COVID-19: Rethinking Administrative Expenses in Chapter 11: How Vendors and Landlords Will Be Affected by “Mothballed” Cases, Partial Freezes, and Critical Expenses in the COVID-19 Crisis

COVID-19: Rethinking Administrative Expenses in Chapter 11: How Vendors and Landlords Will Be Affected by “Mothballed” Cases, Partial Freezes, and Critical Expenses in the COVID-19 Crisis

Client Alerts

Contributors

Read more in our Coronavirus (COVID-19) Center.

View All

Historically, many companies seeking bankruptcy protection have attempted to streamline and shorten their Chapter 11 cases to reduce cost and risk.But the COVID-19 pandemic may be disrupting that trend, especially in industries that rely on in-person shopping or dining or are otherwise disproportionately affected by the economic slowdown. Across the country, many businesses are seeing revenues dry up as consumers stay home, following concerted governmental and social efforts to “flatten the curve” of the novel coronavirus’s transmission.2

Blindsided by the speed and severity of the crisis, some companies have sought to “mothball” their Chapter 11 cases completely, while others have petitioned courts for a partial “freeze” of their Chapter 11 cases, allowing online sales to continue while their brick-and-mortar stores lie vacant. Even when debtors and secured creditors agree that pausing the case is the best way to preserve the going-concern value of the enterprise and protect their interests, these tactics bend the generally applicable practice that companies in Chapter 11 pay on a timely basis their “administrative expenses,” such as invoices for goods delivered during the bankruptcy and rent for real estate occupied during the bankruptcy.3 

Mothballing Cases 

Some companies that filed for Chapter 11 prior to or during the crisis may seek to pause their bankruptcy cases entirely for 30 or 60 days. This strategy of mothballing a case allows a debtor to reduce its expenses sharply—e.g., furloughing employees, slashing operating expenses—while remaining under the shield of bankruptcy protection and hoping for a return to operations within a period of months. The company may plan for its “re-operationalization” to involve only a subset of its most profitable stores. CraftWorks, an operator and franchisor of steakhouses, breweries and restaurants, opted for this approach after declaring a default under the facility that was financing its Chapter 11 case. So did Modell’s Sporting Goods, a retailer of sports equipment and apparel.4 

Because the Bankruptcy Code contains no specific provision clearly allowing a debtor to press the “pause” button, CraftWorks sought relief under Section 105(a) of the Bankruptcy Code, which allows the court to issue any order “necessary or appropriate to carry out the provisions” of the Bankruptcy Code. Modell’s also cited Section 105(a), and additionally relied on Section 305(a), which courts most often employ to abstain from a bankruptcy case in deference to a legal proceeding in another court but also authorizes the court to “suspend all proceedings” in a bankruptcy case. Despite the seemingly broad language of both provisions, invoking them to mothball an entire bankruptcy case is new, and the CraftWorks and Modell’s courts required each of the debtors to make an affirmative case that this relief was warranted and did not violate some other provision of the Bankruptcy Code.5 Even when bankruptcy proceedings are suspended, the automatic stay presumably remains in force, meaning that creditors of CraftWorks or Modell’s cannot attempt to recoup any losses or compel payment without first seeking permission from the bankruptcy court. In other words, vendors and landlords may be held at bay, unable to enforce contracts and leases against the debtor while still themselves being bound to perform. Mothball status for an entire case is a concept where the precise rules for how vendors and landlords will be affected have not yet been written.6 

“Partial Freezes” and “Critical Expenses”

