Broken Beyond Repair
Is BAPCPA Unfairly Blamed for Rash of Retail Liquidations?

(TMA International Headquarters)

The headline story in retail over the past year is not how many large chains have filed for bankruptcy, but how many won’t be coming out. Increasingly, failed retail chains are simply disappearing from the shopping landscape altogether.

Many of these names have been familiar to shoppers for decades: The Bombay Company, Sharper Image, Levitz, Wickes Furniture, and Wilson’s Leather are just some of the retailers whose names are vanishing forever from storefront marquees.

Several were fast-track liquidations that were anticipated from the outset of their Chapter 11 proceedings and implemented via Section 363 auctions held within weeks of the filings. The prospect of reorganizing around a smaller core of stores was never more than a long shot for these distressed companies.

Moreover, the fates of a couple of other failed chains that are currently in Chapter 11 now hang in the balance. Linens N Things, once a 600-store national chain, is also going the liquidation route after failing to solicit any qualified bids to purchase the company as a going concern. It’s fairly certain that the list of extinct retailers will grow longer over the upcoming year.

This apparent phenomenon begs several questions. Foremost, is it empirically true that failed retailers today are less likely to reorganize successfully in bankruptcy than historical experience suggests? Are they less likely to reorganize successfully than failed companies in other industries? Lastly, what reasons might explain the flurry of fast-track liquidations of retailers that seem so prevalent these days?

New Requirements

Several recent articles accept the premise that this phenomenon is not only real, but is also unique to retailing. The authors then expounded on its causes, which they blamed almost entirely on the Bankruptcy Reform Act of 2005 (BAPCPA), which enacted several changes to the U.S. Bankruptcy Code that make it especially challenging for retailers to reorganize in bankruptcy. Specifically, these revisions require that:

• A debtor make accept/reject decisions with respect to commercial property leases within 120 days of filing, which can be extended by the court an additional 90 days to no more than 210 days. Extensions beyond 210 days cannot be granted by the court without the consent of the affected landlord. Prior to BAPCPA, there were no de facto time limitations on this decision, and it was often a routine matter for a debtor to receive extensions—sometimes lasting the duration of the bankruptcy case—to accept or reject property leases, provided it stayed current on lease payments post-petition.
• Product shipments received by a retailer within 20 days of a bankruptcy filing receive administrative claim status and, as such, must be satisfied in full by confirmation. Before BAPCPA, most of these claims would have treated as pre-petition unsecured claims, which typically receive less than full value under a reorganization plan.
• Utilities providing services to a debtor receive adequate assurance of future payment within 20 days of filing in order to keep providing services. This might require a cash deposit equivalent to a month or two of average service charges. Prior to BAPCPA, courts typically found such adequate assurance could be derived by granting administrative claim status to any such claims without requiring a debtor to make cash deposits, but that practice is now expressly prohibited as a means of conferring adequate assurance of payment.

So troubling are these changes to some retail industry officials and restructuring professionals that a hearing on the topic “Is Chapter 11 Bankruptcy Working?” was held in late September before a subcommittee of the U.S. House Committee on the Judiciary. Some of those testifying urged Congress to reform BAPCPA to address these issues.¹

BAPCPA critics contend that these changes, particularly the shortened timetable to accept or reject property leases, have had a chilling effect on lenders’ willingness to commit normal DIP financing to a debtor. By accelerating the timetable to reject store leases, BAPCPA has unwittingly put at risk the value of a retail debtor’s two largest sources of collateral: inventory and store leases that can be assigned.

It is this collateral that has traditionally encouraged potential post-petition lenders to extend DIP financing when a debtor’s reorganization prospects were in doubt. Seven months may sound like plenty of time for a debtor to decide on its keepers but, in reality, it is considerably less time than that.

