Case MFW Doc 287 Filed 06/16/15 Page 1 of 14 UNITED STATES BANKRUPTCY COURT DISTRICT OF DELAWARE

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1 Case MFW Doc 287 Filed 06/16/15 Page 1 of 14 UNITED STATES BANKRUPTCY COURT DISTRICT OF DELAWARE In re: KARMALOOP, INC., et al., 1 Debtors. Chapter 11 Case No (MFW) (Jointly Administered) Hearing Date: June 22, 2015 at 11:30 a.m. (ET) RE: Docket Nos. 253 and 284 REPLY OF OFFICIAL COMMITTEE OF UNSECURED CREDITORS (I) TO OBJECTION OF THE ACTING UNITED STATES TRUSTEE AND (II) IN SUPPORT OF MOTION OF THE OFFICIAL COMMITTEE OF UNSECURED CREDITORS FOR AN ORDER APPROVING SETTLEMENT BY AND AMONG THE OFFICIAL COMMITTEE OF UNSECURED CREDITORS AND COMVEST CAPITAL II, L.P., AS AGENT The Official Committee of Unsecured Creditors (the Committee ), appointed in the above-captioned jointly administered cases, submits this reply ( Reply ) (i) to the Objection of the Acting United States Trustee (the UST ) to the Motion of the Official Committee of Unsecured Creditors for an Order Approving Settlement [D.I. 284] (the Objection ) and (ii) in support of the motion for entry of an order (the Proposed Order ) (x) approving the settlement (the Settlement ) of the Committee and Comvest Capital II, L.P., in its capacity as prepetition lender, agent for prepetition lenders, the post-petition agent for the post-petition lenders, and post-petition lender of the Debtors ( Comvest ) memorialized in the stipulation attached to the Proposed Order (the Settlement Agreement ) and (y) granting the Committee such other and 1 The Debtors and the last four digits of their respective federal taxpayer identification numbers are as follows: Karmaloop, Inc and KarmaloopTV, Inc The Debtors address is 334 Boylston Street, Suite 500, Boston, MA

2 Case MFW Doc 287 Filed 06/16/15 Page 2 of 14 further relief as the Court deems just and proper [D.I. 253] (the Motion ). 2 In support of this Reply, the Committee respectfully represents as follows: PRELIMINARY STATEMENT 1. The Settlement reflects a heavily negotiated compromise of the Committee s informally asserted challenge to Comvest s asserted liens on, and claims to, the Debtors assets and objection to the sale of the Debtors assets to the only bidder Comvest. In consideration for the Committee not formally pursuing either the challenge or sale objection, Comvest agreed to permit a portion of its recovery to be set aside for distribution to unsecured creditors through a Creditor Trust. Absent approval of the Settlement, unsecured creditors face an untenable risk of receiving no recovery in these cases as Comvest s asserted claims are greater than the value of the Debtors assets. Again (and importantly), no party aside from Comvest expressed an interest in bidding on the Debtors assets. 2. As requested by the UST, the Committee filed the Motion and served notice of the Settlement on all parties required under the Bankruptcy Rules and Local Rules. The deadline to object to the Motion was June 11, Other than the UST, no one has opposed entry of the Proposed Order. Now, although the sale has closed and Comvest has received consideration from the sale only the Committee is at risk of not getting the benefit of its bargain. 3. The UST makes a number of general policy arguments in support of its Objection, including that: (i) the cases may be administratively insolvent; (ii) the Settlement falls outside of the priority scheme under section 507 of the Bankruptcy Code; and (iii) the Settlement does not meet the Martin standard for reasonableness. Each of these arguments should be overruled. First, the Settlement pays unsecured creditors only from funds that would otherwise be paid 2 Capitalized terms used herein, but not otherwise defined, shall have the meaning ascribed to such term in the Motion or the Settlement Agreement. -2-

