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Before the COVID-19 outbreak, fashion retail already faced difficult times with numerous bankruptcies, such as Barneys, Sonia Rykiel, Roberto Cavalli and Diesel. Now with COVID-19, fashion retail confronts a “perfect storm” — the hurricane of the disruption of brick and mortar retail caused by omnichannel retailing and the Nor’easter resulting from the shutdown of all retail stores and lockdown of consumers in the US. It is anticipated that retail bankruptcy filings will proliferate in the wake of COVID-19 and, as a result, it is important to have a basic understanding of the bankruptcy process and concepts for fashion businesses, including Chapters 11 and 7, critical vendor status, how to file a claim, and what strategies can be used to sell to an entity once it has filed for bankruptcy.

US bankruptcy law serves the dual goals of seeking to relieve debtors of certain obligations that they are unable to timely repay by potentially providing a “new start” from financial difficulties while still addressing the countervailing interests of creditors and other stakeholders in an orderly manner. The U.S. Bankruptcy Code, which sets the ground rules for US bankruptcy proceedings, balances the conflicting interests of the debtor (the party that is the subject of the bankruptcy), trade creditors (to whom the debtor owes varied obligations) and other stakeholders (such as parties who hold equity or other financial obligations of the debtor).

Chapter 11 Bankruptcy

Chapter 11 affords a business debtor the opportunity to remain in business while seeking to adjust its debts, typically by restructuring its obligations via a comprehensive reorganization plan, or alternatively seeking to sell all or part of its assets via a court approved sale. In the context of a retail bankruptcy, the proceedings may, for example, involve shuttering unprofitable locations, shedding onerous contracts and/or shifting the focus from brick and mortar to online sales. 

A Chapter 11 case typically begins with the filing of a voluntary bankruptcy petition either in the venue where the debtor is primarily located or in its state of incorporation. The debtor’s early filings include schedules of assets and liabilities which purport to, among other things, summarize the nature and status of obligations owed to each vendor. 

Upon filing the Chapter 11 petition, the company automatically assumes the identity of “debtor-in-possession” until the debtor’s case is dismissed or converted to a Chapter 7 proceeding (liquidation), or a Chapter 11 bankruptcy trustee is appointed by the court. In a Chapter 11 retail bankruptcy, an unsecured creditors’ committee is often appointed by the United States Trustee and typically consists of 5‑7 larger unsecured creditors such as vendors and landlords. 

The committee weighs in on material issues during the proceedings on behalf of the unsecured creditor body. Unsecured creditor recoveries are typically pro rata, and the rates of recovery vary from case to case.

Chapter 7 Bankruptcy

A Chapter 7 bankruptcy proceeding is a liquidation-only alternative. Upon the debtor filing a bankruptcy petition, an independent trustee is automatically appointed. The trustee gathers and sells the debtor’s assets and uses the sale proceeds, net of liens, to first pay secured creditors before addressing the administrative costs and claims of unsecured creditors. Chapter 7 liquidations typically result in a very minimal, if any, recovery by unsecured creditors.

Bankruptcy Issues that Retail Vendors Commonly Confront

Critical Vendor Treatment: A “critical vendor” in a Chapter 11 proceeding is a party who provides goods or services that cannot be readily or efficiently replaced, and if discontinued, would have a significant impact on debtor’s operations. In a retail Chapter 11 case, a critical vendor may include a top fashion, apparel or beauty brand or company which is a particular draw for the retailer. A debtor must first obtain bankruptcy court approval to deem a creditor a critical vendor and receive permission to pay the creditor’s pre-bankruptcy claim early in the case, conditioned that the creditor continue supplying the debtor on the same credit terms as were in place prior to the bankruptcy. While a vendor often would want to receive “critical vendor” treatment, the vendor needs to carefully assess the scope of exposure that continued supplying might create.

Filing A Bankruptcy Claim: In a Chapter 11 case, a creditor need not file a claim if the creditor agrees with the claim amount the debtor listed on its schedules and the debt is not listed as disputed, contingent or unliquidated. However, if the creditor believes the claim amount is incorrect or the claim is listed as disputed, contingent or unliquidated, a proof of claim needs to be filed by the “bar date,” which is the court-established claim filing deadline. 

A proof of claim should be filed on the form provided by the bankruptcy court and the creditor needs to indicate how the claim is classified (secured, general unsecured, or priority unsecured) and state the amount owed and provide supporting documentation for the claim. It is imperative that the proof of claim is filed by the bar date. The proof of claim should be carefully prepared and should include the writing on which the claim is based (if the writing exists) including contracts or invoices. As there are various ramifications to filing a proof of claim, legal counsel should be consulted in advance of filing the proof of claim.

Creditors’ Committee: The creditors’ committee, among other things, consults with the debtor-in-possessionon administration of the case, often investigates the debtor’s conduct and operation of the business; and is typically involved in the formulation of any plan and/or sale of assets. The committee may, with the court’s approval, hire counsel and possibly other professionals which are paid by the bankruptcy estate to assist in the performance of the committee’s duties. The committee represents the interests of all unsecured creditors, not just those of the committee members, with a goal of maximizing unsecured creditor recoveries.

Theodore Max and Alan Martin are partners at Sheppard Mullin Richter & Hampton LLP.