Hearing Date: March 10, 2011 at 10:00 a.m. (Eastern Time)

John G. Hutchinson James P. Seery, Jr. Paul S. Caruso John J. Lavelle Alex R. Rovira SIDLEY AUSTIN LLP787 Seventh Avenue New York, New York 10019(212) 839-5300 (tel) (212) 839-5599 (fax)

Attorneys for the Steering Group, and Special Counsel to the Senior Indenture Trustee,in connection with reclamation issue

UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF NEW YORK --------------------------------------------------------------- X

Chapter 11

Case No. 10-14997 (BRL)

(Jointly Administered)

In re:

Blockbuster Inc., et al.,1

Debtors.

:::::::

--------------------------------------------------------------- X

THE STEERING GROUP’S REPLY MEMORANDUM IN SUPPORT OF DEBTORS’ SALE MOTION AND IN OPPOSITION TO VARIOUS SALE OBJECTIONS AND TO

MOTIONS SEEKING TO CONVERT THE DEBTORS’ CHAPTER 11 CASES TO CASES UNDER CHAPTER 7 OF THE BANKRUPTCY CODE

1 The Debtors, together with the last four digits of each Debtor’s federal tax identification number, are: Blockbuster Inc. (5102); Blockbuster Canada Inc. (1269); Blockbuster Digital Technologies Inc. (9222); Blockbuster Distribution, Inc. (0610); Blockbuster Gift Card, Inc. (1855); Blockbuster Global Services Inc. (3019); Blockbuster International Spain Inc. (7615); Blockbuster Investments LLC (6313); Blockbuster Procurement LP (2546); Blockbuster Video Italy, Inc (5068); Movielink, LLC (5575); Trading Zone Inc. (8588); and B2 LLC (5219).

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TABLE OF CONTENTS

Page

TABLE OF AUTHORITIES ......................................................................................................... iii

PRELIMINARY STATEMENT .....................................................................................................1

RELEVANT BACKGROUND .......................................................................................................5

ARGUMENT .................................................................................................................................11

I. THE SENIOR SECURED NOTEHOLDERS AND DIP LENDERS ACTED IN GOOD FAITH THROUGHOUT THESE CHAPTER 11 CASES ..............................11

A. The DIP Facility was Negotiated in Good Faith with Fair and Reasonable Lender Protections ............................................................................. 11

B. The DIP Lenders Acted In Good Faith by Approving Budgets, Authorizing Increased Advertising Spending, and Extending Milestones ............................................................................................................. 15

C. The Debtors Failed to Provide a Viable Business Plan ........................................ 17

D. The Debtors Propose A Sale Under Section 363 of the Bankruptcy Code ...................................................................................................................... 20

E. The DIP Lenders and Senior Secured Noteholders Honored All of Their Obligations .................................................................................................. 22

F. The Creditors’ Committee Fails to Assert Any Legal Basis to Undo this Court’s Final DIP Order Approving the Roll-Up Notes ....................................... 24

G. The Roll-Up is Appropriate as Approved by this Court ....................................... 25

II. THE SALE MOTION IS THE BEST OPTION TO MAXIMIZE THE VALUE OF THE DEBTORS’ ASSETS AND IS IN THE BEST INTERESTS OF THE DEBTORS AND THEIR ESTATES .................................................................................26

A. The Debtors’ Rehabilitation Is Largely Dependent On A Successful Sale Process and It Is Premature To Assume That Rehabilitation is Unlikely................................................................................................................. 28

B. Because the Debtors Could Propose A Chapter 11 Plan of Liquidation, it is Premature to Determine Whether or Not the Debtors Will Be Able To Effectuate The Confirmation of A Plan ........................................................... 31

ii

C. Conversion to Chapter 7 at This Time is Not in the Best Interests of the Creditors of the Estate ........................................................................................... 32

III. SUMMIT’S ALLEGED RECLAMATION RIGHTS ARE SUBORDINATED TO THE RIGHTS OF THE SENIOR SECURED NOTEHOLDERS AND DIP LENDERS..........................................................................................................................34

A. Any Reclamation Rights Summit May Have Are Clearly Subject to the Liens of the Senior Secured Lenders and DIP Lenders ........................................ 35

IV. THE DEBTORS’ UNIVERSAL TITLES SHOULD BE SOLD AS PART OF THE 363 SALE ..................................................................................................................39

A. The Revenue Sharing Agreement is not a “Lease” ............................................... 41

1. Bright Line Test. ....................................................................................... 42

2. Economic Reality Test. ............................................................................. 43

B. Aggregate Payments ............................................................................................. 45

C. Universal has no Expectation that the Discs will be Returned at the End of the Revenue Share Period ................................................................................. 45

D. Universal May Have an Unsecured Claim Against the Debtors for Breach of Contract ................................................................................................ 46

iii

TABLE OF AUTHORITIES

Page(s)CASES

In re The 1031 Tax Group, LLC,374 B.R. 78 (Bankr. S.D.N.Y. 2007) ...........................................................................27, 28, 32

In re 15375 Memorial Corp.,382 B.R. 652 (Bankr. D. Del. 2008), rev’d on other grounds,400 B.R. 420 (D. Del. 2009) ....................................................................................................28

In re Advanced Mktg. Servs., Inc., 360 B.R. 421 (Bankr. D. Del. 2007) ........................................................................................38

In re All Am. of Ashburn, Inc.,40 B.R. 104 (Bankr. N.D. Ga. 1984) .......................................................................................33

In re Alves Serv. Inc.,6 B.R. 690 (Bankr. D. Mass. 1980) ...................................................................................28, 34

In re Arlco Inc.,239 B.R. 261 (Bankr. S.D.N.Y. 1999) ...............................................................................36, 38

In re Braniff, Inc.,113 B.R. 745 (Bankr. M.D. Fla. 1990) ....................................................................................36

In re Chameleon Sys. Inc.,306 B.R. 666 (Bankr. N.D. Cal. 2004) ....................................................................................31

In re Circuit City Stores Inc., et al.,Case No. 0835653 (KRH) (Bankr. E.D.Va. Sept. 14, 2010) ...................................................31

In re Dairy Mart Convenience Stores, Inc.,302 B.R. 128 (Bankr. S.D.N.Y. 2003) .....................................................................................38

In re Dana Corp.,367 B.R. 409 (Bankr. S.D.N.Y. 2007) ..............................................................................36, 38

In re Deer Park, Inc.,136 B.R. 815 (B.A.P. 9th Cir. 1992)........................................................................................33

In re Edison Bros. Stores,207 B.R. 801 (Bankr. D. Del. 1997) ..................................................................................43, 45

In re Finlay Enterprises, Inc. et al.,Case No. 09-14873 (JMP) (Bankr. S.D.N.Y. June 29, 2010) ..................................................32

iv

In re Fortunoff Holdings, LLC et al.,Case No. 09-10497 (RDD) (S.D.N.Y. Oct. 1, 2009) ...............................................................30

In re GPA Technical Consultants, Inc.,106 B.R. 139 (Bankr. S.D. Ohio 1989) ....................................................................................31

In re Grubbs Constr. Co.,319 B.R. 698 (Bankr. M.D. Fla. 2005) ....................................................................................41

In re Linens Holdings Co. et al.,Case No. 08-10832 (CSS) (Bankr. D. Del. Feb. 24, 2010) ......................................................30

In re Lizeric Realty Corp.,188 B.R. 499 (Bankr. S.D.N.Y. 1995) .....................................................................................27

In re Mervyn’s Holdings, LLC, et al.,Case No. 08-11586 (KG) (Bankr. D. Del. 2008) .....................................................................30

In re Midway Games Inc., et al.,Case No. 09-10465 (KG) (Bankr. D. Del. May 21, 2010) .......................................................31

In re Movie Gallery Inc. et al.,Case No. 10-30696 (DOT) (Bankr. E.D.Va. Oct. 29, 2010) ...................................................31

In re Murray,191 B.R. 309 (Bankr. E.D. Pa. 1996) ......................................................................................42

In re New Rochelle Tel. Corp.,397 B.R. 633 (Bankr. E.D.N.Y. 2008) .....................................................................................29

In re Pillowtex, Inc.,349 F.3d 711 (3d Cir. 2003)...................................................................................41, 42, 43, 46

In re Pittsburgh-Canfield Corp.,309 B.R. 277 (B.A.P. 6th Cir. 2004)........................................................................................38

In re PLVTZ Inc.,Case No. 07-13532 (REG) (S.D.N.Y. Oct. 27, 2008)..............................................................30

In re QDS Components, Inc.,292 B.R. 313 (Bankr. S.D. Ohio 2002) ....................................................................................41

In re The SCO Group, Inc.,No. 07-11337, 2009 WL 2425755 (Bankr. D. Del. Aug. 5, 2009) ..........................................32

In re Sydnor,431 B.R. 584 (Bankr. D. Md. 2010) ..................................................................................27, 32

v

In re Taylor,209 B.R. 482 (Bankr. S.D. Ill. 1997) .......................................................................................42

In re Tillary,571 F.2d 1361 (5th Cir. 1978) .................................................................................................41

In re Value City Holdings, Inc. et al.,Case No. 08-14197 (JMP) (Bankr. S.D.N.Y. May 17, 2010) ..................................................31

In re Victory Mkts.,212 B.R. 738 (Bankr. N.D.N.Y. 1997) ....................................................................................36

Pactel Fin. v. D.C. Marine Serv. Corp.,518 N.Y.S.2d 317 (N.Y. Sup. Ct. 1987) ..................................................................................43

Specialty Beverages, L.L.C. v. Pabst Brewing Co.,537 F.3d 1165 (10th Cir. 2008) ...............................................................................................41

STATUTES

11 U.S.C. § 546 (c) ...........................................................................................................34, 35, 36

11 U.S.C. § 546(c)(1) ...............................................................................................................35, 36

11 U.S.C. § 552(a) ........................................................................................................................37

11 U.S.C. § 1112(b)(1) ..................................................................................................................32

11 U.S.C. § 1112(b)(4) ..................................................................................................................27

N.Y.U.C.C. § 1-201(37).................................................................................................................42

N.Y.U.C.C. § 1-201(37)(a) ............................................................................................................42

N.Y.U.C.C. § 2-702(2) ............................................................................................................34, 36

U.C.C. § 1-203, cmt. 2 (2004) .......................................................................................................42

OTHER AUTHORITIES

7 COLLIER ON BANKRUPTCY ¶ 1112.05[1] ...........................................................................27

1

TO THE HONORABLE BURTON R. LIFLAND, UNITED STATES BANKRUPTCY JUDGE:

The Steering Group of Senior Secured Noteholders (defined herein) who are also DIP

Lenders (defined herein) – such beneficial holders are managed by Icahn Capital LP, Monarch

Alternative Capital LP, Owl Creek Asset Management, L.P., Stonehill Capital Management

LLC, and Värde Partners, Inc. (collectively, the “Steering Group”) – submits this reply

memorandum (“Reply in Support of Sale Motion”) (1) in support of the Debtors’ Sale Motion

(defined herein) and (2) in opposition to the Committee’s Objection (defined herein), the

Trustee’s Objection and Conversion Motion (defined herein), the Summit Objection (defined

herein) and Universal Objection (defined herein).2 The facts and circumstances supporting this

Reply in Support of Sale Motion are set forth in further detail in the concurrently filed

Declaration of Michael Henkin in Support of the Reply in Support of the Sale Motion (the

“Henkin Declaration” or “Henkin Decl.”). The Steering Group respectfully represents as

follows:

PRELIMINARY STATEMENT

1. Since the commencement of these Chapter 11 Cases, the Debtors have made

payments of over $854 million to their administrative trade and non-trade vendors. (Henkin

Decl. ¶ 74 & Ex. I.) Those payments have consumed cash from the DIP Facility and the DIP

Lenders’ Cash Collateral for the benefit of virtually every other constituency in these cases

except the Senior Secured Noteholders themselves, including payments of over $174 million to

the movie studios, $76 million to game and merchandise vendors, $151 million to landlords, and

2 Capitalized terms not otherwise defined herein shall have the meaning ascribed to them in the Final DIP Order (defined herein).

2

$146 million to Blockbuster’s employees. (Id.) And if the Sale Motion is granted – as it should

be – the Debtors will pay another $285 million in total operating disbursements from the Cash

Collateral for the benefit of those and other constituencies throughout the sale period. (Id. ¶ 58.)

2. By contrast, the Senior Secured Noteholders have suffered the most adverse

consequences from the Debtors’ cash burn and unexpectedly poor financial performance. Since

the Petition Date, the Senior Secured Noteholders have received NO payments of interest,

principal, or fees on account of their Senior Secured Notes, including the Roll-Up Notes,

notwithstanding that their collateral has been or will be sold in connection with the closing and

liquidation of over 900 hundred stores. (Id. ¶ 80.) The proceeds from those sales have been used

to subsidize the operating losses and administrative expenses of the estates, including significant

payments to movie studios on account of inventory delivered to the Debtors prepetition. The

Senior Secured Notes received nothing from this liquidation of their collateral. (Id.) Nothing.

3. Yet despite the Steering Group’s cooperation with the Debtors, and its agreement to

permit the consensual use of its Cash Collateral to try to preserve the enterprise value of the

business and to pay Blockbuster’s administrative expense creditors, the Creditors’ Committee

filed an objection to the Sale Motion that is littered with offensive and unfounded assertions that

question the actions of the bidders and the DIP Lenders. The Creditors’ Committee claims that

the DIP Lenders caused the Debtors to default under the DIP Facility and Plan Support

Agreement by refusing to approve the Debtors’ proposed business plans, (Committee’s

Objection ¶ 31), even though those unrealistic business plans never addressed the rapidly

deteriorating reality of the Debtors’ financial performance. The Creditors’ Committee claims

that the DIP Lenders issued an “illusory DIP Facility,” (id. ¶ 30), even though the Debtors drew

more than $53 million over the life of the DIP Facility and were permitted to use more than $850

3

million of Cash Collateral to finance their business. (Henkin Decl. ¶ 74.) And the Creditors’

Committee claims that the DIP Lenders will receive an “undeserved windfall” from the Roll-Up

Notes under the Final DIP Order, (Committee’s Objection ¶ 29), even though those heavily

negotiated provisions provided reasonable consideration to compensate the DIP Lenders for the

additional risk of financing these Debtors. (Henkin Decl. ¶ 19.)

4. The Committee’s deliberately misleading allegations have no basis in reality and

should not prevent this Court’s approval of the Sale Motion nor compel entry of the other relief

the objectors seek. As the factual record overwhelmingly demonstrates, the DIP Lenders

extended credit and acted in good faith throughout these Chapter 11 Cases.

5. It is the Debtors that defaulted under the terms of the Plan Support Agreement and

the DIP Credit Agreement by missing numerous milestones under those agreements which the

Steering Group in good faith extended several times. (Id. ¶ 11.) It is the Debtors that failed to

deliver a realistic business plan that addressed Blockbuster’s precipitously deteriorating financial

performance. (Id. ¶¶ 23-28, 36-37.) It is the performance of the Debtors’ businesses and not the

actions of the DIP Lenders or Senior Secured Noteholders that led to this disappointing yet

necessary sale under section 363 of title 11 of the United States Code (the “Bankruptcy Code”).

6. The DIP Lenders never agreed to “backstop” the entire reorganization process or

guarantee payment of all of the Debtors’ administrative and other creditors without limitations,

as the Creditors’ Committee erroneously contends. (Committee’s Objection at 3.) As “Backstop

Lenders,” the Steering Group committed to fund the entire DIP Facility if there were not enough

Senior Secured Noteholders subscribing to the facility. (Henkin Decl. ¶ 76.) They agreed to

provide a revolving credit facility on very specific terms that were negotiated and agreed to by

the Creditors’ Committee and approved by a final order of this Court. (Id. ¶ 15.)

4

7. The Steering Group therefore supports the Debtors’ Sale Motion, and opposes the

various objectors’ premature motions to convert these Chapter 11 Cases, because the auction and

sale process is now the best way to preserve and maximize Blockbuster’s value as a going

concern business. (Id. ¶ 51.) As detailed below and in the accompanying declaration of Michael

Henkin of Jeffries & Company, Inc., the Steering Group’s financial advisor, the Steering Group

has worked in good faith and cooperation with the Debtors to maintain that enterprise value

throughout the restructuring process. The proposed auction process under section 363 of the

Bankruptcy Code has the greatest potential to generate overbids from interested purchasers for

the benefit of all constituents. A going-concern bidder may also assume significant

administrative expenses to the benefit of many constituents. Indeed, according to the Debtors’

financial advisor, at least five or six potential purchasers have conducted due diligence and

expressed serious interest in submitting a bid at the auction.

8. The premature conversion to a chapter 7 liquidation at this stage would be a

disaster for all constituents, causing further harm to the Debtors’ businesses and deterioration to

the value of the Debtors’ assets. With the DIP Lenders’ consent and cooperation, Blockbuster

has tried to stem the decimation of its enterprise value and worked to maintain significant trade

vendor relationships by spending the Senior Secured Noteholders’ Cash Collateral. But that

value could be depleted significantly in a chapter 7 liquidation. And in a conversion, it is highly

unlikely that any other constituent will receive any consideration because the Senior Secured

Noteholders have valid secured liens of approximately $630 million in substantially all of the

Debtors’ property.

9. Under the proposed sale budget, by contrast, the Debtors are slated to use the

Senior Secured Noteholders’ Cash Collateral generated through the operation of the Debtors’

5

business and the ongoing liquidation of inventory at closed stores to pay over $285 million in

total operating expenses to administrative claimants from February 27, 2011 through April 17,

2011, the estimated closing date of the sale. (Henkin Decl. ¶ 58.)

10. Indeed, the $285 million proposed budget – subject to the Sale Motion being

approved and agreement reached with constituents – for the sale process allocates payments of

approximately $65 million to movie studios, game providers, and general merchandise providers,

approximately $68 million to landlords, utilities, and maintenance, approximately $80 million for

rank-and-file employee compensation and benefits, approximately $25 million for taxes, and

approximately $40 million for other operating expenses such as insurance, information

technology, and freight/postage. (Id. ¶ 59.) Of course, all of these payments are to be made

from the Senior Secured Noteholders’ Cash Collateral with NOTHING being paid to the Senior

Secured Noteholders. (Id.) Granting the Sale Motion and implementing the auction process

unquestionably will result in a better economic outcome for administrative claimants compared

to converting these cases to chapter 7.

11. For all of these reasons and as detailed below, the Sale Motion should be granted,

and the various objections and motions to convert these Chapter 11 Cases to a liquidation under

chapter 7 should be denied.

RELEVANT BACKGROUND

12. The commencement of these Chapter 11 Cases resulted from a months-long

negotiation process between the Debtors and the Steering Group, whose members hold in excess

of 80% in face amount of Blockbuster’s Senior Secured Notes. (Id. ¶ 9.) Prior to the Petition

Date, Blockbuster and the Steering Group entered into a plan support agreement dated as of

September 22, 2010 (the “Plan Support Agreement”) in which they agreed to the material

terms of a chapter 11 plan of reorganization and proposed exit financing. (Id.) The Plan Support

6

Agreement contemplated a recapitalization of the Debtors whereby the approximately $630

million of Senior Secured Notes would be exchanged for 100% of the equity interests in a

reorganized Blockbuster. (Id. ¶ 10.)

13. On September 23, 2010 (the “Petition Date”), each of the above captioned debtors

(the “Debtors”) commenced these chapter 11 cases (the “Chapter 11 Cases”) by filing a

voluntary petition under chapter 11 the Bankruptcy Code.

