This article is directed towards the non-bankruptcy practitioner who may be advising a financially troubled retailer. For the bankruptcy specialist, the matters discussed in this article are self-evident and confronted on a daily basis. However, for the general practitioner, this article will set forth some of the issues which should be considered long before a retailer commences a bankruptcy proceeding, and hopefully, points out the importance of seeking the advice of bankruptcy counsel early on in the process.
Some of the most important things a retail chapter 11 debtor can do in connection with a bankruptcy filing should occur prior to the commencement of the case. In many circumstances, the outcome of a retailer's chapter 11 case may be dictated not so much by what happens during the proceeding itself, but by the course of events leading up to the bankruptcy filing.
Mind Your Cash Flow
Prospective chapter 11 debtors must understand that the filing of a bankruptcy petition will not, in and of itself, create "new" money to support operations from and after the commencement of a bankruptcy case. If the cash flow of a prospective debtor is insufficient to satisfy on-going, ordinary course operating expenses, the debtor will have to either increase its revenues, reduce its expenses, or have sufficient funds on hand at the start of the bankruptcy case to fund operating, cash flow losses over the short term.
Once a chapter 11 bankruptcy case is commenced, the debtor-in-possession is obligated to file monthly financial statements with the Clerk of the Bankruptcy Court, which are available for inspection by the public. Post-petition cash flow losses, which will be evident from the monthly operating reports, are likely to generate a motion to convert the bankruptcy proceeding to a chapter 7 liquidation, or a request for the appointment of a chapter 11 trustee, both of which are disastrous to existing management.
Further, one of the primary obligations of a debtor-in-possession is to remain current on its post-petition payables. To the extent a debtor-in-possession has insufficient cash flow to satisfy such payables, the possibility of a conversion or the appointment of a chapter 11 trustee is enhanced.
Moreover, since the life blood of any retailer is its ability to obtain inventory for sale to its customers, limited cash availability is likely to significantly depress financial results. While there are provisions in the Bankruptcy Code which enable a debtor-in-possession to obtain post-petition financing, the parameters necessary to satisfy the legal requirements, let alone the practical problem of finding a willing lender, suggest that the prospects of obtaining new money are extremely limited.
For all these reasons, it is critically important that a prospective chapter 11 debtor-in-possession have sufficient funds on hand as of the date of the filing to sustain operations, and a proven ability to operate its business on a post-petition basis with positive cash flow results.
Have a Plan
A second critical factor to be considered prior to the commencement by a retailer of a chapter 11 bankruptcy case is the identification of an acceptable resolution of the proceeding, and the steps necessary to achieve that result in a timely fashion. All too frequently, chapter 11 bankruptcy proceedings are filed in response to a specific exigent circumstance, without sufficient consideration of how to achieve confirmation of a plan of reorganization.
While a chapter 11 filing may be the only alternative available to respond to a particular emergency, the better practice would involve anticipating the exigent circumstance, and timing a filing when most beneficial for the retailer. For example, a financially troubled retailer may develop a business strategy to "hold on" until the completion of the fourth quarter holiday selling season, so as to commence a bankruptcy case after the holidays, while in a cash rich position.
A chapter 11 bankruptcy proceeding typically terminates in one of two ways, namely, the successful reorganization of the debtor-in-possession or the liquidation of the debtor's assets for the benefit of its creditors. While most business people would prefer to view their company as a viable reorganization candidate, there are circumstances where a liquidation of a debtor's assets may constitute a successful outcome.
For example, if a prospective debtor's assets are encumbered by a bank lien which is personally guaranteed by the principals of the business, and if prior to the filing, a liquidation of corporate assets would generate a significant deficiency liability, a bankruptcy proceeding which enables the corporation to operate, and thereby increase its asset values so as to satisfy the bank's secured claim in full, may be deemed successful regardless of a liquidation or reorganization conclusion. Similarly, in circumstances where a prospective debtor owes "trust fund" taxes which may involve the personal liability of a "responsible party," resolution of the case in a fashion that satisfies such priority tax claims, even without successfully reorganizing, may be acceptable.
Know Who You Are Dealing With
It is important prior to the filing of a bankruptcy proceeding that the debtor understand the elements necessary to obtaining confirmation of a plan of reorganization, including the method of counting votes on the plan and the "business decision" creditors must make in deciding how to cast their ballots. Under the Bankruptcy Code, votes for or against confirmation of a plan of reorganization are counted by class. An accepting class requires a vote for confirmation both by more than 50% of the number of voting creditors in the class, and by at least two-thirds in dollar amount of allowed claims held by voting creditors in the class. 11 U.S.C. 1126(c).
The classification of creditors under the Bankruptcy Code is according to the nature of their claims, with each secured creditor consisting of its own class, priority claims classified according to the scheme set forth in section 507 of the Bankruptcy Code, and generally speaking, unsecured creditors, including the "deficiency" claims of allegedly secured creditors, consisting of one class. Moreover, in order to obtain acceptance of a plan of reorganization, at least one "impaired" class must vote for acceptance of the plan. 11 U.S.C. 1129(a)(10).
In circumstances where a retailer has only one class of creditors, typically unsecured creditors, that class must vote for acceptance for the retailer to confirm its plan. Alternatively, in a two class scenario, where one class consists of a secured creditor and one class of unsecured claimholders, if the secured creditor will not vote for acceptance of a plan under any circumstances, in order to reorganize its financial affairs, the retailer must obtain acceptance of the plan from unsecured creditors. Thus, if there are a few very large unsecured creditors whose votes control the unsecured creditor class, the nature of the debtor's business relationship with these creditors may play as large a role in obtaining confirmation of the plan as the dollar amount of the dividend such creditors will receive.
