Struggling Retailers Require a Level Chapter 11 Playing Field –  Suggested Amendments To US Bankruptcy Code 

By Bradford J. Sandler and Kari Coniglio
Benesch Friedlander Coplan & Aronoff LLP

 

We are in the worst recession since WWII, and perhaps since the Great Depression.  Daily economic news highlights the status of the tight credit markets, tight labor markets, declining consumer spending, declining capital expenditures, failing real estate prices, rising consumer and commercial bankruptcies, and other depressing economic news that transcends global borders. The negative economic news has surfaced as a reality to consumers, businesses and industries, including, but certainly not limited to, the banking industry, automotive industry and retail industry.

Fortunately, the United States has some of the best, if not the best, bankruptcy laws in the world to assist distressed businesses to reorganize, but some peculiarities of the Bankruptcy Code make it difficult for certain businesses to reorganize. Due to a confluence of factors, including, but not limited to, businesses being overleveraged, the aforementioned poor economic data, and changes to the Bankruptcy Code (the “Code”), retailers have significant odds against their ability to successfully reorganize.  Cases in point: Sharper Image, Circuit City, Mervyns, Linens n’ Things, eToys, KBToys, Domain, Kitchen, Etc., Goody’s, Steve & Barry’s, Levitz; and the list of once great (or even not so great), but now extinct, retailers goes on and on, and no doubt, there will be others to join this growing list.

While the Bankruptcy Code provides a mechanism for distressed businesses to reorganize, the mechanism does not assist all businesses equally, and since the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), retailers have had a very low success rate in bankruptcy. Some bankruptcy attorneys have concluded that Chapter 11 is no longer an effective tool to reorganize a retailer.[1]

There can be no question that since BAPCPA was passed, retailers are left with little cash at the outset of a bankruptcy, and they are forced to make critical operational decisions in shorter, arguably unrealistic, time periods, leaving little chance of successful reorganization. Specifically, BAPCPA made five major changes that likely can be attributed to the large number of liquidating retail cases and the few successful retail reorganizations post-BAPCPA[2]:

1) Section 365(d)(4) of the Code has been amended to provide a strict outside limit on decisions to assume or reject leases;

2) Section 366 was amended to prohibit the use of an administrative claim as adequate assurance of payment for utilities, and to give utilities the ability to demand adequate assurance with courts having the ability to change only the amount of assurance;

3) Section 503(b)(1)(B) now provides administrative priority for ad valorem taxes;

4) Sections 507(a)(4) and (a)(5) have been amended to increase the monetary limits on priority wage and pension claims; and

5) Section 503(b)(9) was added to provide administrative priority for goods shipped to the debtor within the 20-day period prior to the bankruptcy filing.

In this article, we provide Congress with some guidance to further amend the Bankruptcy Code in order to balance the interests of creditors and debtors, thus increasing the ability for retailers to reorganize in Chapter 11.

Section 365(d)(4) And The Time To Assume Or Reject Leases

Prior to the effective date of BAPCPA, debtors in possession had an initial 60-day time period in which to assume or reject unexpired leases of nonresidential real property.[3]  Courts, upon a showing of cause, could expand the initial 60-day window indefinitely[4], and, in practice, this was done routinely in retail cases.  Under the current version of Section 365(d)(4), a debtor in possession has an initial 120-day window to assume or reject its leases; however, the court’s discretion is now limited to a one-time extension of up to 90 days.[5] In other words, a debtor in possession has a maximum of 210 days following the date of the order for relief to determine whether to assume or reject leases.

Retailers that may have hundreds of locations spread across numerous states need time to study the markets and the value to the estate of each store location to adequately and appropriately determine which locations should be assumed and which locations should be rejected. In order to balance the rights of a debtor in possession retailer with the rights of its landlord, Congress should amend Section 365(d)(4)(B)(i) to provide generally for an extension of the initial 120-day period for cause with a maximum of three additional extensions of 120 days each, which would give a debtor approximately 16 months to evaluate its leases.  

No doubt landlords may be apoplectic when they hear this suggestion (compared to the current state of the law)[6]; however, the current law is inflexible and makes it unrealistically challenging for large retailers to effectively evaluate leases.