14. On October 1, 2010, the Office of the United States Trustee for the Southern

District of New York (the “Trustee”) appointed an official committee of unsecured creditors

(the “Creditors’ Committee”) to represent the interests of the unsecured creditors in these

Chapter 11 Cases.

15. In connection with the Plan Support Agreement, the Steering Group also agreed to

provide debtor in possession financing so that Blockbuster would have sufficient liquidity to

conduct ordinary course business operations during the restructuring. (Henkin Decl. ¶ 12.)

Accordingly, on the Petition Date, the Debtors filed their Motion for Entry of an Order, on an

Interim and Final Basis, (I) Authorizing the Debtors to Obtain Post-Petition Superpriority

Financing (the “DIP Facility”) Pursuant to 11 U.S.C. §§ 105, 361, 362, 364(c), 364(d)(1), and

364(e), (II) Authorizing Debtors' Use of Cash Collateral Pursuant to 11 U.S.C. § 363, (III)

Granting Liens and Superpriority Claims to DIP Lenders Pursuant to 11 U.S.C. § 364, (IV)

Providing Adequate Protection Pursuant to 11 U.S.C. §§ 361, 362, 363 and 364, and (V)

Scheduling a Final Hearing Pursuant to Bankruptcy Rules 2002, 4001(b), 4001(c), and 6004 (the

“DIP Motion”).

16. On October 27, 2010, this Court entered a final order (the “Final DIP Order”) (i)

authorizing the Debtors to obtain post-petition super-priority secured financing (the “DIP

7

Financing”) from those lenders (the “DIP Lenders”) party to that certain Senior Secured,

Super-Priority Debtor-in-Possession Revolving Credit Agreement dated as of September 23,

2010 (the “DIP Credit Agreement”), (ii) authorizing the Debtors’ post-petition use of Cash

Collateral of the DIP Lenders, the Roll-Up Noteholders, and the Senior Secured Noteholders

(defined in the Final DIP Order, the “Cash Collateral”), and (iii) granting adequate protection to

the beneficial holders (“Senior Secured Noteholders”) of the 11.75% Senior Secured Notes due

2014 (the “Senior Secured Notes”) and U.S. Bank National Association, as trustee and

collateral agent.

17. As security for the DIP Obligations (including the Roll-Up Notes), the Final DIP

Order provided that the Debtors granted to the DIP Agent, for the benefit of itself and the DIP

Lenders and the Roll-Up Noteholders, the DIP Lenders and the Roll-Up Noteholders valid,

enforceable, non-avoidable, and fully perfected first priority liens on and security interests in the

DIP Collateral (defined in the Final DIP Order), which included first priority liens on and

security interests in the Debtors’ unencumbered assets. (Henkin Decl. ¶ 18.) The Debtors’ only

material unencumbered assets were one-third of the equity interests of the Debtors’ foreign

assets, which had not been pledged to the Senior Secured Noteholders for tax purposes, a Danish

subsidiary, and the Avoidance Actions (defined in the DIP Order). (Id. ¶ 19.)

18. In addition, the Senior Indenture Trustee received, on behalf of the Senior Secured

Noteholders, adequate protection of their interests in their Prepetition Collateral (defined in the

Final DIP Order), including Cash Collateral, for and equal in amount to the aggregate diminution

in value of the DIP Lenders’ security interests in the Prepetition Collateral as a result of, among

other things, the Debtors’ sale, lease, or use of cash collateral and any other Prepetition

Collateral, and the priming of the Senior Secured Noteholders’ security interest and liens in the

8

Prepetition Collateral. Such adequate protection included replacement security interests in and

liens upon all DIP Collateral and superpriority administrative expense claims. (Henkin Decl. ¶

18.) The Final DIP Order also found that the DIP Lenders acted in good faith in negotiating the

DIP Credit Agreement, including the Roll-Up Notes. (See Final DIP Order at 12-13, ¶ 6(h).)

19. The revolving DIP Facility has drawn as much as $53 million. (Henkin Decl. ¶

74.) Those draws have been repaid and the DIP Facility was terminated.3

20. During the Chapter 11 Cases, no amounts, whether principal, interest, or fees have

been paid on the Senior Secured Notes, including the Roll-Up Notes. (Id. ¶ 80.)

21. On February 21, 2011, the Debtors’ filed their Motion, Pursuant To 11 U.S.C. §§

105, 363, 364, and Fed. R. Bankr. P. 2002, 4001, 6004, 6006, 9008, and 9014, for Entry of: (I) an

Order Approving (a) Bid Procedures, (b) Stalking Horse Expense Reimbursement, (c) Notice of

Sale, Auction, and Sale Hearing, (d) Assumption Procedures and Related Notices, (e) Incurrence

of Sale-Related Administrative Priority Claims and Related Liens, and (f) Imposition of an

Administrative Stay; and (II) an Order Approving the Sale of Substantially All of the Debtors’

Assets (the “Sale Motion”) [Docket No. 947].

22. On February 3, 2011, Summit Distribution, LLC (“Summit”) filed that certain

Motion for Entry of an Order (I) Compelling Immediate Payment of its Administrative Expense

3 On February 25, 2011, the DIP Agent notified the Debtors of the occurrence of and continuation of certain Events of Default under the DIP Credit Agreement, exercised its rights to terminate the DIP Credit Agreement, and declared all obligations under the DIP Facility due and payable. On February 25, 2011, the Requisite Consenting Noteholders notified the Debtors of the occurrence of and continuation of certain Termination Events under the Plan Support Agreement, and exercised their rights to terminate the Plan Support Agreement. Also on February 25, 2011, the DIP Agent, as directed by the Requisite Lenders, delivered to the Debtors, United States Trustee, and the Creditors’ Committee the Carve-Out Trigger Notice (defined under the Final DIP Order) notifying each of a Termination Event under the Final DIP Order, that all obligations under the DIP Facility had been accelerated, that the Post Carve-Out Trigger Cap had been invoked, and that the delivery of the Carve-Out Trigger Notice constituted a Roll-Up Event (defined under the Final DIP Order). Importantly, the DIP Lenders have consented to the Debtors’ use of Cash Collateral throughout the sale process, if approved.

9

Claim or, in the Alternative, (II) Granting it Relief from the Automatic Stay to Permit

Reclamation of its Goods and Converting the Chapter 11 Cases to Cases Under Chapter 7 for

Cause (the “Summit Motion”) [Docket No. 907]. The Summit Motion asked the Court to

compel the immediate payment of its administrative expense claims (Summit Motion, ¶ 10-13),

or, in the alternative, grant it relief from the automatic stay to permit the enforcement of its

reclamation rights (id. ¶ 14-16), and convert these cases to chapter 7 (id. ¶ 17-19).

23. On February 22, 2011, Universal Studios Home Entertainment (“Universal”) filed

that certain Motion for Entry of an Order (I) Compelling Immediate Payment of its

Administrative Expense Claim or, (II) Granting Adequate Protection or, (III) Ordering Recall of

Goods Pursuant to 11 U.S.C. 105(a) and 362(d) to the Extent Necessary and Applicable or, (IV)

Granting it Relief from the Automatic Stay to Permit Reclamation of its Goods, Including

Memorandum of Law in Support of Motion [Docket No. 951] (the “Universal Motion”). The

Universal Motion seeks the immediate payment of its administrative expense claims (Universal

Motion ¶ 21-24), adequate protection for the declining value of Universal titles (id. ¶ 25-34), and

relief from the automatic stay to permit the enforcement of its reclamation rights (id. ¶35-41).

24. On or about February 28, 2011, the Creditors’ Committee filed an objection to the

Sale Motion and a cross-motion seeking to convert the Debtors’ Chapter 11 Cases to cases under

chapter 7 of the Bankruptcy Code (the “Committee’s Objection”). The Committee’s Objection

alleges that the DIP Lenders acted in bad faith by providing an “illusory” $125 million DIP

Facility. (Committee’s Objection at 3.) The Committee’s Objection asserts that the DIP Lenders

never intended for the DIP Facility to backstop the substantial post-petition credit that was

necessary to fund the Chapter 11 Cases and that the DIP Lenders broke their commitment to

backstop the Debtors’ reorganization process. (Id.) With no evidentiary support whatsoever,

10

and based on clearly incorrect allegations, the Creditors’ Committee requests that this Court,

among other things, (i) find that the DIP Lenders acted in bad faith, (id. ¶¶ 14-18), (ii) reverse its

prior order and limit the benefits granted by this Court to the DIP Lenders under the Roll-Up

Notes, (id. ¶¶ 19-32), and (iii) order the DIP Lenders to guarantee payment of post-sale

administrative expense claims (id. ¶¶ 38-40).

25. The Committee’s Objection also seeks to convert the Chapter 11 Cases if the

stalking horse bidders do not make certain changes to the proposed sale process and their

stalking horse bid. (Id. ¶ 41.) Again with no evidentiary support whatsoever and based on mere

assumptions, the Creditors’ Committee argues that their cross-motion for conversion should be

granted because there is (i) a continuing loss to or diminution of the estate and the absence of a

reasonable likelihood of rehabilitation, (id. ¶¶ 46-49), or (ii) an inability to effectuate substantial

consummation of a confirmed plan, (id. ¶¶ 50-51).

26. On February 28, 2011, the Trustee filed that certain Objection to Order Authorizing

the Incurrence of Sale-Related Administrative Priority Claims (the “Trustee Objection”)

[Docket No. 986]. In the Trustee Objection, the Trustee opposed the Debtors’ proposal to grant

super-priority status to certain administrative claims, (Trustee Objection ¶¶ 22-27), requesting

clarification as to which administrative creditors would receive super-priority treatment and

which would not (id. ¶¶ 28-30).

27. On February 28, 2011, Universal filed an Objection to the Sale Motion (the

“Universal Objection”) [Docket No. 1024]. The Universal Objection asserted Universal’s

rights to Universal titles in the Debtors’ possession, arguing that those titles were leases to the

Debtors (Universal Motion ¶ 4). Universal also objected to the Debtors’ request for the

imposition of the Administrative Stay. (Id. ¶ 5).

11

28. On February 28, 2011, Summit filed an Objection to the Sale Motion (the “Summit

Objection”) [Docket No. 989]. Summit objected to the Debtors’ proposed payment of certain

administrative expense claims on a super-priority basis (Summit Objection ¶¶ 6-8), and again

asserted their right to reclaim their goods from the Debtors (id. ¶¶ 9-12). Summit also moved

for conversion of these cases to chapter 7 (id. ¶¶ 13-17), and described the Sale Motion as a sub

rosa plan of reorganization that was not fair or reasonable (id. ¶¶ 18-19, 20-26).

29. On March 4, 2011, the Trustee filed that certain Motion to Shorten the Notice

Period and Covert these Chapter 11 Cases to Cases Under Chapter 7 (the “Trustee Conversion

Motion”) [Docket No. 1075]. The Trustee Conversion Motion requested the conversion of these

cases to chapter 7, asserting that the Debtors are administratively insolvent (Trustee Conversion

Motion ¶ 29), and unlikely to present a plan of liquidation (id. ¶ 30). The Trustee further

objected to the Sale Motion’s treatment of chapter 7 administrative expense claims in any

subsequent conversion to chapter 7. (Id. ¶ 42.) The Trustee Conversion Motion alleges that the

Debtors have abandoned any meaningful reorganization activity, and that the Debtors’

administrative insolvency makes it highly unlikely that a plan can be confirmed. (Id. ¶ 44.)

ARGUMENT

I. THE SENIOR SECURED NOTEHOLDERS AND DIP LENDERS ACTED IN GOOD FAITH THROUGHOUT THESE CHAPTER 11 CASES

A. The DIP Facility was Negotiated in Good Faith with Fair and Reasonable Lender Protections

30. Without any factual evidence whatsoever, the Committee’s Objection attacks the

bona fides of the DIP Credit Agreement, the lender protections provided therein and granted by

this Court in the Final DIP Order, and the actions of the DIP Lenders thereunder.

31. As this Court has already found when it entered the Final DIP Order, the terms and

conditions of the DIP Credit Agreement and the consensual use of cash collateral were

12

negotiated between the Debtors, the DIP Lenders, and the Creditors’ Committee through

extensive good-faith arm’s length negotiations. (See Final DIP Order at 12-13, ¶ 6(h).)

32. Given Blockbuster’s continued downward trending revenues and the increasing

obsolescence of Blockbuster’s “brick and mortar” distribution platform (as evidenced in the quite

recent liquidation of Movie Gallery, a former Blockbuster competitor), the Steering Group was

highly concerned about loans that would be made to Blockbuster under the DIP Credit

Agreement. (See Henkin Decl. ¶ 14.) Indeed, the rapid decline of Blockbuster’s business is

reflected in the significant decrease in Blockbuster’s total revenues and EBITDA over the

preceding three years. For the year fiscal year ending December 31, 2008, Blockbuster’s total

revenues were approximately $5 billion with EBITDA of approximately $277 million. For the

fiscal year ending 2009, Blockbuster’s total revenues were approximately $4 billion with

EBITDA of approximately $162 million. By the fiscal year ending 2010, Blockbuster’s

revenues were approximately $3 billion and its EBITDA had shrunk to an adjusted $78 million

(a 52% decrease year-over-year). (See id. ¶ 5 & Ex. A.)

33. The net rental revenue from Blockbuster’s sales at domestic retail stores that have

been open for a year or more (i.e., comparative store sales, or “comp store sales”) has trended

significantly downward from a high of approximately 8.4% in the second quarter of 2008, to as

low as approximately 18% down for the fourth quarter of 2010. (Id. ¶ 7 & Ex. B.) For example,

the average comp store sales for the year ending 2008 was down 1.2%, for the year ending 2009

was down 14.6%, and for the year ending 2010 was down another 10.4%. (Id. & Ex. B.) The

week over week decline is even more dramatic. (See id. ¶ 24 & Ex. C.)

34. In light of these risks, the DIP Lenders negotiated a structure and conditions to

protect their potential exposure on the new money loans. The Creditors’ Committee reviewed

13

the structure and conditions of the DIP Facility, including the budget. It objected to provisions

of the DIP Facility; it negotiated with the DIP Lenders with respect to those terms; and it reached

agreement with the Debtors and the DIP Lenders and consented to the Final DIP Order after full

and arm’s length negotiations. (Id. ¶¶ 12-21.)

35. The final, negotiated DIP Facility was structured as a revolving loan facility subject

to an approved budget to fund Blockbuster’s day-to-day operations. (Id. ¶ 15.) Under the DIP

Credit Agreement, Blockbuster was required each month to submit a proposed budget to the DIP

Lenders for approval. The initial 13-week budget submitted to this Court demonstrated that,

from the beginning of these Chapter 11 Cases through the week commencing January 9, 2011,

the largest balance of the DIP Facility was estimated at $69.2 million, with no draw being greater

than $23 million. (See id. ¶ 16.) This was so because store closings and liquidation of the

collateral of the Senior Secured Noteholders from those stores would provide additional cash to

fund administrative expenses. As it turned out, much of that cash was also necessary to fund

operating losses.

36. The DIP Credit Agreement was not a blank check. It provided the Debtors with up

to $125 million of revolving loans on very specific terms and conditions precedent and required

the Debtors to meet specific milestones.4 (Id. ¶ 15.)

4 The milestones included (i) obtaining a final order approving the DIP Credit Agreement by October 23, 2010 (extended by the DIP Lenders to November 7, 2010); (ii) obtaining critical vendor orders with respect to Sony Pictures Home Entertainment Inc., Warner Bros. Home Entertainment Inc. and Twentieth Century Fox by October 28, 2010; (iii) filing a plan of reorganization that conformed to the requirements of the Plan Support Agreement in all respects by November 22, 2010 (extended several times and ultimately to February 18, 2011); (iv) obtaining approval by the Requisite DIP Lenders of an updated business plan by November 30, 2010 (extended several times and ultimately to February 18, 2011); (v) obtaining an order approving the disclosure statement of a plan that conforms to the requirements of the Plan Support Agreement in all respects by January 15, 2011 (extended to February 18, 2011); and (vi) obtaining an order confirming a plan that conforms to the requirements of the Plan Support Agreement by March 15, 2011. (Henkin Decl. ¶ 15.)

14

37. The DIP Credit Agreement also required weekly mandatory prepayments if

aggregate treasury cash exceeded $25 million in the month of December, or $20 million dollars

in any other month. (Id. ¶ 17.) The excess was to be used to pay down the then-outstanding

balance on the DIP Facility. (Id.) The Creditors’ Committee reviewed and negotiated or

accepted each of these reasonable protective provisions and understood them to be limitations on

the availability of the DIP Facility. (Id. ¶¶ 14-17.) In addition, the Debtors and the DIP Lenders,

consistent with the terms of the Plan Support Agreement, sought to achieve a quick

reorganization under a new management team and business plan that would de-lever the Debtors

significantly, leaving little to no funded debt on the Company (other than a new $50 million

working capital exit facility which the Debtors had to obtain). (See id. ¶ 10.)

38. Since the entry of the Final DIP Order and throughout these Chapter 11 Cases, the

DIP Lenders have continued to work cooperatively with the Debtors and the Creditors’

Committee. For example, subsequent to the entry of the Final DIP Order, the Creditors’

Committee requested that the Challenge Period (defined in the Final DIP Order) for commencing

actions pursuant to paragraph 28 of the Final DIP Order be extended from the original expiration

date of December 27, 2010. The Requisite Lenders in good faith granted that request and agreed

to extend the Challenge Period to February 1, 2011, and then further extended the Challenge

Period to February 11, 2011. (See id. ¶ 21.)

39. The Creditors’ Committee conducted a thorough investigation of the DIP Financing

and the liens and obligations related to the Senior Secured Notes, and ultimately completed that

15

investigation without taking any action or commencing an adversary proceeding. 5 (See id. ¶ 22.)

The DIP Lenders relied on their deal with the Creditors’ Committee and the Final DIP Order by

making advances and permitting the use of Cash Collateral to fund ongoing business operations.

B. The DIP Lenders Acted In Good Faith by Approving Budgets, Authorizing Increased Advertising Spending, and Extending Milestones

40. Again, with absolutely no factual evidence, the Creditors’ Committee attempts to

mislead this Court into believing that the DIP Lenders have concocted some mischievous plan

“to direct and control a chapter 11 sale process designed for its exclusive benefit and without

regard to the devastation that it previously caused these estates.” (See Committee’s Objection at

3.) Indeed, the Creditors’ Committee carelessly asserts that the DIP Lenders “walked away

unscathed from their commitment to backstop the reorganization they pledged to sponsor.” (Id.)

In fact, these case have been run for the benefit of every constituent but the Senior Secured

Noteholders and DIP Lenders who have been the most “scathed” party as a result of the

uncompensated liquidation of their collateral.

41. From September 23, 2010 through February 24, 2011, the DIP Lenders approved

every proposed budget submitted by the Debtors (in October, November, December, January and

then week-to-week until the budget period ending February 24, 2011, the date on which the

Debtors filed the Sale Motion). (Henkin Decl. ¶ 23.) By approving each of those budgets, the

5 As provided under the Final DIP Order, “[i]f no such adversary proceeding is timely and properly commenced during the Challenge Period then, without further order of the Court, (i) the claims, liens and security interests of the Senior Indenture Trustee and the Senior Secured Noteholders shall be deemed to be finally allowed for all purposes in these Chapter 11 Cases and any subsequent chapter 7 cases of any of the Debtors and shall not be subject to challenge by any party in interest as to validity, priority, extent, perfection or otherwise, and (ii) the Debtors and their estates shall be deemed to have released any and all claims or causes of action against the Senior Indenture Trustee and the Senior Secured Noteholders with respect to the Senior Note Documents or any conduct or transactions related thereto whether prepetition or postpetition.” (See Final DIP Order at 48, ¶ 28(b) (emphasis added).) Upon information and belief, the professionals of the Creditors’ Committee have incurred fees of over $600,000 and the vast majority of such fees were incurred in connection with the investigation and depositions of the DIP Lenders.

