Posted February 22, 2017

 

By Larz Soper

 

Several of my recent blogs discussed the actual and potential business failures of retail chains and the apparent consensus projections that this trend will continue through 2017. As bankruptcies become more prevalent, more and more companies will be facing the decision as to whether to continue selling to customers that have filed for Chapter 11 protection.

 

Continuing to sell companies post-petition is tempting and seemingly logical. If you continue selling your customers while they restructure, you can profit while at a minimal risk as payments have been approved by the trustee. If the restructuring is successful, those customers to which you showed your commitment and loyalty will remember when they emerge from Chapter 11 as more streamlined and financially stable company, at which time you can make up for the losses you took from their filing, right?

 

Typically, a company in Chapter 11 can operate as a “Debtor in Possession” (DIP). In this status, a company is legally permitted to pay for post-petition purchases for goods and services used in the ordinary course of business and these sales are generally given administrative claim status giving companies that sold those goods and services priority over – and the right to pay before – most pre-filing unsecured claims. Such administrative status is granted if the debtors need the goods or services in order to continue to operate and the cost is reasonable. Such an arrangement sounds relatively risk-free, does it not?

 

Many companies are lulled into sense of false security in such situations as they believe administrative status guarantees payment. But it is important to remember that Chapter 11 provides a company the opportunity to reorganize under the oversight of a designated trustee.  It is not a guarantee that the restructuring will be successful or that the company will survive.

 

The trustee determines if the company restructuring is viable and on track and, if so, is allowed to use or borrow monies to continue to operate. If the trustee determines that the restructuring effort is not viable or will not be successful, the trustee may foreclose on the debtor’s assets and force an involuntary Chapter 7 liquidation. While such actions have been historically uncommon, the trend of forced liquidation seems to be rising.

 

Stephen B. Selbst recently published an interesting article in ABF Journal discussing the increased rate of retail Chapter 11 filings that have ended in liquidation and the impact on lenders. Selbst notes that the high rate of retail liquidations is caused by the typically short amount of time provided to execute a reorganization or sale. Due to a 2005 amendment to the U.S. Bankruptcy code, the restructuring time line was significantly shortened, often only months, time provided to obtain approval for a sale or reorganization. Additionally, trustees and the courts appear unwilling to approve DIP finance agreements without strict timetables for retailers to either confirm a reorganization plan or commence liquidation.

 

Selbst notes another change to the bankruptcy code 365(d)(4), which provides a maximum of just 210 days before existing store leases are deemed assumed. When a store lease is rejected before it is assumed, it’s considered an unsecured debt, versus rejecting a lease after assumption turns it into an administrative claim. It can take up to 90 days for a store to run a “Going Out of Business Sale” resulting in lenders mandating a decision to reorganize or liquidate within 120 of the bankruptcy filing to ensure unwanted leases get rejected prior to the 210-day deadline.

 

Most importantly, lenders have an incentive to push for liquidations based on inventory of a retailer which can make up as much as 50% of the retailer’s assets. Knowing that recent cases of liquidations have returned 100% of inventory values, reduces concerns liquidation will net lower returns.  Liquidations accelerate the time line to recoup lender loss versus waiting for a reorganization that can potentially keep a lender financially exposed to the debtor.

 

Lastly, the article states that another 2005 change to the bankruptcy code provides administrative priority status to vendor claims for the value of goods sold 20 days immediately preceding a bankruptcy filing. A retailer must have cash at confirmation to pay for these good in full to confirm a reorganization plan.  As an administrative-priority claim must be paid in cash on the effective date of the plan, it significantly increases the cost of a reorganization plan.

 

Selbst’s article provokes some very good questions: “Are the intentions of the secured creditors whose retail client has filed for Chapter 11 bankruptcy protection really to liquidate?  Could a Chapter 11 just be a means to keep a company operational so maximize profits while its being sold off?

 

For answers to this critically important question or any others you may have, please contact: Larz Soper, Expert Credit Advisor at ToYourCredit@sopermail.com.