ABI Commission to Study the Reform of Chapter 11

ABI Commission to Study the Reform of Chapter 11

June 4, 2013 Field Hearing

New York Institute of Credit

New York, NY

Bob Keach:Good afternoon, we’re going to go ahead and get started. Welcome. As co-chairs of the ABI Commission to Study the Reform of Chapter 11, Al and I want to thank the New York Institute of Credit for hosting this hearing today. Initially, we'll hear from a number of witnesses today on certain critical, and at times controversial, topics.

One, the Bankruptcy Code’s treatment of leases of non-residential real property, including the effect of the provisions of BAPCPAlimiting the time period for assuming or rejecting such leases on reorganizations.Two, the Bankruptcy Code’s treatment of licenses of intellectual property including patent, copyright and trademark licenses,of which a debtor is a licensor or licensee. In addition, we'll also hear from a witness regarding problems facing middle market and small business debtors, which is a topic we probably can't visit often enough.

Al and I would like to begin with some brief remarks about the Commission and both hearings that have been held and upcoming hearings. Then, I’ll briefly introduce the topic and we'll get started with the introduction of the witnesses and testimony.

Al?

Al Togut:First off, everyone, thank you for coming. I think you're going to find today the next hour and a half time well spent and extremely interesting. I just want to talk a little bit about this process, the field hearing process.

We have posted on the Commission website,a complete opening statement which you can read. We have on there our mission statement. We have a listing of all the Commissioners. We have a listing of all the topic areas that we are studying. We have 130 people populating committees that are looking at various aspects of bankruptcy reform. This piece, which is the field hearing component, is a very important part of what the commission is doing where we had hearings around the country last year and we're continuing this year.

Last year we had public field hearings in Washington, New York, San Diego, Boston, Phoenix and Tucson. Bob Keach and I went out to Arizona twice in three weeks to Phoenix and Tucson and we heard testimony from more than 20 witnesses covering a variety of topics. [*]We have eight more hearings around the country and what we're trying to do is have hearings in each judicial circuit in the U.S.

The testimony we have received has been very helpful to us. We are also accepting written submissions. This is important for the people who cannot get to the table to testify. We are accepting written submissions on any topic. They will be reviewed and considered by the Commission. *This year, we will be in Chicago, Atlanta, Austin, Texas and a variety of other places.

We are very grateful to our panel. We have two panels today. [*] The BAPCPA provisions provided for a maximum time period for the assumption or rejection of commercial leases. It's been controversial since its initial passage. Some have blamed the provision for the demise of both the designation rights market and retail reorganizations, with those two events being perhaps connected.

Others contend that the provisions [of BAPCPA] brought the need for certainty for landlords, preventing a contagion of failures within shopping centers and that the perceived decline in the retail restructurings is the product of externalities rather than any statutory change.

Years of practice under the Bankruptcy Code have exposed other ambiguities affecting commercial leases with courts split over the issue of so called “stub rent” and issues of the standard for measuring adequate assurance of future performance when a lease is assumed and assigned. We will examine those topics and more today.

No category of contracts has generated more controversy than licenses of intellectual property, including licenses of patents, copyrights and trademarks. The circuits have been split for years over whether a debtor in possession may assume such contracts, even when it will not attempt to assign the contract, leading to forum shopping around this issue. Recent decisions have also created a circuit split over the effect of a debtor licensor's rejection of a license on the rights of non-debtor licensees, both in areas covered by Section 363(n) and not expressly covered by that provision. A number of other ambiguities and issues abound in this crucial area for modern reorganizations that often center on such intangible assets. We will hear from witnesses on these critical and complex issues. Concern has been raised in prior hearings on the increasing costs of reorganizations and the impact of such costs on the continuing viability of Chapter 11 for small and middle market companies. We will also briefly revisit that topic today.

With that, by way of introduction, we turn to our first panel of witnesses. We will hear from all of the witnesses on the panel first and then ask the witnesses to take questions from the Commission before moving to the next panel.

I also need to mention that we are pressed for time. The speakers have the red, yellow green lights on the box. [*]Green, you're good for five minutes. Yellow, start wrapping it up and red, your time is up so that light goes on, and you have to quit.

Keach:We will come back to you with the questions so you'll have lots of chances to contribute.

Togut:You'll have plenty of time. You can do like the politicians do. When we ask the question, you answer whatever you want. Okay, so the first panel consists of Lawrence Gottlieb of Cooley L.L.P., Elizabeth Holland of Abbell Credit Corporation and David Pollack of Ballard Spahr. Have you decided among you who would like to lead off?