3 Case MFW Doc 287 Filed 06/16/15 Page 3 of 14 exclusively to Comvest pursuant to its senior liens, administrative expense claims (including the $10 million rollup of its prepetition debt), and superpriority claim granted under the Final DIP Order. Second, as the Third Circuit correctly observes, bankruptcy courts may approve settlements that deviate from the priority scheme of section 507 of the Bankruptcy Code if specific and credible grounds justify [the] deviation. Official Comm. of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.), Case No , 2015 WL (3d Cir. May 21, 2015) at *9 (internal quotation omitted). Here, after careful consideration of its fiduciary duties to unsecured creditors in a case with a hopelessly upside down capital structure and virtually no real interest in the assets despite much rhetoric and press, the Committee chose to settle its dispute with Comvest on the terms set forth in the Settlement Agreement. The Settlement Agreement provides unsecured creditors with the opportunity to share a percentage of (i) any recovery realized from sale of business by the Comvest acquisition vehicle ( Newco ) over and above Comvest s secured debt and carry costs and (ii) any recoveries from certain speculative litigation. This Settlement falls squarely within both the policy goals of the Bankruptcy Code to foster settlements and the Committee s fiduciary duties to its constituency. 4. Finally, the UST notes a lack of information concerning the future of the Debtors estates now that the sale of their assets was approved, post-petition financing has expired, and closing of the sale has been completed. While the Committee sympathizes with, and even shares, the UST s concerns, the Objection only serves to punish the Committee s constituents because of a lack of disclosure by Comvest or the Debtors. Ultimately, such an outcome makes no sense. -3-

4 Case MFW Doc 287 Filed 06/16/15 Page 4 of For all of the reason outlined here and in the Motion, the Objection should be overruled and the Proposed Order entered. REPLY A. THE COMMITTEE DETERMINED THAT PROSECUTING THE COMMITTEE LIEN CHALLENGE WAS ULTIMATELY NOT IN THE BEST INTEREST OF CREDITORS 6. As noted in the Motion, in accordance with its fiduciary duties, the Committee reviewed Comvest s liens and interests in the Debtors property and evaluated the strengths and weaknesses of pursing its objections to the sale to Comvest. The Committee s due diligence revealed that, but for certain limited property, Comvest duly perfected its liens and/or security interests in all of the Prepetition Collateral in accordance with applicable law as of the Petition Date. However, the Committee s investigation revealed that Comvest did not have prepetition liens on (i) thirty-four percent (34%) of the Debtors interest in the equity of Karmaloop Europe AG and (ii) the registered copyright Karma Blend logo (Registration No. VAu ) owned by Karmaloop, Inc. (collectively, the Unencumbered Property ). 7. The Committee, in discussion with its advisors, considered the merits of contesting Comvest s liens on the Unencumbered Property and prosecuting its objections to the sale in light of the prepetition capital structure, prospective costs to prosecute the action, and the risks and probable benefits to unsecured creditors, against the merits of compromising its dispute regarding the Unencumbered Property as incorporated into the Settlement. According to the Debtors, Comvest is owed in excess of $27.9 million, exclusive of fees and pre-petition interest. 3 At a bare minimum, for any value to be distributed to unsecured creditors, the Debtors asset sale needed to realize net cash proceeds in excess of this amount. With the sale only generating a no- 3 See Final DIP Order at D(3). This amount does not include claims of allegedly second- and third-secured creditors who also assert liens on the Debtors assets. -4-

5 Case MFW Doc 287 Filed 06/16/15 Page 5 of 14 cash credit bid of about half that amount, the Settlement satisfies the requisite standard for approval in this Circuit. See In re Capmark Fin. Grp. Inc., 438 B.R. 471, (Bankr. D. Del. 2010) (stating that in determining whether to approve a proposed settlement pursuant to Bankruptcy Rule 9019(a), the Third Circuit requires a bankruptcy court to apprise[] itself of all facts necessary to form an intelligent and objective opinion of the probabilities of ultimate success should the claims be litigated, and estimate[] the complexity, expense and likely duration of such litigation, and other factors relevant to a full and fair assessment of the [claims] (quoting In re Penn Cent. Transp. Co., 596 F.2d 1127, 1146 (3d Cir. 1979))); In re Marvel Entm t Grp., Inc., 222 B.R. 243, 249 (Bankr. D. Del. 1998) (describing the ultimate inquiry to be whether the compromise is fair, reasonable, and in the interest of the estate (quoting In re Louise s Inc., 211 B.R. 798, 801 (Bankr. D. Del. 1997))). 8. The Unencumbered Property consists of a single copyright and a partial interest in the Debtors European subsidiary, Karmaloop Europe AG. The ultimate net realizable value of each of these assets is highly speculative and likely very, very small. First, upon information and belief, there is no ongoing income stream associated with the copyright from royalties or otherwise. Further, valuing a closely-held corporation, such as Karmaloop Europe AG, requires extensive analysis and forensic investigations. The inherent cost of such an investigation in tandem with an unpredictable result made that option impractical. Further, the Committee understood that Karmaloop Europe AG has its own creditors and ongoing litigation issues, further diminishing the prospect of any value. 9. Against this backdrop, the Committee was faced with the stark reality that, in light of the secured claims that on their face are senior to claims of the unsecured creditors, valuation of the Unencumbered Property would have had to exceed the amount of Comvest s -5-

