Business Law

ESL Investments, Inc v. Sears Holding Corp (2nd Cir.)

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The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:


The Second Circuit Court of Appeals (the Second Circuit) recently held that a bankruptcy court was permitted to deviate from replacement value in deciding whether there had been any diminution in value of second-lien creditors’ collateral such that they would be entitled to an administrative priority claim for diminished value.  A valuation based on net orderly liquidation value was reasonable under the circumstances.  ESL Investments, Inc v. Sears Holding Corp, 2022 U.S. App. LEXIS 28584, 2022 WL 7772911, ____ F. 4th ___ (2nd Cir. October 14, 2022). 

To view the opinion, click here.


When Sears Holding Corporation and affiliates (the debtors) filed chapter 11 in 2018, the automatic stay prevented various lien creditors from foreclosing on their collateral or otherwise enforcing defaulted loans.  The Bankruptcy Code provides that when a creditor is so restrained, § 363(e) compels the debtor in possession to give adequate protection to such creditors to the preserve the petition date value of the secured creditors’ collateral.  This appeal arises from motions filed by several second-position secured creditors asserting that the value of their collateral, which was sold during the bankruptcy proceedings to an affiliated creditor by way of a credit bid, had fallen during the case and that they were thus entitled to an administrative priority claim for that diminution in value.  These motions compelled the bankruptcy court to determine the value of the collateral on the petition date.  The relevant collateral was primarily the retail inventory of the debtors when the case was filed.

The bankruptcy court held an evidentiary hearing at which expert witnesses presented various theories on that value.  The valuations ranged from a low of $2. 46 billion to a high of $3.28 billion, with book value at $2.69 billion.  The difference in the values turned on how the experts calculated the revenue debtors could expect to earn from selling the inventory, whether it would be for full retail value, a depressed, going-out-of-business or liquidation price, or an orderly, company-wide sale which would set a net orderly liquidation value (NOLV).  The bankruptcy court adopted the NOLV based on the fact that on the petition date a complete liquidation of the debtors’ assets was a realistic possibility.  It decided that the inventory’s NOLV was 87.4% of the book value, a figure which would result in no post-petition diminution in value when all factors were considered.  (The bankruptcy court also took into consideration the value of some other assets which arguably secured the debt, including letters of credit and “non-borrowing base” inventory, in reaching that conclusion.  This review does not address those rulings by the bankruptcy court nor by the Second Circuit.)

The second-lien creditors appealed, arguing that the bankruptcy court was compelled by the Supreme Court’s decision in Associates Commercial Corp v Rash, 520 U.S. 953 (1997) to use replacement value, which would have resulted in a higher petition date valuation.  The district court affirmed, as did the Second Circuit.


The Second Circuit reviewed the application of Rash to the facts of this case de novo.  Rash involved a chapter 13 debtor who attempted to exercise the “cram down” option afforded by 11 U.S.C. § 1325 (a)(5)(B) which allows a debtor to retain a creditor’s collateral so long as the creditor is paid the present value of the collateral.  The Supreme Court determined that the present value of the subject collateral – a tractor trailer that the debtor used in his business – should be set at replacement value rather than a liquidation value since the debtor intended to “retain and use” the truck, not surrender it or allow foreclosure, the other options available to him.  The second-lien creditors in Sears asserted that the debtors were “retaining” the property on the petition date and further argued the retention was so that debtors could “use” it to generate revenue. 

The Second Circuit took issue with the argued “use” of the collateral, seeing it quite differently than the Rash debtor’s use.  It looked to the language of Bankruptcy Code § 506(a), under which secured collateral is valued, and noted that the statute instructs the value “shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property.”  It then considered the realistic and primarily undisputed fact that when the debtors filed their petitions, the likelihood of their continuing normal retail operations was slim.  The more realistic prediction would be that the debtors would conduct an orderly liquidation sale of all assets, including the collateral inventory.  For that reason the bankruptcy court had weighed the expert opinions and determined that the NOLV, which would fall somewhere in between the replacement/retail value and the foreclosure/liquidation value, was the appropriate measure of value when the cases were filed. The known facts did not support an ongoing retail operation nor a sale of the entire business as a going concern, so piecemeal sales of the major assets, including the inventory collateral, was most probable.  Therefore, the NOLV represented the realistic measure. 

Although the creditors had also argued that the bankruptcy court’s reduction to only 87.4% of book value was impermissibly low, the Second Circuit observed that decision was a factual finding which the appellants had not demonstrated was clearly erroneous.  It affirmed the bankruptcy court’s rulings, which resulted in no diminished value and therefore no administrative priority claim.


The Second Circuit’s departure from Rash’s replacement value approach is sound, given the difference between how the Rash debtor intended to use the collateral – retain it and use it in his business to generate income – and the realistic possibilities facing the Sears debtors on the petition date.  Only if they were going to remain open as retail stores would the facts have paralleled Rash’s rationale; even the testifying experts did not view that as probable.  The bankruptcy court might have chosen liquidation or fire sale value, but opted for a compromise sum based on its factual findings which were not clearly erroneous.  This circuit precedent could have an impact on collateral valuations in future chapter 11’s filed by retail stores, particularly given their uncertain niche in our marketplace based on the exponential rise in online purchases.   However, the applicable measure for valuation most likely will vary because § 506(a) valuations may be done for many purposes and the statute instructs a valuation shall be determined in light of the purposes it serves.

This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.

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