Event of Default under the DIP Credit Agreement and a
Termination Event under the Final DIP Order.
16. The budget process was a central component of the DIP Facility. Under
the terms of the DIP Credit Agreement, each month Blockbuster was required to submit a
proposed budget to the DIP Lenders for approval by holders of 75% of the DIP loan
commitments (the “Requisite DIP Lenders”). The initial 13-week budget filed with this Court as
an exhibit to the DIP Motion indicated that, from the beginning of these cases through the week
commencing January 9, 2011, the largest outstanding balance under the DIP Financing would be
approximately $69.2 million, with no single draw by the Debtors exceeding $23 million, and a
balance of only $16.5 million for the week ending January 15, 2011.
17. To further protect the DIP Lenders, the DIP Credit Agreement also
required mandatory payments (but without a reduction of the DIP commitments), if on any
Friday the aggregate treasury cash of Blockbuster exceeded $25 million in the month of
December, or $20 million dollars in any other month. The excess amounts of the agreed-upon
cash thresholds were to be applied to reduce the then-outstanding balance on the DIP Facility.
As the Debtors liquidated more of the DIP Lenders’ collateral, their cash budgets improved such
that the December budget provided a $2.3 million DIP balance for the week ending January 16,
2011, and a zero DIP balance for the week ending January 30, 2011.
18. The Final DIP Order granted the DIP Lenders valid, enforceable non-
avoidable and fully perfected first priority liens on and security interests in the DIP Collateral (as
defined in the Final DIP Order), which included first priority liens on and security interests in all
10
of the Debtors’ assets, including the Debtors’ previously unencumbered assets. To my
knowledge, the Debtors’ only material unencumbered assets were the stock of certain foreign
subsidiaries, one-third of the equity interests of certain of the Debtors’ other foreign subsidiaries
(which interests had not been pledged to the Senior Secured Noteholders for tax purposes), and
the Avoidance Actions (as defined in the Final DIP Order). In addition, the Senior Indenture
Trustee received, on behalf of the Senior Secured Noteholders, adequate protection of their
interests in their Prepetition Collateral (as defined in the Final DIP Order), including Cash
Collateral (as defined in the Final DIP Order), in an amount equal to the aggregate diminution in
value of the DIP Lenders’ security interests in their Prepetition Collateral as a result of, among
other things, the Debtors’ sale, lease, or use of cash collateral and any other Prepetition
Collateral, and the priming of the Senior Secured Noteholders’ security interest and liens in the
Prepetition Collateral. That adequate protection included replacement security interests in and
liens upon all the DIP Collateral other than the Avoidance Action Proceeds (as defined in the
Final DIP Order).
19. The Final DIP Order also granted DIP Lenders a roll-up of $125 million of
their prepetition Senior Secured Notes (the “Roll-Up Notes”), granting the Roll-Up Notes
superpriority administrative expense claims secured by the priming liens on all of the DIP
Collateral. The Roll-Up Notes were intended to be a form of consideration to compensate the
DIP Lenders for the risk of providing the DIP Facility, but the Roll-Up Notes would only arise
and become effective upon either (i) the occurrence of a Termination Event under the Final DIP
Order and the acceleration or maturity of the DIP Obligations, or (ii) if this Court approved a
disclosure statement for any plan of reorganization or liquidation of any of the Debtors that did
not reflect the terms contained in the Plan Term Sheet or terms consented to by the Requisite
11
DIP Lenders. One of the concessions that the Steering Group made to resolve concerns raised
by the Creditors’ Committee regarding the DIP Financing, as reflected in the Final DIP Order,
was that any Superpriority Claims (as defined in the Final DIP Order) on account of the Roll-Up
Notes would not be paid or satisfied from the Avoidance Actions Proceeds (as defined in the
Final DIP Order). In addition, it should be noted that the Roll-Up Notes were reduced by 50%
(from $250 million to $125 million) through the process of negotiating a consensual Final DIP
Order with the various parties-in-interest, including the Creditors’ Committee.
20. The Final DIP Order further provided that no costs or expenses of
administration of the Chapter 11 Cases or any future proceeding, including liquidation in
bankruptcy, would be charged against or recovered from the DIP Collateral, the Prepetition
Collateral, or the Cash Collateral pursuant to section 506(c) of the Bankruptcy Code or any
similar principle of law without the prior written consent of the Requisite Lenders (as defined in
the DIP Credit Agreement) or the Requisite Noteholders, as applicable.
21. The foregoing protections were heavily negotiated at arm’s length with the
Debtors and the Creditor’s Committee, and the Final DIP Order entered by this Court found that
the DIP Lenders had acted in good faith in negotiating the DIP Credit Agreement, including the
Roll-Up Notes. (See Final DIP Order at 12-13, ¶ 6(h).) Indeed, as discussed above, the DIP
Lenders in good faith made several concessions to the Creditors’ Committee so that a consensual
DIP Facility could be approved by this Court. Furthermore, subsequent to the entry of the Final
DIP Order, the Creditors’ Committee requested that the Challenge Period (as defined in the Final
DIP Order) for commencing a cause of action pursuant to paragraph 28 of the Final DIP Order
be extended from the original expiration date of December 27, 2010. The Requisite DIP Lenders
12
in good faith granted that request and agreed to extend the Challenge Period to February 1, 2011,
and then further extended the Challenge Period for a third time to February 11, 2011.
22. Pursuant to those extensions, upon information and belief, the Creditors’
Committee conducted a thorough investigation of the DIP Financing and the liens and the
obligations related to the Senior Secured Notes, and ultimately completed that investigation
without taking any actions or commencing an adversary proceeding. The time to challenge the
DIP Financing, the prepetition Senior Secured Notes, and all of the liens has now passed. (See
id. at 48, ¶ 28(b).)
