Changes in the law have sharply reduced retailers' ability to reorganize, driving many to liquidate quickly
On Feb. 19 the electronic gizmo retailer Sharper Image filed for Chapter 11 bankruptcy protection. As part of its court filing, Sharper Image management committed to its lenders to close 90 of its 184 stores. But within weeks, newly appointed Chief Executive Robert Conway decided to liquidate the rest of the stores. Conway, who is a principal at turnaround specialist Conway, Del Genio, Greiss & Co., reached the conclusion that it would be nearly impossible to secure adequate financing to restock the remaining 94 stores. "We didn't want to delay the process to a point where there would be no value left, and we decided liquidation was the best option. The last few stores closed at the end of July," says Conway.
But the final nail in the coffin for Sharper Image came three years earlier, when U.S. bankruptcy law was revised to add cash payments to utilities and other suppliers, and place a 210-day cap on the amount of time bankrupt companies have to decide whether to keep a lease.
No Time to Reorganize
The rapid dissolution of Sharper Image took many in the bankruptcy industry by surprise. But that chain isn't alone. Several retailers that have filed for Chapter 11 protection (BusinessWeek.com, 7/21/08) since the economy started swooning have unraveled just as quickly: Wickes Furniture closed down its 36 stores. Friedman's is in the process of selling off jewelry and is closing its 377 stores, while Whitehall Jewelers is liquidating its 300 stores. All these companies filed for bankruptcy reorganization in 2008. And in December 2007, Bombay Co. and Levitz closed all their stores.
The new provisions in the bankruptcy law—pushed primarily by mall owners, suppliers, and utility companies, and signed by President George W. Bush in 2005—were intended to shorten the time that a company stays under court supervision. The point was to protect creditors, who sometimes had to wait years for payments while lawyers racked up hefty fees and managers collected big pay packages. "There was a pattern in some bankruptcy courts of granting extensions for as long as the debtor wanted, and that had to be stopped," says Lynn LoPucki, a professor at the University of California at Los Angeles School of Law and author of Courting Failure: How Competition for Big Cases Is Corrupting the Bankruptcy Courts.
Not everyone thinks sick companies should be given a second, or sometimes third, lease on life. Already many retail experts believe that chains overexpanded during the flush consumer spending of the past decade, and that parts of America now have more stores than people to shop at them. Given the track record of some big retailers, even if the latest bunch of troubled companies were to emerge from bankruptcy, they might wind up right back in court a few years later. Bradlees, Tower Records, and FAO Schwarz are among those that have filed multiple bankruptcies in recent years.
All filers are covered by the new bankruptcy law, but the changes were particularly harsh on retailers. For companies that already are short of cash—and, in the current environment, unlikely to find new financing—these new provisions in the law can amount to a death sentence. "Liquidity is sucked out of the debtor in a way that it becomes hard to survive," says Lawrence Gottlieb, chair of the bankruptcy and restructuring practice at New York law firm Cooley Godward Kronish, who has represented creditors' committees in the bankruptcies of Sharper Image and Linens 'n Things.
Retailers already face strong headwinds. Consumers' appetite for discretionary purchases has dwindled sharply, and credit conditions are tight. That has led to shrinking sales month after month at most retailers and a string of store closings. Foot Locker (FL) is closing 140 stores; Wilson's Leather is closing 160; Ann Taylor (ANN), 117; and jeweler Zales (ZLC) has closed 105.
For some chains, times are even more desperate, and the drumbeat of retail bankruptcies grows louder by the day. So far this year, 15 retailers with assets of $100 million or more have filed for Chapter 11 bankruptcy, up from seven for all of 2007, according to Bankruptcydata.com, which tracks such filings. On Aug. 4, Boscov's, a department-store chain with 49 stores in the Northeast, filed for Chapter 11, just a week after the 177-store Mervyn's chain in California filed for protection from creditors.
Retail experts wonder what fate awaits these and other retailers such as Goody's Family Clothing and Linens 'n Things, which are already in Chapter 11. According to research tracked by LoPucki, in the 20 years prior to 2005, 41% of the 94 retailers that filed for bankruptcy went out of business. Those that emerged included such well-known outfits as Kmart (SHLD), Winn-Dixie Stores, and Macy's (M).
This time around, almost all of the retailers that filed in the first three months of 2008 dissolved quickly. The others face tough choices. Executives from Goody's and Boscov's didn't return calls to discuss their options.
