As a condition precedent to confirming a Chapter 11 plan, Section 1129(a)(11) of the U.S. Bankruptcy Code requires a finding from the Bankruptcy Court that “confirmation of a plan is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor to the debtor under the plan, unless such liquidation or reorganization is proposed in the plan.”
It is difficult to reconcile this feasibility requirement with the abundance of recidivist filers in the retail sector. Approximately 15% of all debtors will enter Chapter 11 for a second time1—affectionately dubbed “Chapter 22” in the restructuring community or “Chapter 33” for third-time filers, etc. The refiling phenomenon is even more prevalent in recent retail cases, which over the three years ending February 2019 clocked in with approximately 32% repeat filers.2
At the root of the discussion is whether Chapter 11 recidivism equals failure. The knee-jerk reaction to a serial filing is that the first reorganization was insufficient to address the issues and that a subsequent Chapter 11 filing should be regarded in a negative light. Viewed through the lens of the feasibility test, one might posit: Should feasibility be more strictly enforced or abandoned altogether?
The current standard for interpreting feasibility is set forth in Kane v. Johns-Manville Corporation and prescribes that the facts established at the confirmation hearing provide “a reasonable assurance of success” though “success need not be guaranteed.” In looking at the recent serial filings in retail, one should query whether the debtors met that burden in their initial filings.
In the initial Gymboree and Payless cases, both of which were followed by Chapter 22s inside of 24 months, confirmation of their plans was consensual and supported by their constituents. That said, while Gymboree and Payless have similarities, there are also significant differences that might affect one’s analysis around the feasibility question and whether their Chapter 11 recidivism was so bad, all things considered.
Gymboree was a private-equity-owned children’s clothing retailer that operated three distinct brands with different store footprints: (1) its flagship store, Gymboree, which sold moderately priced clothing collections and separates; (2) Janie and Jack, which sold higher end clothing collections and separates, and (3) Crazy 8, which sold lower priced basics and separates. In addition, the company operated a play and music business called Gymboree Play Programs Inc. (GPPI).
Gymboree had expanded rapidly and by the end of 2016 was operating about 1,300 retail stores. At the same time, same-store sales continued to decline as a result of increasing competition from better capitalized competitors plus disruption from the Amazon Effect, which refers to the impact of online, e-commerce or digital marketplaces on the traditional brick-and-mortar business model as a result of material changes in customer expectations and shopping behavior.3
To create a longer liquidity runway, Gymboree in July 2016 sold GPPI to an overseas investor for $128.1 million. Eleven months later, Gymboree filed its first Chapter 11 with a restructuring support agreement (RSA) that had the consent of the majority of its term loan lenders and formed the basis of a Chapter 11 plan to quickly reduce its debt. At the time of the filing, the total outstanding debt was $1.1 billion, with a debtor-in-possession (DIP) debt facility of $378.5 million.
On September 29, 2017, after just over three months in bankruptcy, Gymboree emerged with a confirmed plan of reorganization which reduced the debt by more than $900 million and called for the closure of approximately 350 stores. Under the plan, the term loan lenders that provided the DIP financing received 89.6% of the reorganized company. The plan was supported by all of the constituents, and no serious objection to feasibility was lodged.
Post-emergence from Chapter 11, however, Gymboree continued to struggle as in-store profit margins declined. Additional stores were closed, which increased merchandising costs due to lower sales volumes. On January 17, 2019, 16 months after emerging from the first Chapter 11, Gymboree filed its Chapter 22 with $212 million of debt and secured $37 million in a new money DIP financing. In the Chapter 22, Gymboree sold the Janie & Jack assets to Gap Inc. for $35 million and the Gymboree and Crazy 8 assets to The Children’s Place for $76 million, yielding proceeds of $111 million.
Payless Inc. was a private-equity-owned shoe company that, through owned subsidiaries or franchised operations, engaged in worldwide sales of low-priced footwear. In 2015, the company overpurchased inventory as a result of operating antiquated information technology (IT) systems and experienced port strikes that disrupted major supply shipments before major retail selling seasons.