16

DIP Lenders authorized Blockbuster to use the DIP Financing and Cash Collateral to fund the

day-to-day operations of the company and to pay administrative expenses that totaled in excess

of $850 million. (Id. ¶¶ 23, 74, 80 & Ex. I.) While the DIP Lenders received some interest and

fees,6 the Senior Secured Noteholders have received NO payments of any kind on account of

their $630 million Senior Secured Notes, including none on the Roll-Up Notes. (See id. ¶ 80.)

42. Although Blockbuster’s financial performance continued to rapidly deteriorate as

set forth in more detail in the Henkin Declaration, the DIP Lenders continued to support the

Debtors’ efforts to turn around the business. For example, in late October, Blockbuster’s

management requested the DIP Lenders’ consent to an additional $20 million advertising spend

for the holiday season (the “Q4 Ad Campaign”). (Id. ¶ 31.) As discussed in more detail in the

Henkin Declaration, the Debtors’ management expected that the Q4 Ad Campaign would drive

an 8.6% increase in net rental revenue comp stores sales and approximately $8 million in gross

margin. (See Id. ¶ 32 & Ex. F.) In a good-faith effort to support increased customer awareness

and reverse or slow Blockbuster’s further financial deterioration, the Steering Group

unanimously approved the Q4 Ad Campaign.7 (Id. ¶ 33.)

6 Total commitment and underwriting fees to the DIP Lenders for the DIP Facility were $4.375 million plus the benefit of the Roll-Up Notes. 7 As another example of the DIP Lenders good faith, the DIP Lenders also agreed, at the Debtors’ request, to amend the definition of EBITDA in the DIP Credit Agreement to allow an add-back of approximately $10 million so that the Debtors would not trip their minimum EBITDA covenant, given the additional advertising spend. Without this add-back, it is doubtful that Blockbuster would have met its year-end minimum EBITDA covenant, and the Debtors could have been defaulted much earlier under the DIP Credit Agreement. In addition to the Q4 Ad Campaign, Blockbuster’s management also requested additional cash then budgeted in order to bid on certain intellectual property being sold in the Movie Gallery bankruptcy cases. Again, the Steering Group approved this non-budgeted amount, although Blockbuster was ultimately unsuccessful in purchasing the Movie Gallery intellectual property. (Henkin Decl. ¶ 33.)

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43. Throughout the Chapter 11 Cases, the DIP Lenders continued to approve a

significant amount of payments from the Debtors to their trade partners in order to maintain

commercial relations and try to preserve the going concern value of the enterprise. (Id. ¶ 74.)

C. The Debtors Failed to Provide a Viable Business Plan

44. The Creditors’ Committee’s assertion that the DIP Lenders themselves somehow

acted improperly by causing the Debtors to default under the DIP Facility, by refusing to reach

consensus among themselves with respect to the Debtors’ proposed business plans, (Committee’s

Objection ¶ 31), is flat out wrong and simplistic in its failure to understand the significant

decrease in Blockbuster’s total revenues and EBITDA due to the rapid deterioration of the

company’s traditional store-based distribution channel. (See Henkin Decl. ¶¶ 6-7, 36.)

45. Pursuant to the DIP Credit Agreement, the Debtors were required to (i) file a plan

of reorganization that conformed to the requirements of the Plan Support Agreement in all

respects by November 22, 2010 (extended by the Final DIP Order to November 30, 2010) and

(ii) obtain approval by the Requisite Lenders of an updated business plan by November 30, 2010.

In addition to these milestones in the DIP Credit Agreement, the Plan Support Agreement not

only required that the foregoing milestones be achieved but also required that the Debtors

nominate a chief executive officer for reorganized Blockbuster that was acceptable to the

Requisite Lenders. (Id. ¶ 11.)

46. Despite amendments to the DIP Credit Agreement and several extensions of the

milestones under the DIP Credit Agreement and Plan Support Agreement granted in good faith

by the Steering Group, the Debtors were unable to present an economically viable business plan

that the Steering Group could approve, largely because the Debtors’ declining financial

performance accelerated much more rapidly than expected following the Petition Date. Indeed,

since the commencement of these Chapter 11 Cases, Blockbuster’s weekly net rental revenue

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comp store sales have continued to decline at an accelerated pace, falling from negative 5% on

September 5, 2010 to as low as negative 38% in mid-February 2011. (Id. ¶ 24 & Ex. C.) Since

September 5, 2010, total net revenue comp store sales have declined by 18.1%. (Id.)

47. On or about October 12, 2010, Blockbuster’s management presented the Steering

Group with its first proposed Business Plan (the “October Business Plan”). The Steering Group

believed that the October Business Plan presented an overly optimistic forecast of Blockbuster’s

future. In the October Business Plan, Blockbuster optimistically projected year-end adjusted

EBITDA for 2010 at approximately $88 million (representing a 22% decrease from the July

Business Plan), increasing to $98 million for the year ending 2011, to $142 million for the year

ending 2012, to $168 million for the year ending 2013 and up to $192 million for the year ending

2014. (See Henkin Decl. ¶ 27 & Ex. E.) With respect to domestic store revenues, the October

Business Plan projected revenues of $1.9 billion for 2010, a year-over-year decline of negative

24%. However, domestic store revenues were then projected to stabilize for years two and three

at around $1.6 billion, before falling again to $1.2 billion in 2014 with a year-over-year change

of negative 18%. (See id.)

48. In light of Blockbuster’s actual negative double digit comp store trends over the

prior three years, and the gale force headwinds facing the business, the Steering Group did not

believe the October Business Plan could be achieved. Indeed, if the recent comp store sales

downward trend continued, then based on the Debtors’ own analysis, approximately two-thirds

of the Debtors’ stores will be cash flow negative within 24 months. (See Henkin Decl. ¶ 28 &

Ex. D.)

49. The Steering Group expressed concerns with the October Business Plan, and

Blockbuster indicated that it would revise its forecasts and financial projections to project a more

19

realistic view of the future. During the subsequent weeks, however, Blockbuster’s financial

performance continued to plummet while its competitors continued to increase their market

presence in the rapidly growing and more popular distribution channels. (See Henkin Decl. ¶¶

29-31.)

50. In late November 2010, Blockbuster’s management presented a newly revised

business plan to the Steering Group (the “November Business Plan”, together with the October

Business Plan, the “Proposed Business Plans”). The November Business Plan continued to

forecast optimistic net rental revenue comp store sales that could not be reconciled with the

Debtors’ actual financial performance. Specifically, the plan showed net rental revenue comp

store sales of negative 6% for the year ending 2010, up to negative 1.4% for the year ending

2011, negative 1.9% for the year ending 2012, negative 2.7% for the year ending 2013, and

negative 2.8% for the year ending 2014. (See id. ¶ 36 & Ex. H.) Compared to the significantly

downward historical trend of net rental revenue comp store sales since 2008, with average comp

store sales of negative 14.6% for the year ending 2009 and negative 10.4% for the year ending

2010, (id. & Ex. C), management’s November forecast of very modest 1.4% - 2.8% annual net

negative rental revenue comp store sales was unduly optimistic, (id.)

51. The November Business Plan forecasted that EBITDA would increase over the

subsequent five years, despite the fact that EBITDA had decreased substantially from 2008

through 2010 due to competitive headwinds and rapidly changing industry dynamics. Yet the

November Business Plan forecasted year-end adjusted EBITDA for 2010 at approximately $82

million, then increasing to $86 million for the year ending 2011, up to $129 million for the year

ending 2012, up to $143 million for the year ending 2013, and up to $172 million for the year

ending 2014. (See id. ¶ 37.)

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52. The November Business Plan for the first time also called for a $200 million rights

offering, but failed to explain the uses and potential returns on the new money from the proposed

equity investment. The net $190 million equity investment (after fees) was simply described as

needed to (i) provide liquidity; (ii) underscore the company’s near-term financial viability; (iii)

reserve committed capital for future digital business development; (iv) ensure trade partner

confidence; (v) secure studio exclusive content investments; and (vi) support other strategic

growth opportunities. The Debtors never provided any support for how they intended to use the

proposed $190 million equity investment, nor did they demonstrate how the equity infusion was

expected to generate real return on investment. (See Henkin Decl. ¶ 38.) Neither the Plan

Support Agreement nor the DIP Credit Agreement contemplated an additional investment by the

Steering Group of $200 million, on top of the conversion of more than $600 million worth of

debt into equity, as a condition to a plan of reorganization.

53. The Steering Group engaged in extensive discussions with the Debtors’

professionals to address its concerns about the November Business Plan. The Debtors agreed

that further revisions to their business plan were necessary, and the DIP Credit Agreement was

amended to extend the Third Milestone – the date by which the Debtors were required to file a

Disclosure Statement and Plan with this Court and to obtain approval of a Business Plan – from

November 30, 2010 to December 15, 2010 and then further to January 14, 2011. (See id. ¶¶ 39,

41.)

D. The Debtors Propose A Sale Under Section 363 of the Bankruptcy Code

54. On January 11, 2011, management held a meeting with the Steering Group during

which it presented a financial update to the Steering Group. Management conceded that the

company’s financial performance had deteriorated to a much greater extent than it had forecasted

just weeks earlier, and reported that adjusted EBITDA for the year ending 2010 was

21

approximately $78 million as compared to $200 million for the year ending 2009, a decrease of

approximately 56%. Management also reported that the $17 million Q4 Ad Campaign had not

produced the expected results, and that the Debtors had in fact experienced decreased net rental

revenues against the same period in 2009. (See Henkin Decl. ¶ 42.) At this presentation,

management also recognized that the number and pace of store closings would have to increase

substantially due to the significant downward trend of comp store sales, the decrease in customer

foot traffic, and the flawed assumptions made by Blockbuster in its Proposed Business Plans

regarding its ability to stem the significant declines in year-over-year same store comp sales.

(Id.)

55. Importantly, it was at this meeting it was revealed that the Debtors’ Board of

Directors had authorized management to consider other restructuring alternatives, including a

section 363 sale of substantially all of the Debtors’ assets. (Id. ¶ 43.) Management on behalf of

the Board requested stalking horse bids from lenders in the Steering Group given that those

lenders were fully familiar with Blockbuster’s assets and operations, and would be in the best

position to quickly commence a 363 sale. In addition, at the January 11 meeting, the Debtors’

management and advisors disclosed for the first time that the administrative claims incurred

during these Chapter 11 cases were approximately $285 million – far greater than the Steering

Group had expected based upon the prior information provided to it. (Id. ¶¶ 43-48.)

56. The Steering Group concurred with the Debtors’ conclusion that a 363 auction and

sale process would be the best way to maximize Blockbuster’s value as a going concern. (Id. ¶¶

50-51.) The auction process may lead to overbids from potential bidders, and a bidder may agree

to assume administrative expenses to the benefit of many constituents. Auctions of this type

22

often lead to overbids where potential buyers express serious interests in the company or its

assets. (See id. ¶ 51.)

57. The Steering Group clearly behaved in good faith by continuously extending

milestones and working constructively with the Debtors to try to come up with a realistic and

achievable business plan. The Debtors missed numerous milestones despite multiple extensions

granted by the Steering Group. The Debtors failed to produce a rational business plan that

addressed their precipitously deteriorating comp store sales, failed to develop a plan to rapidly

close underperforming stores, and failed to provide EBITDA projections that reflected the reality

of the competitive and rapidly changing market environment in which Blockbuster struggled to

operate.

58. The Debtors’ decision to investigate a 363 sale and the Senior Secured Lenders’

agreement to participate in the process was born from the unfortunate conditions of the Debtors’

business and not from an attempt to “lin[e] the pockets of the [stalking horse bidder].”8

(Committee’s Obj. at 5.)

E. The DIP Lenders and Senior Secured Noteholders Honored All of Their Obligations

59. The Debtors actually drew over $53 million over the life of the DIP Facility,

including draws as high as $17 million and an outstanding balance as high as $26 million at one

point. (Henkin Decl. ¶ 74.) The Debtors have used those draws under the DIP Facility to fund

the company’s operations, pay administrative expenses, and preserve the enterprise. (Id.) The

DIP Lenders met each and every one of their obligations under the DIP Facility and even

8 It should be noted that the agreed upon bidding procedures to not include typical stalking horse protections and the stalking horse is not proposing a credit bid. It is proposing a cash bid and the procedures are wide open for a higher bid.

23

provided the Debtors with numerous amendments and extensions in support of the reorganization

efforts, all without any consideration. (Id. ¶¶ 11, 15.) The Creditors’ Committee would have

this Court overlook that the Debtors have also been using the DIP Lenders’ Cash Collateral,

including cash proceeds from the liquidation of what will be approximately 900 stores. (Id. ¶

80.) Instead of using the proceeds of collateral liquidations to retire secured debt, the Debtors

used the DIP Facility and other Cash Collateral to fund administrative payments to their trade

partners of over $850 million from September 19, 2010 to February 20, 2011. (Id. ¶ 74.)

60. The DIP Lenders did not commit to backstop the Debtors’ reorganization; they

backstopped a lending facility. The Creditors’ Committee misconstrues the meaning of

“backstop” in the context of the DIP Credit Agreement (Committee Objection at 3.) As

expressly set forth in the Final DIP Order, “back stop” simply refers to the commitment of the

Steering Group – the Backstop Lenders –to commit to the entire $125 million DIP Facility if,

after opening up participation of the DIP Facility to all Senior Secured Noteholders, there were

not enough commitments from those other Senior Secured Noteholders (Henkin Decl. ¶ 76; see

also Final DIP Order at 12, ¶ 6(f).) That is the only commitment the Backstop Lenders agreed to

“back stop.” They did not commit in any way to backstop the entire “reorganization process”

nor guarantee to pay all of the Debtors’ administrative expense payments to all of their vendors

and other creditors. (Henkin Decl. ¶ 76.) Of course, the Creditors’ Committee knows that the

Backstop Lenders and the other DIP Lenders have met all of their obligations as evidenced by

the fact that they cannot cite one provision of the DIP Facility which has been breached by the

DIP Lenders. Instead, they rely on false innuendo and misleading hyperbole in a smear attempt

that should not be countenanced.

24

F. The Creditors’ Committee Fails to Assert Any Legal Basis to Undo this Court’s Final DIP Order Approving the Roll-Up Notes

61. In its objection, the Committee fails to set forth any legal basis for undoing this

Court’s Final DIP Order: (i) authorizing the Roll-Up Notes; (ii) granting the DIP Agent and

Senior Indenture Trustee security interests in all of the DIP Collateral, including any of the

Debtors’ unencumbered property, to secure the DIP Obligations, including the Roll-Up Notes;

(iii) providing that the right of a DIP Lender to receive Roll-Up Notes on the occurrence of a

Roll-Up Event is indefeasible and cannot be revoked, avoided, curtailed, or impaired by the

satisfaction, repayment, termination, or acceleration of the Revolving DIP Loan or the

cancellation, reduction or termination of any commitments with respect thereto; and (iv) finding

that the DIP Facility was negotiated in good faith and at arm’s length. (Final DIP Order ¶ 8(a),

12(a), 8(a)(v), 6(h).)

62. Instead, the Creditors’ Committee makes baseless allegations that the DIP Lenders

somehow acted poorly and induced the landlords, vendors, and service providers to finance the

Debtors’ attempted reorganization with an “illusory” DIP Facility. (See Committee Objection ¶

17.) In reality, the members of the Steering Group, in their capacity as DIP Lenders, cooperated

with the Debtors and acted with the upmost good faith at all times by financing Blockbuster

throughout its attempt at reorganization. (Henkin Decl. ¶¶ 14-39.)

63. The Creditors’ Committee’s overheated allegations of bad faith constitute a gross

distortion of the facts designed to frustrate a valid disposition of the Debtors’ assets in a manner

consistent with the principles of section 363 of the Bankruptcy Code, and consistent with the

serious possibility that a public auction of the Debtors’ assets as a going concern will maximize

the value of the Debtors’ assets. Indeed, the Creditors’ Committee’s unsupported request for

25

relief would effectively negate this Court’s Final DIP Order and the good faith reliance of the

DIP Lenders thereunder.

G. The Roll-Up is Appropriate as Approved by this Court

64. The Final DIP Order granted the DIP Lenders a roll-up of $125 million of their

prepetition Senior Secured Notes (the “Roll-Up Notes”) and superpriority administrative expense

claims on such Roll-Up Notes secured by the superpriority priming liens on the DIP Collateral.

(Henkin Decl. ¶ 19.) It should be noted that the Roll-Up Notes did not inure solely to the benefit

of the members of the Steering Group, but to all DIP Lenders which are holders of

approximately 97% of the Senior Secured Notes. The Roll-Up Notes were intended to be a form

of consideration to compensate the DIP Lenders for the risk of providing the DIP Facility. (Id. ¶

19.) One of the concessions that the Steering Group made to the Creditors’ Committee in

negotiating the Final DIP Order was that any Superpriority Claims (defined in the Final DIP

Order) on account of the Roll-Up Notes would not be paid or satisfied from the Avoidance

Actions Proceeds (defined in the Final DIP Order). (Id.)

65. The Committee’s Objection also asserts that the Senior Secured Noteholders

received an “undeserved windfall” through the issuance of the Roll-Up Notes and the priority of

distribution from the DIP Collateral afforded to those notes under the Final DIP Order.

(Committee’s Objection ¶¶ 27-29.) As stated above, prior to the Petition Date, the Senior

Secured Noteholders held valid perfected liens on substantially all of the Debtors’ assets. The

discrete portion of the Debtors’ assets in which the Senior Secured Noteholders did not have

valid liens was a Danish subsidiary and one-third interest in the equity of certain of the Debtors’

foreign subsidiaries. (Henkin Decl. ¶ 72.) The Final DIP Order granted valid, enforceable, non-

avoidable, and fully perfected first priority liens on the DIP Collateral (defined in the Final DIP

Order), which included liens on the Debtors’ limited unencumbered assets. Based upon the

26

risks associated with making the DIP Loans, including the potential material diminution of the

collateral during the pendency of these cases, it was reasonable and appropriate for the DIP

Lenders to take this limited additional collateral to further secure the Senior Secured Notes.

(Henkin Decl. ¶¶ 72-73.)

66. Thus, although the DIP Liens secure both the DIP Loans and the Roll-Up Notes,

the Roll-Up Notes do not benefit from $125 million of previously unencumbered assets as

asserted by the Creditors’ Committee. Rather, the incremental collateral granted under the Final

DIP Order is limited to the value of one-third of the equity interests in certain of the Debtors’

foreign subsidiaries and the stock of the Danish subsidiary. (Id. ¶ 72.) Two-thirds of the foreign

subsidiary stock (other than the Danish subsidiary) was pledged to and perfected by the Senior

Secured Noteholders prepetition.

67. And even if the collateral securing payment of the Roll-Up Notes were limited to

the pre-petition collateral securing the Senior Secured Notes, any administrative claims asserted

by vendors or other unsecured creditors in these cases would be subject to both the Superpriority

Claims granted to the Roll-Up Notes under the Final DIP Order and the Adequate Protection

Superpriority Claims and replacement liens granted to the Adequate Protection Parties (each

defined in the Final DIP Order) under the Final DIP Order for the considerable diminution of the

value of the prepetition collateral during these cases.

