The Retail Debtor's 'Year in Review'

A leading retailer concern in Chapter 11 is maintaining good relationships with vendors and customers. As everyone knows, earlier this year, the Seventh Circuit upheld reversal of Kmart's critical vendor order. In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004), reasoning that the Bankruptcy Code's policy of equal treatment of creditors does not authorize payment of pre-petition claims to select vendors. Criticizing the pre-Code “Doctrine of Necessity” as an inappropriate basis to pay pre-bankruptcy claims during a case, the court also questioned the “business necessity” of these payments. The court observed that vendors should continue shipping if they are paid for post-bankruptcy goods irrespective of paying pre-petition receivables. The court directed the return of post-bankruptcy payments to the “critical vendors” despite their reliance upon such payments for bankruptcy shipments. Fortunately, post-Kmart, courts still approve “critical vendor” orders. See, e.g., In re New World Pasta Co., Case No. 04-02817 (Bankr. M.D. Pa. May 10, 2004 and June 21, 2004).

Nor was the year very good for vendors with leased/licensed departments or consignment relationships with a merchant. Vendors desiring to retain ownership over their inventory use leased departments or consignments, paying the merchant a commission for actual sales. In order to provide a seamless customer shopping experience, sales are run through the merchants' registers. Merchants collect payments, remitting them to the vendor less their commissions. Absent bankruptcy, vendors own the product and their sales proceeds. The key words were “absent bankruptcy.” In In re Ames Dep't Stores, Inc., 2004 WL 1948754 (S.D.N.Y. 2004), a licensor shoe vendor argued that proceeds from shoe sales were not “property of the estate” because the debtor merely collected and held the proceeds in “constructive trust” for the vendor.

The bankruptcy court disagreed and the district court affirmed. The court found that because 1) the actual nature of the parties' relationship did not support an agency or trust relationship; 2) the debtor commingled the disputed sale proceeds with its own funds; and 3) there had been no conversion or unjust enrichment, the funds were not held in constructive trust. The mere failure to pay a debt could not support a constructive trust absent a fiduciary relationship. Because the proceeds were property of the estate, the vendor was merely a general creditor. The Ames decision reflects the reality for vendors that whether goods are delivered by consignment/leased department relationship or through outright sale to a merchant, the vendor remains at risk for unpaid goods. The “fix” — segregation of sales proceeds from the merchant's own sales — is not feasible absent vendors using dedicated cash registers and related processes to collect and track sales.

Customers Are Safe

If courts made life more difficult for vendors in 2004, customers received protection by clarifying the scope of “deposits” entitled to priority status. In In re WW Warehouse, 383 B.R. 588 (Bankr. D. Del. 2004), the debtor issued gift certificates pre-bankruptcy. The debtor scheduled (and classified in its plan) the outstanding gift certificates as general unsecured claims and objected to such claims that asserted a secured or priority status. The U.S. Trustee objected on the grounds that the claims were entitled to priority status.

The court held that because gift certificates are priority “deposits” for purposes of section 507(a)(6), finding that “deposits” are not limited only to partial payments of a purchase price for specific merchandise. Deposits also include situations where full payments have been made such as, lay-away plans and service contracts (ie, lessons, gym membership). Gift certificates are not the ultimate purchase, but only a document entitling a holder to receive something of value.

Desired Assumption and/or Assignment May Be Difficult

A retail debtor's executory contracts and unexpired leases are usually among the most valuable assets of the debtor's estate, and integral to the continued operation of its business. However, in 2004, at least two cases reflected a more restrictive policy on debtors' ability to assign such agreements.

In In re Trak Auto Corp, 367 F.3d 237 (4th Cir. 2004), an auto parts retailer obtained court approval to close various stores and assume and assign certain closed store leases. One of its shopping center leases contained a use restriction clause, only allowing the sale of auto parts. The debtor did not receive any bids from auto parts retailers. The highest bid received — which was accepted — was from a discount clothing outlet.

