Court Declines to Approve First Brands Interim Factoring Agreement Over Due Process Concerns, Sets Feb. 2 Hearing on Adversary Proceeding Requirement; Hearing on Evolution Collateral Dispute Continued to Jan. 20

At a hearing today, Judge Christopher Lopez declined to approve the First Brands Group debtors’ interim agreement with a subset of third-party factors on their factoring procedures motion. The judge also heard evidence today on Evolution Credit Partners’ motion to enforce its stipulation for adequate protection with the debtors and on the debtors’ objection and cross-motion to authorize their continued use of Evolution’s collateral, while indicating he would schedule a further hearing on the dispute on Tuesday, Jan. 20.

Judge Lopez noted today’s hearing was set to determine whether the debtors required an adversary proceeding to release further amounts from the segregated factoring receivables account. The judge said “a lot” of terms of the order agreed to with the consenting factoring parties “makes sense,” but he declined to approve the proposed bifurcated process in the face of objections from non-settling factors Evolution, Katsume and ABC Bank, citing due process concerns.

Judge Lopez said he would give the debtors an opportunity to potentially secure the use of a portion of the segregated cash in early February as contemplated under the agreement. He set a hearing on Feb. 2 at 10 a.m. ET to determine if an adversary proceeding is required to determine entitlements to the receivables, followed by another hearing that week, potentially on Feb. 6, to determine Evolution’s entitlement to adequate protection with respect to its receivables claims.

Judge Lopez noted the hearing would assume Evolution has valid first-priority security interests given that the lender has a pending adversary proceeding asserting a security interest in certain sellers’ prepetition receivables, regardless of whether they were factored. The judge also expressed caution on the debtors’ proposal to set up a procedure akin to an interpleader action that would allow customers that are currently withholding approximately $90 million in funds to deposit the amounts with the court to avoid potential double payment liability to both the debtors and the factors. Judge Lopez said the debtors may need to initiate an adversary proceeding to assert an entitlement to the funds in order to invoke the court’s jurisdiction, but said he would “hate to see” customers violate the automatic stay.

After hearing argument and testimony from the debtors’ Co-CRO Daniel Jerneycic, Judge Lopez found that he lacked sufficient information to determine if the debtors breached their adequate protection stipulation with Evolution in its capacity as lender to special purpose vehicle debtors Patterson Inventory LLC and Starlight Inventory I LLC.

Judge Lopez rejected Evolution’s argument that the $335 million collateral maintenance threshold under the stipulation must be measured solely against inventory held in four warehouse locations, but noted Jerneycic was unable to detail the value or location of additional inventory subject to Evolution’s claims as of the true up date. The judge said he will determine on Jan. 20 if there was a breach, what remedy is appropriate and adequate protection requirements for the debtors’ continued use of the cash collateral.

Judge Lopez urged the parties to work constructively and questioned if Evolution is asking the debtors to “dump” the collateral “on the side of the road,” potentially only realizing liquidation value.

On cross examination by Charles Dale of Proskauer, counsel to Evolution, Jerneycic confirmed that the debtors could exhaust their liquidity “as soon as the first week of February.” Jerneycic also discussed the company’s efforts to improve liquidity, including potential consideration of an orderly wind-down of the company’s break business.

Robert Berezin of Weil Gotshal, counsel to the debtors, asserted that the borrowing base reporting that the stipulation was “anchored on was a complete fabrication,” adding that if the debtors were required to segregate cash to cover the approximately $44 million shortfall asserted by Evolution, it would be “game over for us.” According to Jerneycic, the value of Evolution’s collateral has only declined by approximately $7 million since the petition date.

At the outset of the hearing, debtors’ counsel Sunny Singh of Weil Gotshal reported that they have reached an agreement with the Carnaby secured lenders to continue using the lenders’ cash collateral through Jan. 15. Singh said the debtors are hoping to “get something done” to resolve the Carnaby lenders’ motions for stay relief and to dismiss the Carnaby special-purpose vehicle debtors from the chapter 11 cases before the upcoming Jan. 22 hearing on the matters.

Allan Brilliant of Dechert, representing the Carnaby secured lenders, said the parties are “working hard” to reach an agreement, but noted the debtors are under default under their adequate protection agreement.

Singh reviewed that under the interim factoring procedures agreement reached with Leucadia Asset Management, Raistone and ING Belgium, the parties agreed to streamline the potential release of cash while preserving rights. Under the revised proposal, the debtors agreed to seek the release of only amounts categorized as Category 1 (receivables sold after the company stopped third-party factoring), Category 2A (relating to customers that are not identified by the third-party factors as being one of their receivables sellers) and Category 2B (relating to combinations of selling debtors and customers not identified on factor lists).

Under the agreement, Singh said the debtors would not need an adversary proceeding to secure approximately $18.1 million of funds in these categories. However, no money would be released upon entry of the proposed order. Funds would only be released subject to further order of the court if the parties agree there is no “bona-fide dispute” over ownership, while an adversary proceeding would be required for disputes that cannot be resolved.

He noted the debtors would adjourn relief regarding Category 3 invoices (relating to customers or sellers on factor lists but lacking a specific invoice match) to allow the examiner to conduct an investigation, and would institute an adversary proceeding to determine entitlements to these amounts, if necessary.

Michael Duke of Elsberg Baker & Maruri, counsel to Evolution, raised due process issues, noting the lender had only received the proposed factoring order and reconciliation report around 1 a.m. ET this morning. Duke said Evolution filed a competing proposed order to address potential prejudice from the debtors’ proposed order, but asserted that the “rushed process” demonstrated that the factoring parties should be entitled to the protections afforded by an adversary proceeding.

Sean Scott of Mayer Brown, counsel to Katsumi, likewise argued that an adversary proceeding is necessary to resolve the “literally billions” of competing claims.

Jerneycic’s supplemental declaration in support of the factoring procedures details the debtors’ second reconciliation report regarding amounts currently held in the factoring receivables account.