II. THE SALE MOTION IS THE BEST OPTION TO MAXIMIZE THE VALUE OF THE DEBTORS’ ASSETS AND IS IN THE BEST INTERESTS OF THE DEBTORS AND THEIR ESTATES

68. The United States Trustee, the Creditors’ Committee, and Summit, have objected to

the Sale Motion and have asserted that pursuing a section 363 sale process will not produce a

better outcome for creditors than converting these cases to cases under chapter 7 of the

Bankruptcy Code. (See Trustee Objection ¶¶ 22-41; Trustee Conversion Motion ¶¶ 29-49;

27

Creditors’ Committee’s Objection ¶¶ 41-55; Summit Objection ¶¶ 13-19 (collectively, for the

purposes of this Section only, the “Conversion Arguments”).) A court can only convert a

chapter 11 case to a chapter 7 case for “cause.” 11 U.S.C. § 1112(b)(4).

69. The principal grounds for purported “cause” alleged in the Conversion Arguments

are (i) a continuing loss to or diminution of the estate and the unlikelihood of the Debtors’

rehabilitation, and (ii) the Debtors’ inability to effectuate substantial consummation of a

confirmed plan. Although these are both possible results if the Debtors continue in chapter 11,

they are not yet realities and do not constitute cause for conversion to chapter 7 at this stage of

the Chapter 11 Cases. In fact, there are strong indications that through the contemplated 363

sale, the Debtors can avoid these fates, and maximize the value of the company for the benefit of

all stakeholders.

70. The burden of showing “cause” for conversion lies with the moving party. In re

Lizeric Realty Corp., 188 B.R. 499, 503 (Bankr. S.D.N.Y. 1995); 7 COLLIER ON

BANKRUPTCY ¶ 1112.05[1]. Although the Conversion Arguments suggest that this Court is

absolutely bound to convert these cases by the language of the Bankruptcy Code if any of the

statutory grounds for “cause” is established, the bankruptcy court in fact “has wide discretion to

determine if cause [for conversion] exists and how to ultimately adjudicate the case,” and “even

if there is a finding of cause[,] a court is not obligated to convert the case.” In re The 1031 Tax

Group, LLC, 374 B.R. 78, 93 (Bankr. S.D.N.Y. 2007); see also In re Sydnor, 431 B.R. 584, 591

(Bankr. D. Md. 2010) (even if cause has been established, the court shall not act if conversion

would not be in the best interest of the creditors and estate).

71. The conversion motions should be denied here because the requested relief is not in

the best interests of either the creditors or the estate, but the 363 sale presents the only

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opportunity for all stakeholders to preserve and maximize the going concern value of the estate

and attempt to avoid liquidation. In fact, the financial advisors to the Debtors have indicated that

at least five entities have expressed substantial interest in the sale process and have been

conducting due diligence, thereby increasing the potential for one or more overbids that may

further maximize the value of the estates to the benefit of all stakeholders. (Henkin Decl. ¶ 51.)

As such, conversion to chapter 7 is premature, and the Court should allow these cases to proceed

under chapter 11 until the 363 sale realities are fully explored or it becomes evident that the 363

sale will not be in the best interest of the creditors and the estate. See In re 15375 Memorial

Corp., 382 B.R. 652, 682 (Bankr. D. Del. 2008), rev’d on other grounds, 400 B.R. 420 (D. Del.

2009) (courts should not “precipitously sound the death knell for a chapter 11 debtor by

prematurely converting or dismissing the case”).

A. The Debtors’ Rehabilitation Is Largely Dependent On A Successful Sale Process and It Is Premature To Assume That Rehabilitation is Unlikely

72. The first purported ground for “cause” alleged in the Conversion Arguments is that

the Debtors are suffering substantial or continuing losses to or diminution of the estate and the

absence of a reasonable likelihood of rehabilitation. (Committee’s Objection ¶ 45; Trustee

Objection ¶ 34; Trustee Conversion Motion ¶¶ 39, 42; Summit Objection ¶ 16.) While it is clear

that the Debtors’ businesses have continued to deteriorate significantly (and the party suffering

the most from that deterioration is the Senior Secured Noteholders), losses to the estate only

compel “cause” for conversion if those losses ensure that rehabilitation is unlikely. See 1031 Tax

Group, 374 B.R. at 93 (“The fact that there is a continuing loss to the estate … is insufficient to

establish ‘cause’ within the meaning of § 1112(b).”); see also In re Alves Serv. Inc., 6 B.R. 690,

693 (Bankr. D. Mass. 1980) (“the inability to rehabilitate must be accompanied by continuing

loss to or diminution of the estate to constitute cause”). Here, however, it is premature to assume

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that the diminution of the Debtors’ estates has created or contributed to the “absence of a

likelihood of rehabilitation,” and conversion under this theory would be a classic example of

putting the cart before the horse.

73. Despite the conjecture in the Conversion Arguments, the Sale Motion does not

dictate the conclusion of these Chapter 11 Cases. Rather, it establishes a process by which

various parties can bid on the Debtors’ assets at auction, a process which, by definition, is

predicated on the uncertainty of the ultimate outcome. Therefore, at this stage, it is impossible to

declare that there is no hope for rehabilitation of the Debtors’ estates. It is further disingenuous

to, on the one hand, bemoan the “absence of a reasonable likelihood of rehabilitation,” while at

the same time attempting to block the Debtors’ attempt to conduct what all parties hope will be a

competitive auction that will, at a minimum, generate value for the estate that is greater than

what could be obtained in a chapter 7 liquidation.

74. In theory, the 363 sale process proposed by the Debtors in the Sale Motion could be

the mechanism by which the Debtors achieve rehabilitation of the business. The stalking horse

bid establishes a floor price for the sale of the Debtors’ assets, not a ceiling, and the proposed

auction could yield a greater value for the estate than what could be obtained in a chapter 7

liquidation. This possibility is made promising by the fact that numerous entities have already

approached the Debtors to conduct due diligence and have expressed serious interest in bidding

on the Debtors’ assets. These circumstances increase the likelihood that one of these seriously

interested parties will submit an overbid. (Henkin Decl. ¶ 51.) See In re New Rochelle Tel.

Corp., 397 B.R. 633 (Bankr. E.D.N.Y. 2008) (denying motion to convert and reasoning that

debtor’s ongoing negotiations with and receipt of firm bids from potential buyers created

reasonable likelihood of rehabilitation).

30

75. This fact alone confirms that it is impossible for anyone – the Debtors, the Steering

Group, the United States Trustee, the Creditor’s Committee, Summit, or any other party in

interest – to declare at this early stage that the auction process proposed by the Sale Motion will

fail to rehabilitate these struggling estates. Such a determination can only be made once the

value of the estates is determined through the bidding process. It is not in the best interests of the

Debtors or their various creditor constituencies at this stage to cut the Debtors’ legs out from

under them by blocking their attempt to conduct what could be a very competitive auction

process that maximizes the value of the estates.

76. Courts routinely permit conversion only after the estate’s assets have already been

sold and the debtors are able to evaluate their financial situation. For example, in In re Mervyn’s

Holdings, LLC, et al., Case No. 08-11586 (KG) (Bankr. D. Del. 2008), the debtors’ attempt to

sell their assets was met with a motion for conversion by unsecured creditors based on grounds

similar to the Conversion Arguments asserted here. Both the debtors and their secured lenders

objected to the conversion, arguing that it was premature to force a chapter 7 liquidation as the

Debtors were preparing to institute a 363 sale process. Instead of converting the case, the Court

allowed the sale to proceed, and the debtor’s liquidation efforts remained ongoing.9 As this

authority illustrates, permitting the sale to proceed will not prohibit the Court from converting

the cases at a more appropriate time if it becomes apparent that rehabilitation is not possible. As

9 See also In re PLVTZ Inc., Case No. 07-13532 (REG) (S.D.N.Y. Oct. 27, 2008) (ordering conversion to chapter 7 only after the majority of the debtor’s assets had been sold and the period of exclusivity for filing a chapter 11 plan had expired); In re Linens Holdings Co. et al., Case No. 08-10832 (CSS) (Bankr. D. Del. Feb. 24, 2010) (ordering conversion to chapter 7 only after the debtor had liquidated most of its assets and failed to confirm a proposed plan); In re Fortunoff Holdings, LLC et al., Case No. 09-10497 (RDD) (S.D.N.Y. Oct. 1, 2009) (ordering conversion to chapter 7 only after the debtors sold off their assets, despite a motion to convert the case before the sale).

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such, the Court should not find cause for conversion based on “the unlikelihood of the Debtors’

rehabilitation.”

B. Because the Debtors Could Propose A Chapter 11 Plan of Liquidation, it isPremature to Determine Whether or Not the Debtors Will Be Able To Effectuate The Confirmation of A Plan

77. The Creditors’ Committee further asserts that cause for conversion to chapter 7 also

exists because the Debtors will be unable to effectuate the confirmation of a chapter 11

confirmed plan for a successful sale of substantially all of their assets. (Committee’s Objection ¶

50.) This claim assumes that the Debtors are bound to effectuate a plan of reorganization, and

fails to consider the Debtors’ ability to propose and confirm a plan of liquidation under chapter

11. See In re Chameleon Sys. Inc., 306 B.R. 666, 670 (Bankr. N.D. Cal. 2004) (the Bankruptcy

Code allows for the liquidation of a debtor’s assets in the Chapter 11 context); see also In re

GPA Technical Consultants, Inc., 106 B.R. 139, 141 (Bankr. S.D. Ohio 1989) (finding that

probability of the filing of a chapter 11 plan of liquidation does not serve as ground for

conversion).

78. Moreover, a liquidation plan, pursuant to chapter 11, often allows for a less

expensive, more expeditious, and more orderly disposition of assets than if undertaken by a

trustee pursuant to chapter 7, who would be unfamiliar with the estate and its assets. For these

reasons, it is not uncommon for debtors to liquidate their assets through a 363 sale in the context

of chapter 11, which is exactly what the Debtors have proposed here. See, e.g., In re Movie

Gallery Inc. et al., Case No. 10-30696 (DOT) (Bankr. E.D.Va. Oct. 29, 2010); In re Circuit City

Stores Inc., et al., Case No. 0835653 (KRH) (Bankr. E.D.Va. Sept. 14, 2010); In re Finlay

Enterprises, Inc. et al., Case No. 09-14873 (JMP) (Bankr. S.D.N.Y. June 29, 2010); In re

Midway Games Inc., et al., Case No. 09-10465 (KG) (Bankr. D. Del. May 21, 2010); In re Value

City Holdings, Inc. et al., Case No. 08-14197 (JMP) (Bankr. S.D.N.Y. May 17, 2010). As such,

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the contention that the Debtors are unable to effectuate a plan in a chapter 11 context is

premature and, accordingly, without merit at this stage. The Court should find no cause for

conversion based on “the Debtors’ inability to effectuate the confirmation of a plan.”

C. Conversion to Chapter 7 at This Time is Not in the Best Interests of the Creditors of the Estate

79. Even if the Court were to find the existence of “cause” for conversion under section

1112 of the Bankruptcy Code at this premature stage – and none of the purported grounds for

cause asserted in the Conversion Arguments in fact exists – the “court is not obligated to convert

the case” if it is not in the best interest of the debtor’s estate. 1031 Tax Group, 374 B.R. at 93;

Sydnor, 431 B.R. at 591. This is especially so when unusual circumstances dictate that the

requested conversion is not in the best interests of creditors and the estate. 11 U.S.C. §

1112(b)(1); see, e.g., In re The SCO Group, Inc., No. 07-11337, 2009 WL 2425755 (Bankr. D.

Del, Aug. 5, 2009) (denying multiple motions for conversion, finding that unusual circumstances

existed and that conversion is therefore not in the best interest of the creditors and the estate).

80. Here, a chapter 7 liquidation manifestly is not in the best interests of any

stakeholder. The conversion would further disrupt the Debtors’ businesses and likely will have a

significant negative effect on the value of the Debtors’ assets. (Henkin Decl. ¶ 50.) In a chapter

7 liquidation, not only would the value of the Debtors’ assets likely decrease significantly, but

Blockbuster’s enterprise value and significant trade vendor relationships – which Blockbuster

had continued to maintain and develop throughout the Chapter 11 Cases – likely would suffer

significantly or be wiped out completely. (Id.)

81. In addition to the straightforward harm that a chapter 7 liquidation would cause to

the estate, “unusual circumstances” are present here which further confirm that conversion to

chapter 7 is not in the best interests of creditors and the estate. 11 U.S.C. § 1112(b)(1).

33

Specifically, as of the Petition Date, the Senior Secured Noteholders had valid secured claims of

approximately $630 million. (Henkin Decl. ¶¶ 69-70.) Thus, notwithstanding any distribution to

be made on account of the Roll-Up Notes, under a chapter 7 liquidation of the Debtors’ assets,

general unsecured claims and chapter 11 administrative expense claims would be subject to

approximately $630 million of senior secured claims and likely would receive no recovery. (Id.

¶ 70.) In contrast, administrative claimants have been paid approximately $854 million during

these chapter 11 cases (id. ¶ 74), and will continue to be paid approximately $285 in additional

payments from these estates during the 363 sale process (id. ¶ 59). For these reasons, the sale

process will produce a better economic outcome for administrative claimants compared to

converting these cases to chapter 7. (Id. ¶ 70.)

82. Even assuming, that liquidation is imminent, there are significant benefits to

allowing liquidation in a chapter 11 context as opposed to under chapter 7. For example,

“liquidation under Chapter 11 allows the debtor in possession, one who is presumably more

familiar with the assets of the debtor's organization and its respective values, the ability to plan

for an orderly divestiture of the assets over time as opposed to a Chapter 7 trustee, who is

generally less familiar with the debtor's assets.” In re Deer Park, Inc., 136 B.R. 815, 818

(B.A.P. 9th Cir. 1992). Additionally, “[a] liquidating plan is desirable when the debtor in

possession can bring about a greater recovery for the creditors than would a straight liquidation

under Chapter 7.” Id. Likewise, courts have denied motions to convert in part because of the

“acquired expertise” by the parties’ professionals, such that costs would not be “much greater

than would occur in a proceeding under Chapter 7.” In re All Am. of Ashburn, Inc., 40 B.R. 104,

109 (Bankr. N.D. Ga. 1984). Courts have also denied conversion where “the purported savings

34

derived from a conversion would not offset the additional replacement costs.” Alves Photo Serv.,

6 B.R. at 694.

83. The sale and possible liquidation of the Debtors’ assets in a chapter 11 context

avoids the inevitable waste of time that would result from the appointment of a chapter 7 trustee

possessing no underlying familiarity with the claims against, and assets of, the Debtors or of the

complicated history of these cases. Ultimately, by remaining in chapter 11 and proceeding with

the requested 363 sale, the Debtors can maximize the going concern value of the company for

the benefit of all stakeholders. As such, conversion to chapter 7 is entirely premature, and the

Court should deny the conversion motions and permit the cases to proceed under chapter 11 until

the 363 sale realities are fully explored, or until it becomes evident that the 363 sale will not be

in the best interests of the creditors and the estate.

III. SUMMIT’S ALLEGED RECLAMATION RIGHTS ARE SUBORDINATED TO THE RIGHTS OF THE SENIOR SECURED NOTEHOLDERS AND DIP LENDERS10

84. Summit’s request for reclamation pursuant to Section 2-702 of the New York

Uniform Commercial Code (“UCC”) should be denied because, even if Summit had timely

asserted any reclamation rights to the goods in question,11 Summit’s reclamation right is subject

to the prior perfected liens held by the Senior Secured Noteholders and DIP Lenders, which

10 The Senior Indentured Trustee, on behalf of the Senior Secured Noteholders, joins in support of Section III of this reply memorandum.

11 Summit filed the Summit Motion on February 3, 2011, asserting, among other things, that it had been misled into believing the Debtors were solvent and is therefore entitled to the reclamation of those Summit titles it had shipped to the Debtors. The Debtors, in their Objection to the Summit Motion [Dkt. No. 938], demonstrated that Summit failed to carry its burden under Section 546(c) of the Bankruptcy Code, and Section 2-702(2) of the UCC, because the Debtors never misrepresented their solvency to Summit. The Debtors have established that, in the absence of any evidence that the Debtors misrepresented their solvency to Summit – indeed, the Debtors have been publicly insolvent since the outset of these cases – Summit’s reclamation claim fails as a matter of law.

35

secure claims totaling more than $630 million – an amount well in excess of the value of the

collateral securing such obligations. Summit nevertheless claims that it should be permitted “to

immediately repossess its goods” as “a matter of equity” because the Debtors made

“misrepresentations” and are “trying to ‘game the system’ and discriminate” against

administrative creditors. (Summit Objection at 8, 9, 11 n. 11, 12 n. 12.) These “equitable”

complaints about the Debtors do not support reclamation of the collateral of the Senior Secured

Noteholders and DIP Lenders because, as lien creditors, both the Senior Secured Noteholders

and DIP Lenders are considered good faith purchasers (under the applicable provisions of the

Uniform Commercial Code) of the goods Summit seeks to reclaim. In addition, the Final DIP

Order entered by this Court found that the DIP Lenders acted in good faith in negotiating the DIP

Credit Agreement, including the Roll-Up Notes. (See Final DIP Order ¶¶ 12, 13, ¶ 6(h).)

A. Any Reclamation Rights Summit May Have Are Clearly Subject to the Liens of the Senior Secured Lenders and DIP Lenders

85. Section 546(c) of the Bankruptcy Code addresses a seller’s right of reclamation and

explicitly provides that a seller’s right to reclaim goods is “subject to the prior rights of a holder

of a security interest in such goods or the proceeds thereof.”12 While section 546(c) of the

12 Section 546(c) provides, in relevant part, that:

Except as provided in subsection (d) of this section and in section 507(c), and subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof, the rights and powers of the trustee under sections 544(a), 545, 547, and 549 are subject to the right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller’s business, to reclaim such goods if the debtor has received such goods while insolvent, within 45 days before the date of the commencement of a case under this title, but such a seller may not reclaim such goods unless such seller demands in writing reclamation of such goods –

(A) not later than 45 days after the date of receipt of such goods by the debtor; or

(B) not later than 20 days after the date of commencement of the case, if the 45-day period expires after the commencement of the case.

(Footnote continued)

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Bankruptcy Code recognizes a creditor’s right of reclamation, it is generally understood that

Section 546(c) does not grant an “independent federal right of reclamation nor does it create a

coherent comprehensive federal scheme for reclamation.” In re Dana Corp., 367 B.R. 409, 416

(Bankr. S.D.N.Y. 2007) (Lifland, J.).

86. The New York UCC generally provides a right of reclamation when “the seller

discovers that the buyer has received goods on credit while insolvent,” N.Y. U.C.C. § 2-702(2),

but the seller’s rights under Section 2-702(2) are subject to the “rights of a buyer in the ordinary

course or other good faith purchaser,” id. § 2-702(3). It is well settled that a secured creditor

with a lien on the goods subject to a reclamation demand qualifies as a “good faith purchaser for

value” of those goods for purposes of Section 2-702(2). In re Arlco Inc., 239 B.R. 261, 267-68

(Bankr. S.D.N.Y. 1999). In fact, “[m]ost courts have treated a holder of a prior perfected,

floating lien on inventory … as a good faith purchaser with rights superior to those of a

reclaiming seller.” Id.; see also In re Victory Mkts., 212 B.R. 738, 742 (Bankr. N.D.N.Y. 1997).

