Going-out-of-business Sales and State Law No More Mister Nice Guy

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Jun 2002

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"Going-out-of-business sales," liquidators advise, have a magical cachet, handily
out-drawing the logically equivalent "store-closing sale," not to mention routine
"clearance" or "best prices of the season" sales. Otherwise savvy shoppers are
magnetically drawn to going-out-of-business sales, even though such sales often
initially offer discounts far below those in normal sales, and one may need to stand
in long lines to pay for these "bargains."<a href="#2" name="2a">2</a>

Because of the allure of the "going-out-of-business" and "store-closing" labels, many
states specifically regulate these sales. Absent those limits, a retailer may well
hold a perpetual "going-out-of-business" sale that not only harms consumers by enticing
them to buy items that may be of lower quality and higher prices, but unfairly
competes with other businesses that do not use the charged terms for their sales.
These state laws often limit the length of such sales because a true
going-out-of-business sale can be completed in a relatively short period of time that
should be counted in weeks and not in months or years. In addition, laws typically
bar or limit the amount and nature of goods that the retailer can add to its existing
stock of merchandise during the sale. There are two primary rationales for this:
First, the new merchandise may be of lesser quality, misleading consumers who expect
to be buying the same items normally sold by that store. Second, adding new
merchandise is what operating stores do: It is inherently misleading to advertise a
"closing" sale while adding inventory that merely delays completion of the closing.
Thus, merchandise limits merely supplement time limits on these sales.

In addition to these liquidation-specific laws, general consumer protection laws may
also be implicated in going-out-of-business sales. The Montgomery Ward bankruptcy offers
a prime example. Only 14 months after its first chapter 11, and after a
disappointing Christmas season, Ward refiled without warning on Dec. 28, 2000.
Up to the day it filed, it continued to sell gift certificates, take deposits for
layaways, and market service contracts to unsuspecting buyers. The very next day, it
sought leave to begin a liquidation sale and to change its policies on those
pre-petition consumer obligations. In most cases, it would honor them only for
transactions occurring after Dec. 17, and only by giving vouchers that would be
void after the end of January. Those actions certainly raise serious questions for
state regulators since the company obviously knew of its dire finances while it
continued to assume obligations that it knew it likely would not honor. Certainly,
the actions resulted in a flood of consumer complaints.

While companies may change the terms on which they operate post-petition (at least
so long as the new terms are clearly disclosed), there are minimum terms, such as
implied warranties of merchantability, that many state laws do not allow to be
disclaimed under any circumstance. Even if large signs proclaim that sales are "final"
and "as is," no one should be allowed to sell products where the defects cannot be
discerned by the consumers. No matter how cheaply it is sold, consumers have a right
to expect that a toaster will work and a CD will play—at least if they have no
way of detecting a problem until they take the product home. Some defects make an
item unsalable at any price, and a general disclaimer is not enough to eliminate the
unconscionability of selling such items. There are other examples of deceptive
practices—anything from deceptive advertising to false weights and measures or
product-expiration-date laws—that must be obeyed by any retailer, liquidating or not.

The recent spate of retail bankruptcies cause increasing concerns for states about
the scope of the authorizations that debtors are seeking to carry out these sales.
Again, Montgomery Ward provides a striking example. It requested permission under
§363 to begin an immediate liquidation sale. It asserted that it needed emergency
authorization because it had seasonal merchandise that needed to be sold promptly to
maximize its value—yet so did every other retailer. Any avid shopper knows that stores
are full of racks at 50-75 percent off after Christmas, so an inventory clearance
sale by Ward would hardly be "out of the ordinary course of business." The truth is
that Ward just wanted its sale to stand out—and to have an excuse to override state
law that might otherwise have limited its repudiation of its promises to consumers.