IV. The October 2010 Business Plan
23. Under the terms of the Plan Support Agreement and the DIP Credit
Agreement, Blockbuster was required to meet various milestones, submit monthly budgets, and
obtain approval of its business plan by the Requisite Lenders by no later than November 30,
2010. From September 23, 2010 through February 24, 2011, the DIP Lenders approved each
proposed budget that the Debtors submitted for approval (in October, November, December,
January and then week-to-week until the budget period ending February 24, 2011, the date on
which the Debtors filed the Sale Motion). By approving each of those budgets, the DIP Lenders
authorized Blockbuster to use their Cash Collateral and the DIP Financing to fund the day-to-day
operations of the company and to pay administrative expenses.
24. Despite amendments to the DIP Credit Agreement and extensions of the
milestones under the DIP Credit Agreement and Plan Support Agreement, the Debtors were
unable to present an economically viable business plan that the Steering Group could approve,
largely because the Debtors’ declining financial performance accelerated much more rapidly
than expected following the Petition Date. Indeed, since the commencement of these Chapter 11
Cases, Blockbuster’s net rental revenue comp store sales have continued to decline at an
13
alarming pace, falling from negative 5% on September 5, 2010 to as low as negative 38% in
mid-February 2011. (See Exhibit C attached hereto.) Since September 5, 2010, net rental
revenue comp store sales have declined 18.1%. (Id.) If the rate of decline continues at this
magnitude, the vast majority of Blockbuster’s stores will go cash flow negative within 12-24
months.
25. In connection with the business plan milestone, on or about October 12,
2010, Blockbuster’s management presented the Steering Group with its first proposed Business
Plan (the “October Business Plan”). When compared to Blockbuster’s recent financial
performance and the increasingly competitive business environment confronting the company,
the Steering Group believed, and I agreed, that the October Business Plan presented an overly
optimistic forecast of Blockbuster’s projected financial performance over the subsequent five-
year period.
26. To provide greater context, prior to the Petition Date, Blockbuster had
produced at least two business plans forecasting adjusted EBITDA for the year ending 2010. A
Business Plan dated March 8, 2010 projected Blockbuster’s adjusted EBITDA to be as high as
$201 million for the year ending 2010. (See Exhibit D attached hereto.) Just four months later in
July 2010, however, Blockbuster revised its Business Plan, forecasting its adjusted EBITDA for
the year ending 2010 to be approximately $113 million, representing an approximate 44%
decrease compared to its initial Business Plan. (See id.)
27. In the October Business Plan, Blockbuster optimistically projected year-
end adjusted EBITDA for 2010 at approximately $88 million (representing a 22% decrease from
the July Business Plan), increasing to $98 million for the year ending 2011, and increasing
further to $142 million for the year ending 2012, to $168 million for the year ending 2013 and up
14
to $192 million for the year ending 2014. (See Exhibit E attached hereto.) With respect to
domestic store revenues, the October Business Plan projected revenues of $1.9 billion for 2010, a
year-over-year decline of negative 24%. However, following fiscal year 2010 domestic store
revenues were projected to stabilize for years two and three at around $1.6 billion, then falling to
$1.2 billion in 2014 representing a negative 18% change from the prior year. (See id.)
28. Assessing the October 2010 Budget in light of Blockbuster’s recent actual
negative double digit comp store trends in domestic net rental store revenues over the prior three
years, the Steering Group was concerned as to whether management’s financial forecasts as set
forth in the October Business Plan could be achieved. Indeed, if the recent comp store sales
downward trend continued, then based on the Debtors’ own store financial model, approximately
two-thirds of the Debtors’ stores would be cash flow negative within 24 months.
29. The Steering Group also was concerned, and I agreed, that the October
Business Plan did not focus on increasing and accelerating brick-and-mortar store closures, but
rather on engaging in negotiations with landlords to obtain rent reductions and shorter lease
terms under various lease “kickouts” (including, for example, sales-based kickout clauses, where
failure to meet sales targets would trigger the right to terminate a lease) and other termination
rights. The Steering Group acknowledged that some potential cost improvements could be
achieved through lease renegotiations, but believed that the company’s time and resources would
be better utilized – and its goal of cost rationalization and reorganization better served – by
focusing on store closures rather than on lease renegotiations. The Steering Group encouraged
the Debtors to re-focus their efforts on rightsizing the store base through closing stores affected
or most likely to be affected by the continuing downward trend in comp store sales. In tandem
15
with this priority on closing poor-performing stores, the company could simultaneously engage
in lease renegotiation efforts with respect to its better performing stores.
30. The Steering Group further believed, and I agreed, that many of the
assumptions underlying the October Business Plan were contradicted by empirical market data as
of the time it was delivered for approval. For example, Blockbuster projected significant growth
in its By-Mail and Vending businesses at a time when Blockbuster’s major competitors, Netflix
and Redbox, were capturing significant market share through robust increases in sales at
Blockbuster’s expense. Moreover, Blockbuster failed to account for the additional pricing
pressure that competitors such as Netflix and Redbox were generating in the marketplace and the
significant costs associated with customer acquisitions in such a competitive environment.
