by Meanwhile, in Texas, Buddy Mac gets approval to keep paying people, and in New Jersey, Brian Kahn pleads guilty
WILMINGTON, Del. — In a breathless week for bankruptcy proceedings, including those of Franchise Group, Buddy Mac Holdings and American Signature, the top headline is, of course, former FRG CEO Brian Kahn pleading guilty in federal court in New Jersey to defrauding investors of about $350 million through Prophecy Asset Management. He faces up to five years in prison, according to a transcript of the hearing, and his sentencing has been set for April 2.
In the same Delaware bankruptcy court as the FRG case, the U.S. trustee in the American Signature bankruptcy filed a pair of lengthy objections to the debtors’ plans, arguing that the restructuring process is riddled with conflicts of interest that could suppress competitive bidding and, in the end, shortchange creditors.
The trustee, Andrew R. Vara, challenged the debtors’ motion to approve bidding procedures for selling substantially all assets, especially a proposed “stalking horse” bid proposal. Vara objects because the bidder is owned by the Schottenstein family, the same family that controls the debtors.
As we reported a few days after the initial bankruptcy filing just before Thanksgiving, there is at least one Schottenstein in the C-suite, or on the board, or both, on virtually every side of the proposed transaction. According to court documents, the family indirectly owns American Signature through various trusts. They also wholly own ASI Purchaser, the stalking horse bidder that was presumably formed to make the bid. Additionally, the family holds a 60% stake in the parent company of both the pre-bankruptcy lender and the current bankruptcy financing provider.
“The Schottenstein family stands on all sides of the proposed sale and related transactions,” Vara’s objection states, a reaction to the fact that the family owns or controls the sellers, the proposed buyer, the lender and even the liquidation consultant running store-closing sales, according to American Signature’s own filings.
Raft of objections
Vara raised four primary objections to the American Signature reorganization proposal, with the most significant focusing on proposed “bid protections” worth at least $1.5 million in expense reimbursements, plus an unlimited “augment purchase” provision. These protections are usually to compensate a stalking horse bidder for the time and expense of conducting due diligence and making an initial bid. Vara argues that they are unnecessary because no inducement was needed to encourage a bid from an entity the family created and owns for this exact purpose.
Also problematic, according to the motion objecting to the plan, is the timing of disclosure. The stalking horse bidder will not have to reveal the amount of the reimbursement for additional inventory acquired for liquidation sales until Christmas Day, just five days before the Dec. 30 bid deadline, while other aspects of the stalking horse bid will not be disclosed until Jan. 2, which is after the deadline for bids has passed. Potential competing bidders, therefore, would have to submit financing commitments and firm bids without knowing the actual minimum amount required to qualify.
“It is unclear how the Debtors expect potential bidders to submit Qualified Bids when the bidders will not even know the minimum required bid amount before the Bid Deadline,” Vara’s objection notes.
Vara also objects to granting the payments “super priority” status, which would place them ahead of other administrative expenses in the bankruptcy. The objection argues that the U.S. Bankruptcy Code only authorizes such priority for post-bankruptcy lenders and inadequately protected secured creditors, neither of which applies to a stalking horse bidder.
Price of privacy
If you are old enough to remember the big Living.com bankruptcy in the early 2000s, a big question then was whether a buyer of assets out of bankruptcy would be obligated to fulfill the terms of the privacy policy under which personally identifiable information was collected by the debtor. This has come up again, in the American Signature case. Vara raises important concerns about the proposed sale of private information from customer databases. The asset purchase agreement includes customer contact information and email addresses, just as it did in the Living.com case, but Vara states that the debtors have not provided evidence about whether their privacy policies permit such transfers.
(My first published research article as an academic 20 years ago analyzed this question.)
Lastly, Vara objects to giving the Schottenstein family-controlled lender consultation rights on evaluating competing bids and conducting the auction. With no safeguards against information sharing between the lender and the stalking horse bidder, such rights could further suppress competition, he contends.
Early Thursday morning, the official committee of unsecured creditors filed its own motion objecting to the restructuring plan and stalking horse bid procedure for essentially the same reasons as those presented by Vara.
A hearing on the bidding procedures is scheduled for Dec. 15.
Here a Schottenstein, there a Schottenstein . . .
Vara’s second filing objects to the debtors’ use of an affiliated company, SB360 Capital Partners. as its liquidation consultant, an arrangement he argues violates conflict-of-interest rules and deserves heightened judicial scrutiny rarely seen in bankruptcy proceedings.
“SB360 is the Debtors’ affiliate,” the objection notes, underlining that numerous individuals hold roles at both SB360’s parent company and American Signature. Because SB360 lacks disinterestedness and holds materially adverse interests by virtue of generating additional fees from further store closings, it cannot be retained as a professional under bankruptcy law, Vara argues.
Summarizing, Vara states that “where, as here, a controlling stockholder stands on all sides of a transaction, the Court should not defer to the Debtors’ business judgment.” The Schottenstein family is essentially “loaning its own entities money to fund chapter 11 cases in which the Schottenstein family will purchase principally all assets of those same entities from themselves while simultaneously paying fees to the Consultant (in which they hold a 60% interest) to liquidate those same entities,” Vara states.
Buddy Mac Holdings and Buddy’s Home Furnishings
Checking in on Buddy Mac’s Chapter 11 in Texas, the bankruptcy judge has authorized the debtors to continue operating their existing cash management system, albeit with strict reporting requirements. Such an authorization is common for bankruptcies, but in this case it was opposed by a secured lender, Phonix RBS.
Judge Michelle V. Larson signed an interim order Tuesday allowing the DeSoto-based company to maintain its pre-petition bank accounts and business operations substantially as they existed before the November filing. The relief is designed to minimize disruptions to the company’s business while providing transparency to creditors and the court, according to the motion she signed.
The order authorizes Buddy Mac to continue using its cash management system, maintain existing bank accounts and honor pre-petition obligations related to banking operations. BMH can also continue intercompany transactions, but with significant oversight provisions. For example, the debtors must provide weekly reports to the U.S. trustee, Phonix and any future creditors committee.
Appearing at Tuesday’s hearing were counsel for BMH, the U.S. trustee’s office and Phonix. Testifying were Mark Shapiro, chief restructuring officer, and Ian McDonald, majority owner of BMH.
Circling back to Kahn
In pleading guilty to federal charges of conspiracy to commit securities fraud, Kahn avoids further criminal charges related to Prophecy Asset Management and waives his rights to a jury trial. He was to be released on a $100,000 bond after surrendering his passport to Florida authorities, according to the hearing transcript.
In his testimony answering questions posed by U.S. attorney Kelly Lyons, Kahn admitted to fraudulent “round-trip transactions” to cover losses at Prophecy, to forging documents, to concealing the transactions from auditors and investors, and to trading losses that contributed to the collapse of the funds in March 2020, according to the transcript.
One of the round-trip transactions involved a one-day, $25 million loan in April 2019 from a “financial services firm,” or Company 6 in the transcript, to partially cover Prophecy losses.
Kahn also admitted to creating a fraudulent, backdated preferred stock agreement that same month that granted Prophecy the right to ownership of stock in Kahn-controlled companies, including Franchise Group. The agreements added up to $194 million.
“As a result of your fraudulent activities with Hughes and Co-conspirator-1, did you, Hughes and Co-conspirator-1 cause investors actual losses of between $150 million to $250 million?” Kelly asked Kahn. “Yes,” he said.