In purely objective economic terms, the business decision confronted by a creditor in determining how to vote on a plan of reorganization is whether that creditor will receive more under the plan than it would in a chapter 7 the liquidation of debtor's assets. Given the cyclical nature of many retailers' financial results, this "best interests tests" analysis may affect the timing of any proposed plan of reorganization.
For example, the dividend which creditors may receive in a liquidation of a retailer occurring immediately after the holiday selling season may be materially larger than what the liquidating dividend would be during October, when cash balances may be low and inventory values high in anticipation of the holiday selling season. Further, while the retailer may believe that the prospects of an on-going, post-petition business relationship with its creditors will be a material factor in the voting decision, in my experience, future business potential is given little import by creditors in making a decision to vote on a plan.
Retail bankruptcy cases tend to involve an active role on the part of an official committee of unsecured creditors. The committee is typically made up of an odd number of creditors from among the twenty largest unsecured creditors. Since the committee in a retail bankruptcy proceeding can materially affect the outcome of the case, it is important to establish a positive prepetition relationship with the likely members of the committee. Many a retailer's regular communications tend to be with the sales force of its vendors. However, it is important where possible to develop a prepetition relationship with the credit personnel of each vendor, as in many cases, it is the credit representative who serves on the committee, rather than a sales representative.
Again, with reference to the critical importance of the relationship between a prospective debtor and its creditors, management should only promise on a prepetition basis that which it in fact can deliver. Nothing can doom the prospects of a successful reorganization more than a lack of credibility attributed to management.
Who Gets Preference?
Another significant factor to consider prior to the filing of a bankruptcy petition is the impact of potential preference recoveries. As most lay people are generally aware, a transfer of property of a debtor on account of an antecedent debt, within 90 days prior to a bankruptcy filing, or within one year to an insider, while the debtor was insolvent, and which has enabled the recipient to obtain more than it would receive in a chapter 7 liquidation of the debtor's assets, constitutes an avoidable preference, which obligates the recipient to return the preference to the bankruptcy estate. 11 U.S.C. 547(b).
A general understanding of preference liability and the statutory defenses thereto, including the provision of new credit by the recipient, the ordinary course transaction defense, and the contemporaneous exchange provisions, will be helpful in deflecting prepetition pressure for payments, and will aid in anticipating potential preference liability, all of which may affect a creditor's subsequent decision to vote for or against a plan.
Other Issues
Reclamation claims are another matter which should be considered when deciding if, and when to commence a bankruptcy proceeding. Pursuant to section 546(c) of the Bankruptcy Code, and section 2-702 of the Uniform Commercial Code, a merchant who sells goods to an insolvent retailer, and who makes a demand in writing for the reclamation of such goods within 10 days of the receipt of the goods by the retailer, obtains rights in such inventory which are superior to the rights of all other parties, other than pre-existing lienholders.
While the bankruptcy filing has little impact on reclamation issues other than aiding a creditor in proving insolvency, from a practical perspective, reclamation demand letters are usually triggered only after a bankruptcy filing. Accordingly, simply delaying a filing by a matter of days may protect inventory assets for the retailer.
Of particular relevance to multi-store retailers is the ability under the Bankruptcy Code to reject unexpired leases of non-residential real estate which are burdensome to its business operations. 11 U.S.C. 365(a). Many a bankruptcy filing has been commenced for the sole purpose of rejecting burdensome leases, and reorganizing as a smaller operation. The consequence of a rejection of an unexpired lease by a debtor tenant is to provide the landlord with an additional unsecured claim in the amount of its actual damages that is the greater of one year's unpaid rentals under the lease, or 15% of the unexpired term of the lease, not to exceed three years. 11 U.S.C. 502(b)(6).
Knowledge of this aspect of the Bankruptcy Code may aid a retailer in negotiating a prepetition resolution of its lease liability, thereby possibly avoiding a bankruptcy filing. Landlord rejection claims may also materially affect the calculation of unsecured creditors' votes upon a plan of reorganization.
Another often overlooked aspect to a prospective bankruptcy filing is the current relationship the retailer has with its other professionals, including particularly, its accounting firm. Given the close relationship that frequently develops between a retailer and its accountant, it is likely that the financially distressed retailer may owe significant sums to its financial professionals.
Moreover, a retailer's historical accountants can play an extremely helpful role during the course of the chapter 11 proceeding, particularly if the condition of the debtor's books and records is such that a new accounting firm will end up spending significantly more time performing services than the historical professionals would take to accomplish the same tasks. However, pursuant to the provisions of the Bankruptcy Code as applied in this circuit, an accounting professional may not be retained on behalf of a debtor if that professional has a claim against the debtor's estate. U.S. Trustee v. Price Waterhouse, 19 F.3d 138 (3rd Cir. 1994).
Accordingly, a retailer who owes money to an accounting firm prior to the filing is faced with the dilemma of negotiating the accounting's firm waiver of its claim against the bankruptcy estate in order to render the firm eligible as debtor's post-petition accountants, or choosing a new accountant at a critical point in the financial evolution of the debtor's business.
Conclusion
All too frequently, the involvement of bankruptcy counsel comes later than would otherwise be in the best interests of a financially troubled retailer. For the general practitioner or other professional advising a retailer, management should be made to understand that a bankruptcy filing will not create new money, that communications with bankruptcy counsel earlier in time can only help achieve the desired result, and that above all, credibility and the maintenance of positive business relationships with creditors is critical to the outcome of the case.