6 Case MFW Doc 287 Filed 06/16/15 Page 6 of 14 pre- and post-petition claims including debtor in possession financing of about $3 million and a partial roll-up of about $10 million. The Committee, after consultation with its legal and financial advisors, concluded that even a successful challenge to Comvest s alleged lien in the Unencumbered Property likely would not raise sufficient funds for any creditors to receive a recovery. Plus the cost of such a fight would create additional administrative expense claims, further prejudicing unsecured creditors. 10. For these reasons, the Committee negotiated the proposed Settlement with Comvest to advance the best interests of unsecured creditors under the difficult circumstances presented. The proposed Settlement provides unsecured creditors with the opportunity to receive a possible recovery from Newco in the form of a sharing of net proceeds from (a) the disposition of Comvest s collateral in a sum above $50 million within a multi-year time frame and (b) certain litigation claims. Without the Settlement, all creditors junior to Comvest would not be entitled to a recovery absent Comvest being repaid in full, which was never a possibility under the realities of these cases. However, under the Settlement, the hurdle to a possible recovery for unsecured creditors becomes more feasible and realistic as Newco now has additional time create and improve the value of the assets from which the unsecured creditors might glean a recovery. B. THE PROPOSED SETTLEMENT ADMINISTERS ONLY COMVEST S PROPERTY, TO THE EXTENT ACTUALLY RECEIVED, FOR THE BENEFIT OF UNSECURED CREDITORS 11. The distributions to unsecured creditors under the proposed Settlement are without economic prejudice to more senior creditors. The UST assertion otherwise (that administrative and priority creditors will only recover after the Creditor Trust is funded, see Objection at 14) is fundamentally incorrect. -6-

7 Case MFW Doc 287 Filed 06/16/15 Page 7 of Holders of allowed unsecured claims are receiving value under the proposed Settlement from the sale of collateral and/or proceeds of certain causes of action to which Comvest holds superior title and claims and to which creditors junior to Comvest have no contractual or legal claim. The Final DIP Order grants Comvest with superpriority claims under which it is entitled to recover first from available assets, even as to chapter 5 causes of action and proceeds thereof. However, as agreed in the Settlement, Comvest will share 7.25% of any recoveries with unsecured creditors. 13. The Settlement also provides that property to be shared with unsecured creditors will include a percentage of Comvest s recovery from the sale of Newco over $50 million (net of any additional capital Comvest must provide to sustain the business in the interim). In the event Comvest and the Debtors agree to file a liquidating plan, Creditor Trust recoveries from chapter 5 causes of action, if any, will be net of any additional funds Comvest must provide to the estates to confirm a liquidating plan, pay administrative claims, and the like. See Settlement Agreement at Accordingly, notwithstanding the erroneous contentions of the UST to the contrary, distributions to the Creditor Trust exclude the property of any creditor other than Comvest. C. THE SETTLEMENT MEETS THE THIRD CIRCUIT S STANDARDS FOR APPROVAL UNDER BANKRUPTCY RULE For the reasons stated in the Motion, which are incorporated herein by reference, the Motion should be granted as the Settlement meets the standards set forth in the Martin Factors and under Bankruptcy Rule The UST s contention that the proposed Settlement violates the Bankruptcy Code s distribution scheme disregards that the collateral proceeds and causes of action -7-

