It happens almost weekly in the news – another brick and mortar retailer declares bankruptcy. With the surge of online shopping, it’s hard for brick and mortar stores to stay competitive. Last year alone, 27 large U.S. retailers filed for bankruptcy and this year is on track to be even worse.

Why Are So Many Retailers Going Bankrupt?

This year could prove to be the hardest yet for retailers –  especially ones that are already running low on cash or close to the edge of breaking lender covenants. For those companies that are on the brink of bankruptcy, it’s even more frightening to consider the fact that more and more often Chapter 11 restructuring plans are leading to liquidations. The most recent example of this is Toys ‘R’ Us Inc., who had initially made plans to restructure but have no been forced to close stores.

There might be a secret reason behind all of this: the 2005 changes in the U.S. Bankruptcy Code that allows no more than 210 days for companies in bankruptcy to reject leases. Typically, most real estate today is leased rather than owned. On average, it takes at least 90 days to conduct inventory-clearance sales and at least another two to three weeks to start such sales. What that comes down to is only about 120 days to decide whether to reject leases.  Additionally, 120 days is rarely even long enough to evaluate all stores, decide what to do with inventories, renegotiate leases, etc… As a result of that very short time window, many retailers falter in being able to recover and undoubtedly have to turn to liquidation.

When Chapter 11 Becomes Chapter 7 Liquidation

As part of Chapter 11 bankruptcy protection, a company aims to decrease its debt and restructure. When that is not feasible, and a company decides it can no longer stay in business, it often ends up filing for Chapter 7 bankruptcy liquidation.

Here are the steps of a Chapter 7:

1. The company will file notice that it intends to go out of business.

2. A trustee is appointed to liquidate the company’s assets. This process typically triggers a going-out-of-business sales.

3. Administrative and legal expenses are paid first.

4. Money raised from the sale of assets is used to pay off any debts. Secured creditors are the first to be paid.

5. Unsecured creditors, such as vendors, get what’s left and they rarely receive all that is owed to them.

Chapter 11 Bankruptcy Protection

Under a Chapter 11 bankruptcy protection plan, a debtor is able to reorganize and restructure its financial affairs. The plan is a contract between the debtor and the debtor’s creditors that outlines how a debtor will operate and pay for future obligations.

Often this plan means a debtor will need to downsize operations in order to reduce expenses and free up assets. Often times, as is currently being seen with Chevron and similar oil companies, a move to cut spending and lower costs is a way to recoup some money in order to avoid bankruptcy.

Liquidation and Chapter 11

In some cases, where restructuring will not yield enough income to pay debts, a “liquidation plan” is necessary. Under liquidation, a debtor’s operations are shut down and its remaining property is sold to recoup money to pay off creditors.

Proposing Reorganization

Typically, a debtor receives four months to propose a reorganization plan following its initial filing of Chapter 11. This “exclusivity period” can be extended to up to 18 months following the petition date if the debtor is able to show good cause. While it can be extended, it can also be shortened, depending on the circumstances of the filing.

After the “exclusivity period” ends, the creditors’ committee and/ or other parties are able to propose competing reorganization plans. This is a fairly rare practice though. In these cases, it’s typical that a creditor committee or other party will move to either dismiss the bankruptcy filing or convert the case to Chapter 7. During Chapter 7 a bankruptcy trustee cancels many (or all) of the company’s debts. This can also mean the trustee will sell, or “liquidate” some of the property to pay back creditors.

Though rare, occasionally, a Chapter 11 reorganization plan will allow for every creditor to be paid back immediately, and in full. If this is not the case, as per usual, creditors are allowed to vote on whether or not they will accept the proposed Chapter 11 plan.

During this vote, at least one class of “impaired” claims must approve the Chapter plan in order for the plan to be approved by the bankruptcy court. Upon the plan being confirmed, an “impaired” claim is an obligation that will not be paid in full or when originally due.

Bankruptcy Court Approvals

The bankruptcy court must also approve:

• any sale of assets (property or real property). This excludes items such as inventory that is sold by a retail debtor during the ordinary course of business. For example; if a t-shirt company files for bankruptcy, they would still be allowed to sell their t-shirts.
• entering into or breaking a lease on real or personal property.
• mortgages or other secured financing arrangements that will allow the debtor to borrow money after the bankruptcy case is filed.
• the shut down or expansion of business operations.
• entering into or modifying union, vendor, licensing, and other agreements and contracts, and
• the retention of, and payment of fees and expenses to, attorneys and other professionals.

Role of Creditors

Creditors, shareholders, and other parties that have a vested interest in the company are able to support or oppose actions that will require bankruptcy court approval. These interests and opinions will be considered in bankruptcy court and determinations on how to proceed will be made. It’s only under Chapter 11 plans that formal votes are given by creditors and equity holders.

Unsecured creditors typically participate in Chapter 11 cases via a bankruptcy committee that is appointed to represent their interests. This committee is allowed to retain attorneys at the debtor’s expense. In some bankruptcy cases, shareholder committees are also able to take an active role in the bankruptcy decisions.

Confirmation of the Chapter 11 Plan

“Confirmation” is when a proposed bankruptcy plan is approved by a bankruptcy court. In order to confirm a Chapter 11 bankruptcy plan, the court needs to rule that the plan meets numerous requirements, including:

Feasibility. Feasibility means the proposed plan is likely to succeed. A debtor will need to prove that it will be able to raise sufficient revenues during the course of the plan’s term in order to cover its expenses and payments to creditors.

Good Faith. The plan needs to be proposed in good faith and not by means forbidden under applicable law.

Best Interests of Creditors. The plan must be in best interests of its creditors, meaning that a creditor will receive at least as much under a proposed Chapter 11 plan as they would had the case been converted to a Chapter 7 liquidation. This “best interest” often means that the debtor will need to pay a creditor in pull. Typically, Chapter 11 debtors are not able to meet this “best interest” and thus only pay a fraction of what they owe.

Fair and Equitable. The plan also must be “fair and equitable,” meaning the following:

• Secured creditors (meaning it has a mortgage against a real property or lien against personal property like inventory and equipment) must be paid, over time, at least the value of their collateral.
• The debtor is not able to retain anything on account of their equity interests until all obligations are paid in full. This is either immediately upon plan confirmation or over time (which includes interest). A bankruptcy court is able to allow equity holders to retain ownership interests in the debtor in exchange for “new money” that is put towards paying reorganization expenses. Otherwise, equity holders lose all ownership rights once the plan is confirmed.

Some of the confirmation requirements (like the fair and equitable test) are only applicable if the affected creditors vote against the proposed bankruptcy plan.

Does Chapter 11 Work?

Studies show that about 10 to 15% of Chapter 11 cases are successful, meaning the company is able to reorganize. Often cases are dismissed or converted to Chapter 7 liquidations. For a case to be dismissed the bankruptcy court must approve its dismissal. Conversion or dismissal can be done if a debtor fails to show it will be successful in reorganizing.

Working With a Bankruptcy Attorney

Bankruptcy law can be intricate and confusing. Because of this, if you believe you are a candidate for bankruptcy, you should immediately contact a bankruptcy attorney. They will be able to look at your case and your financial situation to determine if you are a good candidate, and what type of bankruptcy you should file.