Ward's Dec. 28 motion promised that all attorneys general would be served by
overnight mail. Had it done so, the states might have had enough time to object
by the Jan. 11 deadline. In fact, though, the certificate of service shows that
notice was not sent until Jan. 8 by regular mail. As a result, most attorneys
general did not receive the motion by the deadline, much less have time to assign
it to counsel, have it analyzed, prepare a response and hire local counsel. As a
result, there was no organized state opposition to the startlingly broad scope of
relief sought. Ward claimed in its motion that it wanted to eliminate
liquidation-specific laws because it would be too burdensome to figure out what they
were, much less to bother to comply with them. (It conceded that many such laws
exempt court-ordered sales, but argued that it should not be required to determine
what laws were left, much less how much of a burden they actually imposed). It
further asserted that it did not intend to enjoin other state laws, such as health
and safety laws, but ignored general consumer protection laws.

As bad as the motion was, the actual order was far worse. It enjoined
governments from "(a) interfering in any way with, or otherwise impeding, the
conduct of the store-closing sales or (b) instituting any action or
proceeding...seeking an order or judgment that might in any way directly or indirectly
interfere with or adversely affect the conduct of the store-closing sales" and allowed
the sale to proceed "notwithstanding (i) any local, state or federal law or
ordinance...purporting to restrict, limit or otherwise regulate such sales [other than]
in accordance with the store-closing sales protocol." While the store-closing protocol
referenced shopping center guidelines on health and safety, it contained no exception
for state health and safety laws. The order was broad enough to bar the fire marshal
from enforcing occupancy limits if this would adversely affect the sale, and was
entered without hesitation by the court.

The attorney general's office in Ohio happened to get notice of the proceeding early
enough to file an objection, so the final order did incorporate a health and safety
exception, but otherwise continued to broadly preempt all other state law. The court
did not explain on what basis it could enter an injunction against states that had
done nothing to waive their sovereign immunity.<a href="#3" name="3a">3</a> Nor did it discuss the legal basis
for preempting state law even if immunity was not at issue. The debtor argued that
the court's power derived from §§363 and 105, and that <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §959</a>
did not apply.<a href="#4" name="4a">4</a> The states disagreed strongly with the debtor's arguments, but the
order was a fait accompli, and an appeal probably could not have been completed before
the sale was over. Moreover, the states were busy dealing with the specific consumer
problems that continued to crop up. As a result, the order was not further contested
in this case, but the states began reviewing the issues further as several other small
cases were filed in late 2001 and early 2002, including Service Merchandise and
Bugle Boy. As with Ward, these motions were usually filed with little or no notice
to the states, and generally only the state in which the bankruptcy was located
managed to object and obtain some state-specific relief. Matters came to a head with
the Kmart bankruptcy. Although it was reported that Kmart would be closing stores,
the states were still hampered when the motion was filed because there was no effort
to serve the attorneys general with the motion, even though the proposed relief was
almost as broad as in the Ward motion. However, one state noticed the filing and
alerted NAAG. In turn, NAAG advised state contacts, and many states indicated
an interest in challenging the order.

In the states' view, the arguments advanced by Kmart (and other retail debtors
that all use the same form motion and order) fall far short of justifying the
relief sought. Those motions assert the truism that federal law preempts conflicting
state law and then assert the wholly different proposition that state law is also
pre-empted when it merely conflicts with a federal "policy." The motions also assert
that §363 "requires" the debtor to maximize recoveries for creditors, even though
there is no such language in the section.<a href="#5" name="5a">5</a> They end by arguing, in essence, that
debtors may preempt these laws whenever it is convenient to do so and whenever they
can make more money by doing so. Those arguments, of course, go too far. It
would be more convenient for debtors if they did not have to apply the varying sales
tax laws of each community, or pay the local minimum wage. If the debtor could
stay open when all other businesses are closed under local "blue laws," it could
undoubtedly sell more goods. Yet, debtors recognize that they must obey these laws,
and the laws at issue here stand on no different legal footing.

Contrary to the position of these debtors, §363 does not provide the broad
preemption that they argue for. Preemption of state law is disfavored, and one must
show a "clear and manifest" intent on the part of Congress. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Resolution
Trust Corp., 511 U.S. 531, 544 reh'g. denied, 114 S.Ct. 2771
(1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… & Trades Council v. Assoc. Builders, 507 U.S.
218, 224 (1993)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. of Revenue of Oregon v. ACF Industries,
510 U.S. 332, 345 (1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. General Elec. Co., 496
U.S. 72, 87 (1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Kerr-McGee Corp., 464 U.S.
238, 255 (1984)</a>. While there is a limited preemption provision in
§363(l), there is no broad preemption language in the rest of §363, clear or
otherwise.