The seller bears the burden to prove the elements set forth in section 546(c) of the Bankruptcy

Code by a preponderance of the evidence. See, e.g., Victory Markets, 212 B.R. at 741; In re

Braniff, Inc., 113 B.R. 745, 751 (Bankr. M.D. Fla. 1990).

87. Summit cannot meet its burden here because any reclamation rights in the Summit

goods are subject to a host of liens held by the Senior Secured Noteholders and DIP Lenders on

virtually all of the Debtors’ property (id. ¶ 18), including the goods Summit seeks to reclaim, and

the value of the senior secured claims secured by such liens vastly exceeds the value of the

11 U.S.C. § 546(c)(1).

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collateral. Putting aside the liens and secured claims under the DIP Facility, on the Petition

Date, the Debtors owed approximately $630 million to the Senior Secured Noteholders, with all

such obligations secured by liens on substantially all of the Debtors assets, including liens on the

goods Summit seeks to reclaim here. (Id. ¶ 70.) Summit does not and cannot dispute that the

Senior Secured Noteholders acquired their rights to those liens as good faith purchasers.13

88. The Creditors’ Committee has completed its investigation of the prepetition liens

securing the Senior Secured Noteholder claims and no adversary proceeding has been filed. (Id.

¶ 22.) Pursuant to the Final DIP Order, therefore, “the claims, liens and security interests of the

Senior Indenture Trustee and the Senior Secured Noteholders” have been “deemed to be finally

allowed for all purposes in these Chapter 11 Cases and any subsequent chapter 7 cases of any of

the Debtors,” and are not “subject to challenge by any party in interest as to validity, priority,

extent, perfection or otherwise.” (See Final DIP Order at 48, ¶ 28(b).)

89. The Final DIP Order also provides that all prepetition liens granted to the

prepetition lenders are preserved in favor of the postpetition DIP Lenders. Final DIP Order at

51, ¶ 31. The claims arising under the DIP Facility are likewise secured by substantially

identical liens on the Debtors’ assets, including liens on the goods that Summit seeks to reclaim.

In addition, in the Final DIP Order, this Court found that the DIP Lenders acted in good faith in

negotiating the DIP Credit Agreement, including the Roll-Up Notes. (See id. at 12-13, ¶ 6(h).)

90. Because the amount of indebtedness owed to the DIP Lenders pursuant to these

liens – $630 million – overwhelmingly exceeds the value of the goods Summit is seeking to

13 Pursuant to § 552(a) of the Bankruptcy Code, the liens granted to the Senior Secured Noteholders extend to the proceeds, products, offspring, or profits acquired by the estate after the Petition Date – including the goods Summit seeks to reclaim.

38

reclaim, that claim is effectively rendered “valueless.” Dana Corp., 367 B.R. at 419

(“Reclamation is an in rem remedy, and reclaiming sellers have no right to compel a lienholder

to satisfy its claim from other collateral.”). It is well settled that a “‘reclaiming seller is entitled

to a lien or administrative expense claim only to the extent that the value of the specific

inventory in which the reclaiming seller asserts an interest exceeds the amount of the floating

lien in the debtor’s inventory.’” Id. (citation omitted).

91. This Court applied this “prior lien defense” in In re Dana Corp., for example,

holding that the seller’s reclamation claims were “valueless” where, as here, the goods at issue

were collateral covered both by a prepetition lien as well as a DIP lien, which also “provided a

security interest in, and lien upon, all of the collateral constituting the prepetition collateral.”

367 B.R. at 420-21. The $381 million prepetition lien greatly exceeded the largest reclamation

claim of $9.6 million, id. at 419, and the “grant of the DIP Lien was a necessary condition of the

DIP Lenders’ agreement to enter into the DIP Facility,” id. at 421. Because any proceeds from

the disposition of the reclaimed goods would be applied entirely to satisfy the secured creditors’

claims, this Court found that the reclamation claims were “valueless[,] as the goods remained

subject to the Prior Lien Defense.” Id.; see also In re Dairy Mart Convenience Stores, Inc., 302

B.R. 128, 134 (Bankr. S.D.N.Y. 2003) (holding that reclamation claims were valueless in light of

secured lender’s prior existing lien on debtor’s inventory); Arlco Inc., 239 B.R. at 267-68

(finding that rights of holders of prior perfected liens on inventory were superior to rights of any

reclaiming sellers).14

14 See also In re Advanced Mktg. Servs., Inc., 360 B.R. 421, 426 (Bankr. D. Del. 2007) (“[T]he Senior Lenders’ pre-petition and post-petition liens on the Debtors’ inventory are superior to [the sellers’] reclamation claim.”); In re Pittsburgh-Canfield Corp., 309 B.R. 277 (B.A.P. 6th Cir. 2004) (reclaiming that seller was entitled to administrative

(Footnote continued)

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92. The goods Summit seeks to reclaim are subject to the existing liens securing over

$630 million in claims of the Senior Secured Noteholders, plus the claims of the DIP Lenders.

Because the sum total of the value of all the collateral does not exceed the claims of the Senior

Secured Noteholders and the DIP Lenders, Summit may not reclaim its goods and its reclamation

claim is “valueless.”

IV. THE DEBTORS’ UNIVERSAL TITLES SHOULD BE SOLD AS PART OF THE 363 SALE

93. Universal objects to the extent that the Debtors “purport to sell any of USHE leased

titles to the Purchaser,” and argues that the Debtors “should be prohibited from selling property

which does not belong to them … unless the Debtors sequesters any revenue from such sales

sufficient to pay USHE the amount it is due under the applicable agreement under which such

titles were delivered to the Debtors.” (Universal Objection ¶ 4.) Universal’s position mistakenly

assumes that Universal has a superior claim to the discs in the Debtors’ possession as well as the

revenue generated from the sale and/or rental of such discs. To advance this position, Universal

asserts that its discs are “leased” to the Debtors.15 While the Revenue Share Agreement uses the

term “lease” in certain provisions, it is clear under the facts and circumstances, as well as the

economic realities surrounding the Revenue Share Agreement, that the discs in fact are sold to

and not “leased” by the Debtors. The Revenue Sharing Agreement (i) does not provide that

Universal retains title or any interest in the discs; (ii) does not require that the Debtors return

expense claim pursuant to valid reclamation rights, but only to the extent surplus proceeds remained after perfected security interest of secured creditor had been satisfied or released). 15 A similar position was raised by Twentieth Century Fox Home Entertainment LLC (“Fox”) in its Motion for Adequate Protection pursuant to 11 U.S.C. §§ 361 and 363(e) (the “Fox Motion”). The Fox Motion is scheduled to be heard at the March 17, 2011 hearing and, as a result, this Reply does not directly address the arguments advanced therein, however, for the same reasons advanced herein (and certain additional reasons unique to the Debtors’ agreements with Fox) the Steering Group does not believe that the agreements with Fox are leases.

40

discs received thereunder to Universal at the end of the revenue share period; and (iii) subject to

certain limitations, already permits the Debtors to sell the discs at their retail locations.

94. The Revenue Sharing Agreement imposes certain obligations upon the Debtors

which gives rise to a claim by Universal against the Debtors, but such claim is an unsecured

claim against the Debtors estates. For example, the Revenue Sharing Agreement requires the

Debtors to pay Universal an upfront fee and a share of the rental and/or sale revenue, subject to a

minimum payment in order to acquire the discs. If the Debtors fail to make any of those

payments, or fail to destroy the minimum number of discs required by the Revenue Sharing

Agreement, Universal simply has a claim against the Debtors. Because Universal did not secure

the Debtors’ obligations under the Revenue Sharing Agreement by taking a security interest in

the proceeds of the discs (or any other asset of the Debtors, including the discs themselves), its

claim is unsecured.

95. The arrangement between the Debtors and Universal dictates this conclusion, a

result that is further confirmed when the Revenue Sharing Agreement is compared with an

amendment thereto covering only one movie title (the “Amendment”). For that one title,

Universal included the following language in the Amendment:

If Blockbuster’s account is in good standing, title in and to the units of the Picture shall pass to Blockbuster upon receipt of notice from USHE. If Blockbuster’s account is not in good standing, Blockbuster shall promptly return all units of the Picture at its sole cost and expense via a carrier approved by USHE, not to be unreasonably withheld.

- and –

In order to secure Blockbuster’s obligations hereunder, including, without limitation, its obligation to pay USHE, Blockbuster hereby grants to USHE a first priority security interest in its receivables and in all rights granted by USHE to Blockbuster in connection with units of the Picture shipped to Blockbuster hereunder including any receivables derived therefrom, until title in and to such units of the Picture passes to Blockbuster.

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The Revenue Sharing Agreement does not contain similar language, and had that agreement

operated the way Universal now contends that it does (as a lease), there would be no need to

have included the above-quoted language into the Amendment for a single title.

A. The Revenue Sharing Agreement is not a “Lease”

96. It is well-settled law that merely using the term “lease” in an agreement is not

dispositive of such agreement’s true characterization, and a court must look beyond the specific

language and examine all provisions in order to determine the true nature of the agreement. In re

Pillowtex, Inc., 349 F.3d 711, 722 (3d Cir. 2003) (court was “persuaded by the clear weight of

authority that the intent of the parties, no matter how clearly spelled out in the parties’

representations within the agreement, can not control the issue of whether the agreement

constitutes a true lease or a security agreement”) (quoting In re Homeplace Stores, 228 B.R. 88,

94 (Bankr. D. Del. 1998)); In re Tillary, 571 F.2d 1361, 1364-65 (5th Cir. 1978) (court is “not

bound by the denomination of the parties as ‘lessor’ or ‘lessee’ or the agreement as a ‘lease’; but

must look beyond the language used to determine the rights and obligations of the parties”); see

also In re Grubbs Constr. Co., 319 B.R. 698, 711-2 (Bankr. M.D. Fla. 2005)16 (“The distinction

between a true lease and a financing transaction is based upon the economic substance of the

16 It is a well-accepted practice for courts faced with the true lease versus financing arrangement issue to look to relevant decisions from other jurisdictions, since the Uniform Commercial Code has been adopted in all 50 states, and its purpose is to achieve uniformity. Pillowtex, 349 F.3d at 718 n.8 (“Because N.Y. U.C.C. § 1-201(37) is based on the Uniform Commercial Code, decisions from other jurisdictions interpreting this same uniform statute are instructive.”); Specialty Beverages, L.L.C. v. Pabst Brewing Co., 537 F.3d 1165, 1175 n.7 (10th Cir. 2008) (“In the UCC context, decisions from other jurisdictions are particularly persuasive due to the uniform nature of the UCC”); Grubbs Constr. Co., 319 B.R. at 712 (“[C]ourts dealing with the lease versus security agreement issue generally look at cases from various jurisdictions”); In re QDS Components, Inc., 292 B.R. 313, 321 n.3 (Bankr. S.D. Ohio 2002) (“Because the UCC is a uniform law, decisions from other state and federal courts interpreting § 1-201(37) also may be considered.”).

42

transaction and not, for example, upon the locus of the title, the form of the transaction or the

fact that the transaction is denominated as a ‘lease.’”).

97. The determination of whether a transaction is a lease or a financing arrangement is

subject to two tests: (i) the “bright-line” test set forth in § 1-207(37) of the UCC, as adopted by

N.Y.U.C.C. § 1-207(37); and (ii) a review of the totality of the circumstances in the case to

determine whether the economic realities of the transaction suggest that it is a financing

arrangement rather than a lease. Pillowtex, 349 F.3d at 717; In re Taylor, 209 B.R. 482, 484

(Bankr. S.D. Ill. 1997); In re Murray, 191 B.R. 309, 315 (Bankr. E.D. Pa. 1996).

1. Bright Line Test

98. Under the “bright-line” test an agreement is not considered a lease where the

consideration paid by the “purchaser” is an obligation for the term of the agreement not subject

to termination by the lessee and at least one of the other four enumerated conditions is satisfied.17

Pillowtex, 349 F.3d at 717; see also U.C.C. § 1-203, cmt. 2 (2004) (“[s]ubsection (b) further

provides that a transaction creates a security interest if the lessee has an obligation to continue

paying consideration for the term of the lease, if the obligation is not terminable by the lessee …

and if one of four additional tests is met”). Under the “bright-line” test, the Revenue Sharing

Agreement would not be considered a “lease” – the Debtors lack the ability to terminate the

17 Under N.Y.U.C.C. § 1-201(37)(a), the four residual conditions are:

(i) the original term of the lease is equal to or greater than the remaining economic life of the goods, (ii) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods, (iii) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement, or (iv) the lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease arrangement.

43

Revenue Sharing Agreement without paying Universal at least the minimum guaranteed

consideration. In addition, the Debtors satisfy at least one of the other enumerated conditions

because they have the ability to take ownership of the discs for nominal consideration –

specifically, $1.00.

2. Economic Reality Test

99. Alternatively, courts may consider the economic reality of a transaction to

determine, based on “the particular facts of the case, whether the transaction is more fairly

characterized as a lease or a secured financing arrangement.” Pillowtex, 349 F.3d at 719. To do

so, courts will look to various factors in evaluating the “economic reality of the transaction . . . in

determining whether there has been a sale or a true lease.” Pactel Fin. v. D.C. Marine Serv.

Corp., 518 N.Y.S.2d 317, 318 (N.Y. Sup. Ct. 1987). These factors include whether the purchase

option is nominal; whether the lessee is required to make aggregate payments having a present

value equaling or exceeding the original cost of the leased property; and whether the lease term

covers the total useful life of the equipment. In re Edison Bros. Stores, 207 B.R. 801, 809-10

(Bankr. D. Del. 1997).

100. The facts and circumstances here also suggest that the Revenue Sharing Agreement

is not a lease. At bottom, the Revenue Sharing Agreement is a financing arrangement whereby

Universal reduces the Debtors’ up-front acquisition costs in exchange for a “sharing” of the

revenues received by the Debtors from the rental and sale of titles acquired under the revenue

sharing agreement. Unlike traditional retailers such as Best Buy or Wal-Mart, which obtain

movie titles for resale at retail prices, the Debtors finance the acquisition of titles for a

combination of rental and retail transactions. Needless to say, Blockbuster – a name

synonymous with video rental – generates more rental transactions than retail transactions. The

Debtors’ rental transactions generate less immediate revenue than a retail transaction. The

44

Debtors’ business model and capital structure cannot sustain the same “up front” acquisition cost

as a traditional retailer. Recognizing this fact, the Debtors and Universal (among other studios)

entered into revenue sharing financing arrangements which establish a lower “up-front” payment

and a minimum “guaranteed” payment, but allow the Debtors to pay for the discs over time from

the rental and sale revenues during the revenue share period. In this regard, the Revenue

Sharing Agreement is merely a financing (or deferral) of the cost of the discs.

101. Moreover, after the Debtors obtain copies of the movie titles pursuant to the

revenue sharing arrangement they can freely rent the movie titles and are generally free to sell

the titles after a 28-day “blackout” period. During the 26-week period following the release of

the title, the revenue sharing arrangement requires the Debtors to share a portion of the revenue

from the sale and/or rental of a disc. At the end of the 26-week period, the arrangement requires

that the Debtors have paid a certain minimum amount per disc, and requires the Debtors to

destroy a certain minimum number of discs (which number could be increased to up to 100% in

the Debtors’ discretion). The Debtors must pay $1.00 for the remaining discs that are not

destroyed, but are no longer required to share rental and/or sale revenues with Universal on

account of such discs.

102. In sum, the Debtors buy discs from Universal for a smaller up front payment than

other retailers, pay Universal a portion of the proceeds from the Debtors’ rental of the discs

during a limited revenue share period, and then after limited destruction requirements, can

continue to rent or sell the inventory for as long or as little as they like after paying Universal

$1.00. They can even destroy all the inventory. Clearly, the Debtors have the benefits and

burdens of ownership on the inventory sold to them by Universal.

45

B. Aggregate Payments

103. Courts will also look to whether the aggregate payments made over the term of the

agreement equal or exceed the original cost of the property. Edison Bros., 207 B.R. at 814. “[I]f

the alleged lessee is obligated to pay the lessor a sum equal to or greater than the full purchase

price of the leased goods plus an interest charge over the term of the alleged lease agreement, a

sale is likely to have been intended since what the lessor will receive is more than a payment for

the use of the leased goods and loss of their value; the lessor will received a consideration that

would amount to a return on its investment.” Id. at 814.

104. As stated above, the revenue share structure is intended to defer the Debtors’ “up-

front” cost of obtaining titles from the studios. The arrangement does not, however, reduce or

eliminate the cost that would ordinarily be paid by the Debtors – it merely stretches out the

payments and in exchange for such terms, Universal gets a potential financing premium by way

of a share of the rental and sale revenues. If, at the end of the revenue share period, the revenue

sharing did not meet the minimum required payment, the Debtors must pay the difference.

C. Universal has no Expectation that the Discs will be Returned at the End of the Revenue Share Period

105. Courts also consider whether the useful life of the property is shorter than the term

of the agreement. Edison Bros., 207 B.R. at 816. The reasoning behind this factor is that “[a]n

essential characteristic of a true lease is that there be something of value to return to the lessor

after the term.” Id. This is because “[w]here the term of the lease is substantially equal to the

life of the lease property such that there will be nothing of value to return at the end of the lease,

the transaction is in essence a sale,” and “if the lessor expected a remaining useful life after the

expiration of the lease term, it can be reasonably inferred that it expected to retain substantial

46

residual value in the leased property at the end of the lease term and that it therefore intended to

create a true lease.” Id.

106. Especially relevant to the revenue sharing arrangement between Universal and the

Debtors is that courts have noted that even where transferred goods have a useful life extending

beyond the term of the agreement, which could reveal a transferor’s expectation of retaining

some residual value in those goods, such an inference would only be proper “where the evidence

showed a plausible intent by the transferor to repossess the goods.” Pillowtex, 349 F.3d at 720.

By giving the Debtors the discretion to destroy all discs at the end of the 26-week revenue share

period, Universal has no expectation that it will retake possession of the discs. Such a fact

clearly creates a strong inference that Universal does not believe that there is much more than

nominal value in the discs at the end of the revenue share period.

D. Universal May Have an Unsecured Claim Against the Debtors for Breach of Contract

107. As stated above, to the extent that the sale results in the Debtors breaching certain

provisions under the Revenue Sharing Agreement, Universal may have a claim for damages;

however, such damage claim is an unsecured claim that can be asserted against the Debtors’

estates and none of the Revenue Sharing Agreement, Bankruptcy Code or other applicable law

requires the Universal titles to be carved out of the sale or gives Universal a superior claim to the

proceeds of the Universal inventory sold to the Debtors.

47

WHEREFORE, for all the foregoing reasons, the Steering Group respectfully

requests that the Court grant the Sale Motion, and award such other and further relief as the

Court deems appropriate.

