Slo-Mo: Bankruptcy Court Suspends Modell’s Case

A recent decision by the Bankruptcy Court for the District of New Jersey, In re Modell’s Sporting Goods, Inc., illustrates the difficult problems caused by the COVID-19 pandemic, the ways that parties to a bankruptcy case may react and issues distressed companies, their creditors and stakeholders should consider in the current climate before a bankruptcy petition is filed.

The Modell’s Case

Modell’s, a seller of sporting goods, filed a chapter 11 petition on March 11, 2020. The debtors’ intention was to conduct going-out-of-business sales at its 134 locations followed by a sale of its valuable leases. However, the declarations of a state of emergency following the spread of COVID-19 interfered with the debtors’ plans, and ultimately led to the forced closing of most of its stores before the sales could be completed.

The debtors and their lenders were faced with unpalatable alternatives. An immediate liquidation, with the merchandise unsalable and the leases unusable, would have resulted in losses substantially more severe than initially contemplated. However, simply deferring the liquidation until the unknown time when the COVID-19 emergency abates would saddle the debtors and their lenders with operational and rental expense without income.

The debtors chose to close all operations (including online sales) and let go all store-level and distribution-level employees (without severance). They filed a motion seeking relief under Bankruptcy Code Section 305(a), which authorizes a court to suspend all proceedings if “the interests of creditors and the debtor would be better served by such … suspension.” The debtors intended to pay only their remaining employees (management and professionals), utilities, insurance and trust fund taxes in the hope that they could “reoperationalize” at a later date. Landlords objected, insisting that rent be included as essential obligations.

The Judge’s Order

Judge Papalia granted the requested relief. The order’s provisions include (i) there will be a suspension of proceedings through at least April 30, 2020, subject to further extension at an April 30, 2020 hearing; (ii) “essential expenses” will continue to be paid during the suspension; (iii) all other obligations, including rent obligations, will be deferred through April 30, 2020, and “all parties reserve all rights to argue that obligations allegedly accrued during the [suspension] are or are not waived, abated, or otherwise not subject to payment”; (iv) there will be a suspension of deadlines through April 30, 2020 (or a subsequent extended date), and when the suspension expires “the Debtors shall coordinate with the Court, the [United States Trustee], the Debtors’ pre-petition lenders, and the Committee to set appropriate hearing dates and objection deadlines”; and (v) parties are permitted to come back to court for “exigent and unforeseen circumstances” but only if discussions with the debtors, the lenders and the official committee have been unfruitful.

Implications

The problems faced in Modell’s are scarcely unique to a single case. The devastating economic effects of the virus and social separation can be expected to stress the capacities and ingenuity of the bankruptcy courts and professionals. Among the issues shown here are:

• Who will bear the losses while the parties wait for the economy to be restarted? A suspension of bankruptcy proceedings does not suspend the time that passes nor the costs that the passage of time entails.
• It is critical that parties in interest be represented early in a case. The Modell’s landlords were organized and able to timely object to the proposed relief. As a result the initial period of the extension was less than the debtors’ opening request, and the deferral of rent is within the permitted period of extension under Code section 365(d)(3). The Modell’s employees were not represented, and will be out of work, without severance pay, until Modell’s is ready to rehire them.
• How will judges be managing their dockets? The bankruptcy courts remain open, but with judges, clerks and professionals operating remotely the courts cannot be expected to function at anywhere near their old capacity. Parties to a case need to factor into their expectations that judicial relief will likely take longer to obtain, and that judges will have less tolerance for what they consider to be petty wrangling.
• How will the deadlines and schedules built into the Bankruptcy Code be affected? The assumption underlying many of these deadlines is that it is generally beneficial for cases to be moved along relatively quickly. That assumption may have to be revisited in a world in which economic activity is being paused for an indeterminate period of time.
• How will parties be modifying their behavior and strategies? It is expected that negotiations among distressed companies, their creditors and other parties in interest will prioritize out-of-court resolutions, because the costs, delays and risks of bankruptcy will only be exacerbated during the current crisis. However, where an out-of-court resolution is unfeasible or cannot be agreed to it is likely that in many cases debtors will be aggressively seeking stays like in Modell’s.

While the suspension of a case is a drastic remedy, it is one that may be increasingly common in the short term. Parties with exposure to a distressed company should be aware that they may not be able to rely on the ordinary protection of rights in a bankruptcy case and should be prepared to act earlier.