💥Clash of Titans: Biglaw vs. PE Direct Lender💥

Blockbuster Part II, Professional Fee Disputes

Disruption from the Vantage Point of the Disrupted
Freemium Briefing - 9/14/18
Read Time = 4.6 a$$-kicking minutes
Twitter: @petition
Website: petition.substack.com


We were thrilled (and surprised) to learn that Fortune included PETITION in “The Ultimate Guide to the Best Business Newsletters” yesterday. We took it upon ourselves to slightly edit Fortune’s description of us so that everyone has a clear and accurate picture:

This past Sunday we released an epic anniversary-fest with coverage of the (i) 10-year anniversary of the #LehmanBrothers failure (and AIG bailout, which everyone seems to be forgetting about) and (ii) 8-year anniversary of Blockbuster Inc’s disastrous bankruptcy filing (Part II is below). We also discussed, among other things, bankruptcy fees, Toys R Us, Open Road Films LLC, Esports, a variety of at-risk companies (e.g., Endo Pharmaceutical Plc, Barnes & Noble Inc., American Tire Distributors Inc., Ultra Petroleum Corp., Spanish Broadcasting System L.P.), and Theranos’ potential assignment for the benefit of creditors. If you’re not a Member, you didn’t get the Sunday briefing. Which means you — and/or your firm — are willfully dumber than the competition. Good luck with that come bonus time. Cheers!

🗞News of the Week (2 Reads)🗞

1. ☠️R.I.P. Blockbuster Video. Part II. (Short Amort Payments)☠️

September 23 marks the eight year anniversary of Blockbuster Inc’s chapter 11 bankruptcy filing. On Sunday, in “🎆Lehman + Blockbuster = Anniversary Fever🎆,” we laid the foundation for what happened to the once-ubiquitous and revered retailer. In this Part II, we’ll pick up where we left off and discuss what pushed the company into bankruptcy. To refresh your memory, this was Blockbuster’s capital structure at the time of filing:

  • $675mm ‘14 11.75% senior secured notes

  • $300mm ‘12 9% senior subordinated notes


So what led to Blockbuster’s plunge into bankruptcy court? The company stated:

Blockbuster has faced a number of challenges in recent years, which, taken together, have had a negative impact on its overall financial performance. Recently, declining revenues have been driven by: (i) increased competition in the media entertainment industry from alternative forms of entertainment; (ii) technological advances that have changed the landscape of the industry; (iii) changing consumer preferences; (iv) the rapid growth of disruptive new competitors; and (v) the general economic environment. Given these rapid changes and the difficult operating environment of the past several years, the Debtors’ ability to transform their business in response to this ever-changing landscape was severely hindered by the high level of debt that the business had incurred during earlier periods of significantly lower competition and higher operating performance.

It then went on to note the “largest challenge.” Insert Netflix ($NFLX) here. The company stated:

Likely the largest challenge that Blockbuster has faced in the past several years is the rapid rise of new competitors that use alternative distribution methods to meet customer demand. These competitors have garnered substantial market share and have eroded the size of Blockbuster’s traditional “brick and mortar” retail store based customer market, resulting in a decline in revenues. While Blockbuster has successfully launched its own channels of distribution in the by-mail and, through its partnership with NCR, vending kiosk markets, the revenues and profits from these new channels have not offset the negative economic results from the reduced traffic within, and downsizing of, its traditional store-based channel, which historically carried stronger margins than these other channels.

But the blame doesn’t stop with Netflix. Blockbuster also highlighted direct delivery media entertainment, e.g., direct broadcast satellite, cable television, broadband internet, TiVo/DVR, and the rise of digital competitors like Apple Inc. ($AAPL) and…wait for it…wait for it…Amazon Inc. ($AMZN).

With all of this competition nipping away at revenue streams the company had to address its costs via an operational restructuring. This is where the company unleashed its trimming devices. It shed approximately $570 mm in general and administrative costs in 2009 and 2010; it closed 1,061 unprofitable company-owned stores and liquidated inventory; it divested international assets, e.g., Ireland; and it granted security interests in unencumbered collateral in exchange for new credit.

But, with over $1 billion in debt, all of the operational fixes in the world couldn’t do the trick alone. The company had to address its balance sheet. In early 2009. In the middle of the financial crisis. Riiiiiiight. This is where the Great Recession and the capital markets make their appearances, respectively, in the Blockbuster story.