V. The Steering Group Approves Blockbuster’s $17 Million Advertising Campaign
31. In light of the Steering Group’s expressed concerns regarding the October
Business Plan, Blockbuster indicated that it would refine and revise its forecasts and financial
projections. During the subsequent weeks, however, Blockbuster’s financial performance
continued to rapidly deteriorate while its competitors continued to increase their market presence
in the rapidly growing and more popular distribution channels. In late October, Blockbuster’s
management requested the DIP Lenders’ consent to the use of approximately $20 million in
addition to the previously budgeted expenditures to invest in an advertising campaign running up
to and through the expected busy holiday season (the “Q4 Ad Campaign”).1
32. Management’s strategy behind the Q4 Ad Campaign was to increase
customer awareness of Blockbuster’s unique 28-day window advantage, whereby selected new
1 In addition to the Q4 Ad Campaign, Blockbuster’s management also requested additional cash then budgeted in order to bid on certain intellectual property being sold in the Movie Gallery bankruptcy cases. Again, the Steering Group approved this non-budgeted amount, although Blockbuster was ultimately unsuccessful in purchasing the Movie Gallery intellectual property.
16
release movie titles are available at Blockbuster exclusively for a period of 28-days before
competitors such as Netflix and Redbox are able to obtain such titles from the movie studios.
Management believed that this aggressive advertising campaign would lift poor performance
leading into and through the busy holiday season, and prevent further declines in the business.
Specifically, management expected that the Q4 Ad Campaign would drive an 8.6% increase in
net rental revenue comp stores sales and approximately $8 million in gross margin. (See Exhibit
F attached hereto.)
33. The Steering Group was skeptical, as was I, that the Q4 Ad Campaign
would produce the results forecasted by management. Nevertheless, in a good faith-effort to
support management’s attempt to increase customer awareness and reverse or slow further
deterioration of Blockbuster’s business during the holiday season, the Steering Group
unanimously approved an expenditure of approximately $17 million for the Q4 Ad Campaign
(only slightly less than the $20 million spend requested by management), over and above the
previously budgeted amounts. The Steering Group also agreed, at the Debtors’ request, to
amend the definition of EBITDA in the DIP Credit Agreement to allow an add-back of
approximately $10 million relating to the Q4 Ad Campaign so that the Debtors would not trip
their minimum EBITDA covenant, which would be tested at year-end. Without this add-back, it
is doubtful that Blockbuster would have met its year-end minimum EBITDA covenant under the
DIP Credit Agreement, and the Debtors could have defaulted under the DIP Credit Agreement
much earlier in these Chapter 11 Cases.2
34. Through negotiations with TV networks, Blockbuster obtained minimum
target rating point guarantees from each TV network assuring that approximately 87% of 25-46
2 Actual cash EBITDA for 2010 was $1.3 million before non-recurring adjustments such as the Q4 Ad Campaign adjustment.
17
year olds within the targeted audience would be expected to see Blockbuster’s new commercials
at least three times. Blockbuster’s advertisements aired during popular programs such as the
Dancing with the Stars finale, Christmas special programs, Desperate Housewives, Modern
Family, Good Morning America, the Macy’s Thanksgiving Day Parade, NFL Thanksgiving Day
games, and other NFL and college basketball games.
35. On January 11, 2011, Blockbuster’s management held a meeting with the
Steering Group during which management presented, among other things, the results of the $17
million Q4 Ad Campaign. Notwithstanding the aggressive spend, management revealed that the
stores had not experienced a meaningful difference between the pre- and post- advertising
campaign launch, and performance was significantly down from 2009 levels for the comparable
period. (See Exhibit G attached hereto.) Indeed, the net rental revenue and total rental revenue
comp store sales experienced a negative result against the same period in 2009. Accordingly,
notwithstanding the Steering Group’s good-faith efforts to provide Blockbuster with additional
liquidity to increase customer awareness through the Q4 Ad Campaign, Blockbuster’s core
business continued to deteriorate rapidly. Management’s inability to generate a return on capital
from the Q4 Ad Campaign also further called into question the Debtors’ ability to generate a
return on capital under its long-term business plan.
VI. The November 2010 Business Plan
36. On or about November 23, 2010, Blockbuster’s management presented a
newly revised business plan to the Steering Group (the “November Business Plan”, together with
the October Business Plan, the “Proposed Business Plans”). The November Business Plan
continued to forecast net rental revenue comp store sales that appeared difficult to achieve given
market conditions, and difficult to reconcile with the Debtors’ actual recent and historical
financial performance. Specifically, the plan showed net rental revenue comp store sales of
18
negative 6% for the year ending 2010, up to negative 1.4% for the year ending 2011, negative
1.9% for the year ending 2012, negative 2.7% for the year ending 2013, and negative 2.8% for
the year ending 2014. (See Exhibit H attached hereto.) Compared to the significantly downward
historical trend of net rental revenue comp store sales since 2008, with average comp store sales
of negative 14.6% for the year ending 2009 and negative 10.4% for the year ending 2010,
management’s November forecast of very modest 1.4% - 2.8% annual net negative rental
revenue comp store sales appeared unduly optimistic. Indeed, Blockbuster’s actual performance
after the Petition Date had deteriorated substantially, as weekly net rental revenue comp store
sales continued to drop precipitously from 2009 levels in the range of negative 5% to negative
40% through mid-February 2011. (See Exhibit C attached hereto.)
37. In addition, the November Business Plan forecasted that EBITDA would
increase over the subsequent five years, despite the fact that EBITDA had decreased
substantially from 2008 through 2010 due to competitive headwinds and rapidly changing
industry dynamics. Specifically, the November Business Plan forecasted year-end adjusted
EBITDA for 2010 at approximately $82 million then increasing to $86 million for the year
ending 2011, up to $129 million for the year ending 2012, up to $143 million for the year ending
2013, and up to $172 million for the year ending 2014. (See id.) Although these numbers were
lower than those contained in the October Business Plan discussed above, the positive EBITDA
trend was similar to the projections contained in the October Business Plan which was difficult
to reconcile with Blockbusters’ actual comp store performance.