Credit conditions are so tight that lenders are not willing to provide any wiggle room to distressed retailers. Talbots (TLB), for instance, isn't among the litany of bankrupt retailers. But earlier this year the upscale clothing chain had to extend its payment terms with its vendors to 45 days from 22 days, after Bank of America (BAC) and HSBC (HBC) refused to renew lines of credit worth $130 million and $135 million, respectively.
Pressure from Landlords, Vendors
File for bankruptcy, and the pressure now intensifies enormously. Prior to 2005, debtors had 60 days from filing for Chapter 11 to assume or reject a lease. Most of the time, bankruptcy courts would grant repeated extensions that lasted two years or more. Bankruptcy experts argue that gift of time was crucial: They say it takes a minimum of two Christmas cycles before a retailer is ready to put its finances in order and see if its reorganization plan is working.
But mall owners don't like to house bankrupt retailers. An extended, court-run reorganization can hurt the landlord's chance of securing positive financing terms. The real estate industry lobbied successfully for the 210-day cap on how long companies have to assume or reject leases. "Macy's got at least two Christmas seasons, but today if a company files in January, they don't even have until Christmas to decide what they will do," says lawyer Gottlieb.
Even as the lease decision looms, companies have to pay a cash deposit within 30 days to the utility companies that provide gas, electricity, and water to their stores. The purpose of that change was to provide assurance of the filer's ability to pay bills in the months going forward. Previously, just an assurance had been enough.
At the same time, vendors who ship goods to a company in the 20 days preceding a filing can get a priority claim that requires they be paid in full. The 2005 law also put an 18-month limit on how long the bankrupt company has to submit a restructuring plan; previously there was no limit. After the 18 months, creditors or other interested parties can offer their own plans.
Retailers may have stores in multiple locations and hundreds of vendors supplying a variety of items. "Stores immediately lose working capital," says Harvey Miller, a partner and bankruptcy specialist at New York law firm Weil Gotschal. He worked with Macy's in the past and has recently worked with several retailers including Goody's Family Clothing, a 355-store chain that operates in 20 states and filed for bankruptcy on June 9. Miller says Macy's reorganization, which took four years, wouldn't have been possible under the new setup. "In stress situations, you have to analyze by circumstances and not make deals under a formula," he says.
Landlords Say Retailers Overstate Law's Burden
Usually under Chapter 11, stores can sublet the leases to bring in much-required cash. However, most of these lease terms are expensive, because they were drawn up in the past decade when retailers were expanding and consumers' appetite for shopping seemed limitless. Today, not too many retailers are opening up or expanding. It's not surprising that Goody's Family Clothing canceled a lease auction that was to be held in the second week of August for 66 of its stores, after it was able to secure bids on just three of them in a previous auction.
"The rule that was meant to protect landlords is now coming back to bite them, because they will be left with neither stores nor payments," says Weil's Miller.
Landlords say that retailers and their lawyers are making the law look much worse than it is. That's because even though the law set a 210-day cap, it did leave some wiggle room and allowed a bankruptcy judge to grant an extension if the landlord consented.
"Now why wouldn't landlords consent to extend leases, when they know it's difficult to find another tenant?" asks Norman Kranzdorf, chairman of the Bankruptcy Task Force of the International Council of Shopping Centers, a trade group that represents mall owners. Besides, he says, landlords are entitled to a smaller claim—so if a retailer decides to close a store and still has a multiple-year lease outstanding, the landlord can claim payments only for a two-year period rather than for the remainder of the lease as they could previously.
"Sure, retailers don't have the luxury of time as they did before, but it's not that much of a detriment because landlords also lose at the bargaining table," argues J. David Forsyth, a partner at law firm Sessions, Fishman & Nathan in New Orleans, who represents landlords.
Ultimately, though, it's all a question of control, says Elizabeth Warren, law professor at Harvard University. She says that the impact of store closings is bound to be felt across the broader U.S. economy in coming months. "This will have a ripple effect through communities with hundreds of job losses, loss of taxes, and suppliers going out of business," says Warren, who in 2005 testified to Congress against changes to the bankruptcy law. "Bankruptcy is countercyclical—it is a tool designed to be a cushion during a downturn so that everybody takes a small hit for the short term and emerges stronger for the long term."