The landlord objected, arguing assignment would: 1) breach the restrictive use provision, which was enforceable under section 365(b)(3)(C) of the Bankruptcy Code; and 2) disrupt its shopping center's tenant mix, in violation of section 365(b)(3)(D). The debtor argued that the restrictive use provisions were unenforceable anti-assignment provisions under section 365(f)(1). The court, unwilling to adopt a liberal reading of section 365(f), held that the restrictive use clause must be upheld and prevented the assignment of the shopping center lease to the outlet. The court found that the anti-assignment provisions of section 365(f)(1) did not overrule landlord-protective section 365(b)(3)(C) because section 365(f)(1) was a general provision while section 365(b)(3)(C) was a specific provision meant to address situations such as that faced by the shopping center here. (Other courts have previously recognized that the so-called “shopping center” provisions of section 365(b)(3) were not absolute. In re Rickel Home Centers, Inc., 209 F.3d 291 (3rd Cir. 2000)). (This year, a court also upheld a use clause in a deed restriction included in a recorded declaration, holding that section 365(f)'s reach did not extend beyond leases/contracts. In re Ames Dept. Store, Inc., 2004 WL 2516188 (Bankr. S.D.N.Y 2004).)) Strike one for retailers.

Leases are not retailers' only valuable contracts. Retailers may have licensed software that may be tailored specifically for the debtor's operations to assist not only in monitoring sales, but also in inventory allocations and replenishment. Another Fourth Circuit decision in 2004 could impact a debtor's right to assume (let alone assign) these valuable licenses as part of their on-going business. In In re Sunterra Corp., 361 F.3d 257 (4th Cir. 2004), the debtor sought to assume a software license agreement pursuant to which the debtor had a nonexclusive license to use the developer's software. Under the agreement, the debtor would own any enhancements it made to the software and the debtor, in turn, granted the developer a license to use those enhancements. Further, the agreement provided that the debtor could assign the contract to a successor in interest under certain circumstances. The developer filed a motion seeking to have the agreement deemed rejected on the grounds the agreement was an executory contract and the debtor could not assume it without the developer's consent. The court held that the license agreement could not be assumed by the debtor without the non-debtor party's consent. The court found that under a literal reading of section 365(c), assumption and assignment are two conceptually distinct events (reading the “or” in the statute as disjunctive rather than conjunctive), and thus, the debtor could not assume the license agreement without the developer's consent. Sunterra could impose additional costs upon retail debtors requiring continued use of software through either costs associated with “buying” the non-debtor's consent or, in the absence of such consent, implementing replacement software. Strike two for retailers.

Speaking of non-assumable agreements, in In re Twin City Power Equipment, Inc., 308 B.R. 898 (Bankr. C.D. Ill. 2004), the court did not allow the debtor to assume a lawn and garden dealership agreement, which allowed the debtor to sell John Deere equipment in its stores through vendor financing. The court found that the “primary purpose” of the dealership agreement was the extension of credit to buy vendor's inventory, and, thus, a non-assumable financial accommodation. The decision raises some interesting implications for vendors committing to sell future product on credit terms. Strike three …

Issues with Landlords

Debtors may negotiate rent reductions with certain landlords during their Chapter 11 cases. Such agreements may affect whether the debtors will assume or assign a lease. In good news for retailers, a court recently held that landlords who provide post-petition rent reductions are estopped from asserting an administrative claim for the full amount of the rent. In re Nucentrix Broadband Networks, Inc., 314 B.R. 581 (Bankr. N.D.Tex. 2004).

Debtors typically cannot cherry-pick the parts of an agreement to assume and reject the balance. That is, unless the court finds that the agreement actually contains several different — and severable — agreements. Such was the case in In re FFP Operating Partners, LP, 43 BCD 141 (Bankr. N.D. Tex. 2004) where the court, over the landlord's objections, allowed the debtor to assume 10 out of 20 leases subject to a master lease. This decision is quite favorable to debtors operating under older, integrated master leases for multiple stores.

Can Parties Rely on Approved Auction Procedures?

If history has shown anything about a retail Chapter 11 case. it's that you cannot have a retail debtor without having an auction of some, and sometimes all, of the merchant's assets. 2004 shed some interesting light on auction procedures including courts revising previously approved procedures where change results in more money for the debtor's estate.

In Corporate Assets, Inc. v. Paloian, 368 F.3d 761 (7th Cir. 2004), after the debtor held an auction pursuant to court approved procedures, the court allowed the debtor to conduct a second auction to ensure that it received maximum value for its assets. At the first auction, the highest bid was $2.25 million. The day after the auction, the second place bidder advised the debtor that it was unaware that a prior change has been made to the form asset purchase agreement and increased its bid to $2.45 million. The bankruptcy court approved a second auction, and the highest bidder from the first auction again submitted the highest bid, at $2.6025 million. At the sale hearing, the debtors requested that the court approve the $2.6025 million bid, and the successful bidder objected, arguing that the bid from the first auction should be approved.