At the same time, Payless lost market share both to big box retailers at the lower end of the market (Walmart, Target) and to online retailers at the higher end (Zappos, Shoes.com). Payless also repeatedly delayed implementation of its e-commerce strategy due to reduced liquidity and other operational struggles that diverted focus. At the same time, Payless stretched its trade payables for up to 100 days.
On April 4, 2017, Payless filed its first Chapter 11 bankruptcy with an RSA that had the consent of the majority of its first- and second-lien term lenders. At the time of this filing, the total outstanding debt was $838 million, plus a new $80 million term loan DIP. Approximately 3½ months later, on July 24, 2017, the Bankruptcy Court confirmed the plan of reorganization, which eliminated approximately $435 million in debt and closed approximately 675 stores. The $506 million of first-lien debt received a portion of the new $220 million first-lien term loan and 91% of the reorganized equity. The $145 million of second-lien loan holders received 9% of the reorganized equity. The unsecured trade creditors and equity were wiped out. No credible contest to feasibility was launched at confirmation.
Post-bankruptcy, Payless continued to face issues with excess inventory and poor supply chain management, leading to continued declines in sales. The company experienced an inventory supply disruption during the 2017 holiday season and IT system breakdowns in 2018, right before the back-to-school season. Payless also failed to implement its omni-channel strategy to integrate its online and physical store presence.
On February 19, 2019, 22 months after its first filing, Payless filed its Chapter 22, seeking to liquidate its North American assets. The company’s international stores and franchises were not included in the filing. As this article was written, the recovery outcomes of the Payless Chapter 22 were unknown.
In the absence of a contested plan in Gymboree and Payless, should the court or the United States Trustee have independently required more demonstrative evidence of feasibility before the plan was approved?
The two cases raise several questions in the area of feasibility. In the case of Gymboree, unless the company addressed the disruption it faced from the Amazon Effect, was any amount of debt reduction capable of producing a feasible plan? Maybe not, but does that mean that the initial Chapter 11 plan confirmation should not have been attempted and the initial case should have moved directly to a sale or liquidation? After all, for nearly two years, many people retained their jobs, landlords had tenants, vendors continued to have a counterparty with whom to have a commercial relationship, and creditors received the value they negotiated for their claims.
In the case of Payless, the problems went beyond disruption. Missteps in the business plan that predicated the first filing continued after emergence, almost promising a subsequent filing. But again, initially at least, jobs were saved, tenancies were preserved, and creditors received what they bargained for.
Strict constructionists would argue that the Bankruptcy Code requires an affirmative finding of feasibility and that retail debtors are, for the most part, incapable of meeting that burden unless they have changed their business model to account for the Amazon Effect or addressed other challenges with the business model. They would also argue that the burden of establishing feasibility requires an independent evidentiary showing and that the support of the preponderance of the constituencies is not enough.
This view assumes that a Chapter 22 filing is indicative of failure and somehow blemishes the bankruptcy system as a whole. Strict constructionists also argue that sophisticated creditor constituencies game the bankruptcy system inappropriately by using their leverage in the RSA process to extract concessions.
But is that an appropriate view? Shouldn’t those whose recoveries are at stake have the opportunity to roll the dice to see if their plan can work? And why should an extended battle over feasibility, which would add additional costs to the bankruptcy proceeding, be tolerated if no one wants to prosecute such a challenge?
Fundamentally, the Bankruptcy Code is designed to provide entities with a fresh start, which can include the chance to try a strategy to get the business back on track, even if it doesn’t ultimately work. It seems that whether the initial filing was a result of an external event or an inability to execute on the business strategy, at least in the cases of Gymboree and Payless, those who were potentially likely to be harmed by a future filing overwhelmingly asked the court to confirm the plan, no matter how likely it might have been that the plan was not feasible. And, in each of those cases, there were constituents who received little or no recoveries who elected not to launch a serious challenge under 1129(a)(11).
In other cases, such as Toys R Us and BonTon Stores, creditors were not so willing to roll the dice on a second chance and elected instead to liquidate; thus, no showing of feasibility was required.
So, notwithstanding the strict language of the Bankruptcy Code, if those who would be most affected by another Chapter 11 filing are willing to agree to allow a company to try again, why should a Bankruptcy Court overrule the constituents’ belief in a second—or even a third—chance?