Ever wonder why retailers use the bankruptcy code as an exit strategy or path to restructure? Here’s a look.
By: Daniel F. Blanks, partner, Nelson Mullins
Circuit City, Blockbuster, Sharper Image, Friedman’s Jewelers, Bombay Company, Lillian Vernon, Movie Gallery, KB Toys, Borders and Linens-N-Things all filed for Chapter 11 in an attempt at reorganizing their companies. Each of them failed to reorganize, and instead liquidated. In the past, retailers such as Kmart, Macy’s, Montgomery Ward, Ames and Federated Department Stores filed for bankruptcy protection, reorganized and emerged from Chapter 11 as a restructured company. For landlords of retailers, it is important to understand what’s different now.
To understand the current bankruptcy code, it may help to view it through the prism of history. The Great Depression was the defining cataclysmic event of the American economy and political system. In the severe downturn of the economy at that time, preservation of businesses from liquidation, and the preservation of the employment and capital generated by those businesses was a major objective of the government. The Chandler Act of 1938 codified the reorganization principles to include large companies, including those that are publicly traded. Notwithstanding the general objectives of providing the opportunity for rehabilitation of the distressed business and avoiding liquidation, there were significant obstacles for American companies to utilize the 1938 Act.
In the decades that followed World War II, businesses obtained liberal access to capital markets and leverage grew exponentially. With the attendant financial distress occurring more frequently with this leverage, Congress passed the Bankruptcy Reform Act of 1978. The 1978 Act ushered in a transformative array of new concepts including, among others, the abandonment of the mandatory trustee and application of the “debtor-in-possession,” the automatic stay — expanding the ability of a debtor to obtain financing in Chapter 11 — and the authority to assume or reject unexpired leases and contracts.
In 2005, Congress dramatically altered the bankruptcy code in several important respects, many of which directly impacted a Chapter 11 retailer’s ability to reorganize. Several ongoing changes to the financial system have also evolved since 1978, some of which significantly impact Chapter 11. Prior to 2005, a debtor had 60 days to decide whether to assume or reject leases. This 60-day period could be extended by the Bankruptcy Court “for cause.” As a practical matter, this 60-day period was routinely extended, often for long periods of time. Today, a debtor must assume or reject non-residential leases by the earlier of (i) 120 days after the petition date; or (ii) confirmation of a plan. Courts may extend this 120-day period by an additional 90 days only once “for cause.” Extensions beyond 210 days may only be granted upon the consent of the landlord. Since “going out of business sales” typically require 60 days to complete, debtors are given three to five months to accomplish a reorganization. If it cannot, going out of business sales are instituted to maximize a return to the lender before the debtor must relinquish its leasehold. Outside of retail cases, most Chapter 11 debtors do not have hundreds or thousands of leases. Retailers’ leasehold interests, inventory and “brand” are often their primary, if not only, significant assets.
In addition, secured creditors now dominate Chapter 11 cases. Corporate debtors now pledge substantially all of their assets — including cash — to finance their businesses. When all of a debtor’s assets are liened, a debtor’s likely only source for debtor-in-possession financing is the secured creditor. To secure this financing, the secured creditor typically requires the debtor to consent to provisions and conditions that enhance the secured creditor’s position, including dictating going-out-of-business sales.
Historically, a retailer’s creditor pool was comprised of creditors with a vested interest in the survival of the retailer in Chapter 11. Today, that is much less likely. First, with the rise of international trade, a retailer’s trading partner is likely to be on another continent with little or no vested relationship with the retailer. Furthermore, there may be cultural differences in interpreting bankruptcy and debts. Second, section 503(b)(9) of the bankruptcy code now requires debtors to pay in full all claims of creditors that provided goods to the debtor in the 20 days before the bankruptcy filing. Unlike other trade vendors, these creditors do not share in a pro rata distribution of the pool of funds for creditors. Moreover, this class of creditors often comprises a substantial amount of money that must be paid before other creditors. Third, debt trading dominates Chapter 11. Private equity funds and hedge funds regularly purchase claims from institutional lenders and ordinary creditors. These debt purchasers have no interest in the rehabilitation and restructuring of the debtor. They much prefer quick sales and immediate distributions. Finally, gone are the days when customers had only one or two options of stores from which to purchase goods. Now, local companies compete with national companies and everything is available online.
Unlike many other industries, a retailer survives on its reputation with its customers. The disparate public has no appetite or interest in the nuances of financial difficulties. If a retailer files for Chapter 11, it must be “bad” or mistakenly believed to be closing simply because it filed for bankruptcy. The brand name of the retailer is destroyed immediately upon the public becoming aware of a Chapter 11 filing.
All of this presents owners of shopping centers with a unique set of problems. Some of these cannot be remedied by better drafted leases or even federal legislation, however, there are things that can be done to ameliorate one’s position. First, landlords of Chapter 11 debtors should play an active role in the Chapter 11 case from the first day. Second, landlords should participate on official committees of unsecured creditors to progress the case. Third, landlords may want to act in a collective manner, and proactively engage the debtor about the leases instead of allowing the debtor — or the secured creditor — to drive the decision. SCB
Daniel F. Blanks is a partner in Nelson Mullins’ Jacksonville, Florida, office. He counsels clients, including retailers, in matters related to bankruptcy, financial restructuring, distressed asset acquisitions, commercial workouts and commercial litigation. He may be reached by email at [email protected].