The court held that when faced with a late bid, it must walk a “tightrope” between preserving the “integrity and finality of the auction process and to recognize the reasonable expectations of the parties” on the one side, and the “governing principle in confirming a sale, which is to secure the highest price for the benefit of the estate and creditors” on the other. In this balancing act, the court should look at the auction process on a “continuum.” On one end, once the sale is approved, it takes “compelling reason” such as fraud, mistake, or gross inadequacy in price to upset a winning bid in favor of a higher late bidder. But in the twilight between the auction and the sale hearing, the bankruptcy court has broader discretion to authorize late bidding where the circumstances dictate, especially where the auction and bidding are “complex and fluid” or “informal and flexible,” such that there is no undue frustration of participants' reasonable expectations as to whether the highest bid at the auction would be subject to late overbids.

Paloian follows on the heels of certain cases from 2003, where courts revised previously approved auction procedures to eliminate or reduce bid protections. For example, in In re 310 Associates, 346 F.3d 31 (2d Cir. 2003), the court vacated its prior order approving break-up fee and bidding protections after first discovering: 1) the presence of another bidder; and 2) continued active interest in the property to be sold. In In re Epic Capital Corp., et al., Case No. 01-02458 (Bankr. D. Del Aug. 14, 2003), the court revised its prior procedures order, and deleted the break-up fee and bid protections when another potential bidder was willing to make a substantially similar offer without such bid protections. And, in In re SHC, Inc., et al., Case No. 03-12002 (Bankr. D. Del July 23, 2003), the court required a proposed stalking horse to give up its break-up fee and bid protections to be approved as the stalking horse.

Welcome to the most magical time of a retailer's year — the Holiday Selling Season. It seems fitting as retailers enter this “make-it-or-break-it” period that we examine the Retail Debtors' Year in Review. After all, if Santa is kind to bankruptcy professionals, a few retailers currently holding on will go down the … chimney.

If 2004 provides any indication as to how some courts are approaching issues affecting retailers, various courts were anti-vendor in special relief; pro-contract party regarding assumption and assignment issues; and, when it comes to the asset-disposition auction process, it is anybody's game!

Clean Up in Aisle 3: Vendors At Risk

A leading retailer concern in Chapter 11 is maintaining good relationships with vendors and customers. As everyone knows, earlier this year, the Seventh Circuit upheld reversal of Kmart's critical vendor order. In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004), reasoning that the Bankruptcy Code's policy of equal treatment of creditors does not authorize payment of pre-petition claims to select vendors. Criticizing the pre-Code “Doctrine of Necessity” as an inappropriate basis to pay pre-bankruptcy claims during a case, the court also questioned the “business necessity” of these payments. The court observed that vendors should continue shipping if they are paid for post-bankruptcy goods irrespective of paying pre-petition receivables. The court directed the return of post-bankruptcy payments to the “critical vendors” despite their reliance upon such payments for bankruptcy shipments. Fortunately, post-Kmart, courts still approve “critical vendor” orders. See, e.g., In re New World Pasta Co., Case No. 04-02817 (Bankr. M.D. Pa. May 10, 2004 and June 21, 2004).

Nor was the year very good for vendors with leased/licensed departments or consignment relationships with a merchant. Vendors desiring to retain ownership over their inventory use leased departments or consignments, paying the merchant a commission for actual sales. In order to provide a seamless customer shopping experience, sales are run through the merchants' registers. Merchants collect payments, remitting them to the vendor less their commissions. Absent bankruptcy, vendors own the product and their sales proceeds. The key words were “absent bankruptcy.” In In re Ames Dep't Stores, Inc., 2004 WL 1948754 (S.D.N.Y. 2004), a licensor shoe vendor argued that proceeds from shoe sales were not “property of the estate” because the debtor merely collected and held the proceeds in “constructive trust” for the vendor.