38. Furthermore, the November Business Plan for the first time also called for
a new equity investment of $190 million into Blockbuster, but failed to explain the uses and
potential return from such proposed equity investment. The November Business Plan simply
19
stated, without any specific allocation or detail, that the purpose of the $190 million equity
investment was to (i) provide liquidity; (ii) underscore the company’s near-term financial
viability; (iii) reserve committed capital for future digital business development; (iv) ensure trade
partner confidence; (v) secure studio exclusive content investments; and (vi) support other
strategic growth opportunities. Despite requests from the Steering Group, Blockbuster did not
provide support for how it intended to use the proposed $190 million equity investment, or
demonstrate how the equity infusion was expected to generate real return on investment.
Needless to say, the Steering Group had no obligation to make any such equity infusion under
either the Plan Support Agreement or the DIP Credit Agreement.
39. The Steering Group engaged in extensive discussions with the Debtors’
professionals to address its concerns about the November Business Plan. In connection with
these ongoing discussions, the Debtors agreed that further revisions to their business plan were
necessary, and the Requisite DIP Lenders agreed to amend the DIP Credit Agreement to extend
the Third Milestone – the date by which the Debtors were required to file a Disclosure Statement
and Plan with this Court and to obtain approval of a Business Plan – from November 30, 2010 to
December 15, 2010.
VII. The Steering Group Considers The Liquidation Value of the Debtors’ Assets as a Benchmark to Compare With the Debtors’ Business Plan
40. During the time that Blockbuster was preparing a further revised business
plan in late November and December 2010, the Steering Group began to consider the liquidation
value of the Debtors’ assets pursuant to chapter 7 of the Bankruptcy Code, or a sale of all or
substantially all of the Debtors’ assets pursuant to section 363 of the Bankruptcy Code, as a
benchmark to compare with the Debtors’ Proposed Business Plans. The Steering Group’s
consideration of these alternatives was based upon, among other things, the continued
20
deterioration of Blockbuster’s financial performance, the poor return on capital generated by the
$17 million Q4 Ad Campaign, Blockbuster’s request for a $190 million new equity investment
without any clear return on investment from such a capital infusion, and the company’s inability
to present a rational plan with respect to a reduced store footprint in light of the declining comp
store sales performance. During this time, however, the Steering Committee and its
professionals continued to work in good faith with Blockbuster and granted additional extensions
of the milestones to accommodate Blockbuster’s management and the Debtors’ restructuring
efforts.
41. On or about December 14, 2010, the Requisite Lenders consented to a
further good-faith extension of the Third Milestone to January 14, 2011 in order to provide
Blockbuster with additional time to evaluate the company’s performance during the holiday
season, and to revise its forecasts accordingly. As the Debtors amended their Business Plan in
advance of the revised Third Milestone deadline of January 14, however, Blockbuster’s business
continued to decline, calling into question Blockbuster’s ability to achieve even a significantly
discounted budget.
42. At the January 11, 2011 meeting referenced in paragraph 35 above,
Blockbuster’s management presented a financial update to the Steering Group. Management
conceded that the company’s financial performance had deteriorated to a much greater extent
than it had forecasted just weeks earlier, and reported that adjusted EBITDA for the year ending
2010 was approximately $87 million as compared to $201 million for the year ending 2009, a
decrease of approximately 57%. Management also reported at this meeting that the $17 million
Q4 Ad Campaign had not produced the expected results, and that Blockbuster in fact had
experienced decreased net rental revenues against the same period in 2009. At this presentation,
21
management also noted that the number and pace of store closings would have to increase
substantially in light of the significant continued downward trend of comp store sales, the
decrease in customer foot traffic, and the flawed assumptions made by management in its
Proposed Business Plans regarding Blockbuster’s ability to stem the significant declines in year-
over-year same store comp sales.
43. It was at this meeting that Blockbuster’s management stated that
Blockbuster’s Board of Directors had authorized management to consider other restructuring
alternatives, including a section 363 sale of substantially all of the Debtors’ assets. Management
reported that the Board of Directors would consider stalking horse bids from lenders in the
Steering Group given that those lenders were fully familiar with Blockbuster’s assets and
operations, and would be in the best position to quickly commence a 363 sale process as a
stalking horse bidder. In addition, shortly after the January 11 meeting the Debtors’ management
and advisors disclosed for the first time that the gross administrative claims incurred during these
Chapter 11 cases (including the studios “roll-up” of approximately $65 million of prepetition
claims) were approximately $285 million – far greater than the Steering Group had known based
upon the prior information and budgets provided to it by the Debtors and their advisors.
VIII. Payments Made During the Chapter 11 Cases & “Trade Neutrality”
44. As the Steering Group considered the liquidation value of the company
and potential recoveries from a sale of all or substantially all of the Debtors’ assets as alternative
paths to maximize the value of the estates, it closely reviewed the company’s cash burn through
the Chapter 11 Cases, and the expenses that would be required to get the company to an auction
and sale of the Debtors’ assets.
45. For example, in the month of September 2010, Blockbuster’s
administrative expenses (total domestic accounts payable and accrued expenses) were
22
approximately $225 million, with approximately $90 million in accounts payable and accrued
expenses attributable to the movie studios and company’s other trade vendors (with the
remainder relating to critical expenses such as compensation, taxes, insurance, and customer
deferred revenue and expenses such as gift cards and prepaid subscriptions). (See Exhibit I
attached hereto.)