Dated: New York, New York March 9, 2011 Respectfully submitted,

SIDLEY AUSTIN LLP

By: /s/ John G. HutchinsonJohn G. Hutchinson James P. Seery Jr. Paul S. Caruso John J. Lavelle Alex R. Rovira 787 Seventh Avenue New York, New York 10019 Tel: 212-839-5300 Fax: 212-839-5599 jhutchinson@sidley.comjseery@sidley.compcaruso@sidley.comjlavelle@sidley.com arovira@sidley.com

Attorneys for the Steering Group, and Special Counsel to the Senior Indenture Trustee,in connection with reclamation issue

EXHIBIT 1

1

UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF NEW YORK ---------------------------------------------------------------x : In re : Chapter 11 : BLOCKBUSTER INC., et al., : Case No. 10-14997 (BRL) : : (Jointly Administered) Debtors. : ---------------------------------------------------------------x

DECLARATION OF MICHAEL HENKIN IN SUPPORT OF THE STEERING GROUPS’ REPLY MEMORANDUM IN SUPPORT OF DEBTORS’ SALE MOTION

AND IN OPPOSITION TO VARIOUS SALE OBJECTIONS AND TO MOTIONS SEEKING TO CONVERT THE DEBTORS’ CHAPTER 11 CASES TO CASES UNDER

CHAPTER 7 OF THE BANKRUPTCY CODE

I, Michael Henkin, hereby declare under penalty of perjury of law as follows:

1. I am a Managing Director of Jefferies & Company, Inc. (“Jefferies”), Co-

Head of the firm’s Recapitalization and Restructuring Group, and am duly authorized to make

this declaration in connection with the Reply Memorandum (the “Memorandum”) of the Steering

Group of Senior Secured Noteholders (as defined hereafter) who are also DIP Lenders (as

defined hereafter) (the “Steering Group”), submitted in support of the Debtors’ motion for entry

of: (I) an Order Approving (A) Bid Procedures, (B) Stalking Horse Expense Reimbursement,

(C) Notice of Sale, Auction, and Sale Hearing, (D) Assumption Procedures and Related Notices,

(E) Incurrence of Sale-Related Administrative Priority Claims, and (F) Imposition of an

Administrative Stay; and (II) an Order Approving the Sale of Substantially All of the Debtors’

Assets (collectively, the “Sale Motion”), and in opposition to the various objections to the Sale

Motion and certain objectors’ motions for an order to convert the Debtors’ Chapter 11 Cases into

cases under chapter 7 of the Bankruptcy Code. Except as otherwise indicated, all of the facts set

forth herein are based upon my personal knowledge, my discussions with the Debtors and their

2

advisors, and my review of relevant documents, including the objections to the Sale Motion, or

upon information provided to me by professionals of Jefferies.

2. I have principal responsibilities for managing the ongoing financial

advisory services that Jefferies is performing on the Steering Group’s behalf, and I have

significant expertise in restructuring advisory assignments involving distressed companies,

representing both companies and creditors in a wide range of industries – including

communications, technology, manufacturing, retail, automotive, services, and consumer. I have

executed over 70 transactions, including more than 25 chapter 11 cases (and foreign

equivalents), auctions and sales under Section 363 of the Bankruptcy Code, and numerous public

/ private financings, M&A and other advisory assignments, with over $90 billion in aggregate

transaction value. I have also testified as an expert via trial, deposition, and expert reports in

connection with multiple restructurings and chapter 11 proceedings, including Adelphia

Communications, Allied Holdings, Calpine, DBSD, Extended Stay, Federal-Mogul, Loral Space

& Communications, Newcomm Wireless Services, Philip Services, and Union Power.

3. Jefferies is a global investment banking firm with its principal office

located at 520 Madison Avenue, 12th Floor, New York, New York 10022. Jefferies provides a

broad range of corporate advisory services to its clients including, without limitation, services

relating to: (a) general financial advice; (b) corporate restructurings; (c) mergers, acquisitions

and divestitures; (d) special committee assignments; and (e) capital raising. Jefferies and its

senior professionals have extensive experience in the reorganization and restructuring of troubled

companies, both out-of-court and in chapter 11 proceedings. The employees of Jefferies have

advised debtors, creditors, equity constituencies, and purchasers in many reorganizations,

3

including in connection with debtor in possession financings and Section 363 auctions and sales

processes.

4. As of September 24, 2010, Jefferies was retained to act as the financial

advisor to Sidley Austin LLP (“Sidley”), as counsel to the Steering Group, comprised of certain

beneficial holders (the “Senior Secured Noteholders”) of the 11.75% Senior Secured Notes due

2014 (the “Senior Secured Notes”) of Blockbuster, Inc. (together with its subsidiaries and

affiliates, “Blockbuster” or the “Debtors”). Since the commencement of this engagement,

Jefferies has provided financial advisory services on behalf of the Steering Group related to the

Debtors’ Chapter 11 Cases. In such capacity, Jefferies has become familiar with the Debtors’

business operations, capital structure, financing documents, and other material information.

I. The Deteriorating Performance of Blockbuster’s Business

5. The rapid decline of Blockbuster’s traditional “brick and mortar” retail

store-based customer business which precipitated these bankruptcy proceedings, is reflected in

the significant decrease in Blockbuster’s total revenues and EBITDA over the preceding three

years. For the year fiscal year ending December 31, 2008, Blockbuster’s total revenues were

approximately $5 billion with adjusted EBITDA of approximately $304 million. For the fiscal

year ending 2009, Blockbuster’s total revenues were approximately $4 billion with adjusted

EBITDA of approximately $201 million. By the fiscal year ending 2010, Blockbuster’s

revenues were approximately $3 billion and its adjusted EBITDA had shrunk to an adjusted $78

million (a 61% decrease year-over-year). (See Exhibit A attached hereto.)

6. The driving force behind Blockbuster’s poor financial performance has

been the deterioration of the company’s traditional store-based distribution channel caused by

competition from new market participants leveraging more cost effective, convenient, and

technology-driven distribution methods and channels. The alternative distribution channels –

4

including direct delivery media entertainment through direct broadcast satellite, cable television

(particularly on-demand and pay-per-view offerings), broadband Internet access, DVR-based

services such as TiVo, and digital video offerings from companies such as Apple, Amazon, and

Google – have eroded the market for the rental and sale of physical video discs.

7. As a result, the net rental revenue from Blockbuster’s sales at its domestic

retail stores that have been open for a year or more (i.e., comparative store sales, or “comp store

sales”) has trended significantly downward from a high of approximately 8.4% in the second

quarter of 2008, to as low as approximately 18% down for the fourth quarter of 2010. (See

Exhibit B attached hereto.) For example, the average comp store sales for the year ending 2008

were down 1.2%, for the year ending 2009 were down 14.6%, and for the year ending 2010 was

down another 10.4%, and that 10.4% decline were aided by the closing of a number of the worst

performing stores. (Id.) Without the closing of the worst stores and the use of the liquidation

proceeds in the business, Blockbuster’s financial performance would have been even worse.

8. Compounding the eroding margins generated by the Debtors’ retail

locations, Blockbuster also has failed to establish and maintain significant market share in the

By-Mail distribution channel (where NetFlix is the market leader), and its participation in the

Vending channel (where Redbox is the market leader) suffers from limitations under

Blockbuster’s current contractual arrangement with NCR Corporation.

II. The Plan Support Agreement

9. In this competitive and rapidly changing environment, in mid-2010,

Blockbuster recognized that its financial situation and capital structure were unsustainable. The

commencement of these chapter 11 cases (the “Chapter 11 Cases”) resulted from a months-long

negotiation process between the Debtors and the Steering Group, whose members hold in excess

of 80% in face amount of Blockbuster’s Senior Secured Notes. Prior to the commencement of

5

these Chapter 11 Cases, Blockbuster and the Steering Group entered into a plan support

agreement dated as of September 22, 2010 (the “Plan Support Agreement”) in which they agreed

to the material terms of a chapter 11 plan of reorganization and proposed exit financing.

Although the Plan Support Agreement was largely negotiated before Jefferies was engaged by

Sidley, I am generally familiar with its terms and the Plan Term Sheet which was attached

thereto.

10. The Plan Support Agreement contemplated a recapitalization of

Blockbuster whereby the approximately $630 million of Senior Secured Notes would be

exchanged for 100% of the equity interests of a reorganized Blockbuster. The recapitalization

was designed to try to provide reorganized Blockbuster with a de-levered capital structure and

the financial flexibility needed to navigate the rapidly transitioning movie content distribution

business, develop new distribution channels, and implement a viable long-term strategy. In

pursuing that strategy, Blockbuster sought to differentiate itself as the only provider of content

access across multiple delivery channels, offering convenience, service, and value to its multi-

channel customers. The Plan Support Agreement contemplated that the DIP Facility (as defined

below) would be largely undrawn at exit and that there would only be a $50 million first lien exit

revolver for the purpose of providing funding for ongoing working capital needs.

11. Given the challenging and evolving competitive environment, it was

important to the Steering Group that Blockbuster reorganize as quickly as possible to minimize

business disruption, ensure that Blockbuster maintain relevance on digital platforms (e.g., obtain

a “seat at the digital table”), and exit bankruptcy with virtually no debt. Because the key to a

successful reorganization would be a brief stay in chapter 11, and to prevent the dissipation of

assets that would result from a protracted proceeding, the Plan Support Agreement provided

6

specific milestones that the Debtors had to achieve to maintain the support of those Senior

Secured Noteholders who were parties to the Plan Support Agreement (the “Consenting

Noteholders”). The Plan Support Agreement required the Debtors, among other things, to (i) file

their Plan and Disclosure Statement by November 22, 2010 (later extended to November 30,

2010 and further extended several times and ultimately to February 18, 2011); (ii) obtain

approval of their business plan from 75% of the Consenting Noteholders (the “Supermajority of

Consenting Noteholders”) by November 30, 2010 (extended several times and ultimately to

February 18, 2011); (iii) obtain approval of the Debtors’ selection for chief executive officer of

reorganized Blockbuster from the Supermajority of Consenting Noteholders by December 31,

2010 (extended several times and ultimately to February 18, 2011); (iv) obtain an order

approving the adequacy of their disclosure statement by January 15, 2011; and (v) obtain an

order confirming the proposed plan of reorganization by March 15, 2011. The Plan Support

Agreement expressly provided that, if the Debtors failed to meet any of these milestones, the

Steering Group could terminate the Plan Support Agreement, with no further obligation to

support the plan of reorganization contemplated therein. As described below, the Debtors were

unable to meet several milestones, although the Steering Group in good faith agreed to extend

the first three milestones several times to accommodate Blockbuster and its reorganization

efforts.

III. Terms of the DIP Credit Agreement and DIP Order

12. In connection with the Plan Support Agreement and the Debtors’ proposed

restructuring, the Steering Group also agreed to allow for the consensual use of Cash Collateral

and provide debtor in possession financing so that Blockbuster would have sufficient liquidity to

conduct ordinary course business operations during the pendency of the restructuring. On

September 23, 2011 (the “Petition Date”), the Debtors filed their Motion for Entry of an Order,

7

on an Interim and Final Basis, (I) Authorizing the Debtors to Obtain Post-petition Superpriority

Financing (the “DIP Facility”) Pursuant to 11 U.S.C. §§ 105, 361, 362, 364(c), 364(d)(1), and

364(e), (II) Authorizing Debtors' Use of Cash Collateral Pursuant to 11 U.S.C. § 363, (III)

Granting Liens and Superpriority Claims to DIP Lenders Pursuant to 11 U.S.C. § 364, (IV)

Providing Adequate Protection Pursuant to 11 U.S.C. §§ 361, 362, 363, and 364, and (V)

Scheduling a Final Hearing Pursuant to Bankruptcy Rules 2002, 4001(b), 4001(c), and 6004 (the

“DIP Motion”).

13. On October 27, 2010, this Court entered a final order [Docket No. 432]

(the “Final DIP Order”) (i) authorizing the Debtors to obtain post-petition super-priority secured

financing (the “DIP Financing”) from those lenders (the “DIP Lenders”) party to the DIP Credit

Agreement, (ii) authorizing the Debtors’ post-petition use of Cash Collateral of the DIP Lenders,

the Roll-Up Noteholders (as defined in the Final DIP Order) and the Senior Secured Noteholders

(collectively, and as defined in the Final DIP Order, the “Cash Collateral”), and (iii) granting

adequate protection to the Senior Secured Noteholders and U.S. Bank National Association, as

trustee and collateral agent. Jefferies advised the Steering Group in connection with the

negotiations finalizing the use of Cash Collateral and the Senior Secured, Super-Priority Debtor-

in-Possession Revolving Credit Agreement (the “DIP Credit Agreement”). Accordingly, I am

familiar with the principal terms of the DIP Financing.

14. Since the date of Jeffries’ retention, I have observed the Steering Group

engage in extensive, good-faith, arm’s-length negotiations with the Debtors concerning terms

and provisions of the DIP Financing and the use of Cash Collateral. Given Blockbuster’s

continued downward trending revenues and the increasing obsolescence of Blockbuster’s “brick

and mortar” distribution platform (as evidenced in the quite recent liquidation of Movie Gallery,

8

a former Blockbuster competitor), the Steering Group was very concerned about its pre-petition

exposure as well as the loans that would be made to Blockbuster under the DIP Credit

Agreement. These concerns were particularly acute in light of the likely diminution of the

collateral securing the DIP Financing and the Senior Secured Notes through the closing of stores

and the dissipation of the liquidation proceeds in the business.

15. The Steering Group therefore structured the DIP Facility and negotiated

DIP covenants and other terms to protect the DIP Lenders’ exposure on new money loans to be

made to Blockbuster. For example, the DIP Facility was structured as a revolving loan facility

subject to an approved budget. Like many out of court revolving credit facilities, the structure

limited the Debtors’ ability to draw the loans to compliance with an approved budget and

satisfaction of conditions precedent. The revolving facility also required immediate repayment

from cash above an agreed upon maximum. In addition, like the Plan Support Agreement, the

DIP Credit Agreement required the Debtors to meet specific milestones by certain dates.

Specifically, the Debtors were required to (i) obtain a final order approving the DIP Credit

Agreement by October 23, 2010 (extended by the DIP Lenders to November 7, 2010); (ii) obtain

critical vendor orders with respect to Sony Pictures Home Entertainment Inc., Warner Bros.

Home Entertainment Inc., and Twentieth Century Fox by October 28, 2010; (iii) file a plan of

reorganization that conformed to the requirements of the Plan Support Agreement in all respects

by November 22, 2010 (later extended to November 30, 2010 and further extended several times

and ultimately to February 18, 2011); (iv) obtain approval by the Requisite DIP Lenders of an

updated business plan by November 30, 2010 (extended several times and ultimately to February

18, 2011); (v) obtain an order approving the disclosure statement of a plan that conforms to the

requirements of the Plan Support Agreement in all respects by January 15, 2011 (extended to

9

February 18, 2011); and (vi) obtain an order confirming a plan that conforms to the requirements

of the Plan Support Agreement by March 15, 2011. The Debtors’ failure to meet any of these

milestones would constitute an Event of Default under the DIP Credit Agreement and a

Termination Event under the Final DIP Order.

16. The budget process was a central component of the DIP Facility. Under

the terms of the DIP Credit Agreement, each month Blockbuster was required to submit a

proposed budget to the DIP Lenders for approval by holders of 75% of the DIP loan

commitments (the “Requisite DIP Lenders”). The initial 13-week budget filed with this Court as

an exhibit to the DIP Motion indicated that, from the beginning of these cases through the week

commencing January 9, 2011, the largest outstanding balance under the DIP Financing would be

approximately $69.2 million, with no single draw by the Debtors exceeding $23 million, and a

balance of only $16.5 million for the week ending January 15, 2011.

17. To further protect the DIP Lenders, the DIP Credit Agreement also

required mandatory payments (but without a reduction of the DIP commitments), if on any

Friday the aggregate treasury cash of Blockbuster exceeded $25 million in the month of

December, or $20 million dollars in any other month. The excess amounts of the agreed-upon

cash thresholds were to be applied to reduce the then-outstanding balance on the DIP Facility.

As the Debtors liquidated more of the DIP Lenders’ collateral, their cash budgets improved such

that the December budget provided a $2.3 million DIP balance for the week ending January 16,

2011, and a zero DIP balance for the week ending January 30, 2011.

18. The Final DIP Order granted the DIP Lenders valid, enforceable non-

avoidable and fully perfected first priority liens on and security interests in the DIP Collateral (as

defined in the Final DIP Order), which included first priority liens on and security interests in all

10

of the Debtors’ assets, including the Debtors’ previously unencumbered assets. To my

knowledge, the Debtors’ only material unencumbered assets were the stock of certain foreign

subsidiaries, one-third of the equity interests of certain of the Debtors’ other foreign subsidiaries

(which interests had not been pledged to the Senior Secured Noteholders for tax purposes), and

the Avoidance Actions (as defined in the Final DIP Order). In addition, the Senior Indenture

Trustee received, on behalf of the Senior Secured Noteholders, adequate protection of their

interests in their Prepetition Collateral (as defined in the Final DIP Order), including Cash

Collateral (as defined in the Final DIP Order), in an amount equal to the aggregate diminution in

value of the DIP Lenders’ security interests in their Prepetition Collateral as a result of, among

other things, the Debtors’ sale, lease, or use of cash collateral and any other Prepetition

Collateral, and the priming of the Senior Secured Noteholders’ security interest and liens in the

Prepetition Collateral. That adequate protection included replacement security interests in and

liens upon all the DIP Collateral other than the Avoidance Action Proceeds (as defined in the

Final DIP Order).

19. The Final DIP Order also granted DIP Lenders a roll-up of $125 million of

their prepetition Senior Secured Notes (the “Roll-Up Notes”), granting the Roll-Up Notes

superpriority administrative expense claims secured by the priming liens on all of the DIP

Collateral. The Roll-Up Notes were intended to be a form of consideration to compensate the

DIP Lenders for the risk of providing the DIP Facility, but the Roll-Up Notes would only arise

and become effective upon either (i) the occurrence of a Termination Event under the Final DIP

Order and the acceleration or maturity of the DIP Obligations, or (ii) if this Court approved a

disclosure statement for any plan of reorganization or liquidation of any of the Debtors that did

not reflect the terms contained in the Plan Term Sheet or terms consented to by the Requisite

11

DIP Lenders. One of the concessions that the Steering Group made to resolve concerns raised

by the Creditors’ Committee regarding the DIP Financing, as reflected in the Final DIP Order,

was that any Superpriority Claims (as defined in the Final DIP Order) on account of the Roll-Up

Notes would not be paid or satisfied from the Avoidance Actions Proceeds (as defined in the

Final DIP Order). In addition, it should be noted that the Roll-Up Notes were reduced by 50%

(from $250 million to $125 million) through the process of negotiating a consensual Final DIP

Order with the various parties-in-interest, including the Creditors’ Committee.

20. The Final DIP Order further provided that no costs or expenses of

administration of the Chapter 11 Cases or any future proceeding, including liquidation in

bankruptcy, would be charged against or recovered from the DIP Collateral, the Prepetition

Collateral, or the Cash Collateral pursuant to section 506(c) of the Bankruptcy Code or any

similar principle of law without the prior written consent of the Requisite Lenders (as defined in

the DIP Credit Agreement) or the Requisite Noteholders, as applicable.

21. The foregoing protections were heavily negotiated at arm’s length with the

Debtors and the Creditor’s Committee, and the Final DIP Order entered by this Court found that

the DIP Lenders had acted in good faith in negotiating the DIP Credit Agreement, including the

Roll-Up Notes. (See Final DIP Order at 12-13, ¶ 6(h).) Indeed, as discussed above, the DIP

Lenders in good faith made several concessions to the Creditors’ Committee so that a consensual

DIP Facility could be approved by this Court. Furthermore, subsequent to the entry of the Final

DIP Order, the Creditors’ Committee requested that the Challenge Period (as defined in the Final

DIP Order) for commencing a cause of action pursuant to paragraph 28 of the Final DIP Order

be extended from the original expiration date of December 27, 2010. The Requisite DIP Lenders

12

in good faith granted that request and agreed to extend the Challenge Period to February 1, 2011,

and then further extended the Challenge Period for a third time to February 11, 2011.