Regarding the former, the company noted:

…Blockbuster has for the last two years been operating in one of the most challenging economic environments since the Great Depression. During this time, the world economy and in particular the domestic economy, has suffered a severe economic downturn. Generally, domestic unemployment has remained high and consumer spending has remained low. As a result, customer sensitivity to changes in pricing and convenience has increased, negatively impacting the performance of most retailers, including Blockbuster.

Regarding the latter, the company hired Rothschild in February 2009 — rightfully a full year and a half ahead of its ultimate bankruptcy filing — to conjure up some financing options. This was the backdrop:

At this time, during the depths of the global financial crisis, Blockbuster was facing the imminent maturity of its revolving credit facility (which was its primary source of liquidity), with effectively no access to new capital given the state of the bank and bond markets and the accelerating deterioration of its financial performance.

In other words, the capital markets were, for all intents and purposes, closed. You couldn’t paint a more perfect storm for a business.

Consequently, these circumstances forced Blockbuster to replace its credit facility with a…

…steeply amortizing term loan that carried high rates of interest and fees and an amortization schedule that significantly reduced available liquidity and constrained operations.

This, for those who don’t remember or were to young to recognize the lessons of the financial crisis, is what happens when there is no longer a fervent frenzy for yield, baby, yield. Covenants return. Amort payments return. It is definitely not — in contrast to today — a borrower’s market. For Blockbuster, indeed it was NOT a borrower’s market.

And but for the sale of the Ireland assets and the liquidation of excess game inventory, liquidity would have been even more effed.

Shortly thereafter, in October 2009, Blockbuster issued $675mm in (quarterly amortizing) senior secured notes to refinance out the term loans and and get out ahead of its onerous and significant amortization payments. This gave the company a little bit of breathing room provided…provided…that it could execute on its business.

It couldn’t. The company continued to suffer as (i) competitors rapidly expanded, (ii) big-box retailers discounted sales of new-release titles, (iii) it failed to secure the 28-day competitive advantage on key titles ahead of the holidays, and (iv) just generally poor holiday performance. To put some numbers around just how bad it was:

In fiscal year 2009, revenues generated by the Debtors’ domestic segment decreased by 15.6%, declining same store comparables resulted in a $1.0 billion decrease in revenue, and Blockbuster reported a loss of $558.2 million.

Adding to the perfect storm, the announcement of these generally horrendous numbers triggered an expected response: (i) the company’s security prices declined considerably; (ii) the media homed in exacerbating matters; and (iii) the company now had to deal with tightening trade credit in both its domestic and international markets, all of which helped further constrain liquidity.

By March 2010, the company had to draw water from a stone. As negotiations with the various constituents in the company’s capital structure took place, the business continued to falter and, ahead of a $43mm amort payment on the new(ish) senior secured notes, the company was forced to lien-up unencumbered Canadian collateral in exchange for an additional 30 days of credit terms.

At and around the same time, the company attempted an out-of-court transaction pursuant to which the senior subordinated noteholders — the lowest tranche in the capital structure — would equitize their positions and backstop a rights offering that would infuse the business with a $100mm injection of much-needed cash. Under this plan, the senior secured notes would be left unimpaired and reinstated. But the business was deteriorating too quickly. This plan was wishful thinking. The company’s rapidly diminishing valuation simply didn’t support it. And so the company and its advisors had to turn to Plan B.

We’ll discuss that Plan B and more in Part III on Sunday.

2. Professional Fees (Long Nasty Records)

We expect to see more disputes over professional fees as (i) rates continue to rise into the stratosphere and (ii) large asset management firms try to exert their considerable pull. The good thing is that the rest of us can just sit back, pop some popcorn and put our feet up. A brawl between biglaw and a direct lender is WAY more entertaining than, say, Pacific Rim.

Late last week, Cerberus Business Finance LLC (“CBF”) gave Hughes Hubbard & Reed LLP (“HH&R”) some light weekend reading when it objected to the firm’s fees in the Patriot National Inc. (“PN”) case — an objection that Cerberus said “will not come as a surprise to Hughes Hubbard.” Cerberus stated (Docket 1001):

Given the Debtors' obvious financial distress and substantial cash needs for operations, CBF very vocally expressed its concerns regarding the potential magnitude of all professional fees and the need to manage them and keep them under control. Among other things, CBF specifically questioned whether these cases were "too small" for Hughes Hubbard, and whether it would more efficient and cost effective for the Debtors to be represented by a firm with a Delaware office and significant experience representing Chapter 11 debtors. Hughes Hubbard (who had previously been counsel to the Board of Directors of Patriot National, Inc. and choreographed the termination of the Debtors' prior counsel in order to take on that role themselves) was party to those discussions with CBF, was thus acutely aware of CBF's concerns, and at the request of CBF provided- and agree to abide by - a specific line-item budget relating to the performance of legal services for the Debtors. Hughes Hubbard also agreed that prior to incurring fees beyond the agreed budget (whether for unforeseen events or otherwise), Hughes Hubbard would seek the approval of the Debtors and CBF.

