Why bankruptcy is rarely the end for retailers in dire straits

RIP to a real one.
RIP to a real one.
Image: REUTERS/Andrew Kelly
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Discount retailer Century 21 announced on Sept. 10 it was filing for bankruptcy and would close all 13 of stores, mostly in the northeastern US. The company blames its financial demise on its insurance, which didn’t pay to insulate Century 21 from business interruptions caused by the coronavirus pandemic.

It’s far from the only retailer to have suffered similar losses over the past six months. Brooks Brothers, J. Crew, JC Penney, Lord & Taylor, Muji, and Neiman Marcus are among those that declared bankruptcy as Covid-19 has transformed the industry.

And yet, Century 21 is one of the few that said that it will completely shut down. The rest plan to restructure their debts, close money-losing stores, and continue operation. What determines whether we can keep buying products from troubled but trusted retailers, or whether those companies simply seem to evaporate?

“By no means does bankruptcy mean a company is going out of business,” says Jim Van Horn, a partner at Barnes & Thornburg LLP in Washington, DC who has practiced bankruptcy law for 20 years. “When people hear bankruptcy, they often assume that company is not going to be around anymore. That can be the case, but it’s often not. Many companies that go into bankruptcy are able to survive, either at the same size or smaller.”

Chapters 7, 11, and 13

It’s worth noting that there are a few different kinds of bankruptcy. Chapter 11 is for companies overloaded with debt and through which a federal judge helps the company’s existing management restructure that debt in order to pay back its lenders. Chapter 7, also for companies, means that existing management cedes control to a trustee and the business is automatically liquidated. Chapter 13 bankruptcy is for individuals and involves paying back debts over a period of years.

There are lots of factors that affect whether a company is able to survive after declaring bankruptcy, Van Horn says. First among them: Why they went bankrupt in the first place. Has the whole business tanked, or are just a few stores no longer profitable? Are there expensive lawsuits pending? Are they overpaying for leases, or have a bad mix of inventory? Did they make decisions that in retrospect were simply bad for business?

Any of these reasons (or a combination of them) could cause a company to declare bankruptcy, which then gives them room to maneuver. “There are a whole bunch of things a Chapter 11 debtor can do if they declare bankruptcy that they wouldn’t be allowed to legally do otherwise,” Van Horn says. They can get out of leases or other contracts and just keep their most profitable operations open. They can have going-out-of-business sales that are not allowed by most retail leases in places like shopping malls. All lawsuits are automatically stopped, and litigation is unlikely to proceed.

Which of these actions a company takes depends in part on what its lenders decide. The lender, a financial institution or third party that loaned the company money to do things like buy inventory or pay its leases, will conduct an independent assessment and see which action gives them the best chance to recoup their money. “Sometimes the lender will decide to try to make a go of it for a longer period, thinking hopefully the company won’t file for bankruptcy for a few years, and maybe it’ll get paid out some amount of money through some reorganization,” Van Horn says. Those are the situations in which some stores stay open. These companies can sometimes successfully reorganize, he says. “They can come out the other side maybe smaller and more nimble, but the same company.” Many of the retailers that filed for bankruptcy but still have stores open, such as J. Crew and Muji, took this route.

Zombies and liquidation

Other times a lender will decide it’s best to cut its losses. “It’ll say, ‘Let’s just stop, let’s not put any more money into this,'” Van Horn says. They’ll want to shut things down in a short timeframe—often 60 to 90 days—so the company doesn’t incur any more expenses. The bankrupt company will liquidate all its inventory and the lender will seek to collect as much money from the liquidation as possible.

In these situations, companies will have to sell off everything of value—not just its merchandise and real estate, but sometimes its branding and logo, too. That’s how we get things like zombie brands, which seem to still exist, but have their name on products that have nothing to do with those they once sold. For example, after famed toy company FAO Schwarz went out of business in 2004, Toys ‘R Us bought the company name to use on some of its products (it, in turn, also filed for Chapter 11 in 2017, though it still exists).

What happens to the groups that are owed money, such as landlords, employees, or plaintiffs suing the company? They get in line to get paid out, with the understanding it might not be much in the end. The law determines the order in which these payments are made. Any money the company has first goes to pay back its secured debt, those for which the company has put up assets as collateral. So-called “priority creditors” are up next, which includes those with certain wage and tax claims. At the very bottom of priorities are unsecured claims, which is often the largest chunk of debt. Anyone with whom the company has a contract, such as landlords, are often lumped into a trust of the largest unsecured creditors, which negotiates with the secured lenders to try to get some money.

“It’s often a mess,” Van Horn says. “Not everyone likes the process or gets what they want…but that’s what bankruptcy is for, to try to clear these things up. And it usually works.”

Correction: An earlier version of this article stated that Chapter 11 was the most common type of bankruptcy. In fact, Chapter 7 is the most common.