The “for cause” language, which gives courts significant discretion, will enable courts to provide sufficient time for large retailers to completely assess each lease before making a critical decision, while the time limitation will provide more protection to landlords than that which existed pre-BAPCPA.

Section 366 And Cash Payments To Utilities

Prior to BAPCPA, courts frequently provided utilities with administrative expense priority as adequate assurance of future payment. Confusing language added to Section 366 now has a majority of courts ordering cash payments of anywhere between two weeks to two months worth of service to be paid to the utility as adequate assurance. Courts have also interpreted the amended language to leave the form of adequate assurance up to the demands of the utility with the court having the ability to merely modify the amount of assurance.[7]  The justification for these protections to utilities rests upon the idea that utilities are forced to continue to provide service to the debtors; however, nothing prohibits a utility from terminating service based upon post-petition defaults in payment or lack of adequate assurance at anytime after the 31st day following the entry of an order for relief.

From the debtor’s perspective, an order requiring the debtor to provide cash upfront in amounts that may reach up to two months worth of services typically provided by the utility is a severe hardship that dwindles the availability of much needed cash early on in the Chapter 11 process. Therefore, to balance the interests of the debtor and the utilities, Section 366(c)(1)(A)(i) should be amended to specifically provide that “a cash deposit, not to exceed an amount equal to the average value of services provided to the debtor over a twoweek period as averaged over the 12-month period immediately proceeding the bankruptcy filing,” is adequate assurance of future payment.  Further, a new clause (vii) should be added to Section 366(c)(1)(A) providing for “such other form of security that the court deems appropriate upon a showing of cause by the utility, the debtor, or the trustee.”[8]

These amendments will balance the competing interests by still providing utilities with cash payments, but limiting the amount so as to not drain the debtor’s limited resources at the inception of its case. Further, these amendments will reinstate the courts’ power to modify the type of assurance based upon the equities in the case. 

Administrative Claims And Priority Treatment For Taxes And Wages

Although the amendments providing for administrative claim treatment for ad valorem taxes and increased limitations for priority wage claims may adversely impact some retailer’s ability to reorganize, in reality these provisions do not significantly impact a debtor and therefore they should not be amended or removed from the Code.[9] 

Section 503(b)(9) And Administrative Priority For Prepetition Goods

Perhaps the most deadly BAPCPA amendment for retailers is the addition of Section 503(b)(9) which provides administrative priority in the value of goods provided to debtors in the 20-day period immediately proceeding the bankruptcy filing.[10] Retailers often receive high volumes of inventory with significant turnover rates[11], which means that at the time of a bankruptcy filing, a retailer may have received a significant volume of goods within the 20-day period before the bankruptcy filing resulting in a large administrative claim.

Unlike reclamation rights which require that the goods still be in the debtor’s possession13 (and, for the most part, are of little practical value), section 503(b)(9) does not limit the administrative expense to the amount representing the value of goods still on hand.  This new provision leaves debtors saddled with significant administrative expense claims that must be paid in full at confirmation.[13]

The only way to avoid these massive claims would be for the retailer to suspend deliveries during the twenty days prior to the bankruptcy filing, which would similarly diminish the amount of cash on hand for the debtor, and practically speaking, may not be possible if the retailer wants to continue normal operations. On a slightly different note, it is also unfair to treat this new 503(b)(9) class of claimants differently from others who might provide beneficial pre-petition services to the debtor during the same 20-day window set forth in Section 503(b)(9).  Section 503(b)(9) creates a privileged class to the detriment of others similarly situated, and is the only provision that provides an administrative claim for conduct arising prepetition. For all of these reasons, Section 503(b)(9), should be stricken from the Code. 

