BAPCPA’s Effects on Retail Chapter 11s Are Profound

(TMA International Headquarters) A recent article in The Journal of Corporate Renewal, “Is BAPCPA Unfairly Blamed for Rash of Retail Liquidations?” (December 2008), argued that the Bankruptcy Reform Act of 2005 (BAPCPA) has been unfairly blamed for the spate of Chapter 11 liquidations that have plagued the American economy over the past few years. While the article correctly noted that since the enactment of BAPCPA, troubled retailers are unlikely to survive once they are forced to file for bankruptcy protection, it attributed this result to a variety of factors unrelated to the Bankruptcy Code amendments, including:

• The overleveraged capital structure of bankrupt companies as they enter Chapter 11, compared to companies that filed in previous cycles
• The scarcity of capital in the aftermath of the credit crisis and the risk aversion of lenders following years of lax lending policies
• The continuing dominance of large discount retailers at the expense of specialty stores
• The growth of online sales
• The fading popularity of enclosed shopping malls
• The decline in value of real estate and leasehold interests

With so many variables in play, the article concluded, pinning all of the blame for retail failures on BAPCPA is all too easy.

Despite those arguments, BAPCPA’s numerous creditor-friendly amendments and modifications have profoundly impacted the Chapter 11 process, to the point that it is nearly impossible for retailers to reorganize, regardless of the prevailing national and international economic conditions.

Time and again in the three years since its enactment, BAPCPA has significantly impaired the ability of retailers to obtain the necessary post-petition financing and breathing room from creditors to test and implement a reorganization strategy, regardless of the debtor’s capital structure, the fluctuating state of the credit markets, or the extent to which they compete with large discount retailers like WalMart or online retailers like Amazon.

As a result, retail cases over the past three years have invariably taken one of two forms: either the case is filed as a liquidation or the debtor is given a small window within which to conduct a going concern sale under Bankruptcy Code Section 363 that typically generates only enough value to satisfy administrative and secured creditors. Which path a case takes often turns on the timing of the bankruptcy filing relative to the all-important Christmas shopping season.

Constraints on Retailers

As the authors have noted in several other contexts, most recently in testimony before the U.S. House Judiciary Subcommittee on Commercial and Administrative Law, BAPCPA’s amendments have significantly constrained the ability of retail debtors to reorganize. Among other things, the revised Bankruptcy Code:

• Amended Section 365(d)(4) to require debtors to assume or reject their real property leases within 120 says of filing, subject to an additional 90-day court-approved extension. Extensions beyond this initial 210-day period cannot be granted without the consent of the landlord, regardless of the size of the retailer. This amendment marked a sea change for retailers, who faced no real deadlines in analyzing whether to assume or reject their leases prior to BAPCPA
• Provided utilities with increased forms of adequate assurance of future payments within 20 days of filing
• Provided vendors that ship products received by the debtor within 20 days of the bankruptcy filing with an administrative claim for the value of such goods that must be satisfied for a plan of reorganization to be confirmed. Prior to BAPCPA, these claims generally were afforded general unsecured status and were paid out at cents on the dollar after the debtor’s emergence from bankruptcy
• Raised the aggregate monetary limits on unsecured priority claims from $4,925 to $10,950 for wages and benefits earned within 180 days prior to filing
• Allowed post-petition claims on account of ad valorem taxes to prime secured and administrative claims, regardless of whether the claim is secured or unsecured or whether the liability for the property tax is in rem or in personam
• Limited the period in which a debtor may exclusively file and solicit acceptances for a plan of reorganization

Collectively, these amendments have made it more difficult for Chapter 11 retailers to obtain the post-petition financing that is vital to fund ongoing operations while simultaneously constraining the company’s ability to utilize the financing it does receive in furtherance of a reorganization.

From a lender’s perspective, a retailer’s ability to routinely obtain extensions of the assumption/ rejection period provided two critical protections. First, a lender could be assured that a retailer was provided with sufficient time to analyze the value of each individual store lease before making the critical decision to assume or reject a lease. Second, and more importantly, lenders were assured that they would be provided with enough time to conduct a going-out-of-business (GOB) sale on the premises if a decision was subsequently made to terminate the reorganization process.

Absent the ability to conduct a GOB sale from the debtor’s store locations, a lender is deprived of the most commercially viable location from which to liquidate its inventory. Because a well-run GOB process takes about 12 weeks, post-BAPCPA debtors must decide to assume or reject leases within three to four months to provide enough time to conduct GOB sales should the need arise.

