The unsecured creditors’ committee in the Rhythm & Hues bankruptcy case filed a report objecting to some proposed bidding procedures ahead of today’s scheduled hearing. Their report, filed last night, is the committee’s legal position in an adversarial process. They want to get paid and don’t care whether the company continues to exist or whether its employees continue to have jobs. However, they paint a picture of  R&H that makes its future even more precarious than we thought.

The committee complains that the structure is heavily stacked in favor of Fox and Universal and unsecured creditors are being shortchanged by those two studios and R&H management.

Some highlights:

Fox and Universal granted R&H a $17 million “debtor in possession” loan to keep the doors open. The committee calls that loan a “hurdle for a prospective purchaser” and doesn’t regard it as a good deed.

When the Committee met for the first time on March 4, 2013  (having only been officially formed on February 28, 2013), it was confronted with the following predicament. The Debtor had already negotiated a $17 million debtor in possession loan (the “DIP Loan”), granting a  lien on substantially all assets of the estate in favor of two studios – Twentieth Century Fox (“Fox”) and Universal City Studios LLC (“Universal” and with Fox, the “DIP Lenders”) – whose sole interest was and is the completion of their projects. … Thus, to a great extent, when the Committee first met, the destiny of this case had already been determined – there would be no attempt at a reorganization, the Debtor had no plan to continue in operation beyond the time needed to complete the Fox and Universal projects, and the estate would likely be administratively insolvent unless a buyer emerged who would be willing and able to pay or assume the $17 million DIP Loan. Although the Debtor acknowledges that it is insolvent and, therefore, equity is “out of the money,” the fate of unsecured creditors may well have been decided before the ink was dry on the U.S. Trustee’s order appointing the Committee.

…. It is clear what Fox and Universal are getting out of the DIP Loan. Their projects will be completed, and then they will be at the front of the line to be repaid. It is not at all clear what other unsecured creditors are getting.

(Emphasis added.)

The committee also complains it’s been allocated only $50,000 for counsel, while Fox and  Universal get $500,000 for counsel. But the creditors, it seems, doubt R&H is ever make any money. In fact they doubt R&H is going to continue to exist.

If there were evidence that completing existing work and competing for new work might yield substantial profits, or if there were evidence that the Debtor’s sale process were likely to monetize meaningful going-concern value, such a generous deal might be justified. There is, however, no such evidence.

…. The Debtor’s concept of a “going concern” sale is illusory; the Debtor is not a going concern. Rather, the Debtor has committed to wind down its business and is only working for the purpose of completing existing projects with Fox and Universal.

And they think they’re getting shafted.

It was apparent that the parties who negotiated the DIP Loan had little interest in providing the Committee with a meaningful opportunity to evaluate alternative strategies or advocate any position other than the game plan that the Debtor was implementing. Notwithstanding the fact that the Debtor’s shareholders had no economic interest in this case (with the exception of the possibility of being hired by a prospective purchaser) and had, literally, handed over management to third parties, the Debtor had set in motion a scenario that had the effect of curtailing the rights and options of the creditors who have the largest economic stake in this case.

The report says that the principals of R&H borrowed $14 million from the company to finance the purchase of R&H’s El Segundo HQ. Those notes “may be the single most valuable asset of this estate,” says the report, but they were pledged as security for the DIP loan. The building is being sold and R&H is expecting $5 million from the sale, and the report complains those funds won’t be available to repay other debts. The report questions whether, for purposes of repaying debt, R&H would have done better by simply closing its doors.

Regarding the upcoming auction, the report says the “Stalking Horse” bidder has demanded an increase in the “Break-Up Fee” it would be paid should it fail to win the auction: $675,000 instead of $150,000.

…Such a break-up fee creates a substantial barrier to a competitive bid process. Simply stated, any competitive bid will have to be come in at no less than $775,000 above the “stalking horse bid” to be considered. Accordingly, conferring stalking horse status on this potential bidder will only serve to discourage other prospective purchasers from participating in the sale process – at which point, the “stalking horse” will be free to renegotiate its deal.

JS Communications of Korea is the Stalking Horse bidder. That larger fee would make sense if R&H wants JS Communications to win the auction.

JS Communications’ “Stalking Horse” bid is due today. More later when we know more details on the bid.