46. As the Chapter 11 Cases progressed, Blockbuster’s administrative
expenses (total domestic accounts payable and accrued expenses) continued to grow
significantly, especially leading into the holiday season. For example, one month later in
October 2010, Blockbuster’s total administrative expenses grew to approximately $292 million,
with approximately $130 million in accounts payable and accrued expenses attributable to the
movie studios and company’s other trade vendors. In November and December of 2010,
Blockbuster’s administrative expenses increased further to over $320 million. (See id.) Given
the Debtors’ continued decreasing comp store sales and the negative impact of the $17 million
Q4 Ad Campaign – during what should have been the company’s busiest and most profitable
fiscal quarter in light of the Thanksgiving and Christmas holiday seasons – the significant growth
in total domestic accounts payable and accrued expenses became unsustainable. The expenses
and the cash burn were simply too great.
47. Nevertheless, throughout the Chapter 11 Cases, the DIP Lenders have
continued to approve a significant amount of payments from the Debtors to their trade partners in
order to maintain commercial relations and preserve the going concern value of the enterprise.
Most notably, among the biggest beneficiaries of the use of the Cash Collateral – the studios,
which provide content to Blockbuster – have been paid over $175 million from September 19,
2010 to February 27, 2011, a large portion of which is on account for product delivered to the
23
Debtors prior to the filing. In further support of preserving the enterprise, the DIP Lenders also
approved Blockbuster’s payment of over $39 million to its games vendors and over $37 million
to its merchandise vendors during that same time period.
48. In light of management’s January 11, 2011 presentation – which showed
that adjusted EBITDA for year ending 2010 had decreased from 2009 approximately 57% and
net rental revenues had decreased against the same period in 2009 notwithstanding the $17
million Q4 Ad Campaign – the Steering Group’s consideration of alternatives to preserve the
value of its collateral became more imperative.
49. Indeed, with Blockbuster facing the pending milestone deadline of January
18, 2011 (which had been extended for the third time from the original date of November 30,
2010), the Steering Group considered whether to terminate the DIP Facility and seek conversion
of the Chapter 11 Cases to liquidation cases under chapter 7. Alternatively, the Steering Group
considered whether the path for maximizing the value of the Debtors’ estates would instead
result from consenting to the Debtors’ further use of the Senior Secured Noteholders’ pre-
petition Cash Collateral while Blockbuster proceeded to a public auction of its assets and
businesses – as Blockbuster’s management had proposed at the January 11, 2011 meeting.
50. Blockbuster asserted that the conversion of the Chapter 11 Cases to a
chapter 7 liquidation would further disrupt the Debtors’ businesses and likely would have a
significant negative effect on the value of the Debtors’ assets. Moreover, in a chapter 7
liquidation not only would the value of the Debtors’ assets likely decrease significantly, but
Blockbuster’s enterprise value and significant trade vendor relationships – which Blockbuster
had continued to maintain and develop throughout the Chapter 11 Cases by spending the Senior
24
Secured Noteholders’ Cash Collateral – likely would suffer significantly given the Senior
Secured Noteholders’ pre-petition senior secured $630 million claim.
51. The Steering Group concurred with the Debtors’ conclusion. The Steering
Group believed, and I agreed (and continue to believe), that a 363 auction and sale process would
be the best way to maximize Blockbuster’s value as a going concern. In my experience, 363
auctions often lead to overbids where potential buyers express serious interest in the company or
its assets. In fact, I have subsequently been advised by Rothschild, the financial advisor to the
Debtors, that five or six potential purchasers have been conducting due diligence since the Sale
Motion was filed, and have expressed serious interest in the company.
52. Accordingly, the Steering Committee determined that it would forbear
from exercising its rights to terminate the DIP Credit Agreement and the Plan Support
Agreement, and instead would further extend the Third Milestone from January 18, 2011 to
February 4, 2011. During this extension, the DIP Lenders agreed to work with Blockbuster to
approve a short-term budget through the remainder of January and February, and to assess the
process and structure of a potential sale of all or substantially all of the Debtors’ assets through
an auction and 363 sale in the Chapter 11 Cases to preserve the ongoing value of the Debtors’
businesses. The Debtors set a deadline of January 28, 2011 for initial proposals from members
of the Steering Group to become a stalking horse bidder in the potential 363 sale of the Debtors’
assets.
53. During the discussions to approve a budget for the company between the
filing of a sale motion and completion of a sale process, Blockbuster’s management maintained
that it was important to ensure that Blockbuster’s trade partners – the movie studios, game
providers, maintenance and janitorial service providers, landlords, utilities, and employees –
25
would not be prejudiced through the extension of unsecured credit during the period after
January 17, 2011. Accordingly, management proposed the concept of “trade claim neutrality,”
which would allow management to closely monitor Blockbuster’s expenses and disbursements to
attempt to ensure that no trade creditor’s claim would increase from January 17, 2011, essentially
freezing the amount of such claims as of that date.
54. As such, on January 17, 2011, the DIP Lenders approved a budget for the
Debtors to pay their administrative expense creditors for goods and services provided to
Blockbuster after January 17, 2011, thereby ensuring that all administrative expense creditors
would be treated essentially equally in the post-January 17, 2011 period. Management
maintained that these creditors would provide value to the estates from their continued provision
of goods and services, enabling the Debtors to sell their assets in an orderly process and maintain
their going concern values. Importantly, in pursuing “trade claims neutrality,” the Debtors
continued to pay the major movie studios revenue share or “rent” payments on account of
product delivered to the company prior to January 17, 2011, and some product delivered pre-
petition,
55. Upon information and belief, it is my understanding that management held
discussions with Blockbuster’s significant trade vendors notifying them of the trade claim
neutrality concept. I understand from discussions with management and advisors to the Debtors
that the trade claim neutrality was not favorably received by various vendors and, indeed, several
vendors threatened to stop providing goods and services. From on or about mid-January 2011,
all the major movie studios, for example, stopped shipping product to the Debtors on previously
agreed trade terms, but agreed to provide product on a cash in advance basis. The DIP Lenders
26
agreed that the Debtors could use the Cash Collateral to make such cash advance payments to the
studios.
