Retail Bankruptcies on the Rise: How to Avoid Becoming A Statistic

Retailers may be headed for a tough year. Recent articles in The Wall Street Journal suggest that we may see a rise in retail bankruptcies in 2016, and, once in bankruptcy, retailers are more likely than other industries to shut down and liquidate, as opposed to reorganize.

According to The Wall Street Journal, a lack of liquidity in the credit markets, retailers' existing debt levels, and online competitors may cause a steep increase in retail bankruptcies in 2016.  While bankruptcy is always a last resort, it can provide retailers with useful tools.  For example, the Bankruptcy Code provides a mechanism to shed unprofitable stores, cap landlord damage claims, and move forward with a smaller, more profitable core.

Despite these available tools, retailers are still having a particularly difficult time in bankruptcy.  The Wall Street Journal, citing a study from the AlixPartners advisory firm, stated that "roughly 55 percent of bankrupt retailers never reopened..."  The newspaper noted that the authors of the AlixPartners study "compared that [55 percent] rate with a separate study that found that non-retailers liquidate in bankruptcy less than 5 percent of the time." Thus, while the overwhelming majority of non-retail debtors reorganize, more than half of the retailers that file bankruptcy liquidate. This disparity is startling.

Cracking the code on retail bankruptcies
Consumer preference for the convenience of mobile and online alternatives to traditional brick-and-mortar stores continues to impact retail revenues, causing many companies to reevaluate their business models. This includes reducing the number of physical store locations.  Difficulties with profitability due to online competition could be one factor impacting retailers in bankruptcy.

Changes to the Bankruptcy Code may also be a contributing factor to the struggles of retailers in bankruptcy.  The Bankruptcy Code permits retailers to either assume or reject their unexpired real property leases.  The decision to assume or reject an unexpired real property lease is an important one that could have a significant impact on a retailer's reorganization efforts.

The filing of a bankruptcy petition creates a separation between the pre-bankruptcy obligations and debts of the company and those incurred by the company after the bankruptcy is filed.  Rejection of a lease constitutes a breach of the lease agreement as of the bankruptcy petition date, giving rise to a damage claim in favor of the landlord. 

Under the Bankruptcy Code, landlord damage claims are capped based on the length of the remaining term and are considered general unsecured claims.  General unsecured claims are the lowest in priority of repayment amongst claims.  Subject to the other requirements of the Bankruptcy Code, a debtor is not required to pay general unsecured creditors in full, but only as much as those creditors would receive if the assets of the company were liquidated.  Thus, depending on the value of its assets, a debtor may be required to pay only a small percentage of the amount of the general unsecured claims.

In contrast, if a real property lease is assumed by the debtor, then it becomes an obligation of the post-bankruptcy estate.  Post-bankruptcy obligations of the debtor, such as its post-petition attorney's fees, trade debt, and rent are considered administrative claims.  Administrative claims are entitled to the highest priority of repayment.  Unlike general unsecured claims, administrative claims must be paid in full.  Importantly, if a lease is assumed and then terminated or otherwise breached, the landlord's breach of contract claim is entitled to administrative priority.  Thus, the consequences of mistakenly assuming a lease can be crippling to a retailer's reorganization efforts.

Prior to the 2005 amendments of the Bankruptcy Code, a debtor was required to assume or reject a commercial real property lease within 60 days after the bankruptcy filing.  However, the debtor could request that the court extend that deadline with or without the consent of the landlord and there were no limitations on the number of requests the debtor could make.  Thus, in practice, debtors could delay the decision to assume or reject a lease virtually indefinitely while it determined whether a particular location could be turned around and whether it could reorganize as a whole. 

Now, retailers must make a quick decision on whether to hold onto or rid itself of a store location.  In 2005, the Bankruptcy Code was amended to provide that a commercial real property lease is automatically rejected if it is not assumed by the 120-day deadline following the bankruptcy filing.  This deadline can be extended once, for an additional 90 days, or a grand total of 210 days following the bankruptcy filing.  Any extension beyond the 210-day deadline requires the landlord's written consent, which may be difficult to obtain.  Thus, a retailer must decide to assume a commercial real property lease within 210 days following the filing of the bankruptcy or it is deemed rejected.  In light of this quick timeline and the severe consequences if a company is wrong in its decision to assume a particular lease, companies opt to reject "bubble" stores (i.e., those that could potentially be saved) or opt to liquidate all together.

To stay ahead, retailers must think ahead
The amendments to the Code highlight the need for pre-bankruptcy planning.  Retailers contemplating bankruptcy – and even those that have not yet explored bankruptcy as an option – should meet with restructuring professionals as early as possible. 

Retailers must assess which stores should be closed immediately, which are profitable and should be kept, and which potentially can be turned around, especially with the redirection of effort and resources from anticipated closures.  Restructuring professionals can assist with this evaluation by helping retailers understand what benefits and savings can be achieved under the Bankruptcy Code.

For example, the Bankruptcy Code permits companies to reduce their secured debt to the value of the collateral that secures it.  In addition, interest rates can be reduced to "market" rates.  These provisions can provide companies with valuable savings in principal and monthly debt service payments.  Savings on secured debt could alter how many physical store locations can and should be salvaged and whether reorganization can be achieved.

The goal is always to avoid bankruptcy completely.  However, the Bankruptcy Code does contain provisions that can be the difference between a retailer becoming profitable or shutting its doors.  The key to taking advantage of these provisions is to start the evaluation process early.

Robert Marticello is president of the California Bankruptcy Forum and is a partner of Smiley Wang-Ekvall, LLP, a Southern California firm specializing in business litigation, real estate transactions, and bankruptcy and insolvency matters. He works with clients in a broad range of industries, including retail, real estate, non-profit, restaurant, and technology and has represented clients in multiple forums throughout the United States.