The process of selecting a liquidator and conducting going out of business (GOB) sales and store winddowns typically takes three months for a reasonably large retail chain. Hence, the accept/reject decisions on stores leases should occur within three to four months of filing to ensure sufficient time to carry out the store liquidation and closing process. That’s not much time for a large national chain. Moreover, store leases, sometimes hundreds of them, must be thoroughly analyzed and select groups of them must be renegotiated or, if possible, monetized within this timeframe in a manner that maximizes value to the debtor.

This all requires time and money. The bottom line is that unless a debtor has completed an exhaustive analysis of its store base and four-wall profitability prior to filing, a hastened timeframe within which to complete these many complex activities in a Chapter 11 case can only serve to compromise values realized during the process.

Recognizing this development, DIP lenders have become reluctant to commit funding that would typically be needed to carry a debtor through a conventional reorganization. For many lenders these days, even before the recent standstill in credit markets added to the problems, the level of commitment is only enough to provide funding to carry a debtor through the first few months of a case, after which an accelerated sale or liquidation of the company would need to take place unless the debtor has a stand-alone plan supported by its lenders, vendors, creditors’ committee, and other key constituents.

BAPCPA changes affecting adequate assurance payments to utility providers and administrative claim status for goods received within 20 days of filing are less severe in impact but are also uniquely onerous to large retailers. The former requires that a debtor have more cash or access to cash going into bankruptcy, while the latter potentially requires significantly more cash on hand prior to emerging from bankruptcy.

Deeper Issues

Hardly anyone would disagree that changes implemented by BAPCPA have only harmed the reorganization prospects of failed companies. But is BAPCPA ultimately responsible for the recent rash of fast-track liquidations, as many argue? That is indeed a different question, and the author has doubts about this supposed cause and effect relationship.

It could easily be argued that failing businesses today are more broken, more leveraged, and more irreparable than those that failed in previous bankruptcy cycles due largely to the easy credit environment that existed until mid-2007. Accommodating credit markets and unprecedented access to cheap credit, with few restrictions for marginally creditworthy borrowers, especially between 2004 and 2006, provided many underperforming and troubled businesses with the chance to get it right.

Some surely did, although one doesn’t really hear about them. Those that didn’t get it right only moved further down the demise curve—arguably arriving in Bankruptcy Court more beaten up, talent depleted, insolvent, and indebted than they otherwise would have been had normal credit market conditions prevailed all along because the end of the line would have been reached earlier.

The Bombay Company had negative earnings before interest, taxes, depreciation, and amortization (EBITDA) for three consecutive years prior to its bankruptcy filing. Linens N Things—a leveraged buyout (LBO) target despite years of underperformance—was EBITDA negative for a full year before it failed. Steve & Barry’s never generated a normalized operating profit. These were very broken companies when they arrived at the courthouse steps.

Furthermore, much of the new debt that enabled hobbled borrowers to carry on their business in recent years came in the form of senior secured term loans and second-lien loans, often from institutional investors. These second-lien loans are rightfully viewed as funding a company’s last “best chance” to fix its problems before bankruptcy becomes inevitable—utilizing whatever collateral cushion exists to fund a turnaround.

However, should this last-ditch effort fail, the reorganization process holds little hope for the debtor to successfully reorganize, as all of its collateral value has been fully pledged to pre-petition lenders and its remaining collateral cushion, if any, is likely to be negligible relative to its borrowing needs in bankruptcy. 

In essence, a distressed company this past decade often had a choice that was unavailable to troubled companies before the advent of second-lien loans: it could attempt a turnaround using second-lien money, understanding that this option was more limiting than a formal reorganization because the company could not avail itself of the remedies available to it as a debtor in Chapter 11. If successful in its efforts, however, the ownership structure would largely be preserved and extant shareholders—often including members of senior management—would reap the economic value of the turnaround.