56. As the Debtors negotiated with two potential stalking horse bidders that
emerged from the Steering Group, the DIP Lenders continued to work with the Debtors to
approve a budget for the Debtors to consensually use Cash Collateral through the filing of a sale
motion, the public auction of the Debtors’ assets, and the closing of any such sale. In addition,
the Debtors negotiated bidding procedures and a sale process that reflects time constraints caused
by the continuing cash burn from business losses and downward-trending same store comp sales.
To prevent disruption of these negotiations and the preparations for the filing of a sale motion,
the Steering Group agreed to continue to forbear from exercising its rights to terminate the DIP
Credit Agreement and the Plan Support Agreement, and instead consented to again extend the
Third Milestone from February 4, 2011 to February 18, 2011.
57. As the Court is aware, the Debtors filed their sale motion on February 21,
2011, based on their decision to enter into a purchase and sale agreement with an entity named
Cobalt Video Holdco LLC, which consists of four of the members of the Steering Group.
IX. The Termination of the DIP Credit Agreement and Plan Support Agreement With Consent to Use Cash Collateral to Preserve the Value of the Debtors’ Estates
58. Through the negotiations to approve a budget for the payment of
Blockbuster’s expenditures during the sale process, the Debtors determined that they would not
need to draw down on the DIP Facility, and would be able to pay the expenses incurred during
the sale process solely through the consensual use of Cash Collateral. Indeed, the proposed sale
budget contemplates the use of Cash Collateral to pay over $285 million in total operating
expenses from February 27, 2011 through the closing date of the sale (on or about April 17,
2011). The Cash Collateral is generated through the operations of the Debtors’ business and the
27
ongoing liquidation of inventory at closed stores which is collateral of the holders of the Senior
Secured Notes.
59. Of the $285 million total operating disbursements to be paid from Cash
Collateral during the sale period, approximately $65 million is allocated for payment to movie
studios, game providers, and general merchandise providers; approximately $68 million is
allocated for payment to landlords, utilities, and maintenance; approximately $84 million is
allocated for payment of rank-and-file employee compensation and benefits; approximately $25
million is allocated for payment of taxes; and approximately $40 million is allocated for payment
of other operating expenses such as insurance, information technology, and freight/postage.
These amounts represent all budgeted expenditures during the sale period.
60. Given all of the facts and circumstances leading up to the filing of the
Debtor’s motion to sell all or substantially all of the Debtors’ assets as described herein, and the
Debtors’ inability to meet the requirements by the Third Milestone Date (among other things),
the Requisite DIP Lenders determined to exercise their right to terminate the DIP Credit
Agreement, and a Supermajority of the Consenting Noteholders determined to exercise their
right to terminate the Plan Support Agreement.
61. On February 25, 2011, the DIP Agent, as directed by the Requisite DIP
Lenders, and the DIP Lenders notified the Debtors of the occurrence of and continuation of
certain Events of Default under the DIP Credit Agreement, exercised their rights to terminate the
DIP Credit Agreement, and declared all obligations under the DIP Facility due and payable. On
February 25, 2011, the Requisite Consenting Noteholders notified the Debtors of the occurrence
of and continuation of certain Termination Events under the Plan Support Agreement, and
exercised their rights to terminate the Plan Support Agreement. Also on February 25, 2011, the
28
DIP Agent, as directed by the Requisite DIP Lenders, and the DIP Lenders delivered to the
Debtors, United States Trustee, and the Creditors’ Committee the Carve-Out Trigger Notice (as
defined under the Final DIP Order) notifying each of a Termination Event under the Final DIP
Order, that all obligations under the DIP Facility had been accelerated, that the Post Carve-Out
Trigger Cap had been invoked, and that the delivery of the Carve-Out Trigger Notice constituted
a Roll-Up Event (as defined under the Final DIP Order).
X. Analysis of Administrative Claims
62. Given the amount of disbursements that have occurred during the course
of the Chapter 11 Cases (to virtually every constituency except the Senior Secured Noteholders),
it is important to discuss the estimated amount of Administrative Claims.
63. The most recent estimated amount of administrative expense claims
provided by the Debtors’ financial advisors, which is as of February 24, 2011, is approximately
$281 million. It is notable that of this estimated $281 million, according to the Debtors’
financial advisor, at least $132 million is expected to be either assumed, paid in cash,
reclassified, satisfied by cash collateralization pursuant to pre-petition vendor term requirements,
or may be satisfied through enforcement of a lien. After taking into consideration these
reductions, an estimated $148 million in administrative expense claims will remain, which
represents a greatly reduced figure relative to the total of $281 million. (See Exhibit J hereto for
a description of the estimated Administrative Claims.)
64. Furthermore, according to the company’s budget, Blockbuster expects to
disburse approximately $170 million to various trade and non-trade vendors for ongoing
operating expenses during the sale process from February 27, 2011, and leading up to the
estimated sale closing on or about April 17, 2011. The amount of these additional
disbursements demonstrates the intense cash needs of Blockbuster’s business, and the DIP
29
Lenders’ consent to the use of their Cash Collateral to pay such administrative trade and non-
trade vendors further demonstrates their ongoing good-faith efforts to maximize value for the
Debtors’ estates. Of this $170 million, approximately $50 million represents payments to movie
studios, $17 million represents payments to other product vendors such as game vendors, and
$34 million represents payments to non-product vendors. Significantly, all of these anticipated
payments will be paid cash in advance. As such, the administrative expense claims pool is not
expected to increase during the sale process as the April 17 sale date approaches.