22. Pursuant to those extensions, upon information and belief, the Creditors’

Committee conducted a thorough investigation of the DIP Financing and the liens and the

obligations related to the Senior Secured Notes, and ultimately completed that investigation

without taking any actions or commencing an adversary proceeding. The time to challenge the

DIP Financing, the prepetition Senior Secured Notes, and all of the liens has now passed. (See

id. at 48, ¶ 28(b).)

IV. The October 2010 Business Plan

23. Under the terms of the Plan Support Agreement and the DIP Credit

Agreement, Blockbuster was required to meet various milestones, submit monthly budgets, and

obtain approval of its business plan by the Requisite Lenders by no later than November 30,

2010. From September 23, 2010 through February 24, 2011, the DIP Lenders approved each

proposed budget that the Debtors submitted for approval (in October, November, December,

January and then week-to-week until the budget period ending February 24, 2011, the date on

which the Debtors filed the Sale Motion). By approving each of those budgets, the DIP Lenders

authorized Blockbuster to use their Cash Collateral and the DIP Financing to fund the day-to-day

operations of the company and to pay administrative expenses.

24. Despite amendments to the DIP Credit Agreement and extensions of the

milestones under the DIP Credit Agreement and Plan Support Agreement, the Debtors were

unable to present an economically viable business plan that the Steering Group could approve,

largely because the Debtors’ declining financial performance accelerated much more rapidly

than expected following the Petition Date. Indeed, since the commencement of these Chapter 11

Cases, Blockbuster’s net rental revenue comp store sales have continued to decline at an

13

alarming pace, falling from negative 5% on September 5, 2010 to as low as negative 38% in

mid-February 2011. (See Exhibit C attached hereto.) Since September 5, 2010, net rental

revenue comp store sales have declined 18.1%. (Id.) If the rate of decline continues at this

magnitude, the vast majority of Blockbuster’s stores will go cash flow negative within 12-24

months.

25. In connection with the business plan milestone, on or about October 12,

2010, Blockbuster’s management presented the Steering Group with its first proposed Business

Plan (the “October Business Plan”). When compared to Blockbuster’s recent financial

performance and the increasingly competitive business environment confronting the company,

the Steering Group believed, and I agreed, that the October Business Plan presented an overly

optimistic forecast of Blockbuster’s projected financial performance over the subsequent five-

year period.

26. To provide greater context, prior to the Petition Date, Blockbuster had

produced at least two business plans forecasting adjusted EBITDA for the year ending 2010. A

Business Plan dated March 8, 2010 projected Blockbuster’s adjusted EBITDA to be as high as

$201 million for the year ending 2010. (See Exhibit D attached hereto.) Just four months later in

July 2010, however, Blockbuster revised its Business Plan, forecasting its adjusted EBITDA for

the year ending 2010 to be approximately $113 million, representing an approximate 44%

decrease compared to its initial Business Plan. (See id.)

27. In the October Business Plan, Blockbuster optimistically projected year-

end adjusted EBITDA for 2010 at approximately $88 million (representing a 22% decrease from

the July Business Plan), increasing to $98 million for the year ending 2011, and increasing

further to $142 million for the year ending 2012, to $168 million for the year ending 2013 and up

14

to $192 million for the year ending 2014. (See Exhibit E attached hereto.) With respect to

domestic store revenues, the October Business Plan projected revenues of $1.9 billion for 2010, a

year-over-year decline of negative 24%. However, following fiscal year 2010 domestic store

revenues were projected to stabilize for years two and three at around $1.6 billion, then falling to

$1.2 billion in 2014 representing a negative 18% change from the prior year. (See id.)

28. Assessing the October 2010 Budget in light of Blockbuster’s recent actual

negative double digit comp store trends in domestic net rental store revenues over the prior three

years, the Steering Group was concerned as to whether management’s financial forecasts as set

forth in the October Business Plan could be achieved. Indeed, if the recent comp store sales

downward trend continued, then based on the Debtors’ own store financial model, approximately

two-thirds of the Debtors’ stores would be cash flow negative within 24 months.

29. The Steering Group also was concerned, and I agreed, that the October

Business Plan did not focus on increasing and accelerating brick-and-mortar store closures, but

rather on engaging in negotiations with landlords to obtain rent reductions and shorter lease

terms under various lease “kickouts” (including, for example, sales-based kickout clauses, where

failure to meet sales targets would trigger the right to terminate a lease) and other termination

rights. The Steering Group acknowledged that some potential cost improvements could be

achieved through lease renegotiations, but believed that the company’s time and resources would

be better utilized – and its goal of cost rationalization and reorganization better served – by

focusing on store closures rather than on lease renegotiations. The Steering Group encouraged

the Debtors to re-focus their efforts on rightsizing the store base through closing stores affected

or most likely to be affected by the continuing downward trend in comp store sales. In tandem

15

with this priority on closing poor-performing stores, the company could simultaneously engage

in lease renegotiation efforts with respect to its better performing stores.

30. The Steering Group further believed, and I agreed, that many of the

assumptions underlying the October Business Plan were contradicted by empirical market data as

of the time it was delivered for approval. For example, Blockbuster projected significant growth

in its By-Mail and Vending businesses at a time when Blockbuster’s major competitors, Netflix

and Redbox, were capturing significant market share through robust increases in sales at

Blockbuster’s expense. Moreover, Blockbuster failed to account for the additional pricing

pressure that competitors such as Netflix and Redbox were generating in the marketplace and the

significant costs associated with customer acquisitions in such a competitive environment.

V. The Steering Group Approves Blockbuster’s $17 Million Advertising Campaign

31. In light of the Steering Group’s expressed concerns regarding the October

Business Plan, Blockbuster indicated that it would refine and revise its forecasts and financial

projections. During the subsequent weeks, however, Blockbuster’s financial performance

continued to rapidly deteriorate while its competitors continued to increase their market presence

in the rapidly growing and more popular distribution channels. In late October, Blockbuster’s

management requested the DIP Lenders’ consent to the use of approximately $20 million in

addition to the previously budgeted expenditures to invest in an advertising campaign running up

to and through the expected busy holiday season (the “Q4 Ad Campaign”).1

32. Management’s strategy behind the Q4 Ad Campaign was to increase

customer awareness of Blockbuster’s unique 28-day window advantage, whereby selected new

1 In addition to the Q4 Ad Campaign, Blockbuster’s management also requested additional cash then budgeted in order to bid on certain intellectual property being sold in the Movie Gallery bankruptcy cases. Again, the Steering Group approved this non-budgeted amount, although Blockbuster was ultimately unsuccessful in purchasing the Movie Gallery intellectual property.

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release movie titles are available at Blockbuster exclusively for a period of 28-days before

competitors such as Netflix and Redbox are able to obtain such titles from the movie studios.

Management believed that this aggressive advertising campaign would lift poor performance

leading into and through the busy holiday season, and prevent further declines in the business.

Specifically, management expected that the Q4 Ad Campaign would drive an 8.6% increase in

net rental revenue comp stores sales and approximately $8 million in gross margin. (See Exhibit

F attached hereto.)

33. The Steering Group was skeptical, as was I, that the Q4 Ad Campaign

would produce the results forecasted by management. Nevertheless, in a good faith-effort to

support management’s attempt to increase customer awareness and reverse or slow further

deterioration of Blockbuster’s business during the holiday season, the Steering Group

unanimously approved an expenditure of approximately $17 million for the Q4 Ad Campaign

(only slightly less than the $20 million spend requested by management), over and above the

previously budgeted amounts. The Steering Group also agreed, at the Debtors’ request, to

amend the definition of EBITDA in the DIP Credit Agreement to allow an add-back of

approximately $10 million relating to the Q4 Ad Campaign so that the Debtors would not trip

their minimum EBITDA covenant, which would be tested at year-end. Without this add-back, it

is doubtful that Blockbuster would have met its year-end minimum EBITDA covenant under the

DIP Credit Agreement, and the Debtors could have defaulted under the DIP Credit Agreement

much earlier in these Chapter 11 Cases.2

34. Through negotiations with TV networks, Blockbuster obtained minimum

target rating point guarantees from each TV network assuring that approximately 87% of 25-46

2 Actual cash EBITDA for 2010 was $1.3 million before non-recurring adjustments such as the Q4 Ad Campaign adjustment.

17

year olds within the targeted audience would be expected to see Blockbuster’s new commercials

at least three times. Blockbuster’s advertisements aired during popular programs such as the

Dancing with the Stars finale, Christmas special programs, Desperate Housewives, Modern

Family, Good Morning America, the Macy’s Thanksgiving Day Parade, NFL Thanksgiving Day

games, and other NFL and college basketball games.

35. On January 11, 2011, Blockbuster’s management held a meeting with the

Steering Group during which management presented, among other things, the results of the $17

million Q4 Ad Campaign. Notwithstanding the aggressive spend, management revealed that the

stores had not experienced a meaningful difference between the pre- and post- advertising

campaign launch, and performance was significantly down from 2009 levels for the comparable

period. (See Exhibit G attached hereto.) Indeed, the net rental revenue and total rental revenue

comp store sales experienced a negative result against the same period in 2009. Accordingly,

notwithstanding the Steering Group’s good-faith efforts to provide Blockbuster with additional

liquidity to increase customer awareness through the Q4 Ad Campaign, Blockbuster’s core

business continued to deteriorate rapidly. Management’s inability to generate a return on capital

from the Q4 Ad Campaign also further called into question the Debtors’ ability to generate a

return on capital under its long-term business plan.

VI. The November 2010 Business Plan

36. On or about November 23, 2010, Blockbuster’s management presented a

newly revised business plan to the Steering Group (the “November Business Plan”, together with

the October Business Plan, the “Proposed Business Plans”). The November Business Plan

continued to forecast net rental revenue comp store sales that appeared difficult to achieve given

market conditions, and difficult to reconcile with the Debtors’ actual recent and historical

financial performance. Specifically, the plan showed net rental revenue comp store sales of

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negative 6% for the year ending 2010, up to negative 1.4% for the year ending 2011, negative

1.9% for the year ending 2012, negative 2.7% for the year ending 2013, and negative 2.8% for

the year ending 2014. (See Exhibit H attached hereto.) Compared to the significantly downward

historical trend of net rental revenue comp store sales since 2008, with average comp store sales

of negative 14.6% for the year ending 2009 and negative 10.4% for the year ending 2010,

management’s November forecast of very modest 1.4% - 2.8% annual net negative rental

revenue comp store sales appeared unduly optimistic. Indeed, Blockbuster’s actual performance

after the Petition Date had deteriorated substantially, as weekly net rental revenue comp store

sales continued to drop precipitously from 2009 levels in the range of negative 5% to negative

40% through mid-February 2011. (See Exhibit C attached hereto.)

37. In addition, the November Business Plan forecasted that EBITDA would

increase over the subsequent five years, despite the fact that EBITDA had decreased

substantially from 2008 through 2010 due to competitive headwinds and rapidly changing

industry dynamics. Specifically, the November Business Plan forecasted year-end adjusted

EBITDA for 2010 at approximately $82 million then increasing to $86 million for the year

ending 2011, up to $129 million for the year ending 2012, up to $143 million for the year ending

2013, and up to $172 million for the year ending 2014. (See id.) Although these numbers were

lower than those contained in the October Business Plan discussed above, the positive EBITDA

trend was similar to the projections contained in the October Business Plan which was difficult

to reconcile with Blockbusters’ actual comp store performance.

38. Furthermore, the November Business Plan for the first time also called for

a new equity investment of $190 million into Blockbuster, but failed to explain the uses and

potential return from such proposed equity investment. The November Business Plan simply

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stated, without any specific allocation or detail, that the purpose of the $190 million equity

investment was to (i) provide liquidity; (ii) underscore the company’s near-term financial

viability; (iii) reserve committed capital for future digital business development; (iv) ensure trade

partner confidence; (v) secure studio exclusive content investments; and (vi) support other

strategic growth opportunities. Despite requests from the Steering Group, Blockbuster did not

provide support for how it intended to use the proposed $190 million equity investment, or

demonstrate how the equity infusion was expected to generate real return on investment.

Needless to say, the Steering Group had no obligation to make any such equity infusion under

either the Plan Support Agreement or the DIP Credit Agreement.

39. The Steering Group engaged in extensive discussions with the Debtors’

professionals to address its concerns about the November Business Plan. In connection with

these ongoing discussions, the Debtors agreed that further revisions to their business plan were

necessary, and the Requisite DIP Lenders agreed to amend the DIP Credit Agreement to extend

the Third Milestone – the date by which the Debtors were required to file a Disclosure Statement

and Plan with this Court and to obtain approval of a Business Plan – from November 30, 2010 to

December 15, 2010.

VII. The Steering Group Considers The Liquidation Value of the Debtors’ Assets as a Benchmark to Compare With the Debtors’ Business Plan

40. During the time that Blockbuster was preparing a further revised business

plan in late November and December 2010, the Steering Group began to consider the liquidation

value of the Debtors’ assets pursuant to chapter 7 of the Bankruptcy Code, or a sale of all or

substantially all of the Debtors’ assets pursuant to section 363 of the Bankruptcy Code, as a

benchmark to compare with the Debtors’ Proposed Business Plans. The Steering Group’s

consideration of these alternatives was based upon, among other things, the continued

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deterioration of Blockbuster’s financial performance, the poor return on capital generated by the

$17 million Q4 Ad Campaign, Blockbuster’s request for a $190 million new equity investment

without any clear return on investment from such a capital infusion, and the company’s inability

to present a rational plan with respect to a reduced store footprint in light of the declining comp

store sales performance. During this time, however, the Steering Committee and its

professionals continued to work in good faith with Blockbuster and granted additional extensions

of the milestones to accommodate Blockbuster’s management and the Debtors’ restructuring

efforts.

41. On or about December 14, 2010, the Requisite Lenders consented to a

further good-faith extension of the Third Milestone to January 14, 2011 in order to provide

Blockbuster with additional time to evaluate the company’s performance during the holiday

season, and to revise its forecasts accordingly. As the Debtors amended their Business Plan in

advance of the revised Third Milestone deadline of January 14, however, Blockbuster’s business

continued to decline, calling into question Blockbuster’s ability to achieve even a significantly

discounted budget.

42. At the January 11, 2011 meeting referenced in paragraph 35 above,

Blockbuster’s management presented a financial update to the Steering Group. Management

conceded that the company’s financial performance had deteriorated to a much greater extent

than it had forecasted just weeks earlier, and reported that adjusted EBITDA for the year ending

2010 was approximately $87 million as compared to $201 million for the year ending 2009, a

decrease of approximately 57%. Management also reported at this meeting that the $17 million

Q4 Ad Campaign had not produced the expected results, and that Blockbuster in fact had

experienced decreased net rental revenues against the same period in 2009. At this presentation,

21

management also noted that the number and pace of store closings would have to increase

substantially in light of the significant continued downward trend of comp store sales, the

decrease in customer foot traffic, and the flawed assumptions made by management in its

Proposed Business Plans regarding Blockbuster’s ability to stem the significant declines in year-

over-year same store comp sales.

43. It was at this meeting that Blockbuster’s management stated that

Blockbuster’s Board of Directors had authorized management to consider other restructuring

alternatives, including a section 363 sale of substantially all of the Debtors’ assets. Management

reported that the Board of Directors would consider stalking horse bids from lenders in the

Steering Group given that those lenders were fully familiar with Blockbuster’s assets and

operations, and would be in the best position to quickly commence a 363 sale process as a

stalking horse bidder. In addition, shortly after the January 11 meeting the Debtors’ management

and advisors disclosed for the first time that the gross administrative claims incurred during these

Chapter 11 cases (including the studios “roll-up” of approximately $65 million of prepetition

claims) were approximately $285 million – far greater than the Steering Group had known based

upon the prior information and budgets provided to it by the Debtors and their advisors.

VIII. Payments Made During the Chapter 11 Cases & “Trade Neutrality”

44. As the Steering Group considered the liquidation value of the company

and potential recoveries from a sale of all or substantially all of the Debtors’ assets as alternative

paths to maximize the value of the estates, it closely reviewed the company’s cash burn through

the Chapter 11 Cases, and the expenses that would be required to get the company to an auction

and sale of the Debtors’ assets.

45. For example, in the month of September 2010, Blockbuster’s

administrative expenses (total domestic accounts payable and accrued expenses) were

22

approximately $225 million, with approximately $90 million in accounts payable and accrued

expenses attributable to the movie studios and company’s other trade vendors (with the

remainder relating to critical expenses such as compensation, taxes, insurance, and customer

deferred revenue and expenses such as gift cards and prepaid subscriptions). (See Exhibit I

attached hereto.)

46. As the Chapter 11 Cases progressed, Blockbuster’s administrative

expenses (total domestic accounts payable and accrued expenses) continued to grow

significantly, especially leading into the holiday season. For example, one month later in

October 2010, Blockbuster’s total administrative expenses grew to approximately $292 million,

with approximately $130 million in accounts payable and accrued expenses attributable to the

movie studios and company’s other trade vendors. In November and December of 2010,

Blockbuster’s administrative expenses increased further to over $320 million. (See id.) Given

the Debtors’ continued decreasing comp store sales and the negative impact of the $17 million

Q4 Ad Campaign – during what should have been the company’s busiest and most profitable

fiscal quarter in light of the Thanksgiving and Christmas holiday seasons – the significant growth

in total domestic accounts payable and accrued expenses became unsustainable. The expenses

and the cash burn were simply too great.

47. Nevertheless, throughout the Chapter 11 Cases, the DIP Lenders have

continued to approve a significant amount of payments from the Debtors to their trade partners in

order to maintain commercial relations and preserve the going concern value of the enterprise.

Most notably, among the biggest beneficiaries of the use of the Cash Collateral – the studios,

which provide content to Blockbuster – have been paid over $175 million from September 19,

2010 to February 27, 2011, a large portion of which is on account for product delivered to the

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Debtors prior to the filing. In further support of preserving the enterprise, the DIP Lenders also

approved Blockbuster’s payment of over $39 million to its games vendors and over $37 million

to its merchandise vendors during that same time period.

48. In light of management’s January 11, 2011 presentation – which showed

that adjusted EBITDA for year ending 2010 had decreased from 2009 approximately 57% and

net rental revenues had decreased against the same period in 2009 notwithstanding the $17

million Q4 Ad Campaign – the Steering Group’s consideration of alternatives to preserve the

value of its collateral became more imperative.

49. Indeed, with Blockbuster facing the pending milestone deadline of January

18, 2011 (which had been extended for the third time from the original date of November 30,

2010), the Steering Group considered whether to terminate the DIP Facility and seek conversion

of the Chapter 11 Cases to liquidation cases under chapter 7. Alternatively, the Steering Group

considered whether the path for maximizing the value of the Debtors’ estates would instead

result from consenting to the Debtors’ further use of the Senior Secured Noteholders’ pre-

petition Cash Collateral while Blockbuster proceeded to a public auction of its assets and

businesses – as Blockbuster’s management had proposed at the January 11, 2011 meeting.

