Thoughts on the New Bankruptcy Law for Small Retail Debtors

Journal Issue:

Jun 2005

Column Name:

Journal Article:

On April 20, 2005, press release issued by The National Retail Federation claimed that the Bankruptcy Abuse Prevention and Consumer Protection Act will increase the likelihood of retailers to recover their losses from individual customers who later file for bankruptcy protection.¹ The new law is designed to make it harder for people to wipe out their debt entirely. Individual bankruptcy petitioners who can afford to repay a significant part of their debt will now be required to do so under chapter 13 rather than having all debts erased under chapter 7, leaving the chapter 7 option for a smaller segment of the population. One controversial estimate by the U.S. Chamber of Commerce is that businesses lost $40 billion in unpaid bills as a result of the approximate 1.56 million bankruptcy cases filed in 2004.² The new law presumably will benefit both the national retail chains as well as those mom-and-pop retailers who sell merchandise on store credit because, in far more cases, individuals who qualified for credit in the first place will have to pay at least some of their debts. However, the new law does have a potential downside for some retailers, specifically troubled retailers.

The new law imposes tougher rules and requirements for small businesses with aggregate debt of less than $2 million. This new classification establishes a new strict 180-day exclusivity period, which will only be extendable for a reasonable time, where the court determines that confirmation is likely to result.³ If no plan is filed within a 300-day period, the bankruptcy case can be dismissed, converted to a chapter 7 liquidation or result in the companies' creditors submitting their own reorganization plan. In addition, this small-business classification implements a more streamlined process to confirm a plan, which includes the filing of additional forms and new financial reporting requirements. This reporting consists of both periodic financial reporting of profit and loss as well as projected cash receipts and disbursements.

Additionally, the new law gives landlords leverage they did not have under the old law. Previously, retailers would use the lease-rejection process to help them to efficiently liquidate stores or exit under-performing or overly expensive leases. Debtors must now affirmatively assume nonresidential real property leases within 120 days (which may be extended an additional 90 days "for cause"). If the debtor does not assume the lease, it is deemed rejected.⁴ Although the legislation doubles the initial time a bankrupt tenant has to assume or reject its lease from 60 days under the old law to 120 days under the new law, the courts will now only be able to extend that date once—for an additional 90 days, after which any further extensions require the written consent of the lessor. The new time constraints will severely limit the retailer's ability to effectively evaluate the overall viability of the business before it has to elect to assume or reject a lease or leases.

The retail industry may well see a significant rise in the number of liquidations compared to reorganizations.

In the past, courts have routinely granted numerous extensions of time, for months and even years, for debtors to assume or reject leases. These extensions have given companies sufficient time to adequately assess the true viability of such leases. The need for a quick decision may leave many retail debtors inadequate time to effectively evaluate their sales performance on a store-by-store basis, potentially resulting in a debtor's decision to reject more leases than necessary and ultimately resulting in more liquidations rather than the successful reorganization of retailers.

Additionally, a quick decision to reject the lease will result in the termination of rent payments to a lessor on short notice. On the other hand, a quick assumption of a lease would require the debtor to pay all defaults and cure costs in full to landlords for any unpaid back rent and other charges. The quick need to pay these landlords' cure claims in full early in a bankruptcy case not only affects the assets ultimately available to all creditors, but it may also create a cash-flow crisis and further inhibit the viability of the retailer's business. In the event that the tenant-debtor later rejects an assumed lease, the cure payments made will significantly enhance the landlord's position as a creditor, while negatively affecting other creditors. Further, the lessor will benefit from the payment of both the cure costs plus all the post-petition administrative expense claims, all of which are of higher priority than the statutory capped general unsecured damage claim resulting from a rejected lease. Therefore, creditors' committees will be more likely to push a tenant to reject a marginal performing lease and liquidate rather than allow the retailer to cure lease defaults and convert the remaining lease obligations to a higher priority than when a lease is rejected. As a result, the retail industry may well see a significant rise in the number of liquidations compared to reorganizations.

These time constraints placed on retail debtors may render unrealistic the ability for some businesses to survive a successful reorganization. Due to the current sluggish U.S. economy and the very competitive retail environment, troubled companies require more time and resources to focus on more than just the balance sheet, cash flow, financials and real estate. They are often faced with uncontrollable operational, industry, union or employee issues that need to be addressed before being able to successfully emerge from chapter 11. Management must have sufficient time and tools available to be able to ensure that faulty operational, supply and service issues alike can be corrected. In addition, it is important for retailers wishing to remain viable upon emergence from bankruptcy to maintain adequate customer service.

Another issue that affects all commercial debtors but may have a greater impact on small-business retailers includes additional payment requirements for adequate assurance. The new law requires the court to determine specific actions to assure payment to a service utility; payment must be made within 20 days of the order for relief to avoid the utility's altering, refusing or discontinuing its service. In the past, debtors relied on the utilities' right to administrative expense claim. However, that option is now specifically excluded. The only forms of adequate assurance are cash, letters of credit, certificates of deposit or similar securities, or prepayment for services.

In addition, new §1112(b) establishes that a party in interest may request the court to convert or dismiss a case for cause. Specifically included in §1112(b)(4)(D) is "unauthorized use of cash collateral substantially harmful to one or more creditors." In most situations, secured creditors require budgets for which the debtor is held accountable before allowing use of cash collateral. Given that small-business debtors often do not have the personnel to monitor daily sources and uses of cash, it is possible for such debtors to exceed authorized expenditures in certain categories. It is unclear whether such overspending will constitute unauthorized use of cash collateral. This is an area that may require litigation before answers will be provided.

For many years, practitioners have been trying to stress to clients the need for pre-bankruptcy planning. Because of stricter time and cash requirements upon filing, planning becomes even more important, even critical, in pursuing a successful reorganization of small-business retailers.