Welcome to the 130th Pari Passu newsletter.

After back-to-back-to-back deep dives, this week we are going over Section 365.

Today’s retail landscape looks vastly different from even 10 years ago. Online retailers have experienced immense success, compounded by the COVID-19 pandemic, while traditional brick-and-mortar retailers have struggled to adapt. Because of this, we’ve seen a number of high-profile retailers, such as Party City, Forever 21, Joann Fabrics, and Rue21, restructure within the past couple of years.

One of the largest burdens for struggling retailers is the rent expense for leased store locations. While getting out of leases can be tough, Section 365 of the Bankruptcy Code provides debtors with the flexibility to manage their executory contracts and unexpired leases effectively. This write-up will dive into some important considerations under Section 365 and highlight its importance during retail bankruptcies, using the recent Express, Inc. Chapter 11 as an example of its significance. 

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Importance of Section 365 in Retail Bankruptcies

A common theme among recent retail bankruptcies, including those listed above,  is reduced storefront foot traffic due to consumers moving online. Facing declining revenues and large fixed rent payments, Chapter 11 bankruptcy provides a much-needed out for retailers. 

Section 365 allows retailers to reject leases for unprofitable locations while assuming or assigning leases for high-performing ones. To put some numbers to an example, imagine Retailer ABC operates 250 leased stores. Each store pays $400,000 in rent expense. Other operating expenses are 75% of revenue. Assume 50 stores are extremely poor performers, earning $400,000 in revenue annually. In contrast, the other 200 earn $2mm. Retailer ABC’s financial profile is reflected below.

After experiencing some vendor troubles and severe cash burn, Retailer ABC files for Chapter 11 bankruptcy protection. Under Section 365, the debtor chooses to reject the leases for the underperforming stores and close them.  On a per-store basis, the underperformers are losing $300,000 each year (-$15mm/50). For every underperforming lease that Retailer ABC rejects, it can increase net income by $300,000. Assuming they shutter all 50 underperformers, on a pro forma basis, annual revenue would be $400mm with net income of $20mm, saving the retailer $15mm per year. The rejections increased the net margin from 1% to 5%. While a very simplified example, this shows the impact of rejecting leases and optimizing store footprint on a retailer’s bottom line. Additionally, a sale of the business now becomes much more attractive to debtors, as we’ll see with Express. 

Executory Contracts

While not explicitly defined under section 365 of the bankruptcy code, an executory contract is an ongoing legal agreement where both parties still have obligations to fulfill. Courts often rely on the “Countryman” test to determine if a contract is executory. The Countryman definition outlines two conditions that make a contract executory. First, both parties still have obligations to perform. Second, failure to perform these obligations would result in a material breach – a contract violation that gives the non-breaching party the right to seek damages or contract termination. While some courts have been moving away from the Countryman definition, it remains a baseline test for determining whether or not a contract is executory [2]. 

Let’s test some examples under this definition:

A fast food franchisor enters franchise agreements with various fast food franchisees. Under the agreement, the franchisor provides its trademarks, systems, and support, while the franchisee pays a fee and must adhere to specific standards. Because both parties have ongoing obligations, this contract would be considered executory.

An educational institution enters a 3-year service agreement with an IT firm to provide ongoing tech support and cybersecurity services. In exchange, the company pays monthly fees to the IT firm. This service agreement would be considered an executory contract.

A retailer enters a supply contract with a widget manufacturer. Prior to filing, the manufacturer delivers the amount of widgets outlined under the agreement, but the retailer has yet to pay the manufacturer. This contract is not executory because the manufacturer has already fulfilled its obligations. Instead, the money owed to the manufacturer would likely be treated as an unsecured debt claim. 

A lender provides the debtor with a promissory note, where the debtor's only obligation is to repay principal and interest would not be considered an executory contract.

Many executory contracts are crucial to a business’s operations, and their treatment in bankruptcy is critical to ensuring the stability of the reorganized entity. 