50. Blockbuster asserted that the conversion of the Chapter 11 Cases to a

chapter 7 liquidation would further disrupt the Debtors’ businesses and likely would have a

significant negative effect on the value of the Debtors’ assets. Moreover, in a chapter 7

liquidation not only would the value of the Debtors’ assets likely decrease significantly, but

Blockbuster’s enterprise value and significant trade vendor relationships – which Blockbuster

had continued to maintain and develop throughout the Chapter 11 Cases by spending the Senior

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Secured Noteholders’ Cash Collateral – likely would suffer significantly given the Senior

Secured Noteholders’ pre-petition senior secured $630 million claim.

51. The Steering Group concurred with the Debtors’ conclusion. The Steering

Group believed, and I agreed (and continue to believe), that a 363 auction and sale process would

be the best way to maximize Blockbuster’s value as a going concern. In my experience, 363

auctions often lead to overbids where potential buyers express serious interest in the company or

its assets. In fact, I have subsequently been advised by Rothschild, the financial advisor to the

Debtors, that five or six potential purchasers have been conducting due diligence since the Sale

Motion was filed, and have expressed serious interest in the company.

52. Accordingly, the Steering Committee determined that it would forbear

from exercising its rights to terminate the DIP Credit Agreement and the Plan Support

Agreement, and instead would further extend the Third Milestone from January 18, 2011 to

February 4, 2011. During this extension, the DIP Lenders agreed to work with Blockbuster to

approve a short-term budget through the remainder of January and February, and to assess the

process and structure of a potential sale of all or substantially all of the Debtors’ assets through

an auction and 363 sale in the Chapter 11 Cases to preserve the ongoing value of the Debtors’

businesses. The Debtors set a deadline of January 28, 2011 for initial proposals from members

of the Steering Group to become a stalking horse bidder in the potential 363 sale of the Debtors’

assets.

53. During the discussions to approve a budget for the company between the

filing of a sale motion and completion of a sale process, Blockbuster’s management maintained

that it was important to ensure that Blockbuster’s trade partners – the movie studios, game

providers, maintenance and janitorial service providers, landlords, utilities, and employees –

25

would not be prejudiced through the extension of unsecured credit during the period after

January 17, 2011. Accordingly, management proposed the concept of “trade claim neutrality,”

which would allow management to closely monitor Blockbuster’s expenses and disbursements to

attempt to ensure that no trade creditor’s claim would increase from January 17, 2011, essentially

freezing the amount of such claims as of that date.

54. As such, on January 17, 2011, the DIP Lenders approved a budget for the

Debtors to pay their administrative expense creditors for goods and services provided to

Blockbuster after January 17, 2011, thereby ensuring that all administrative expense creditors

would be treated essentially equally in the post-January 17, 2011 period. Management

maintained that these creditors would provide value to the estates from their continued provision

of goods and services, enabling the Debtors to sell their assets in an orderly process and maintain

their going concern values. Importantly, in pursuing “trade claims neutrality,” the Debtors

continued to pay the major movie studios revenue share or “rent” payments on account of

product delivered to the company prior to January 17, 2011, and some product delivered pre-

petition,

55. Upon information and belief, it is my understanding that management held

discussions with Blockbuster’s significant trade vendors notifying them of the trade claim

neutrality concept. I understand from discussions with management and advisors to the Debtors

that the trade claim neutrality was not favorably received by various vendors and, indeed, several

vendors threatened to stop providing goods and services. From on or about mid-January 2011,

all the major movie studios, for example, stopped shipping product to the Debtors on previously

agreed trade terms, but agreed to provide product on a cash in advance basis. The DIP Lenders

26

agreed that the Debtors could use the Cash Collateral to make such cash advance payments to the

studios.

56. As the Debtors negotiated with two potential stalking horse bidders that

emerged from the Steering Group, the DIP Lenders continued to work with the Debtors to

approve a budget for the Debtors to consensually use Cash Collateral through the filing of a sale

motion, the public auction of the Debtors’ assets, and the closing of any such sale. In addition,

the Debtors negotiated bidding procedures and a sale process that reflects time constraints caused

by the continuing cash burn from business losses and downward-trending same store comp sales.

To prevent disruption of these negotiations and the preparations for the filing of a sale motion,

the Steering Group agreed to continue to forbear from exercising its rights to terminate the DIP

Credit Agreement and the Plan Support Agreement, and instead consented to again extend the

Third Milestone from February 4, 2011 to February 18, 2011.

57. As the Court is aware, the Debtors filed their sale motion on February 21,

2011, based on their decision to enter into a purchase and sale agreement with an entity named

Cobalt Video Holdco LLC, which consists of four of the members of the Steering Group.

IX. The Termination of the DIP Credit Agreement and Plan Support Agreement With Consent to Use Cash Collateral to Preserve the Value of the Debtors’ Estates

58. Through the negotiations to approve a budget for the payment of

Blockbuster’s expenditures during the sale process, the Debtors determined that they would not

need to draw down on the DIP Facility, and would be able to pay the expenses incurred during

the sale process solely through the consensual use of Cash Collateral. Indeed, the proposed sale

budget contemplates the use of Cash Collateral to pay over $285 million in total operating

expenses from February 27, 2011 through the closing date of the sale (on or about April 17,

2011). The Cash Collateral is generated through the operations of the Debtors’ business and the

27

ongoing liquidation of inventory at closed stores which is collateral of the holders of the Senior

Secured Notes.

59. Of the $285 million total operating disbursements to be paid from Cash

Collateral during the sale period, approximately $65 million is allocated for payment to movie

studios, game providers, and general merchandise providers; approximately $68 million is

allocated for payment to landlords, utilities, and maintenance; approximately $84 million is

allocated for payment of rank-and-file employee compensation and benefits; approximately $25

million is allocated for payment of taxes; and approximately $40 million is allocated for payment

of other operating expenses such as insurance, information technology, and freight/postage.

These amounts represent all budgeted expenditures during the sale period.

60. Given all of the facts and circumstances leading up to the filing of the

Debtor’s motion to sell all or substantially all of the Debtors’ assets as described herein, and the

Debtors’ inability to meet the requirements by the Third Milestone Date (among other things),

the Requisite DIP Lenders determined to exercise their right to terminate the DIP Credit

Agreement, and a Supermajority of the Consenting Noteholders determined to exercise their

right to terminate the Plan Support Agreement.

61. On February 25, 2011, the DIP Agent, as directed by the Requisite DIP

Lenders, and the DIP Lenders notified the Debtors of the occurrence of and continuation of

certain Events of Default under the DIP Credit Agreement, exercised their rights to terminate the

DIP Credit Agreement, and declared all obligations under the DIP Facility due and payable. On

February 25, 2011, the Requisite Consenting Noteholders notified the Debtors of the occurrence

of and continuation of certain Termination Events under the Plan Support Agreement, and

exercised their rights to terminate the Plan Support Agreement. Also on February 25, 2011, the

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DIP Agent, as directed by the Requisite DIP Lenders, and the DIP Lenders delivered to the

Debtors, United States Trustee, and the Creditors’ Committee the Carve-Out Trigger Notice (as

defined under the Final DIP Order) notifying each of a Termination Event under the Final DIP

Order, that all obligations under the DIP Facility had been accelerated, that the Post Carve-Out

Trigger Cap had been invoked, and that the delivery of the Carve-Out Trigger Notice constituted

a Roll-Up Event (as defined under the Final DIP Order).

X. Analysis of Administrative Claims

62. Given the amount of disbursements that have occurred during the course

of the Chapter 11 Cases (to virtually every constituency except the Senior Secured Noteholders),

it is important to discuss the estimated amount of Administrative Claims.

63. The most recent estimated amount of administrative expense claims

provided by the Debtors’ financial advisors, which is as of February 24, 2011, is approximately

$281 million. It is notable that of this estimated $281 million, according to the Debtors’

financial advisor, at least $132 million is expected to be either assumed, paid in cash,

reclassified, satisfied by cash collateralization pursuant to pre-petition vendor term requirements,

or may be satisfied through enforcement of a lien. After taking into consideration these

reductions, an estimated $148 million in administrative expense claims will remain, which

represents a greatly reduced figure relative to the total of $281 million. (See Exhibit J hereto for

a description of the estimated Administrative Claims.)

64. Furthermore, according to the company’s budget, Blockbuster expects to

disburse approximately $170 million to various trade and non-trade vendors for ongoing

operating expenses during the sale process from February 27, 2011, and leading up to the

estimated sale closing on or about April 17, 2011. The amount of these additional

disbursements demonstrates the intense cash needs of Blockbuster’s business, and the DIP

29

Lenders’ consent to the use of their Cash Collateral to pay such administrative trade and non-

trade vendors further demonstrates their ongoing good-faith efforts to maximize value for the

Debtors’ estates. Of this $170 million, approximately $50 million represents payments to movie

studios, $17 million represents payments to other product vendors such as game vendors, and

$34 million represents payments to non-product vendors. Significantly, all of these anticipated

payments will be paid cash in advance. As such, the administrative expense claims pool is not

expected to increase during the sale process as the April 17 sale date approaches.

65. It is also important to emphasize again that, throughout the course of these

Chapter 11 Cases, the DIP Lenders have extended credit and worked in good faith to create a

value-maximizing restructuring of the Debtors’ estates, thus providing substantial benefits to

many other constituents. In fact, while the DIP Lenders have worked in concert with the Debtors

by extending milestones, providing unplanned expenditures for the Q4 Advertising Campaign,

and continuously providing additional time to amend the Proposed Business Plans, the studios

have continued to benefit from the ongoing business relationship with Blockbuster,

notwithstanding the Debtors’ financial challenges. Specifically, during the Chapter 11 Cases,

Blockbuster has paid approximately $175 million to the movie studios through February 27, and

is now paying the movie studios on a cash-in-advance because they have refused to extend credit

terms to the Debtors.

66. It is equally important to understand the composition of the movie studios’

estimated administrative expense claims. As of February 24, 2011, the studios’ total claims are

estimated to be $116 million, comprising approximately 41% of the total estimated

administrative expense claims prior to any adjustments to the claims pool as discussed herein.

Pursuant to the Asset Purchase Agreement filed as an exhibit to the Sale Motion, the studios

30

negotiated to receive a payment of approximately $25 million for assumed obligations. In

addition, the Debtors’ financial advisors have indicated that the studios that are secured by the

liens on the Debtors’ Canadian assets (including Sony Pictures Home Entertainment Inc

Twentieth Century Fox Home Entertainment LLC and Warner Home Video) may benefit from

that lien.3 All told, the studios’ claim could potentially be reduced to approximately $91 million.

(See Exhibit J hereto.)

67. In addition to this potential reduction of the studios’ $116 million

administrative expense claims, it should be noted that approximately $65 million of such claims

are not truly post-petition administrative expense claims at all, but rather a roll-up of the studios’

pre-petition claim pursuant to the terms of the Accommodation Agreements with Blockbuster

that the studios executed at the commencement of these Chapter 11 Cases. As such, after taking

into consideration these adjustments, the studios’ post-petition administrative expense claim

could effectively amount to zero. (See Exhibit J hereto.)

XI. Response to Objections to Sale Order

68. I understand that certain parties in interest, including the United States

Trustee and the Creditors’ Committee, have objected to the Sale Motion and have asserted,

among other things, that (i) pursuing a 363 sale process would not produce better outcomes for

creditors compared to converting these cases to chapter 7, and (ii) a 363 sale process would

benefit only the Senior Secured Noteholders. I disagree with those assertions.

69. Prior to the Petition Date, the Senior Secured Noteholders held valid,

perfected, first priority liens on substantially all of the Debtors’ assets, including a pledge of two-

3 It should be noted that these movie studios secured by the Debtors’ Canadian assets obtained the liens in and against the Canadian assets prepetition by threatening to stop shipping to Blockbuster, essentially shutting Blockbuster down.

31

thirds of the equity interests in the Debtors’ foreign subsidiaries. The Debtors’ only material

unencumbered assets that had not been pledged to the Senior Secured Noteholders were certain

equity interests in some of the Debtors’ foreign subsidiaries. The Challenge Period (as defined

in the Final DIP Order) during which the Creditors’ Committee could have challenged the liens

of the Senior Secured Noteholders has expired. No challenge was brought.

70. As of the Petition Date, the Senior Secured Noteholders had valid secured

claims of approximately $630 million. Thus, under a chapter 7 liquidation of the Debtors’ assets,

general unsecured claims and chapter 11 administrative expense claims would be subject to

approximately $630 million of senior secured claims and almost certainly would receive no

recovery. In contrast, as set forth above, prior to and through the 363 sale process,

administrative vendor claimants have been paid substantial amounts during these chapter 11

cases and are budgeted to receive approximately $127 million in additional cash payments from

these estates during the sale process. Thus, pursuing the sale process is economically a better

outcome for administrative claimants compared to converting these cases to chapter 7.

71. The Creditors’ Committee has also asserted that the Senior Secured

Noteholders have received an “undeserved windfall” through the issuance of the Roll-Up Notes

and the priority of distribution from the DIP Collateral afforded to those notes under the Final

DIP Order. I disagree.

72. As stated above, prior to the Petition Date the Senior Secured Noteholders

held valid perfected liens on substantially all of the Debtors’ assets. The one discrete portion of

the Debtors’ assets in which the Senior Secured Noteholders did not have valid liens was on

Blockbuster’s Denmark subsidiary and a one-third interest in the equity of certain of the Debtors’

other foreign subsidiaries. The Final DIP Order granted valid, enforceable, non-avoidable, and

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fully perfected first priority liens on and security interests in the DIP Collateral (as defined in the

Final DIP Order), which included liens on and security interests in the Debtors’ unencumbered

assets -- the remaining one-third equity interests in the Debtors’ foreign subsidiaries. Based

upon the risks associated with making the DIP Loans, including the potential material diminution

of the collateral during the pendency of these cases, it was reasonable and appropriate for the

DIP Lenders to take this limited additional collateral to secure the DIP Obligations (as defined in

the Final Order).

73. Thus, although the DIP Liens secure both the DIP Loans and the Roll-Up

Notes, the Roll-Up Notes do not benefit from $125 million of previously unencumbered assets as

asserted by the Creditors’ Committee. Rather, the incremental collateral granted under the Final

DIP Order is limited to one-third of the equity interests in certain of the Debtors’ foreign

subsidiaries.

74. I also understand that the Creditors’ Committee has asserted that the DIP

Lenders in these Chapter 11 Cases effectively issued an “illusory DIP Facility.” I disagree with

this claim. In fact, the Debtors’ actually drew over $53 million over the life of the DIP

Financing, and the greatest amount drawn on the DIP Financing was $26.2 million. The

Debtors used those draws to fund the company’s operations, pay administrative expenses, and

preserve the enterprise. As described above in paragraph 47, the Debtors used the DIP Facility

and the DIP Lenders’ pre-petition Cash Collateral to fund various administrative payments to

their trade partners and others of over $854 million from September 19, 2010 to February 27,

2011, including over $174 million to studios, $39 million to games vendors, $37 million to

merchandise vendors, $151 million to landlords, and $146 million to employees.

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75. Furthermore, the fact that the current balance of the DIP Facility is zero

does not render the facility “illusory” at all, but rather is a function of a specific covenant in the

DIP Credit Agreement – which was set forth on day one and known to the Creditors’ Committee

and the Court – that required Blockbuster to use excess cash to make mandatory pre-payments of

any outstanding revolving loans under the DIP Facility at the end of each week if Blockbuster

had treasury cash in excess of $20 million (or $25 million during the month of December). That

covenant was designed to protect against draw-downs under the DIP Credit Agreement that were

not needed in the Debtors’ business, but also to ensure that Blockbuster had sufficient access to

liquidity during its reorganization. Indeed, the Plan Support Agreement contemplated that the

DIP Facility would be largely undrawn at exit, with only a new $50 million first lien exit

revolver thereafter.

76. I also disagree with the Creditors’ Committee’s claim that the “Backstop

Lenders” somehow committed to “backstop the reorganization process they pledged to sponsor.”

(Creditors’ Committee Objection at 3.) The Committee misconstrues the meaning of “backstop”

in the context of the DIP Credit Agreement. In fact, “backstop” refers only to the commitment

of the five members of the Steering Group – the Backstop Lenders – who agreed to commit to

fund the entire $125 million DIP Facility if, after opening participation in the DIP Facility to all

Senior Secured Noteholders, there were not enough commitments from those other lenders to

fully fund the $125 million. That is, the Backstop Lenders agreed to provide a fully committed

DIP facility regardless of whether any other Senior Secured Noteholders agreed to participate in

the facility. They did not commit in any way to backstop the entire “reorganization process” nor

guarantee to pay all of the Debtors’ administrative expense payments to all of their vendors and

other creditors.

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77. I also disagree with the Creditor’s Committee’s claim that the DIP

Lenders somehow acted improperly by causing the Debtors to default under the DIP Facility,

thus triggering the issuance of the Roll-Up Notes, by refusing to reach consensus among

themselves with respect to the Debtors’ Proposed Business Plans. If the DIP Lenders had

intended to cause a default in the manner imagined by the Credit Committee, they never would

have agreed to extend the milestones under the DIP Credit Agreement and the Plan Support

Agreement multiple times after November 30, 2010, but would have triggered the default at the

time the Debtors initially failed to meet the first deadline.

78. Instead, the DIP Lenders granted multiple extensions of various

milestones in good faith, agreed to amend the DIP Financing, and consented to multiple budgets

after November 30, 2010 that enabled the Debtors to fund their operations and pay

administrative expenses in excess of $473 million between December 5, 2010 and February 27,

2011. I also do not believe that the DIP Lenders would have agreed to fund the $17 million Q4

Ad Campaign at management’s request if they harbored any intent to capture an “undeserved

windfall,” as the Creditors’ Committee suggests. And I certainly do not believe that the DIP

Lenders actually received an “undeserved windfall” as the Debtors have disbursed approximately

$854 million of the Senior Secured Noteholders’ pre-petition Cash Collateral to fund their

operations and pay administrative expenses to the benefit of many other constituents during these

Chapter 11 Cases, including the use of approximately $16.3 million in proceeds from 207 stores

already closed and have actually received approximately $21.7 million in proceeds from 780

stores that are in the process of being liquidated and which have also been pledged as collateral

to the Senior Secured Noteholders.

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79. Accordingly, while some of the DIP Lenders may have had different

investment strategies internally, such differences did not trigger the termination of the Debtors’

reorganization efforts. Rather, the Plan Support Agreement and DIP Credit Agreement were

terminated for all the reasons I discussed above. It is undisputed that the Debtors defaulted

under the terms of the Plan Support Agreement and the DIP Credit Agreement by missing

numerous milestones despite multiple extensions granted by the DIP Lenders. The Debtors

failed to produce a business plan that addressed Blockbuster’s precipitously deteriorating comp

store sales, or develop a plan to rapidly close underperforming stores, or provide forecasts that

reflected the reality of the competitive and rapidly changing market environment in which

Blockbuster struggled to operate. Instead, the Debtors invested capital in a $17 million Q4 Ad

Campaign that unfortunately failed to produce the expected results. They later requested an even

larger, $190 million equity investment without providing support for the uses or expected return

on such an investment, and without finding any interested investors to fund such a plan. And

during the entire time, the company’s financial performance continued its significant decline.

80. The reality of the situation is that rather than an “undeserved windfall,”

the Senior Secured Noteholders are the parties that have been most negatively affected by the

Debtors’ poor performance during these Chapter 11 Cases. Senior Secured Noteholder collateral

from approximately 900 stores has been or will be liquidated and used to fund the business,

including the post-petition payment of approximately $850 million to studios, other product and

non-product vendors, landlords, taxing authorities, employees, service providers and others. No

interest or other payments have been made on account of the Senior Secured Notes.