8 Case MFW Doc 287 Filed 06/16/15 Page 8 of 14 administered in accordance with the Settlement represents Prepetition Collateral or DIP Collateral, i.e., not estate property, and the proposed Settlement is neutral as to any prospective chapter 11 plan. See, e.g., In re World Health Alts., Inc., 344 B.R. 291, 298 (Bankr. D. Del. 2006) ( Section 1129(b)(2)(B) and the absolute priority rule, however, are not implicated here because the settlement does not arise in the context of a plan of reorganization. ). 17. Moreover, bankruptcy courts in this District allow for the settlement and compromise of claims in the manner proposed by the Settlement. See id.; see also In re G.I. Joe s Holding Corp., Case No (KG) (Bankr. D. Del. Mar. 10, 2011) (approving a settlement in the context of a structured liquidation in which an undersecured creditor agreed to partially fund an escrow account with collateral proceeds to be distributed to general unsecured and priority creditors on a pari passu basis); In re Kainos Partners Holding Co. LLC, Case No (BLS) (Bankr. D. Del. Apr. 1, 2010) (approving, inter alia, a carve out of a secured creditor s collateral in the context of a sale for the repayment of committee professionals and distributions to unsecured creditors in exchange for a release of claims against the secured creditor); Official Comm. of Unsecured Creditors v. Perseus Partners VII, L.P. (In re Distributed Energy Sys. Corp.), Case No (KG), Adv. No (KG), 2009 WL (Bankr. D. Del. May 18, 2009) (approving a settlement in the context of a sale of collateral under which a secured creditor agreed to distribute certain proceeds from the sale of its collateral to unsecured creditors on the grounds that such collateral proceeds were not property of the estate); In re TSIC, Inc., 393 B.R. 71 (Bankr. D. Del. 2008) (approving a settlement in a sale context in which the funds of the section 363 sale purchaser were remitted to unsecured creditors because the funds were not property of the estate); In re PSO Successor Corp., Case No (MFW) (Bankr. D. Del. Feb. 10, 2006) (approving a settlement in a sale context and recognizing -8-

9 Case MFW Doc 287 Filed 06/16/15 Page 9 of 14 a secured creditor may agree to give part of its collateral to another class skipping priority classes in between ). 18. The Objection relies, in part, on the Second Circuit s decision in Motorola, Inc. v. Official Committee of Unsecured Creditors (In re Iridium Operating LLC), 478 F.3d 452 (2d Cir. 2007), which is inapposite to the merits of the Settlement. See Objection at In Iridium, the Second Circuit panel (that included then Judge, now Justice Sotomayor) was asked to approve a pre-plan settlement in which half of the settlement funds would be provided to the secured lenders, while half would be provided to a newly created trust set up to fund litigation against one of the administrative creditor of the debtor. See Iridium, 478 F.3d at 459. In Iridium, the absolute priority rule issue concerned a settlement term directing that any of the initial estate funds put into the litigation trust remaining at the conclusion of the contemplated litigation be distributed to general unsecured creditors. Id. Significantly, in Iridium, the secured lenders liens would not have been rendered senior, perfected, and unavoidable except through entry of the settlement itself. Id. at Ultimately, the Second Circuit remanded the matter to the bankruptcy court because no reason ha[d] been offered to explain why any [cash] balance left in the litigation trust [as estate property] could not or should not be distributed pursuant to the rule of priorities. Id. at , 466. In short, the Second Circuit held that where, unlike here, a pre-plan settlement agreement contemplating the distribution of estate property directly to general unsecured creditors violates the Bankruptcy Code s order of distributive priorities, the specific and credible grounds to justify such a variance must be articulated by a bankruptcy court in approving such a settlement agreement. Id. Further, the Second Circuit held that a settlement -9-