David Pollack:We'll start with Larry.

Togut:Okay, we'll start with Larry. You don't have to read your statement. We've got them and we’ve read them, so you can feel free to summarize.

Lawrence Gottlieb:My name is Larry Gottlieb and I've been practicing in the field since when the Bankruptcy Act still existed, so I don't know if I'm unique, but I'm there. I've been handling retail cases. I think most of you would agreeI've had more than my share of retail cases over the last three decades. I want to talk about [Section] 365(d)(4). In my view, that is the worst provision of all the bad provisions of the 2005 [BAPCPA] amendments.

Why is that? Well, first because of the 210 day limit and the little time that you have to market leases, assuming that you can't be assured that they’ll be assumed past the 210 days. As the value of leases has decreased markedly, there are no more meaningful designation rights and as a result, creditors do significantly worse in retail Chapter 11s than they did before.

In several instances, in the old days, that is prior to 2005, designation rights enabled unsecured creditors, who otherwise were being treated poorlyto say the least in these cases, to have a fund to litigate if necessary. Certainly in a case that we handled, Montgomery Ward, the debtor believed that there were no funds for unsecured creditors andthey could do whatever they want. As a result of designation rights, they were able to litigate against GE which otherwise would have been impossible. But most important, no retailers in my view, as best I can tellfrom my research,[*] have reorganized except for very few and in each one of those that did reorganize, they were very unusual circumstances that generally do not exist.

Why should be care about whether or not retailers can be organized? In my view, the most important reason is that retailers are the employers of last resort. Indeed, when Circuit City closed its doors one day, approximately 30,000 people lost their jobs.You tell me, what type of jobs those people were going to be able to find when they were let go by Circuit City.

The question really is why has it created such harm, this amendment? A little background, more than 30 years ago, under the old Act, retailers did not lien up their inventory. If they borrowed money, it wasn't an asset-based loan. For some reason, starting in the late 70s, early 80s, the banks convinced creditors, the unsecured vendors, that indeed they were okay, the inventory can be liened up and it still made sense for venders to extend credit and they agreed to. Now it would be hard for you to find any retailer who does not have its inventory liened to the hilt.

How do the lenders lend on this? They have an advance rate. The advance rate is generally a percent of the cost or retail value of the inventory based upon what the lender believes it can liquidate that inventory for in the going out of business sale. That's a going out of business sale in the stores, not removing the inventory or giving it to a jobber or trying to sell it on the street corner. They know what they need to recover and they know they need to recover that in the going out of business sale.

Now we have the 210 day limit. What does that mean? First, the going out of business sale takes 90-120 days, generally, to operate to conclusion. You need 30 days or something like that, in order to get the court to approve a going out of business sale, a liquidation of the debtor. That's 150 days or so, 180 days, leaving, if you subtract that from the 210 days, it leaves you 60-90 days at the most before you need to move into a liquidation sale.

The banks who are lending and they know one thing, or they think they know one thing, that as of the 210th day, perhaps the debtor rejects the leases. Perhaps the debtor doesnot assume the leases that are necessary. They know or they’re afraid that on the 210th day, they lose an outlet or outlets in which to liquidate their inventory.

What do they do? It's clear. In almost every single instance, in fact, every one of the cases I've had which is more than a couple, the lender comes in at the beginning of the case before it’s filed and agrees to a DIP loan. What does that DIP loan say? It says, "You have 30-60-90 days to sell your company or to sell the assets and if you cannot sell it within that amount of time, you're going to liquidate this company. "

The DIP loans can get clever. Sometimes they don't have those particular milestones, the milestone might be that after 60 days, we're going to reduce your advance rate by 10% and after 90 days, we're going to reduce it by 30%, all of which create a circumstance in which the debtor does not have the ability to continue in business. They know that. That's what they want and they decide that before the Chapter 11 is filed. Those people who suggest, “Well, once you file, you can go to the landlords and negotiate with the landlords, get a little bit more time and perhaps we can extend it.” It doesn't work. It's not practical and it hasn't happened. The point is, it hasn't happened.

The lender goes into the case, it's decided that it needs to be out in 210 days, one way or the other. No if, ands, or buts and the momentum is created, the milestones are there, the covenants are created. No one's talking to the landlords. You don't have time to talk to the landlords. The lenders don't care anymore. They’ve made up their mind that they are going to liquidate this company or dispose of the assets before the 210 days expires.