Unexpired Leases

Unexpired leases are lease agreements for real or personal property that remain in effect at the filing date and are treated similarly to executory contracts under the Bankruptcy Code. To quickly define real vs. personal property, real property includes land and anything permanently attached to it, such as buildings, fixtures, etc. Personal property, such as vehicles and equipment, is movable and not connected to land. Some common examples of unexpired leases include retail leases of mall space, corporate office leases, and lease agreements for fleets of company vehicles. For companies that rely heavily on leased assets, such as retailers, rent payments for unexpired leases may be more burdensome than interest on debt, so restructuring lease obligations is just as important as treating debt. 

Treatment Under Section 365

Section 365 of the Bankruptcy Code outlines the treatment of executory contracts and unexpired leases. Importantly, it gives the debtors the power to assume, reject, or assign leases. Let’s summarize what each of these options entails under Section 365:

Assumption: The debtor commits to fulfilling the contract or keeping the lease post-bankruptcy. This is often seen with leases for favorable locations or agreements at favorable terms to the debtor, which they may not want to reject. In order to assume a contract or lease, the debtor must satisfy a couple of conditions. First, the debtor must cure any defaults, such as overdue payments, and cover any other associated damages. Additionally, the debtor must assure future performance, such as showing improved cash flows post-reorganization, at a rate sufficient to cover the lease obligations on a go-forward basis [1]. 

Rejection: The debtor terminates the agreement and is effectively treated as a pre-petition breach of contract. Under rejection, the debtor is free from future obligations, and the counterparty has an unsecured claim for damages. For leases, the debtor must surrender the leased property. Claims for damages from rejected leases are also subject to specific caps. Section 502(b)(6) limits lessors’ claims to the greater of one year’s rent or 15% of the remaining lease term, capped at three years [1]. For example, if the debtor rejects a lease with 6 years remaining and $10,000 monthly payments, damages would be capped at $120,000 (one year’s worth of expenses) despite total remaining payments of $720,000 (720,000 x 15% = 108,000, which is less than one year’s rent). For executory contracts, damages are often treated as an unsecured claim and typically receive poor recoveries. Rejection allows the debtor to exit unfavorable agreements while providing creditors with less-than-ideal recoveries. 

Assignment: The debtor transfers the agreement to a third party. For example, a retailer may transfer its valuable shopping mall lease to another retailer. To assign a contract or lease, the debtor must first assume it, meaning it must also provide a remedy for damages. Additionally, the assignee must provide assurance of future performance [1]. Assignment of leases and contracts can be a critical tool for raising funds for the estate. If the debtor assumes a favorable lease at a rate far below the market, it may assign it to a third party in exchange for a one-time fee. There are additional hoops to jump through for retailers that we’ll cover momentarily. 

Timing Under Section 365

Important timing considerations come into play for the treatment of leases and contracts. To start with the most simple, in a liquidation under Chapter 7, the debtor has 60 days to assume any agreements before they are automatically deemed as rejected [1]. Due to the nature of Chapter 7, this is rarely relevant as there is no ongoing business to preserve in a complete liquidation. 

Under Chapter 11, the debtor has a bit more freedom. In general, the debtor can assume or reject executory contracts and specific leases at any time before the plan is confirmed. However, contract counterparties have the right to request a deadline to avoid the uncertainty associated with prolonged Chapter 11 cases [1]. During the period between filing and the decision to assume or reject, the debtor is granted an automatic stay, meaning counterparties can not enforce rights such as eviction. Additionally, the debtor will use this time to analyze whether or not to actually reject the lease/contract. In the case above, the debtor would have used this period to analyze the profitability of various locations, determining the bottom-line effects of rejecting each lease. 

