A Look at the Hottest Retail Trend of 2017: Chapter 22 Bankruptcy Filings

Is bankruptcy the new “black” in the retail industry? With the rise in retail bankruptcies, some commentators believe repeat chapter 11 bankruptcy filings are the “hottest 2017 retail trend.”[1] “Chapter 22” is the designation given to these repeat filings.

Radio Shack, Wet Seal, and American Apparel are recent examples of retail Chapter 22s. Every week, it appears that a string of long-established retailers close additional stores. Many turnaround professionals believe that the retail industry will suffer the most financial distress this year, ousting the oil and gas industry which held the top spot in 2015 and 2016.[2] It is also predicted that many of these retail bankruptcies will be orderly liquidations rather than restructurings.[3]

 General bankruptcy statistics show that between 15 and 18% of all chapter 11 debtors file again.[4] In light of the exorbitant administrative expenses accompanying a bankruptcy proceeding, no creditor wants to escort a debtor back to bankruptcy court.[5]

Courts frown upon serial filings. Creditors deserve an element of finality to chapter 11 proceedings. During plan confirmation hearings, § 1129(a)(11) requires a bankruptcy court to find that confirmation is “not likely to be followed by liquidation or the need for further financial reorganization.”

Sections 727(a)(8) and 1328(f)(1) of the Bankruptcy Code set forth discharge waiting periods for entities filing repeat chapter 7 and chapter 13 bankruptcies. However, there are no such provisions for chapter 11 filers.[6] This article looks at limitations on repeat chapter 11 filers, particularly in the retail industry.

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Modification of Prior Plans and Motions to Dismiss. Modifying a previously filed plan is likely a chapter 11 debtor’s quickest route to relief. Bankruptcy Code § 1127(b) expressly prohibits modification, though, if the plan has been “substantially consummated.”[7] The party seeking to modify the plan has the burden of showing that substantial consummation of the plan has not been effected.[8]

A bankruptcy court, however, may permit plan modification (either in the first chapter 11 or in the second case) of a substantially consummated plan if a modification was “filed in good faith and as a result of unforeseen, changed circumstances.”[9] Some may argue that the plan proposed in the second case is simply a modification of the plan confirmed in the first. Typically, serial filings will only survive where extraordinary and limited circumstances have substantially impaired the debtor’s ability to perform under the first confirmed plan (i.e., impacting operations or the debtor’s new funding source). If such circumstances are not present, a bankruptcy court may grant a creditor’s motion to dismiss or convert the second case to a chapter 7.

While “good faith” is not defined in the Bankruptcy Code, the Fourth Circuit Court of Appeals has articulated a two-prong test for a “bad faith” filing. Specifically, courts examine (i) the objective futility of any possible reorganization and (ii) the subjective bad faith of the petitioner.[10] The objective question is whether there is any hope for rehabilitation. The subjective question examines the debtor’s motive for the filing. For example, was the debtor’s intention to cause hardship or delay to creditors without any possible benefit, to achieve a reprehensible purpose, or to avoid what the debtor now perceives to be a “bad deal” in the prior plan?

Regarding unforeseen, unknown changed circumstances, courts consider the following factors: (i) the length of time between cases; (ii) the foreseeability and substantiality of events; (iii) whether the new plan contemplates liquidation or reorganization; (iv) the extent of creditor consent; and (v) the proposed alteration of objecting creditor’s rights. Courts will look at whether the distress has been caused by external or unforeseen forces (e.g., volatility in industry, unforeseen liabilities, sudden changes to operations, or inability of plan funder to continue to contribute). For example, maybe the first plan provided for balloon payments on certain secured debts or left unaddressed certain unliquidated debts.

Decreased revenue and general market volatility generally do not amount to extraordinary and unforeseen circumstances. Unusual weather, fire, debtor’s poor health problems, and unanticipated changes in laws, however, have been deemed sufficiently unique and unanticipated in “change of circumstance” repeat filings.[11]

Why so many repeat filings? Proving plan feasibility is a necessary part of the confirmation process. The Bankruptcy Code provides for oversight of a debtor’s actions by the bankruptcy judge, the Office of the United States Trustee, any official committees appointed in a case, and creditors generally.[12]

Perhaps in your specific debtor’s case, no one thing is responsible for the repeat filings. Sometimes, a debtor can only do so much given certain legacy liabilities. For example, the Bankruptcy Code constrains a debtor’s ability to reduce certain taxes and liabilities arising out of collective bargaining agreements, pension and health benefits. [13]

Can we predict those cases that will result in a repeat filing? For example, consider the following: How much prepetition debt was eliminated in the first filing, to what extent were financial projections errant, did the budget account for seasonality and business contraction, and what are broader market trends? Have underlying operational inefficiencies or noncore businesses been addressed? Did the debtor enter or exit different lines of business? Did creditors including distressed investors pressure the debtor to take on too much debt upon emergence? Has the debtor’s ownership shifted from shareholders to secured creditors, with new boards of directors, managers, lawyers and advisors?[14]

Creditors’ attorneys must remember the tools available to prevent serial chapter 11 filings such as invoking certain automatic stay protections that effectively prohibits a serial filing in individual and small business chapter 11 cases pursuant to sections 362(c)(3) and 362(n)(1) of the Bankruptcy Code. Additionally, creditors should look to include “bankruptcy proof” contractual provisions in the first chapter 11 plan or confirmation order which prevent an altered repayment plan in future bankruptcy filings.[15]

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Industry-wide problems have plagued retailers. Decreased mall traffic and increased online shopping have been lethal.[16] Retailers have also been grappling with brick and mortar footprints that are too large, as well as an “almost daily evolution of trends.”[17] Usually, trend-setting is a good thing, but not if the trend is to file a chapter 11 bankruptcy.

The business landscape in which we now operate has been forever transformed by sweeps of political, social and technological change. Renowned attorney, the late Harvey Miller formerly of Weil, Gotshal & Manges, once suggested that bankruptcy recidivism (repeating an undesirable behavior) may occur because we now live in a “volatile, unique world” in which economic cycles occur with greater frequency and competition is more prevalent.[18] Are your clients prepared to handle this new reality?