The bankruptcy court disagreed and the district court affirmed. The court found that because 1) the actual nature of the parties' relationship did not support an agency or trust relationship; 2) the debtor commingled the disputed sale proceeds with its own funds; and 3) there had been no conversion or unjust enrichment, the funds were not held in constructive trust. The mere failure to pay a debt could not support a constructive trust absent a fiduciary relationship. Because the proceeds were property of the estate, the vendor was merely a general creditor. The Ames decision reflects the reality for vendors that whether goods are delivered by consignment/leased department relationship or through outright sale to a merchant, the vendor remains at risk for unpaid goods. The “fix” — segregation of sales proceeds from the merchant's own sales — is not feasible absent vendors using dedicated cash registers and related processes to collect and track sales.

Customers Are Safe

If courts made life more difficult for vendors in 2004, customers received protection by clarifying the scope of “deposits” entitled to priority status. In In re WW Warehouse, 383 B.R. 588 (Bankr. D. Del. 2004), the debtor issued gift certificates pre-bankruptcy. The debtor scheduled (and classified in its plan) the outstanding gift certificates as general unsecured claims and objected to such claims that asserted a secured or priority status. The U.S. Trustee objected on the grounds that the claims were entitled to priority status.

The court held that because gift certificates are priority “deposits” for purposes of section 507(a)(6), finding that “deposits” are not limited only to partial payments of a purchase price for specific merchandise. Deposits also include situations where full payments have been made such as, lay-away plans and service contracts (ie, lessons, gym membership). Gift certificates are not the ultimate purchase, but only a document entitling a holder to receive something of value.

Desired Assumption and/or Assignment May Be Difficult

A retail debtor's executory contracts and unexpired leases are usually among the most valuable assets of the debtor's estate, and integral to the continued operation of its business. However, in 2004, at least two cases reflected a more restrictive policy on debtors' ability to assign such agreements.

In In re Trak Auto Corp, 367 F.3d 237 (4th Cir. 2004), an auto parts retailer obtained court approval to close various stores and assume and assign certain closed store leases. One of its shopping center leases contained a use restriction clause, only allowing the sale of auto parts. The debtor did not receive any bids from auto parts retailers. The highest bid received — which was accepted — was from a discount clothing outlet.

The landlord objected, arguing assignment would: 1) breach the restrictive use provision, which was enforceable under section 365(b)(3)(C) of the Bankruptcy Code; and 2) disrupt its shopping center's tenant mix, in violation of section 365(b)(3)(D). The debtor argued that the restrictive use provisions were unenforceable anti-assignment provisions under section 365(f)(1). The court, unwilling to adopt a liberal reading of section 365(f), held that the restrictive use clause must be upheld and prevented the assignment of the shopping center lease to the outlet. The court found that the anti-assignment provisions of section 365(f)(1) did not overrule landlord-protective section 365(b)(3)(C) because section 365(f)(1) was a general provision while section 365(b)(3)(C) was a specific provision meant to address situations such as that faced by the shopping center here. (Other courts have previously recognized that the so-called “shopping center” provisions of section 365(b)(3) were not absolute. In re Rickel Home Centers, Inc., 209 F.3d 291 (3rd Cir. 2000)). (This year, a court also upheld a use clause in a deed restriction included in a recorded declaration, holding that section 365(f)'s reach did not extend beyond leases/contracts. In re Ames Dept. Store, Inc., 2004 WL 2516188 (Bankr. S.D.N.Y 2004).)) Strike one for retailers.

Leases are not retailers' only valuable contracts. Retailers may have licensed software that may be tailored specifically for the debtor's operations to assist not only in monitoring sales, but also in inventory allocations and replenishment. Another Fourth Circuit decision in 2004 could impact a debtor's right to assume (let alone assign) these valuable licenses as part of their on-going business. In In re Sunterra Corp., 361 F.3d 257 (4th Cir. 2004), the debtor sought to assume a software license agreement pursuant to which the debtor had a nonexclusive license to use the developer's software. Under the agreement, the debtor would own any enhancements it made to the software and the debtor, in turn, granted the developer a license to use those enhancements. Further, the agreement provided that the debtor could assign the contract to a successor in interest under certain circumstances. The developer filed a motion seeking to have the agreement deemed rejected on the grounds the agreement was an executory contract and the debtor could not assume it without the developer's consent. The court held that the license agreement could not be assumed by the debtor without the non-debtor party's consent. The court found that under a literal reading of section 365(c), assumption and assignment are two conceptually distinct events (reading the “or” in the statute as disjunctive rather than conjunctive), and thus, the debtor could not assume the license agreement without the developer's consent. Sunterra could impose additional costs upon retail debtors requiring continued use of software through either costs associated with “buying” the non-debtor's consent or, in the absence of such consent, implementing replacement software. Strike two for retailers.