Recognizing the increased leverage that the amendments to Section 365(d)(4) provided them, as well as the higher costs of confirming a plan as a result of BAPCPA, DIP lenders have been reluctant to provide retail debtors with financing to do anything more than a nominal restructuring effort before gearing up for the inevitable liquidation.

Timing Is Key

Prior to BAPCPA, lenders were far more likely to finance a debtor’s attempt at reorganization, partly because the Bankruptcy Code essentially provided them with an indefinite period of time to market and assign a debtor’s below-market leases to third parties at a premium in the course of a subsequent liquidation. Post-BAPCPA, however, both lenders and debtors are well aware that the 210-day assumption/rejection period currently proscribed by Section 365(d)(4) is too short to enable Chapter 11 retailers to judge the vitality of their business and adequately evaluate which of their commercial leases are necessary for a successful reorganization and which should be jettisoned.

As a result, post-BAPCPA Chapter 11 retail cases have almost uniformly been postured at the outset as either full-chain liquidations or a truncated sale process, followed by liquidation if going concern bids are not sufficient to pay off secured lenders. This pattern has been remarkably consistent, appearing in cases that occurred both before and after the credit crunch began to affect banks’ ability to lend and the bursting of real estate bubble caused property values to decline.

The path on which a particular retail bankruptcy will proceed depends on the timing of the debtor’s filing of petition. Indeed, it is the authors’ experience that Chapter 11 retailers that file for bankruptcy in the early or middle part of the calendar year are provided with the opportunity to quickly market their assets as going concerns, provided that these efforts do not interfere with the lenders’ ability to conduct GOB sales.

On the other hand, retailers that file later in the year are given virtually no opportunity to conduct a going concern sale process, as lenders insist that GOB sales commence during the critical holiday shopping season to maximize the value of their collateral. In the latter scenario, lenders aware of the low likelihood of a successful reorganization are simply unwilling to risk conducting GOB sales after the holiday season.

For example, Boscov’s Department Stores and its affiliates commenced a Chapter 11 proceeding in Delaware on August 4 of last year. After much negotiation among the debtors, the creditors’ committee, and the post-petition lenders, the debtors were able to obtain sufficient DIP financing to conduct a robust sales process in the three-month period immediately prior to the shopping holiday season. As a result, on November 21 the Bankruptcy Court approved the sale of the debtors as a going concern to former owners of the company.

Similarly, retailers Mervyn’s and Linens ’n Things each filed bankruptcy petitions in the middle of 2008 and were afforded the opportunity to seek out going concern buyers prior to conducting liquidations of their respective chains.

In contrast, when The Bombay Company, Inc., filed for bankruptcy in late September 2007, its lenders were unwilling to finance a full marketing process, insisting that the retailer begin liquidating its stores soon after the filing. Notably, financial advisors for both the debtors and the creditors’ committee acknowledged that Bombay’s fate would have been far different had it filed for bankruptcy protection earlier in the year. Other retailers, such as KB Toys and Value City, both of which filed in recent months, suffered similar fates.

Is BAPCPA to Blame?

To be sure, numerous economic factors, including the credit crunch, the subprime lending crisis, and the eroding value of commercial leases, have clearly contributed to the current environment in which Chapter 11 retail reorganizations are nothing more than pipe dreams. Nevertheless, characterizing the difficulties currently facing bankrupt retailers as solely the result of one or more of these economic factors would be to ignore the effect that the increased leverage granted to lenders and other creditor constituencies by BAPCPA has wrought on the Chapter 11 process. In fact, since the enactment of BAPCPA, only two retailers have successfully emerged from Chapter 11 as reorganized entities.

Unless and until Section 365(d)(4) of the Bankruptcy Code is amended further to provide a debtor with a full and fair opportunity to evaluate its lease portfolio before being forced to assume or reject leases, lenders will be unwilling to provide debtors with sufficient financing to effectuate a true reorganization process. In the interim, troubled retailers will be faced with two unappealing options: (i) file for bankruptcy in the middle of a calendar year and obtain DIP financing sufficient to run a lightning quick sale process, and then liquidate if the sale process does not generate sufficient value for the estate, or (ii) delay filing until later in the year and liquidate at the outset of the case.