10 Case MFW Doc 287 Filed 06/16/15 Page 10 of 14 nonetheless can be approved when the normal priority distribution scheme was not followed provided the remaining factors weigh heavily in favor of approving a settlement. Id. at The Iridium facts are readily distinguishable from these cases. Namely, the deadline to challenge Comvest s prepetition liens has expired. See Final DIP Order at 8. As such, the proposed Settlement does not, by itself, render Comvest s liens unavoidable. Therefore, the UST s policy considerations, see Objection at 14 15, as applied to the Settlement, miss the mark for the principal reason that the Settlement does not purport to administer or distribute estate property or any collateral proceeds in excess of the amounts owed to Comvest. As to any estate property herein, for example any funds remaining in the Debtors bank accounts (and therefore Comvest s cash collateral), distributions (if any) remain controlled by the distributive priority scheme established by the Bankruptcy Code. 21. Notably, the Objection fails to address the United States Court of Appeals for the Third Circuit s recent decision, In re Jevic Holding Corp., 2015 WL (3d Cir. May 21, 2015). In Jevic, the Third Circuit approved the bankruptcy court s decision to approve a settlement that did not provide a distribution to all similarly situated creditors and the subsequent dismissal of a chapter 11 case. Id. at *9 10. The facts and circumstances underlying the Third Circuit s ruling are applicable here. 22. The debtor, Jevic Transportation, Inc. (together with its parent holding company, Jevic Holding, Inc., the Company ), was a New Jersey-based trucking company purchased by the private equity firm Sun Capital Partners ( Sun ) in 2006 through a leveraged buyout. See id. at *1. Sun financed the purchase with a group of lenders led by CIT Group/Business Credit Inc. ( CIT ). Id. The Company, however, was unsuccessful under new ownership, eventually having to cease operations and lay off all of its employees on May 19, Id. The next day -10-

11 Case MFW Doc 287 Filed 06/16/15 Page 11 of 14 Jevic filed a voluntary petition under chapter 11 of the Bankruptcy Code. Id. At the time of the filing, the Company owed approximately $53 million to Sun and CIT, both of whom held a firstpriority lien on almost all of the Company s assets. Other creditors, who held tax and general unsecured claims, were owed approximately $20 million. Id. Their interests were represented by an official committee of unsecured creditors appointed in the case (the Jevic Committee ). Id. 23. Two lawsuits were filed in the case. The Jevic Committee filed suit against Sun and CIT. Id. A subsequent suit was filed by the Company s terminated truck drivers ( Drivers ). Id. Before the establishment of the Company s liability for the Drivers claims, however, the Jevic Committee, the Company, CIT, and Sun negotiated a settlement agreement (the Jevic Settlement ). Id. at *2. Under the terms of the Jevic Settlement, the parties would execute mutual releases, the fraudulent conveyance and preference actions would be dismissed, CIT would contribute $2 million to an account to pay the Company s and the Jevic Committee s legal fees and administrative expenses; Sun would transfer its lien on the Company s only remaining assets ($1.7 million in cash) to a trust set up to first pay administrative and tax creditors, followed by unsecured creditors on a pro rata basis, and then the entire bankruptcy case would be dismissed. Id. The Driver s claims against the Company were not addressed in the Jevic Settlement. Id. 24. The United States Trustee s office and the Drivers both objected to the Jevic Settlement. Id. at *3. Each argued that the Jevic Settlement denied the Drivers their statutory protections as priority wage claimants. Id. The United States Trustee also argued that the Jevic Settlement should not be approved as structured dismissals were not authorized under the Bankruptcy Code. Id. The Jevic bankruptcy court overruled the Drivers and the United States -11-