Speaking of non-assumable agreements, in In re Twin City Power Equipment, Inc., 308 B.R. 898 (Bankr. C.D. Ill. 2004), the court did not allow the debtor to assume a lawn and garden dealership agreement, which allowed the debtor to sell John Deere equipment in its stores through vendor financing. The court found that the “primary purpose” of the dealership agreement was the extension of credit to buy vendor's inventory, and, thus, a non-assumable financial accommodation. The decision raises some interesting implications for vendors committing to sell future product on credit terms. Strike three …

Issues with Landlords

Debtors may negotiate rent reductions with certain landlords during their Chapter 11 cases. Such agreements may affect whether the debtors will assume or assign a lease. In good news for retailers, a court recently held that landlords who provide post-petition rent reductions are estopped from asserting an administrative claim for the full amount of the rent. In re Nucentrix Broadband Networks, Inc., 314 B.R. 581 (Bankr. N.D.Tex. 2004).

Debtors typically cannot cherry-pick the parts of an agreement to assume and reject the balance. That is, unless the court finds that the agreement actually contains several different — and severable — agreements. Such was the case in In re FFP Operating Partners, LP, 43 BCD 141 (Bankr. N.D. Tex. 2004) where the court, over the landlord's objections, allowed the debtor to assume 10 out of 20 leases subject to a master lease. This decision is quite favorable to debtors operating under older, integrated master leases for multiple stores.

Can Parties Rely on Approved Auction Procedures?

If history has shown anything about a retail Chapter 11 case. it's that you cannot have a retail debtor without having an auction of some, and sometimes all, of the merchant's assets. 2004 shed some interesting light on auction procedures including courts revising previously approved procedures where change results in more money for the debtor's estate.

In Corporate Assets, Inc. v. Paloian , 368 F.3d 761 (7th Cir. 2004), after the debtor held an auction pursuant to court approved procedures, the court allowed the debtor to conduct a second auction to ensure that it received maximum value for its assets. At the first auction, the highest bid was $2.25 million. The day after the auction, the second place bidder advised the debtor that it was unaware that a prior change has been made to the form asset purchase agreement and increased its bid to $2.45 million. The bankruptcy court approved a second auction, and the highest bidder from the first auction again submitted the highest bid, at $2.6025 million. At the sale hearing, the debtors requested that the court approve the $2.6025 million bid, and the successful bidder objected, arguing that the bid from the first auction should be approved.

The court held that when faced with a late bid, it must walk a “tightrope” between preserving the “integrity and finality of the auction process and to recognize the reasonable expectations of the parties” on the one side, and the “governing principle in confirming a sale, which is to secure the highest price for the benefit of the estate and creditors” on the other. In this balancing act, the court should look at the auction process on a “continuum.” On one end, once the sale is approved, it takes “compelling reason” such as fraud, mistake, or gross inadequacy in price to upset a winning bid in favor of a higher late bidder. But in the twilight between the auction and the sale hearing, the bankruptcy court has broader discretion to authorize late bidding where the circumstances dictate, especially where the auction and bidding are “complex and fluid” or “informal and flexible,” such that there is no undue frustration of participants' reasonable expectations as to whether the highest bid at the auction would be subject to late overbids.

Paloian follows on the heels of certain cases from 2003, where courts revised previously approved auction procedures to eliminate or reduce bid protections. For example, in In re 310 Associates, 346 F.3d 31 (2d Cir. 2003), the court vacated its prior order approving break-up fee and bidding protections after first discovering: 1) the presence of another bidder; and 2) continued active interest in the property to be sold. In In re Epic Capital Corp., et al., Case No. 01-02458 (Bankr. D. Del Aug. 14, 2003), the court revised its prior procedures order, and deleted the break-up fee and bid protections when another potential bidder was willing to make a substantially similar offer without such bid protections. And, in In re SHC, Inc., et al., Case No. 03-12002 (Bankr. D. Del July 23, 2003), the court required a proposed stalking horse to give up its break-up fee and bid protections to be approved as the stalking horse.