New Rule Could Limit Retailer Financing Options
Recently passed bankruptcy lease assumption limitations may limit retailer financing options.
Mary Ellen Welch Rogers

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 became effective October 17, 2005. Although the primary focus of the act was consumer bankruptcy fraud, Congress significantly amended key business bankruptcy provisions. Some of the most significant business amendments relate to commercial leases. Namely, the new bankruptcy code sets forth specific time deadlines for a retailer to assume or reject a lease and limits the court's discretion to extend such deadlines and overlook certain lease provisions. Many commercial landlords believe that the bankruptcy courts have unfairly eroded retail property owners' rights over the last several years and welcome the amendments. The changes, however, may profoundly impact the viability of working capital financing for retailers ultimately affecting their status as tenants.

Based on well-accepted practices developed under the bankruptcy code, asset-based lending has provided significant liquidity at competitive prices to retailers who were formerly unable to obtain commercial credit. Such financing funds growth, buildout and other critical working capital needs for retailers. The bankruptcy code amendments impact fundamental industry assumptions about the liquidation values and strategies for recovery that have underwritten retail finance loans over the last two decades.

Lenders to retailers rely on appraisals that assume the ability to liquidate inventory in a “going-out-of-business” (“GOB”) sale conducted at the retailer's store locations. A GOB sale usually requires 12 to 14 weeks to complete. In most cases, a willing retailer as a “debtor-in-possession” in a Chapter 11 case engages a special liquidation firm to conduct the GOB sale as the retailer's agent. Due to formerly friendly bankruptcy rules and intense competition among lenders, retailers have become accustomed to aggressive advance rates sometimes as high as 100 percent of appraised GOB sale value.

Under the former version of the bankruptcy code, bankruptcy courts could grant retailers virtually unlimited time in which to conduct GOB sales and reject leases for under-performing stores. Under the new statute, retailers face a hard deadline of 210 days to decide whether to reject their store leases (although this deadline may be extended with landlord consent). If a retailer files for bankruptcy and seeks post-bankruptcy or “DIP” financing with an eye towards reorganization, it must provide its lender some assurance that retail locations will be in place and available for GOB sales after expiration of that 210-day period. Such assurance would either require convincing landlords to consent to extension of the time to assume or reject leases beyond the 210-day period or the retailer's early assumption of a critical number of leases with prior court or landlord approval of the retailer's right to conduct post-assumption GOB sales. Otherwise, given the time needed to complete a GOB sale, the lender has no choice except to insist that GOB sales be commenced within the first few months after commencement of a bankruptcy so as to be completed prior to expiration of the deadline. Because lease assumption has other substantial implications for retailers including, among others, the obligation to cure lease defaults and the potential for significant administrative liability, any attempt at retail reorganization will require substantial forethought and attention to critical financing and other issues well in advance of filing.

Also potentially limiting retailer-financing options are changes that make it more difficult for retailers to assign commercial leases to third parties. Under the former version of the code, bankruptcy courts enjoyed broad, perhaps unfairly broad, discretion to assign leases free of overly restrictive use and continuous operation covenants. The ability of retailers to assign commercial leases freely also led to a healthy and competitive lease acquisition market. Under the amendments, courts have lost much of that discretion and, consequently, the market for lease assignments will become more restricted.

Retailers, lenders and other case constituents formerly relied on lease assignments to generate precious liquidity. In some cases, lease proceeds generated a bridge to a strategic or going concern sale and substantial dividends to unsecured creditors. Assignable leases also provide lenders with valuable collateral to support increases in advance rates during a bankruptcy reorganization. Absent the prospect for liquidity generated by the lease sales, many troubled retailers may have insufficient assets to support DIP financing and reorganization expenses. If assets are already highly leveraged to pre-petition secured creditors, a successful reorganization and going concern sale will be significantly more challenging.

The consequences of the new law on the availability of financing for retailers remain to be seen and await some interpretive case law. Absent flexibility on the part of the courts and property owners, however, the availability of DIP financing for retailers, particularly smaller specialty retailers, seems likely to contract over time, resulting in less liquidity to fund retail reorganizations and the greater likelihood of liquidations resulting vacancies for shopping centers and other retail real estate. On the horizon are less generous advance rates and higher costs generally for working capital finance retailer borrowers.

Currently, the market for retail finance remains strong and competitive notwithstanding the new law. Andy Moser, senior managing director of GMAC's retail finance group, believes that this trend will continue, at least in the short term. “However,” he observes, “in the long term, keeping options open for weaker retailers and those who need to restructure will require flexibility and creativity on the part of retailers and their landlords and lenders. We are looking forward to the dialogue.”  

In any event, as retailers, landlords and lenders (and their advisors) become familiar with the changes in the bankruptcy code, they should develop strategies to deal with the need for retailer financing well before reorganization becomes a possibility, let alone a necessity. These same parties should also consider the long-term impact of bankruptcy code changes and work proactively to maintain the availability of financing for retailers, both in and out of bankruptcy. Failure to address the retailer financing issues raised by changes to the code could result in unnecessary retail liquidations, tenant vacancies and a scarcity of financeable replacement retailers.

Mary Ellen Welch Rogers practices in Boston-based Goulston Storrs' Commercial Law and Bankruptcy Groups, representing clients in asset-based and other secured and unsecured loans, including documentation, intercreditor and subordination issues, loan workouts and debtor-in-possession financing, with a focus on   financing for specialty and other retailers.