The landlords, however much the landlords might be willing to talk, and indeed, during the recession I suspect they would have liked to talk more often than they did to the debtor and to the lenders, the lenders aren't interested.

What do we have? We have as you can see in that chart is that almost every retailer's assets are liquidated in less than 210 days. The vendors for the unsecured creditors do poorly and if the company is sold, it's generally sold at a 363 sale.The 363 sale in my view is nothing more than liquidation. The creditors get liquidation value. As you can see from that, the creditors do poorly so they don't have designation rights to monetize leases and the liquidation value is all the money that's distributed to unsecured credit.

Togut:Larry, we'll come back to you. [*] Ms. Holland?

Elizabeth Holland:Thank you. Good afternoon Commissioners, fellow panelists, ladies and gentleman. My name is Elizabeth Holland and I appreciate the opportunity to testify today on behalf of the International Council of Shopping Centers on a number of issues that arise between shopping center owners and their retail tenants who have sought protection under the Bankruptcy Code.

I have sat on every side of this issue. As an attorney, I've represented retail debtors as well as retail landlords and financers of retail businesses. I was privileged to serve as a senior staff attorney for the National Bankruptcy Review Commission charged with making recommendations to Congress for amending the Bankruptcy Code.

For the last 15 years, I've been the C.E.O. of Abbell Associates, a 72-year-old commercial property owner, developer and manager of office and retail properties including enclosed mall and open-air shopping centers.

I have worked directly with all types of retailers, local, regional and national stores in good times and in bad times, stores that have successfully restructured outside of the bankruptcy process as well as within the bankruptcy process. I’ve also worked with stores large and small for whom bankruptcy was not a restructuring but rather an orderly liquidation of their business. As a result, I'm sympathetic to all of the constituencies interested in these issues.

The two issues I would like to discuss this afternoon are the time to assume or reject the non-residential real property lease and the treatment of stub rent payments following the filing of a Chapter 11 case. The BAPCPA 2005 amendments changing the time under Section 365(d)(4) from 60 days with four cause extensions, to a maximum of 210 days unless the applicable property owner consents to a longer extension, has been the focus of much attention, as Mr. Gottlieb very eloquently pointed out, in the wake of some very high profile retail liquidations, Borders Books, Circuit City, and Linens ‘n Things, just to name a few. I, more than anyone else in this room, would benefit in myriad ways if the only thing standing between a struggling retailer and a successful reorganization under the Bankruptcy Code was more time under Section 365 to assume or reject their store leases.

The fact of the matter is that the business of operating bricks and mortar stores has changed radically in the last 10 to 15 years. Internet retailing has shrunk margins as well as desirable store sizes, traditional inventory finance has changed in ways that's squeezed retailers and constrained operations and customers shopping patterns have shifted, changing the way people shop and how and what they buy. All of these forces and the speed with which new technology has brought them about made adaptation to the new reality a necessity for retail businesses to survive, let alone thrive.

In the face of these economic headwinds, some retail has been slow to adapt or unable to adapt or have simply found themselves in the buggy whip business. The dramatic downturn in the economy and the glacially slow emergence from that recession no doubt accelerated the demise of debtors like Circuit City, Hancock Fabrics, Movie Gallery and Linens ‘n Things.

Nothing in the bankruptcy code can make an unviable business model viable. The 2005 amendment to Section 365(d)(4) has done nothing more than to include retail property owners in the process of reorganization in a more meaningful way. In every one of the retail liquidation cases cited by the professionals on the other side of this issue, landlord support for extensions of time under Section 365(d)(4) was overwhelming.

The issue that has prevented each of these retailers from successfully reorganizing has been the lack of post-petition liquidity, due to onerous financing terms from DIP or exit lenders or loss of support from merchandise venders. It was the inability to finance these debtors as a going concern business following the bankruptcy, that has forced the liquidation of these businesses, not the inability to extend the time to assume or reject the lease.

The second issue I would like to address is the issue of stub rent, which is the rent that accrues between the filing date and the end of the calendar month when the filing took place and the treatment of it as a pre-petition amount due. Despite the fact that it is a pattern in practice in all retail setting to prorate everything down to the day of operations in a store premises, the Third Circuit in the Montgomery Ward case found that the date of billing determines when certain lease obligations must be paid. Timing the filing of the case to the first or second day of the month results in property owners losing rent and charges that accrue post-petition. In other words, during the stub period, before the next month's rent and charges are due.