Preferences And Their Effect On Suppliers

Although not a new addition to the Code, preferences under Section 547 create problems for debtors and suppliers with few benefits for the estate overall. The current version of Section 547 essentially leaves any creditor who received payments from a debtor within the 90-day period immediately proceeding the bankruptcy filing at risk of being pursued when the debtor is unable to pay unsecured creditors in full.[14]  While the overall goal of preferences was to deter creditors from taking aggressive collection actions against a distressed debtor,[15] the current (as well as the pre-BAPCPA) version of the Section leaves suppliers who have extended credit terms in order to give debtors more leniency in payments unable to demonstrate the ordinary course defense. As a result of this anomaly, the application of the Code actually discourages suppliers from extending credit terms to a distressed entity, which may, in the aggregate, push the debtor towards bankruptcy. Therefore, Section 547 should be amended to include an additional defense that provides that a trustee may not avoid a transfer “to the extent the transfer was made pursuant to contractual terms existing between the debtor and creditor or to the extent the transfer was made according to extended trade credit terms provided by the creditor.”

This additional defense, which will protect creditors who have acted in good faith, will encourage suppliers to work with a distressed debtor to potentially avoid bankruptcy and avoid a potentially adversarial relationship between the parties in the ultimate event of bankruptcy. Further, it will leave open the ability to recover preferences from overly aggressive creditors.

Conclusion

As Congress contemplates changes to the Bankruptcy Code to provide relief to consumer debtors, it should also consider making changes that will provide struggling retailers (and others) with a greater likelihood of a successful reorganization in Chapter 11. Such changes would no doubt also inure to the benefit of employees and consumers, and thus, achieve the likely policy goals of Congress.

 

[1] See Matters of First Impression — Business: The Death of Retail Chapter 11? BAPCPA in Practice in Retail Bankruptcy Cases, Panel: Laura Davis Jones, Ivan Gold, Jay R. Indyke, M. Steven Liff, Peter M. Schwab, 18th Annual Winter Leadership Conference.

[2] See The Disappearance of Retail Reorganization in the Post-BAPCPA Era, Lawrence C. Gottlieb, Sept. 26, 2008, p. 2 at N.1 (stating that only two retail cases have been successfully reorganized since BAPCPA).

[3] See 11 U.S.C. § 365(d)(4) (2004).

[4] See id.

[5] See 11 U.S.C. § 365(d)(4) (2009).

[6] We also suggest, in the alternative, that the number of extensions and/or length of extensions could be tied to the number of non-residential real estate leases to which the debtor is a tenant.

[7] See e.g. In re Viking Offshore (USA) Inc. 2008 WL 782449 at *3 (Bankr. S.D. Tex. Mar. 20, 2008) (declining to answer question of whether court continued to have the authority to modify the form of assurance rather than merely the amount).

[8] Further, Section 366(c)(2) should be amended to provide that the utility may discontinue service if it has not received adequate assurance “satisfactory to the court” in order to clarify that the court’s ability to modify the form of assurance has been reinstated.

[9] For example, the Code currently provides priority for $10,950 in prepetition wage and pension benefits. An employee earning twice the current federal minimum wage of $6.55 an hour would need to work over 835 hours, or approximately five and a half months of 40 hour work weeks, without pay to reach the new limitation. Therefore, it is unlikely that any retailer would face a substantial number of employees with claims reaching the new amounts (which is periodically adjusted to reflect changes in the Consumer Price Index).

[10] See 11 U.S.C. § 503(b)(9).

[11] See The Disappearance of Retail Reorganization in the Post-BAPCPA Era, Lawrence C. Gottlieb, Sept. 26, 2008, p. 7. 

[12] See e.g. Matter of Adventist Living Centers Inc., 52 F.3d 159 (7th Cir. 1995) (providing that an element to reclamation is a demonstration that the debtor had possession of the goods at the time of the reclamation demand).

[13] See 11 U.S.C. § 1129(a)(9)(A).

[14] Subject to certain jurisdictional amounts set forth in Section 547(c)(9), as periodically modified by Section 104.

[15] See In re Thompson Boat Co., 173 F.3d 430 (6th Cir. 1999), quoting H.R.Rep. No. 595, 95th Cong., 1st Sess. 373 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6329 (discussing legislative history to Section 547 “indicates that Congress’ purpose was ‘to leave undisturbed normal financial relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor’s slide into bankruptcy.’”)