Unexpired leases for nonresidential real property are subject to tighter deadlines. Remember that real property is land and anything attached to it, so this clause often applies to retail and office space. Under Section 365(d)(4), the debtor has 120 days after filing before the lease is assumed as rejected. The debtor also has the option to extend this deadline by 90 days with court approval, bringing the total deadline to 210 days. After this point is reached, the debtor will need written consent from the lessors to extend the deadline [1]. This deadline typically gives the debtor enough time to evaluate which leases to assume while protecting creditors from indefinite delays. 

Unique Considerations

Section 365 also provides special protections to certain contract counterparties. Two of the most commonly seen protections deal with IP licenses and shopping center lease agreements. These protections aim to prevent the rejection of the lease/contract from harming the non-debtor counterparty.   

Intellectual Property Licenses: Section 365(n) outlines the treatment of license agreements for intellectual property and protects licensees by providing optionality. This section only applies when the debtor is the licensor, receiving royalties instead of paying them. If a debtor/licensor rejects the license agreement, the licensee will have the option to retain the IP, as long as it keeps paying royalties. While it may seem odd for the debtor to reject what is likely a profitable contract, considering it is simply licensing IP, there are situations where this makes sense for the debtor. 

Imagine a small software company licensing its proprietary platform to larger enterprises. Given the size difference between the companies, the software company takes on the large contractual burden of providing ongoing support for its enterprise customers, costing the company substantial amounts in labor costs. If the software company files and can no longer afford its enterprise-support IT staff, it has the option to reject these contracts. If the contracts are rejected, the enterprise customers may keep the platform, but the software company will no longer be required to deliver any software updates or support services. Section 365(n) provides debtors, often software companies, with an escape from burdensome support agreements, while providing customers with the option to retain the IP itself.  

Shopping Center Leases: Section 365(b)(3) outlines the special treatment of leases in a shopping center. First, for the debtor to assume or assign the lease, it must not disrupt the center's tenant mix. For example, replacing a fashion retailer’s space with a gym may violate exclusivity clauses of other leasing agreements in the shopping center. Additionally, the debtor or assignee must prove financial stability so that it does not erode the center's value as a whole [1]. No shopping center wants tenants who can’t drive customers to the location. These considerations become important in retail bankruptcies due to the number of leases retail companies often have in shopping centers. 

Express Case Study

The April 22, 2024 Chapter 11 of Express, Inc. provides a great example of the treatment of leases in bankruptcy while also highlighting the broad trend of retail bankruptcies. Unlike Party City or Joann Fabrics, Express will continue to operate as a going concern. Express’s treatment of leases played a significant role in its reorganization, as the company rejected leases of underperforming stores before pursuing a sale transaction. 

Express Overview

Express, Inc. was a fashion retailer that owned and managed the Express, Bonobos, and UpWest brands. Headquartered in Columbus, Ohio, the company was established in 1980 and went public in 2010. With 16,000 employees, Express utilizes an omnichannel platform that primarily caters to young professionals, providing both casual and business clothing. Historically, the company has generated over $2 billion in annual revenue and had a market cap of roughly $15bn in 2019. As of February 2024, Express operated 589 brick-and-mortar locations, all of which were leased under long-term agreements [3]. Revenue per store was roughly $3.4mm, while market cap per store was $25.5mm.

Topline Pressure & Burdensome Rent Expenses

Over the past decade, Express has faced intense and increasing competition from other retailers and online fast-fashion platforms. This pressure dampened growth and slightly decreased revenue from a peak of $2.35bn in 2015 to $2bn in 2019. With a cost structure that was primarily fixed, consisting of long-term bulk supply and lease agreements, Express’s declining revenue caused normalized operating income to swing from $208mm in 2015 to -$13mm in 2019. Intuitively, COGS expense for retailers is variable, as it represents the cost of products to sell. However, when revenue declines, retailers’ COGS don’t decline proportionately. For one, Retailers like Express purchase inventory in large volumes through long-term contracts, and it is challenging to predict sales declines ahead of time, especially those resulting from a global pandemic. Additionally, unsold inventory is written down, resulting in additional expenses reported during a sales decline. Lastly, if retailers do end up purchasing less inventory, they may end up missing out on bulk discounts. 