Alternatively, a distressed company could have opted for a Chapter 11 filing sooner rather than later, knowing it had powerful legal remedies in bankruptcy to facilitate the reorganization effort and, likely, some collateral cushion to support the effort. But existing owners—senior management included, most likely—would be highly impaired or wiped out, even if the reorganization effort succeeded. Faced with this choice many distressed companies opted to take the second-lien money in recent years.

In many instances, the absence of any sufficient collateral value at the very outset of a case—often the result of years of underperformance, persistent operating deficits, and previous failed turnaround efforts—would have discouraged most traditional DIP lenders—with or without BAPCPA.

The appropriate cohort group against which to test this thesis would be the retail bankruptcies of the early 1990s, whose advent also coincided with a recession that followed an LBO boom amid a generally borrower-friendly credit environment. Some major retail bankruptcies of that period were huge LBOs done in the mid- to late 1980s, such as Federated Stores, Allied Stores, Carter Hawley Hale, and Best Products. Although this wasn’t studied empirically for this article, unlike the loan-heavy structures of today, leveraged retailers of the late 1980s were financed largely with junk bonds—unsecured debt paying equity-like rates of interest.

This distinction is a critical one, as unsecured creditors, especially trade creditors, are much more inclined to favor a reorganization of a debtor in some fashion. For unsecured bond holders, reorganization almost always offers better recovery prospects than liquidation, while trade creditors can look forward to salvaging an ongoing business relationship with a rehabilitated debtor.

Conversely, secured lenders look primarily to collateral values and have less incentive to play along unless they’re confident that they’ll stay well-secured throughout the process. Hence, it appears that the specific constituencies of creditor groups have changed significantly since the previous retail downturn, and this shift toward secured lending (and, of course, secured creditors) works against the prospect of a traditional reorganization path for a failed retailer—with or without BAPCPA.

Other noteworthy considerations that might condemn more failed retailers to irrelevance irrespective of BAPCPA include:

• An overreaction by lenders toward risky borrowers following years of lending laxity.
• A general scarcity of capital and reduced lending capacity at banks in the aftermath of the credit crisis.
• The continuing dominance of the largest discount retailers at the expense of specialty stores.
• The penetration of online sales, which now account for at least 5 percent of U.S. retail sales nationally and more than 10 percent in several product categories.
• The fading popularity of enclosed shopping malls after a multidecade run in favor of nearby venues.
• The declining value of retail real estate and leases.
• The diminishing concentration of company-wide operating losses coming from a relatively small cluster of stores.

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

Academic Questions

The author doesn’t mean to imply that most retail bankruptcies will end in liquidation. Each situation is unique, and some have passed through the gauntlet of reorganization even during these challenging times.

Goody’s Family Clothing had its reorganization plan confirmed only four months after filing for bankruptcy. It emerged around a core of 287 stores after shuttering 69 others and a distribution center during the process and terminating its e-commerce business. Goody’s also left bankruptcy with more than $200 million in exit financing, even in today’s troubled credit environment.

Such a speedy and successful outcome would not have been possible without the close cooperation of lenders and vendors all along the way. Hancock Fabrics was another recent case with a good outcome for all involved. Only time will tell if these are exceptions to a new paradigm.

The consensus among restructuring professionals is that BAPCPA was a creditor-friendly piece of legislation. While that sentiment may be true, it remains conjecture at this point whether the amendments are directly responsible for the liquidations that are afoot in retail. In time academics who study such topics with keen statistical rigor will evaluate the entirety of this unfolding bankruptcy cycle compared to the 1990-1991 cycle and estimate whether BAPCPA significantly influenced outcomes in bankruptcy or whether such outcomes were the inevitable result of company-specific events and market-related factors that preceded failure.

One observation that few will disagree with is that if a consumer-led recession is protracted, and increasingly it is looking that way, default rates among retailers should far exceed those of all speculative-grade issuers, as seen historically in Figure 1. Academics who eventually study the BAPCPA phenomenon and its influence on retail bankruptcy outcomes will have many more data points to evaluate.