65. It is also important to emphasize again that, throughout the course of these
Chapter 11 Cases, the DIP Lenders have extended credit and worked in good faith to create a
value-maximizing restructuring of the Debtors’ estates, thus providing substantial benefits to
many other constituents. In fact, while the DIP Lenders have worked in concert with the Debtors
by extending milestones, providing unplanned expenditures for the Q4 Advertising Campaign,
and continuously providing additional time to amend the Proposed Business Plans, the studios
have continued to benefit from the ongoing business relationship with Blockbuster,
notwithstanding the Debtors’ financial challenges. Specifically, during the Chapter 11 Cases,
Blockbuster has paid approximately $175 million to the movie studios through February 27, and
is now paying the movie studios on a cash-in-advance because they have refused to extend credit
terms to the Debtors.
66. It is equally important to understand the composition of the movie studios’
estimated administrative expense claims. As of February 24, 2011, the studios’ total claims are
estimated to be $116 million, comprising approximately 41% of the total estimated
administrative expense claims prior to any adjustments to the claims pool as discussed herein.
Pursuant to the Asset Purchase Agreement filed as an exhibit to the Sale Motion, the studios
30
negotiated to receive a payment of approximately $25 million for assumed obligations. In
addition, the Debtors’ financial advisors have indicated that the studios that are secured by the
liens on the Debtors’ Canadian assets (including Sony Pictures Home Entertainment Inc
Twentieth Century Fox Home Entertainment LLC and Warner Home Video) may benefit from
that lien.3 All told, the studios’ claim could potentially be reduced to approximately $91 million.
(See Exhibit J hereto.)
67. In addition to this potential reduction of the studios’ $116 million
administrative expense claims, it should be noted that approximately $65 million of such claims
are not truly post-petition administrative expense claims at all, but rather a roll-up of the studios’
pre-petition claim pursuant to the terms of the Accommodation Agreements with Blockbuster
that the studios executed at the commencement of these Chapter 11 Cases. As such, after taking
into consideration these adjustments, the studios’ post-petition administrative expense claim
could effectively amount to zero. (See Exhibit J hereto.)
XI. Response to Objections to Sale Order
68. I understand that certain parties in interest, including the United States
Trustee and the Creditors’ Committee, have objected to the Sale Motion and have asserted,
among other things, that (i) pursuing a 363 sale process would not produce better outcomes for
creditors compared to converting these cases to chapter 7, and (ii) a 363 sale process would
benefit only the Senior Secured Noteholders. I disagree with those assertions.
69. Prior to the Petition Date, the Senior Secured Noteholders held valid,
perfected, first priority liens on substantially all of the Debtors’ assets, including a pledge of two-
3 It should be noted that these movie studios secured by the Debtors’ Canadian assets obtained the liens in and against the Canadian assets prepetition by threatening to stop shipping to Blockbuster, essentially shutting Blockbuster down.
31
thirds of the equity interests in the Debtors’ foreign subsidiaries. The Debtors’ only material
unencumbered assets that had not been pledged to the Senior Secured Noteholders were certain
equity interests in some of the Debtors’ foreign subsidiaries. The Challenge Period (as defined
in the Final DIP Order) during which the Creditors’ Committee could have challenged the liens
of the Senior Secured Noteholders has expired. No challenge was brought.
70. As of the Petition Date, the Senior Secured Noteholders had valid secured
claims of approximately $630 million. Thus, under a chapter 7 liquidation of the Debtors’ assets,
general unsecured claims and chapter 11 administrative expense claims would be subject to
approximately $630 million of senior secured claims and almost certainly would receive no
recovery. In contrast, as set forth above, prior to and through the 363 sale process,
administrative vendor claimants have been paid substantial amounts during these chapter 11
cases and are budgeted to receive approximately $127 million in additional cash payments from
these estates during the sale process. Thus, pursuing the sale process is economically a better
outcome for administrative claimants compared to converting these cases to chapter 7.
71. The Creditors’ Committee has also asserted that the Senior Secured
Noteholders have received an “undeserved windfall” through the issuance of the Roll-Up Notes
and the priority of distribution from the DIP Collateral afforded to those notes under the Final
DIP Order. I disagree.
72. As stated above, prior to the Petition Date the Senior Secured Noteholders
held valid perfected liens on substantially all of the Debtors’ assets. The one discrete portion of
the Debtors’ assets in which the Senior Secured Noteholders did not have valid liens was on
Blockbuster’s Denmark subsidiary and a one-third interest in the equity of certain of the Debtors’
other foreign subsidiaries. The Final DIP Order granted valid, enforceable, non-avoidable, and
32
fully perfected first priority liens on and security interests in the DIP Collateral (as defined in the
Final DIP Order), which included liens on and security interests in the Debtors’ unencumbered
assets -- the remaining one-third equity interests in the Debtors’ foreign subsidiaries. Based
upon the risks associated with making the DIP Loans, including the potential material diminution
of the collateral during the pendency of these cases, it was reasonable and appropriate for the
DIP Lenders to take this limited additional collateral to secure the DIP Obligations (as defined in
the Final Order).
73. Thus, although the DIP Liens secure both the DIP Loans and the Roll-Up
Notes, the Roll-Up Notes do not benefit from $125 million of previously unencumbered assets as
asserted by the Creditors’ Committee. Rather, the incremental collateral granted under the Final
DIP Order is limited to one-third of the equity interests in certain of the Debtors’ foreign
subsidiaries.