Additionally, Express spent over $350mm in capital expenditures during that same period, leaving cash flow negative in 4 out of the 5 years. This competitive pressure did not position Express well for what would follow with the COVID-19 Pandemic. The pandemic hit Express hard, nearly halving revenue to $1.2bn in 2020. Despite Express’s declining revenue, the company continued to operate over 500 stores nationwide, all of which were leased. While some percentage of store rent was contingent on location sales, this amount was minimal, and most store rent was based on a fixed minimum payment. Express had to manage $200mm+ of annual rent payments, which severely drained the company’s liquidity[3].

Liquidity Preservation and WHP Transaction

Prior to COVID-19, Express had little debt in its capital structure. However, the massive cash burn during the pandemic forced the company to draw down its revolver and issue a term loan facility in an aggregate amount of $190mm. This allowed Express to regain its footing and ride out the pandemic. Despite consumer returns to brick-and-mortar stores after the pandemic fizzled out, Express’s revenue would never fully recover to pre-COVID numbers.

By 2022, Express was once again in need of additional cash. In December of 2022, Express entered into a strategic partnership with WHP Global, a consumer brand management and licensing firm [5]. Express and WHP formed a joint venture called EXP Topco, LLC, into which Express (1) transferred $400mm worth of brand intellectual property. Express would (2) receive a 40% stake while WHP owned 60% of the new entity. In exchange for WHP’s stake, the firm (3) contributed $235mm of equity to the joint venture. Express, Inc. would also have to pay annual royalties of 8% of net sales, with a minimum guaranteed payment of (4) $60mm, increasing by $1mm per year, to Express Topco (the joint venture). WHP (5) purchased newly issued EXPR shares through a PIPE offering for $25mm [4]. The $260mm ($235 Topco contribution + $25mm common equity contribution) raised through this transaction again provided much-needed liquidity to the struggling retailer, which burned $157mm in cash from operations that year [3]. Lastly, in exchange for the royalty payments, Express would license back (6) the IP it contributed to the joint venture. One note highlighted in the petition-date org chart below is that EXP Topco, LLC would be a bankruptcy-protected, non-debtor entity. This transaction was essentially a sale-leaseback of Express’s brand IP, allowing the company to raise capital while committing to future royalty payments on the IP, which it was now licensing from the joint venture. 

Lender Troubles

Despite Express’s efforts to manage liquidity and effectuate a turnaround, the company struggled amidst increasing competition. Post-COVID revenue remained stagnant, and inventory costs increased from supply chain disruptions. Additionally, in an effort to drive in-store traffic, Express began offering significant discounts, further eating into its margins. In September 2023, the company was once again in need of liquidity and issued a $65mm ABL second lien FILO term loan. The term FILO, meaning “first in last out”, meant that the FILO loan was secured on the same assets as Express’s revolving credit facility but may only be paid out after the RCF receives a full recovery [4]. 

In early 2024, the FILO creditors noticed Express’s deteriorating financial position and decided to act. The FILO lenders imposed a borrowing base reserve of $20mm, lowering the company’s borrowing capacity and restricting liquidity. A borrowing base reserve reduces the availability of funds under an ABL agreement. Express’s Lenders may impose reserves if they deem that a business’s poor performance threatens recovery on their collateral. Because of this, the company did not have enough liquidity to meet the availability requirements under the ABL credit agreements. Express also received an inventory appraisal, reducing its value and the borrowing base's value (the borrowing base consisted of accounts receivable, inventory, and cash collateral). This series of events triggered a cash dominion period, meaning all cash Express generated would now be swept straight to the ABL creditors [4]. 

