When Chapter 11 Is the End of the Story

The 2005 rules are squeezing out bankrupt chains, which face harsher time constraints than in the past

When Sharper Image filed for bankruptcy back in February, new Chief Executive Officer Robert Conway decided to close half of the chain's 184 stores and craft a turnaround plan. But critical court deadlines loomed, and Conway, a restructuring specialist, gave up hope a few weeks later. In July the company shuttered the last location. Says Conway: "Not only do lenders have limited patience, but there are many additional pressures."

It would be difficult enough if retailers were just getting hit by the double whammy of weak consumer spending and tight credit. But new bankruptcy rules passed in 2005 are proving fatal for some. In Chapter 11, companies continue to operate while getting relief from creditors. The recent changes, though, require that businesses move more quickly on key decisions and find cash up front to pay off certain debts.

Facing those hurdles, retailers such as Sharper Image, Wickes Furniture, Bombay, Levitz Furniture, Friedman's, and Whitehall Jewelers have rapidly dissolved, going from broke to out of business in a matter of months. In previous downturns, it took years to reach that dramatic end—and most companies actually emerged from bankruptcy. The worry is that more retailers will disappear. Roughly 15 have filed for Chapter 11 so far this year, more than double the number in all of 2007, according to research firm bankruptcy.com.

Although the new rules apply to all companies, retailers are feeling the changes acutely. Before 2005, businesses had an unlimited amount of time to file a restructuring plan. Now they have 18 months to do so. After that, creditors and other interested parties can offer up their own ideas to the court. In a concession to mall owners and landlords, the new laws also force retailers to decide within 210 days whether to keep a location open. Under the old procedure, courts would grant extensions of two years or more. "Lenders are not willing to refinance a shopping center if a major tenant hasn't decided whether to stay," says J. David Forsyth, a partner at Sessions, Fishman, Nathan & Israel.

But time can be crucial. Retailers often need to monitor sales trends for at least a year, including the highly profitable holiday shopping season, before getting a complete picture of their prospects. Macy's (M), which filed for Chapter 11 in the early 1990s, took two years to hash out a plan and three years to climb out of its financial hole. "In stress situations, you have to analyze by circumstances and not make deals under a formula," says Harvey R. Miller, a partner at firm Weil, Gotshal & Manges, who is working with Goody's Family Clothing, the 355-store chain that filed for Chapter 11 on July 9.

Bankrupt companies also have to come up with cash to pay suppliers and utilities. Under the old laws, the two groups had to wait until a company emerged from bankruptcy before collecting. Those demands can be particularly burdensome on retailers, which may have bills from dozens of vendors and multiple water, gas, and electric companies. Steve & Barry's, the bankrupt apparel store that was acquired by a private equity firm on Aug. 22, manages operations across 39 states. Says Lawrence C. Gottlieb, a partner at Cooley Godward Kronish, which is representing creditors of the bankrupt Linens 'N Things: "Liquidity is sucked out of the debtor in a way that becomes hard to survive."

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