74. I also understand that the Creditors’ Committee has asserted that the DIP
Lenders in these Chapter 11 Cases effectively issued an “illusory DIP Facility.” I disagree with
this claim. In fact, the Debtors’ actually drew over $53 million over the life of the DIP
Financing, and the greatest amount drawn on the DIP Financing was $26.2 million. The
Debtors used those draws to fund the company’s operations, pay administrative expenses, and
preserve the enterprise. As described above in paragraph 47, the Debtors used the DIP Facility
and the DIP Lenders’ pre-petition Cash Collateral to fund various administrative payments to
their trade partners and others of over $854 million from September 19, 2010 to February 27,
2011, including over $174 million to studios, $39 million to games vendors, $37 million to
merchandise vendors, $151 million to landlords, and $146 million to employees.
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75. Furthermore, the fact that the current balance of the DIP Facility is zero
does not render the facility “illusory” at all, but rather is a function of a specific covenant in the
DIP Credit Agreement – which was set forth on day one and known to the Creditors’ Committee
and the Court – that required Blockbuster to use excess cash to make mandatory pre-payments of
any outstanding revolving loans under the DIP Facility at the end of each week if Blockbuster
had treasury cash in excess of $20 million (or $25 million during the month of December). That
covenant was designed to protect against draw-downs under the DIP Credit Agreement that were
not needed in the Debtors’ business, but also to ensure that Blockbuster had sufficient access to
liquidity during its reorganization. Indeed, the Plan Support Agreement contemplated that the
DIP Facility would be largely undrawn at exit, with only a new $50 million first lien exit
revolver thereafter.
76. I also disagree with the Creditors’ Committee’s claim that the “Backstop
Lenders” somehow committed to “backstop the reorganization process they pledged to sponsor.”
(Creditors’ Committee Objection at 3.) The Committee misconstrues the meaning of “backstop”
in the context of the DIP Credit Agreement. In fact, “backstop” refers only to the commitment
of the five members of the Steering Group – the Backstop Lenders – who agreed to commit to
fund the entire $125 million DIP Facility if, after opening participation in the DIP Facility to all
Senior Secured Noteholders, there were not enough commitments from those other lenders to
fully fund the $125 million. That is, the Backstop Lenders agreed to provide a fully committed
DIP facility regardless of whether any other Senior Secured Noteholders agreed to participate in
the facility. They did not commit in any way to backstop the entire “reorganization process” nor
guarantee to pay all of the Debtors’ administrative expense payments to all of their vendors and
other creditors.
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77. I also disagree with the Creditor’s Committee’s claim that the DIP
Lenders somehow acted improperly by causing the Debtors to default under the DIP Facility,
thus triggering the issuance of the Roll-Up Notes, by refusing to reach consensus among
themselves with respect to the Debtors’ Proposed Business Plans. If the DIP Lenders had
intended to cause a default in the manner imagined by the Credit Committee, they never would
have agreed to extend the milestones under the DIP Credit Agreement and the Plan Support
Agreement multiple times after November 30, 2010, but would have triggered the default at the
time the Debtors initially failed to meet the first deadline.
78. Instead, the DIP Lenders granted multiple extensions of various
milestones in good faith, agreed to amend the DIP Financing, and consented to multiple budgets
after November 30, 2010 that enabled the Debtors to fund their operations and pay
administrative expenses in excess of $473 million between December 5, 2010 and February 27,
2011. I also do not believe that the DIP Lenders would have agreed to fund the $17 million Q4
Ad Campaign at management’s request if they harbored any intent to capture an “undeserved
windfall,” as the Creditors’ Committee suggests. And I certainly do not believe that the DIP
Lenders actually received an “undeserved windfall” as the Debtors have disbursed approximately
$854 million of the Senior Secured Noteholders’ pre-petition Cash Collateral to fund their
operations and pay administrative expenses to the benefit of many other constituents during these
Chapter 11 Cases, including the use of approximately $16.3 million in proceeds from 207 stores
already closed and have actually received approximately $21.7 million in proceeds from 780
stores that are in the process of being liquidated and which have also been pledged as collateral
to the Senior Secured Noteholders.
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79. Accordingly, while some of the DIP Lenders may have had different
investment strategies internally, such differences did not trigger the termination of the Debtors’
reorganization efforts. Rather, the Plan Support Agreement and DIP Credit Agreement were
terminated for all the reasons I discussed above. It is undisputed that the Debtors defaulted
under the terms of the Plan Support Agreement and the DIP Credit Agreement by missing
numerous milestones despite multiple extensions granted by the DIP Lenders. The Debtors
failed to produce a business plan that addressed Blockbuster’s precipitously deteriorating comp
store sales, or develop a plan to rapidly close underperforming stores, or provide forecasts that
reflected the reality of the competitive and rapidly changing market environment in which
Blockbuster struggled to operate. Instead, the Debtors invested capital in a $17 million Q4 Ad
Campaign that unfortunately failed to produce the expected results. They later requested an even
larger, $190 million equity investment without providing support for the uses or expected return
on such an investment, and without finding any interested investors to fund such a plan. And
during the entire time, the company’s financial performance continued its significant decline.
80. The reality of the situation is that rather than an “undeserved windfall,”
the Senior Secured Noteholders are the parties that have been most negatively affected by the
Debtors’ poor performance during these Chapter 11 Cases. Senior Secured Noteholder collateral
from approximately 900 stores has been or will be liquidated and used to fund the business,
including the post-petition payment of approximately $850 million to studios, other product and
non-product vendors, landlords, taxing authorities, employees, service providers and others. No
interest or other payments have been made on account of the Senior Secured Notes.