Pier 1, a home décor and furniture retailer, took a more nuanced approach. Pier 1 planned to freeze its in-person stores while maintaining its active e-commerce business, effectively asking the bankruptcy court to approve the business strategy adopted by many of its peers in reaction to the COVID-19 crisis. It obtained court permission to continue paying “critical expenses” that related to e-commerce, while temporarily ceasing to pay landlords, vendors, shippers and suppliers. In support of its motion, Pier 1 argued that nonbankruptcy law—including the Takings Clause, force majeure and frustration of purpose—would have allowed it to forestall payment outside of bankruptcy.7 Anticipating a wave of motions seeking to compel Pier 1 to pay, or seeking relief from the automatic stay, Pier 1 proactively asked the court to push consideration of those motions to a future date. This strategy represents a departure from the general requirement that companies in Chapter 11 must pay their current vendor and landlord obligations in a timely manner. But in the upside-down world of the COVID-19 crisis, Pier 1 successfully argued that it should get some of the benefits of the (potentially more permissive) out-of-bankruptcy rules and relax the (more restrictive) requirements that apply to companies in Chapter 11.

Modell’s, too, sought to carve out a special category of administrative expenses for immediate payment. These “essential expenses” were any payments that the company deemed critical for the re-operationalization that it planned after social distancing measures are relaxed.

Potential Roadblocks to Returning to “Bankruptcy as Usual”

There are a number of issues—beyond the inability to collect present payment from debtors—that may arise when companies employ mothballing and partial freeze strategies.

First, while companies may be able to achieve temporary financial relief from a mothballing or partial freeze strategy, accruing large unpaid administrative expense balances may make the confirmation of a Chapter 11 plan more difficult. The Bankruptcy Code provides that expenses incurred by the debtor during the course of its Chapter 11 case must be paid in full as part of a confirmed Chapter 11 plan. See 11 U.S.C. §§ 507(a)(2), 1129(b)(2). If the debtor cannot pay its administrative expenses in full, the debtor is deemed “administratively insolvent” and the case is vulnerable to being converted to a Chapter 7 liquidation. Failure of a debtor to confirm a Chapter 11 plan could result in adverse effects for all parties involved in the bankruptcy case.

Second, prioritizing some administrative creditors over others, while possibly acceptable for a short period of time, has met resistance when attempted on a permanent basis in the past. In the bankruptcy case of Toys “R” Us, the debtors faced an inability to pay all administrative expenses in full after a disastrous 2017 holiday season and planned a wind-down within Chapter 11. In March 2018, Toys “R” Us attempted to set aside money to compensate vendors only for goods shipped after March 5, 2018, leaving prior administrative creditors unpaid. The company’s intent was to incentivize vendors to continue shipping to Toys “R” Us to provide runway for an orderly wind-down. But the notion of affording disparate treatment to two groups of administrative claimants based solely on which side of the March 5 divide they fell on drew a massive outcry from vendors, and Toys “R” Us eventually dropped the March 5 concept, agreeing to make pro rata distributions to administrative creditors. Similarly, in the COVID-19 crisis, courts may allow companies to fast-track funds for “critical expenses” to the employees, professionals and partners who keep online sales humming. Courts may be most likely to approve such requests as stopgap measures only. Where creditors raise meaningful uncertainty about the debtor’s ability, in the end, to pay all of its administrative expenses, courts may be reluctant to endorse an approach that appears to discriminate among administrative expense claimants.

Conclusion

Even if the immediate economic effects of the COVID-19 crisis are resolved relatively quickly, there likely will be a period of readjustment for businesses affected. Companies that have filed Chapter 11 cases before or during the crisis may continue to seek innovative relief from bankruptcy courts to assist with that readjustment. Vendors and landlords should be mindful that, much like other aspects of the COVID-19 crisis, Chapter 11 in the era of COVID-19 is not “bankruptcy as usual,” and some historic vendor and landlord protections—such as timely payment of administrative expenses—may face new challenges. Whether it’s mothballing, a partial freeze or something not yet seen, vendors and landlords may need to pay renewed attention to the relief sought by debtors in order to protect their interests.

This analysis is fact-intensive and requires consideration of multiple factors. Please reach out to the authors listed above or to your regular contact at WilmerHale if you have questions or to analyze your company’s particular situation and make the decision best suited to your goals.

Contributors