Gary Eisenberg (Courtesy photo)
Retail bankruptcies continue apace in 2017. Their effects on commercial real estate are potentially widespread. What has been less well understood is how changes to the Bankruptcy Code from over a decade ago and trends in bankruptcy practice have combined to limit considerably the likelihood that any retailer filing for Chapter 11 bankruptcy relief can emerge successfully as a reorganized company.
Dozens if not hundreds of retail companies have filed for bankruptcy in 2017 alone. The common culprit typically identified in each of them is the mega-trend from in-person to online retailing. One could say the trend is of Amazonian proportions.
As the migratory trend in retail from in-person to online continues, unlike the case with past waves of retail bankruptcies, predictions do not abound for a “recovery” in traditional retailing. However, that seismic industry change is only part of the explanation why companies such as The Limited, Gordmans stores and hhgregg have not only filed for bankruptcy but have ceased operations with their cases proceeding rapidly. The legal regime and common practices of Chapter 11 are substantially different from those facing the large retailers such as Kmart and Caldor, whose filings shaped the course of retail Chapter 11 practice in the 1990s. Those legal realities compound the difficulties facing any retailer in a Chapter 11 case today.
A major change to the Bankruptcy Code affects retail bankruptcies today that was not in place in the 1990s. In 2005, Congress amended the Bankruptcy Code to limit the total number of days that a retail bankruptcy entity has to assume or reject its leases without landlord consent to 210 days. This is lightning-quick compared to the several years of extensions that were granted seemingly routinely in bankruptcies such as Channel Homes, Caldor and Kmart.
When a retailer files for bankruptcy, assuming or rejecting a store lease is one of the most consequential decisions that the retailer must make early in the case. A decision to reject the lease will usually result in prompt closure of the corresponding store, as the tenant will be excused from paying further rent while relegating the landlord to a capped unsecured claim amount.
By contrast, if the retailer assumes the lease early on, the future stream of rent payments (and damages for terminating the lease after assumption) will according to most case law have administrative priority claim status. Claims with administrative priority status have to be paid promptly upon confirmation of a reorganization plan and cannot be “crammed down” (meaning restructured involuntarily over the objection of the landlord) as part of a Chapter 11 plan. A claim based on an assumed lease thus can become a very large claim that would have to be paid in full to permit confirmation. Thus, traditionally, a retailer has an incentive to postpone the decision to assume or reject as long as possible.
To summarize, the traditional retail bankruptcy case was modeled on the following realities: Early assumption can cost the estate massively; early rejection is the death knell of the affected store; delay avoids both consequences and gives the retailer a chance to grow its way out of financial distress through a business turnaround. However, legal and technological changes have removed the element of delay.
The 2005 amendments curtail the ability of the retailer in Chapter 11 to postpone the day of reckoning. And, the seismic shift in retailing undermines the hope of a business turnaround. All the more so, a turnaround within 210 days that will permit rapid lease assumptions to undergird a viable reorganization plan is fiction for most retailers.
Another reality affects current retail Chapter 11 cases. Most retailers who file Chapter 11, like many companies filing Chapter 11 cases, enter Chapter 11 heavily leveraged. This leads to the initial important action in such cases being a sale of substantially all of the assets of the company under §363 of the Bankruptcy Code. In a retail case, the sale process typically has two prongs: rapid “bricks and mortar” closings and efforts to sell the intellectual property (trademarks, brand names and intellectual property related to online retailing) to try to maximize creditor recoveries, which tend to be meager.
In the case of The Limited, for example, this was the approach; it yielded a competitive bid for the e-commerce portion of the business. Gordmans entered into a “stalking horse” agreement that provided for sale of substantially all of its inventory and hard assets; the winning bidder, Stage Stores, gave some indication it would keep over half the stores open, but it faces its own challenges as a retailer.
The challenges facing the industry led the financial advisor for Gordmans (Joshua Benn of Duff & Phelps) to recite the industry’s woes succinctly in a declaration in support of the stalking horse sale proposal. He noted that “numerous retailers have filed for Chapter 11 protection—some more than once—including hhgregg, The Limited, BCBG Max Azria, American Apparel, Aéropostale, Gander Mountain, DEB Stores, Vestis Retail Group, Pacific Sunwear of California, Sports Authority, Quiksilver, and RadioShack.” The scope and prominence of the list overwhelms at the outset.
However colorful the descriptions, the prescriptions follow similar paths: an expedited liquidation at the outset, of many or most of the assets; a rapid wind-down of “bricks and mortar”; and, conversion in some instances to pure e-commerce operations (often with a sale of the e-commerce platform to a private equity group or a competitor).
The results from a Chapter 11 standpoint tend to be the same. The cases move rapidly. Protracted extensions of the time to assume or reject leases are relegated to the Bankruptcy Code’s equivalent of the ash heap of history. Retail industry trends have made the lengthy retail turnaround plan in bankruptcy court extinct.
In essence, in the realm of retail Chapter 11 cases, the best opportunities are for buyers seeking to acquire discounted e-commerce platforms. However, any prospective bidder must act quickly at the outset. The string cites to other retailer filings can be expected to continue to grow longer. Absent both amendment of the Bankruptcy Code and a shift away from the tidal wave of e-commerce, it is likely to remain the case that the disciplined buyer at the outset of a Chapter 11 case will be the prime beneficiary of Chapter 11 retail bankruptcies.