12 Case MFW Doc 287 Filed 06/16/15 Page 12 of 14 Trustee s objections, approved the Jevic Settlement, and allowed the case to be dismissed pursuant thereto. Id. The Jevic bankruptcy court noted the dire circumstances of the Company meant there was no chance for reorganization. Id. (internal citation omitted). Furthermore, any recovery for the Company s unsecured creditors by other means was unlikely as the estate s remaining assets consisted of (i) $1.7 million in cash, upon which Sun held a lien, and (ii) the claims against Sun and CIT. Id. (internal citation omitted). The Jevic bankruptcy court determined that if the case was converted to chapter 7 of the Bankruptcy Code, a chapter 7 trustee most likely would lack the funds to further litigate the claims against Sun and CIT, and likely would simply turn over the cash and close the case. Id. (internal citation omitted). The Jevic bankruptcy court concluded that the Settlement was a better alternative to all unsecured creditors, including the Drivers, receiving nothing. Id. (internal citation omitted). 25. The Drivers appealed the Jevic bankruptcy court s decision to the United States District Court for the District of Delaware. Id. at *4. The Jevic district court affirmed 4 and the decision was subsequently appealed to the Third Circuit. Id. The Third Circuit denied the appeal and upheld that the lower courts decisions. Id. at The Third Circuit was persuaded by the reasoning of Iridium, and adopted what it determined was a more flexible standard that would aid parties in crafting settlements. Id. at *9 (noting the need for bankruptcy courts to have flexibility when approving settlements). Like the Second Circuit in Iridium, the Third Circuit held that courts could approve settlements that deviate from the standard priority scheme when they have specific and credible grounds to justify the deviation. Id. at *9 (citing Iridium, 748 F.3d at 466). Furthermore, on the record provided, the Jevic bankruptcy court was in a situation where there was no alternative that would 4 Caismir Czyzewski v. Jevic Holding Corp. (In re Jevic Holding Corp.), Case Nos and (SLR), 2014 WL , at *4 (D. Del. Jan. 24, 2014). -12-

13 Case MFW Doc 287 Filed 06/16/15 Page 13 of 14 have provided some recovery to any creditors other than CIT and Sun. Id. at *9. Thus, while a close call, the Third Circuit held that the Jevic bankruptcy court was correct to approve the Jevic Settlement and structured dismissal. Id. at * The Committee is faced with a situation very similar to the one addressed by the Jevic Committee. Prior to the Petition Date, the Debtors liabilities exceeded the value of their assets. Despite efforts to market these assets, both pre and post-petition, see Sale Motion [D.I. 71] at 13 16, only Comvest sought to purchase them. Although the Committee s lien investigation revealed Unencumbered Property, which Comvest disputed, determining the value of the Unencumbered Property would have cost the estates more in fees than the anticipated amount generated from the Unencumbered Assets for creditor distributions. Therefore, the grounds for the Settlement are specific and credible, and the Motion should be granted. See Jevic Holding Corp, 2015 WL at * Upon information and belief, the Debtors (actually Comvest through the debtor in possession funding) paid administrative claims arising from the Debtors operations in the ordinary course pursuant to the approved budgets, with the consent of Comvest pursuant to the Final DIP Order approved by the Court, or as otherwise assumed by Comvest. Further, the chapter 11 professionals retained in these cases consented to certain treatment of their claims under the Final DIP Order. The payment of professional fees as a part of a proposed settlement remains appropriate as any such fees and expenses must still be approved and allowed by the Court and payment thereof is exclusively remitted from Comvest s cash collateral. See, e.g., World Health, 344 B.R. at (approving carve out for, inter alia, payment of professional fees). -13-

14 Case MFW Doc 287 Filed 06/16/15 Page 14 of Finally, and most importantly, absent approval of the Settlement Agreement, there will be no available assets for distribution to any creditor other than Comvest. While Comvest does not have a lien on chapter 5 causes of action, Comvest was granted a superpriority claim in the proceeds of chapter 5 causes of action, effectively leaving the balance of the estates creditors without any assets from which a distribution might be made. See Final DIP Order at 3(e), Ex. A at 30 (definition of Postpetition Collateral ). Indeed, many of these causes of action were sold by the Debtors estates to Newco pursuant to the previously entered Sale Order (as defined in the Objection). For these and the reasons cited in the Motion, the Settlement is the best, and only chance, for any creditor to receive a recovery in these cases. CONCLUSION WHEREFORE, the Committee respectfully requests that the Court enter the Proposed Order granting the Motion and such other relief as may be just or proper. Dated: June 16, 2015 Wilmington, Delaware LOWENSTEIN SANDLER LLP Sharon L. Levine Cassandra Porter 65 Livingston Avenue Roseland, New Jersey Telephone: (973) Facsimile: (973) and- YOUNG CONAWAY STARGATT & TAYLOR, LLP /s/ Jaime Luton Chapman M. Blake Cleary (No. 3614) Sean M. Beach (No. 4070) Jaime Luton Chapman (No. 4936) Rodney Square 1000 North King Street Wilmington, Delaware Telephone: (302) Facsimile: (302) Counsel for the Official Committee of Unsecured Creditors -14-