COVID-19: A Massive Impediment to Bankruptcy Relief

These Chapter 11 Cases were pending for just three days when on March 11, 2020, the World Health Organization declared the novel coronavirus disease (COVID-19) outbreak to be a pandemic. These Chapter 11 Cases were pending for just five days when on March 13, 2020 the Trump administration declared a national emergency in response to COVID-19 outbreak. These Chapter 11 Cases were pending for just six days when on March 14, 2020, government regulators in Pennsylvania, one of four states in which the Debtors' core retail operations are concentrated, issued guidance urging all non-essential business to close, with other states and localities soon to follow. And, these Chapter 11 Cases were pending for just eleven to fourteen days when the four states in which the Debtors' principal operations are located — Michigan, Pennsylvania, Ohio and Illinois — issued "stay at home" or "shelter in place" orders.

With this dire start in Chapter 11, Art Van's case quickly changed directions. On April 6, Art Van Furniture's motion to convert to Chapter 7 was granted.

In Chapter 11, debtors are left in control of their business and are provided with an immediate injunction — the automatic stay under section 362(a) of the Bankruptcy Code. The automatic stay prevents creditors from seeking to enforce debts or to recover collateral, and provides debtors with a period of repose to stabilize operations, garner financing, and effectuate plans of reorganization—or at least orderly liquidation, through GOB sales, auction proceedings, and the like.

In Chapter 7 cases, however, management of a debtor is divested from control and a Chapter 7 trustee is appointed. There is no opportunity to reorganize, and liquidation is less than orderly. A Chapter 7 trustee steps in for management, marshals and liquidates assets for quick sale, or if a quick disposition is not feasible, the debtor's assets are abandoned. The prospects for creditor recovery are typically reduced in a Chapter 7, with virtually no possibility of job preservation.

In Art Van Furniture's bankruptcy case, the COVID-19 pandemic made it clear that continued operations of almost 170 stores in Chapter 11, while shut down, would result in expenses eclipsing any potential revenues generated for creditors. While Art Van attempted to come up with a plan with its lenders to suspend the Chapter 11, pending stabilization of broader economic and COVID-19 public safety issues, a path forward could not be forged. The uncertainty of the pandemic and the limited cash on hand made a suspension strategy impossible, without the consent of Art Van's lender. Such consent was not forthcoming, leaving no alternative but Chapter 7. Upon conversion to a Chapter 7, with no ability to operate, retail operations shuttered, no access to cash, and the dismissal of the vast majority of employees, the possibility of recovery to creditors seems dismal, and the prospect of a going concern transaction and preservation of jobs impossible.

Modell's Staves off Chapter 7

Similar to Art Van, Modell's Sporting Goods' ability to pursue Chapter 11 relief has been thwarted by COVID-19. Modell's filed its bankruptcy case on March 11, 2020, and announced that it was closing all 134 of its stores. Modell's intention was to complete liquidation sales by the end of April and potentially sell a portion of its stores in a going concern transaction.

The government-imposed closure of non-essential retailers due to COVID-19 rebuffed Modell's efforts to liquidate. However, in contrast to Art Van, Modell's sought to stay in Chapter 11, with the consent of its lenders. On March 23, Modell's and its affiliated entities filed an emergency application to suspend their bankruptcy cases, which was granted by the Bankruptcy Court in New Jersey on March 27. The court allowed Modell's to suspend its Chapter 11 proceeding under Section 305, a rarely used section of the Bankruptcy Code, until April 30, 2020, when another hearing on suspension will be held. Unlike Art Van, Modell's has avoided Chapter 7 for now, and will remain in a state of partial Chapter 11 repose with extremely modest expenses.

Landlords' Outcry

Modell's initially sought a 60-day suspension period, noting that it had "no choice but to temporarily 'mothball' … operations to preserve value, with the hope that …" they can restart operations in the near future in order to liquidate their inventory. Landlords widely objected to the suspension, during which time Modell's did not propose to pay rent. Under Modell's proposed bankruptcy budget, post-bankruptcy rent was to be deferred until July or August 2020, after significant bank debt was paid down.

The period of suspense coupled with the delay of rent, while the pay down of significant bank debt was budgeted, alarmed landlords. Under Section 365(d)(3) of the Bankruptcy Code, rent must be timely paid by debtors post-bankruptcy, with the exception of a limited grace period, for cause. COVID-19 is certainly sufficient cause for such a grace period. However, landlords were upset that the proposed suspension may be used to circumvent Modell's mandatory rent obligations, beyond the time period allowed under Section 365(d)(3), particularly where bank debt was budgeted to be paid down. Landlords cried foul at the prospect of Modell's and its lenders utilizing landlords' premises to conduct GOB on their backs. However, Modell's was quick to remind the court that rent may not be owed whatsoever during the period of shutdown, based upon force majeure and other legal theories and lease provisions.

In a temporary bandage to the dispute between Modell's and its landlords, parties agreed to reduce the initial period of suspense through to April 30, the eve of May rent obligations. At that point, unless consensually resolved, the court will be left to decide if a suspension under Section 305 of the Bankruptcy Code can somehow circumvent the mandatory obligations for payment of rent under Section 365(d)(3), and/or will need to address Modell's force majeure arguments. At least for the time being, the prospect of orderly liquidation in Chapter 11 and a potential going concern transaction remain intact. However, as each day of the COVID-19 pandemic and associated shutdowns continue, the prospect of resuscitating an orderly liquidation for Modell's and its lenders appear grim, as does the prospects for replacement tenants for landlords, in the short term.

Reorganization Efforts Disintegrate Under COVID-19

If entities such as Modell's and Art Van cannot orderly liquidate in a bankruptcy case, the prospect of reorganization seem impossible in the face of COVID-19. Consider VIP Cinema, a manufacturer of reclining seats for movie theaters, which along with certain affiliated entities filed for Chapter 11 bankruptcy protection on Feb. 18, 2020. On that date, VIP filed a Joint Prepackaged Plan of Reorganization. The Plan of Reorganization had been negotiated over a period of months and resulted in a comprehensive and consensual prepackaged reorganization of VIP's businesses, which would allow for VIP's emergence from bankruptcy with $150 million less debt.

These well laid out plans have now gone to waste. With the COVID-19 imposed shutdown of movie theaters, demand for VIP's product and its customers' ability to repay have been substantially eroded and feasibility of performing under the Plan of Reorganization became doubtful. These factors, coupled with the resignation of VIP's CEO, caused those supporting the plan to terminate their support. In turn, VIP recognized that it was impossible to operate as a going concern and abandoned efforts to confirm the pre-packaged plan. Rather, VIP decided to shut down and orderly liquidate assets, with the resulting loss of hundreds of jobs, announced this past week.

The blunt impact of COVID-19, on VIP Cinema, Art Van Furniture, and Modell's, among others, has been devastating. Bankruptcy is usually a safe haven for troubled companies to stabilize under the rubric of statutorily imposed procedures, timeframes, and priorities that debtors and other constituents can rely upon. The unknown duration of COVID-19 and its debilitating impact on retail operations makes a road in Chapter 11 extremely rocky to navigate and the prospects of orderly recoveries for creditors specious, at best. For now, retailers may be well-served to stay on the bankruptcy sidelines until the COVID-19 pandemic lifts, when the full extent of its wreckage can be assessed.

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Joseph H. Lemkin is a shareholder of Stark & Stark in Princeton and a member of the firm's Bankruptcy & Creditors' Rights Group. His practice focuses on the areas of bankruptcy law, commercial litigation, business reorganization, and related matters, with a particular emphasis on creditors' rights.