Express reported a cash balance of $36mm on February 3, 2024 [3]. While the cash dominion trigger date wasn’t explicitly outlined, we can infer that it occurred in February/March 2024. Cash dominion means that starting on a specific trigger date, Express’s ABL creditors collected all cash that Express brought in via sales.  The company could no longer generate cash or borrow new funds. Express was burning roughly $20mm of cash per month and could not support its monthly rent expense of $20mm. Even if the company were to defer its rent payments, it would run out of cash in April. Consequently, Express filed for Chapter 11 bankruptcy on April 22, 2024, in the District of Delaware. In the end, it was the FILO creditors aiming to protect their returns who put Express out of business.

Chapter 11 Bankruptcy

Express’s capital structure at the time of filing is detailed below. Remember that the Prepetition ABL Credit Agreement was senior-secured on all assets of Express and its guarantors (excluding the IP it transferred to the WHP joint venture). The Prepetition FILO Credit Agreement was secured on the same assets but subordinated to the ABL Agreement. 

The debtor’s plan of reorganization included the following:

1. $214mm of DIP financing 

2. The rejection of leases for underperforming stores

3. A sale process for Express

To start with the DIP financing, on April 24, to secure necessary liquidity for Express’s operations, the company secured $214mm of debtor-in-possession financing. The DIP consisted of $25mm of new money and the roll-up of the entirety of its $189mm of prepetition debt. All prepetition obligations now had a super-priority claim and would be repaid in full in Express’s restructuring [4]. 

The debtors also immediately started a sale process for Express and received a bid from Phoenix JV, an affiliate of WHP. The initial non-binding bid was $10mm plus 100% of the liquidation value of the acquired merchandise plus any applicable liabilities (because all of Express’s locations were leased and its IP was already licensed, the company’s only real asset value came from its merchandise on hand). The bid also outlined the assumption of leases for at least 280 stores and the rejection of all – roughly 270 – other leases. After contacting 23 potential buyers, the debtors took the bid from Phoenix (which made sense, considering WHP already owned Express’s brand IP). Ultimately, the buyers paid $134mm in cash and assumed $38mm in liabilities [4]. All prepetition debt, which was previously rolled up into DIP, was paid in full with the proceeds. Additionally, general unsecured claims, consisting of rejection damages, received 10-15% [4]. Remember that rejection damages are limited to the greater of one year’s rent or 15% of the remaining lease term, capped at three years. The debtors projected $212mm of total general unsecured claims, which closely aligns with the annual rent expense Express reported up to filing. With a 10-15% estimated recovery, unsecured creditors recovered between $21mm and $32mm.

One of the most significant parts of Express’s restructuring was the assumption and rejection of leases. Remember that under Section 356(d)(4), Express, which had handled a $200mm+ rent expense for over a decade, had 120 days to analyze its store footprint and determine which leases to reject and which to assume in the event of a sale. Express ended up rejecting the leases of 101 stores, saving roughly $50mm in rent expenses per year, and Phoenix decided to keep more leases than it initially bid for, assuming the remaining 450+ stores [4]. 

Key Takeaways

Section 365 is a pivotal tool in retail bankruptcies. It provides debtors with the flexibility to optimize their store footprint by rejecting, assuming, or assigning executory contracts and unexpired leases. This flexibility is crucial for retailers facing declining revenues and burdensome rent obligations, which is becoming increasingly common. In Chapter 11, Section 365 can be the difference between fully liquidating or continuing to operate as a going concern.

Express’s cash serves as a great example of Section 365’s impact. The company faced enormous rent expenses with a substantial amount of underperforming stores, straining its liquidity amidst declining revenue. By rejecting the leases for over 100 underperforming locations, the company was able to market a more attractive asset group during the sale process. Not only did this move preserve value for creditors, but it very well could have been the difference between Express’s shutdown or successful reorganization. In the end, Express, now owned by Phoenix JV (WHP), was able to preserve over 7,500 jobs, keep 450 stores open, and continue to serve customers. 

[1][2][3][4][5]

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