With weeks of mandates that businesses close up their brick-and-mortar shops only beginning to lift, and falling consumer demand still in play, retailers have been devastated by the COVID-19 pandemic and its seemingly endless fallout. It is no surprise that, as a result, a number of major retailers have filed for bankruptcy – from Neiman Marcus and True Religion to J. Crew and JCPenney. While the impact that such Chapter 11 filings will have on consumers may be minimal, when a company files for Chapter 11 bankruptcy, its suppliers may be put in a difficult position.
As bankruptcy-filing companies (i.e., debtors) need trade support – and in many cases, stock – in order to survive, they usually reach out to suppliers in an attempt to maintain a steady supply of goods to keep their business afloat. This is particularly true for retailers, such as Neiman Marcus, which rely significantly on third-party brands’ products.
Companies can continue doing business with a debtor in bankruptcy and provide it with merchandise to stock, but there are risks inherent in doing so, including of course, the fact that the debtor may simply not pay for the goods sold after the bankruptcy proceeding has been filed. There are ways to manage such risks including, for example, by requiring that the debtor pay a deposit on the goods or pay for them in full upon delivery, or even in advance. Alternatively, a company may opt to shorten the trade credit terms, or require a letter of credit as security. Hardly fool-proof remedies, these options can be fraught with peril for the unwary, as payment does not guarantee that the transaction will not be challenged in court.
Below is an outline of some of the issues that can arise in the context of doing business with a Chapter 11 debtor in bankruptcy.
Chapter 11 is a Reorganization Bankruptcy
A case filed under Chapter 11 of the United States Bankruptcy Code is frequently referred to as a “reorganization” bankruptcy. In other words, the debtor – such as J. Crew or Neiman Marcus – is not planning on liquidating its assets and going out of business. On the contrary, it plans on reorganizing and continuing to do business.
A chapter 11 case begins with the filing of a petition with the bankruptcy court serving the area where the debtor has a domicile or residence. Unless the court orders otherwise, a debtor must file with the court: (1) schedules of assets and liabilities; (2) a schedule of current income and expenditures; (3) a schedule of executory contracts and unexpired leases; and (4) a statement of financial affairs. The petition filed by the debtor will include standard information about the company and its reorganization plan or intention to file a reorganization plan, as well as a request for relief under the Bankruptcy Code. Upon filing of the petition, the debtor automatically assumes an additional identity as the “debtor in possession.” In other words, the debtor is in possession and control of its assets while undergoing a reorganization under chapter 11.
Ultimately, the debtor files a plan of reorganization with the court, which includes a classification of claims reflecting the money its owes to creditors and specifies how each class of claims will be treated under the plan. Creditors whose claims are impaired – or altered by the debtor’s plan – get to vote on the plan by ballot. After the ballots are collected and tallied, the court conducts a confirmation hearing to determine whether to confirm the debtor’s proposed plan.
Post-Bankruptcy Sales are “Administrative Expense Claims”
In the meantime, once the debtor files its petition with the bankruptcy court, it is legally permitted to acquire and pay for post-bankruptcy filing (“post-petition”) purchases of goods and services in the ordinary course of business. For a company like Neiman Marcus, this could mean everything from the pricey Tom Ford dresses and Balmain suits that it regularly stocks to the expensive La Mer skincare and designer beauty products that usually line its shelves.
Such purchases are accorded administrative claim status, which means they are given priority over unsecured and certain other claims – in other words, they have priority over certain pre-bankruptcy claims. It also means that the debtor is permitted to pay them, even if the purchase was made post-filing. The reason the Bankruptcy Code prioritizes such expenses is because it encourages vendors to continue doing business with debtors in possession. In order to use the bankruptcy process to successfully restructure their company, a Chapter 11 debtors are obligated to pay their bills in a timely manner, and if the debtor fails to pay such post-petition bills, the court can step in and order payment. As a result, it is not uncommon for vendors to feel payment is “guaranteed” when dealing with a debtor in possession.
Secured Creditors Trump “Administrative Expense Claims”
It is important to note, however, that there is no such guarantee. Indeed, the Bankruptcy Code gives priority to a Chapter 11 debtor’s secured lenders, and forbids a debtor from using “cash collateral” (i.e. cash subject to a lender’s security interest) unless the lender consents, or the court has entered an order authorizing such use. In other words, if the debtor in possession uses cash collateral to pay for post-petition purchase orders, the transaction can be challenged in court and the vendor can be ordered to pay back all of the money it received.
That is exactly what happened in In re Delco Oil, Inc., when the Eleventh Circuit Court of Appeals ordered a vendor to return more than $1.9 million that it had received from the debtor in bankruptcy. The vendor in that case had provided petroleum products worth $1.9 million to Delco Oilafter Delco had filed for bankruptcy. Delco, however, did not have a court order or stipulation allowing it to use cash collateral to pay for the goods. As a result, the vendor was required to pay every single penny back of the $1.9 million in received from Delco, despite its lack of knowledge that the company was using the cash improperly. In other words, the vendor was strictly liable to return the monies.
“Ordinary Course of Business” Transactions
Another important point is that these post-petition transactions must be done in the “ordinary course of business.” Therefore, if the order is an unusually large purchase, or on unusual terms, the transaction runs the risk of not being incurred in the ordinary course of business. If that is the case, the vendor should consider getting the bankruptcy court’s approval so that its rights are protected.
Conversion to Chapter 7 Liquidation
Finally, it is not uncommon for a Chapter 11 bankruptcy proceeding to turn into a Chapter 7 liquidation. If that occurs, Chapter 7 administrative claims have priority over Chapter 11 claims. The likelihood of recovering monies on post-petition purchases thus becomes cents on the dollar, rather than the full payment that was originally anticipated in the context of Chapter 11 proceedings.
This post addresses some of the issues that may arise when a retailer files for Chapter 11 bankruptcy. Each situation is unique and a Chapter 11 proceeding can be complicated. Any contract negotiated with a retailer in Chapter 11 bankruptcy must be done carefully and requires thorough due diligence to determine whether the debtor is creditworthy.
Olivera Medenica is the Fashion Practice Group Chair at Dunnington Bartholow & Miller LLP.
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