The courts agree. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Solutions Inc. v. Service Support Specialties
Inc., 124 F.3d 487, 493-94 (3rd Cir. 1997)</a>, the ruling held
that the court could not use §363 to allow the debtor to sell an asset at all
if that sale would violate state law (a far more intrusive provision than the state
regulations at issue here). It rejected the debtor's assertions that §§363 and
704 "demonstrate that the 'overriding purpose of the Bankruptcy Code is the
expeditious and equitable distribution of the assets of the debtor's estate'" and that
the trustee is required to "maximize the potential return to creditors," even if this
would violate state law. To the contrary, the court held:

<blockquote>
[N]either §363(b)(1) nor §704(1) expressly authorizes the trustee to
sell property in violation of state law transfer restrictions. Moreover,
Integrated points to nothing in the legislative history that would even raise an
inference that Congress intended to give the trustee such authority under these
provisions. The clear lack of congressional intent to preempt state law
restrictions on transferring property of the estate is even more telling given the
explicit language that Congress uses when it intends to displace state
non-bankruptcy law in other provisions of the Bankruptcy Code...[citing to
§363(l)]. Because both Code provisions relied upon by Integrated fail to
explicitly express Congress's intent to supersede state law restrictions on the
transfer of estate property, Integrated's preemption claim is rendered wholly
unconvincing, especially in light of our strong presumption against inferring
congressional preemption in the bankruptcy context.
</blockquote>

The Third Circuit also cited <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Schauer, 835 F.2d 1222, 122
(8th Cir. 1987)</a>, which similarly concluded that there is no conflict between
the Code and state law defining the debtor's property rights. "Sections
363(b)(1) and 704 are...simply enabling statutes that give the trustee the
authority to sell or dispose of property if the debtors would have had the same
right under state law (emphasis added). See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Crossman, 259
B.R. 301 (Bankr. N.D. Ill. 2001)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Lauriat's Inc., 219
B.R. 648 (Bankr. D. Mass. 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re White Crane Trading Co.
Inc., 170 B.R. 694 (Bankr. E.D. Cal. 1994)</a>

Accordingly, some 25 states authorized the filing of an objection to Kmart's
sale. After extended negotiations, the debtor agreed to several substantial revisions
of its orders. Rather than preempting state laws, the order provided for a simple
presumption that the debtor's sale procedures (as revised in the negotiations) did
not violate liquidation laws<a href="#6" name="6a">6</a> with a process for challenges to be raised to that
presumption if governmental entities felt there was an issue as to their specific
law. It also explicitly recognized that all other state laws would remain in effect
and that states could move to enforce them in their own home courts instead of
returning to the bankruptcy court. A number of other provisions were worked out to
deal with the treatment of pre-petition obligations (such as gift certificates and
layaway deposits) and how post-petition sales would be conducted. Augmenting the
existing store merchandise with any additional items that were not already owned by
Kmart was also barred.<a href="#7" name="7a">7</a> Accordingly, the objection was not filed.

In two other cases, arising shortly after Kmart—Florsheim and The Museum
Company—the states raised similar questions and actually filed objections to the
proposed orders. Both orders used virtually identical language to that in Kmart,
and the states' objections were also similarly worded. On the other hand, because
each sale differed somewhat in terms of the numbers of stores at issue, the
proportion of the business that was being closed and the proposed terms of the
sales, the negotiated final orders differed somewhat. In each case, though, the
order as entered reduced the states' ability to enforce their laws.

The states who have been contesting these orders intend to continue doing so
while looking at proactive steps to deal with these issues. One of their biggest
problems is the lack of notice. They intend to react aggressively to future
failures to receive proper service and to alert the U.S. Trustees to their
concerns in this area. Hopefully the latter may be willing to raise the issue
with the court if they see that adequate notice is not provided so that this
problem can be resolved when the motions are filed, not when objections are being
dealt with. The states also expect that their objections will put liquidators on
notice of these issues. There are only a handful of such entities and they have
extensive knowledge of the laws applicable to their sales. It should be possible
to agree on whether, and to what extent, laws are applicable to a given sale.
If there are none, or if compliance is only a minimal issue, then there is
no need to stir up trouble with the states by trying to preempt a law that
doesn't even apply.