Nothing like one paragraph that simultaneously says (i) the law firm Game of Thrones’d its way into the representation, (ii) wasn’t the first or preferred choice, (iii) is inadequately suited for debtor cases, (iv) flagrantly busted a “specific line-item budget,” and (v) didn’t adhere to its pre-petition agreement to keep the lines of communication open about fees.

Cerberus further argued that, among other things, HH&R was inefficient. It noted:

Even the most cursory review of the actual time entries evidences the fact that senior attorneys were devoting substantial time and attention to matters that more properly should have been handled by more junior attorneys or paralegals.

A law firm tried to make as much money possible? Never in a million years would we expect that to happen.

Meanwhile, we find it very interesting that it at last appears that a future owner of a company — by way of a debt for equity swap — is understanding the extent that professional choices can result in (potential) value leakage to the estate. Indeed, as the now owner of PN, CBF has every incentive to claw back HH&R’s fees because each incremental dollar that it doesn’t pay to HH&R remains with and enhances the value of PN.

And so this is precisely what HH&R focuses on in its response. Indeed, HH&R wastes no time whatsoever leading off its response by stating (Docket 1011):

The Objection should be seen for what it is: an attempt to improve Cerberus’ return on a bad investment by shifting the cost of these Chapter 11 Cases to estate professionals. Having lent close to $200 million to the Patriot Debtors only to see the business collapse within a year, Cerberus apparently is frustrated by the Bankruptcy Code’s requirement that part of the price of confirming a chapter 11 plan of reorganization is paying the professional fees incurred in achieving that result. This Objection is brought out of naked self-interest. Now that the cases are over and the Plan effective, Cerberus simply does not want to pay the fees.

Bam! Counter-punch! Nothing like one paragraph that, if we may paraphrase, essentially says (i) you’re a crappy investor, (ii) you reap what you sow, (iii) you obviously don’t read PETITION enough because you clearly didn’t recognize that bankruptcy is big business (sorry, we had to), and (iv) you’re not even remotely slick, bro.

For good measure, HH&R throws Schulte Roth & Zabel LLP under the bus, highlighting that its invoices came in well over the budgeted amount for HH&R —creating a record that it, too, is certainly no bargain.

Moreover, HH&R highlights a fundamental issue with bankruptcy cases these days: who is the client? Clearly CBF believed it to be them. HH&R begged to differ.

Speaking of clients, HH&R sure seems to be cautioning law firms about what it might expect from the way CBF does business. HH&R wrote:

Cerberus waited until after Hughes Hubbard achieved confirmation of the Debtors’ chapter 11 plan of reorganization to object to Hughes Hubbard’s fees, despite the fact that Hughes Hubbard timely filed monthly fee statements in these Cases—fee statements that made it clear from the beginning that the fees incurred were substantially more than the DIP budget envisioned. Much like the numerous other estate professionals that Cerberus has stiffed throughout these cases (except its own professionals who demanded and received prompt payment from the Debtors), Cerberus refused to fund any interim payments to Hughes Hubbard after a single payment of $364,706.

This tactic of lying in the weeds while Hughes Hubbard achieved the results Cerberus wanted and then objecting to the fees required to achieve those results is inherently dishonest. It is also fundamentally unfair. The Court should not tolerate it here.

Something tells us that CBF’s direct lending competitors will have a field day with that language. Something also tells us that HH&R won’t be servicing any companies with CBF in the cap stack anytime soon. Yes, call us Captain Obvious.

At the end of the day, we can’t believe that this dispute saw the light of day. Clearly there is no love lost between HH&R, Schulte and CBF and now the record is replete with unflattering commentary about all three. Their loss. Our gain.

A hearing on the HH&R application is scheduled for tomorrow, Thursday September 13.


We want to also note that it’s fundamentally unfair to HH&R that The Wall Street Journal covered CBF’s objection without covering HH&R’s response.
WSJ Pro Bankruptcy@WSJBankruptcy

A lender that took over Patriot National after the company sought chapter 11 protection says the insurance firm’s lawyers went over budget to complete the restructuring https://t.co/zU6XNGYBgt

September 10, 2018
Not cool. It’s almost as if CBF planted the story. 🤔

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