By the same token, if liquidators and debtors are aware of the operational concerns
that the states perceive, it should be possible to structure the sales procedures to
meet those concerns—and to do so before the bids are taken, rather than afterward.
In the recent cases, the debtors argued that they were limited in making changes to
their sale orders because the bid process had already begun and certain methods of
operation were presumed to apply. Changing those terms in mid-stream, the states were
informed, would be unduly disruptive and costly. While the states are less than
impressed by the legal merits of the argument that "we've already contracted away the
applicability of your laws," the reality is that most courts would be reluctant to
upset those arrangements. Thus, it is critical to put all parties on notice before
the fact as to the likelihood that they will face objections if they continue proposing
overreaching orders. This article is that warning.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The author is bankruptcy counsel for the National Association of Attorneys General, but the views expressed herein are solely those of
the author. In addition, not all states have participated in the proceedings described herein, and the views ascribed to "the states" should
not be taken as applying to any states beyond those that have joined in a specific action. <a href="#1a">Return to article</a>

<a name="2">2</a> For example, when a local retail chain closed one unprofitable store in Washington, D.C., area and advertised a "40 percent off
going-out-of-business sale," the identical food processor was available in a regular sale at its other stores for a nickel less and without
the hour-long lines in which eager purchasers were standing at the store that was closing. <a href="#2a">Return to article</a>

<a name="3">3</a> While the order was sought by way of a motion, it asked for injunctive relief, which the rules explicitly require be sought through
an adversary proceeding. That procedural irregularity obscured, but did not change, the essential nature of the court's actions. "A judicial
proceeding is considered brought against the sovereign if the result could serve 'to restrain the government from acting, or to compel it to
act.'" <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. E.P.A. v. General Elec. Co., 197 F.3d 592, 597 (2nd Cir. 1999)</a> amended on other grounds, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
F.3d 689 (2nd Cir. 2000)</a>, quoting <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Rank, 372 U.S. 609, 620 (1963)</a>. Cf. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pacific Gas &

Electric Co., 273 B.R. 795, 818-819 (Bankr. N.D. Cal. 2002)</a> (language in the plan that barred the state from
enforcing its laws violated the Eleventh Amendment; immaterial that rules allow such relief without adversary complaint since critical issue is
relief sought, not form of action), and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Coeur d'Alene Tribe of Idaho, 521 U.S. 261, 270 (1997)</a> ("The real
interests served by the Eleventh Amendment are not to be sacrificed to elementary mechanics of captions and pleading."). <a href="#3a">Return to article</a>

<a name="4">4</a> The reference to §959 is a red herring. While many courts hold that it does not apply in a liquidation, many of these sales are
not true liquidations but merely restructuring and downsizing of the sort that are carried out by operating companies in or out of bankruptcy.
In any event, the question is not whether §959 applies, but rather whether there is any Code provision that bars application of state
law. Generally applicable laws apply to all issues unless there is a specific exception, and as shown below, there is no such exception
in the Code. <a href="#4a">Return to article</a>

<a name="5">5</a> The closest the section comes is the provision that the amount received from a collusive sale may be attacked. <a href="#5a">Return to article</a>

<a name="6">6</a> Keep in mind that most such laws have an exception for court-ordered sales. <a href="#6a">Return to article</a>

<a name="7">7</a> That agreement was not as strong as it could have been since it only became clear at the last minute that the debtor' expressed intention
of "fully stocking its stores to begin the sale" would cover some $750 million in merchandise—fully 60 percent of all of the goods already
in the stores. Moreover, the debtor also advertised for several weeks that "new merchandise was arriving daily." The states will be alert
to those problems in future cases. <a href="#7a">Return to article</a>

Journal Authors

Karen Cordry

Journal Date

Saturday, June 1, 2002 - 12:00

Bankruptcy Rule

2002