Stephen B. Selbst, Partner, Herrick, Feinstein LLP
Stephen B. Selbst, Partner, Herrick, Feinstein LLP
Few investors or lenders in the retail industry could have been surprised when RadioShack sought Chapter 11 protection in February 2015. Like a fading Hollywood star resorting to plastic surgery to hold off the ravages of time, RadioShack’s many efforts to reinvent itself from 2000 to 2015 had failed. None of its makeovers were successful, and some were so abruptly abandoned that their results couldn’t even be properly evaluated. The Chapter 11 case was nasty and litigious; it imposed deep losses on RadioShack’s trade and other unsecured creditors, which are likely facing recoveries of just pennies on the dollar.

The troubles that beset RadioShack and led to its Chapter 11 filing reflect the dramatic changes in retailing over the past 15 years. The Internet truly has been disruptive, particularly for merchants who sell commodity goods, but many of RadioShack’s problems were self-inflicted. It operated too many small, unprofitable stores, and its dizzying changes in focus confused its customer base. Finally, it recognized the importance of e-commerce far too late.

Although battered and much reduced in size, RadioShack survived its trip through Chapter 11 after being acquired by Standard General, a hedge fund that was its largest pre-petition lender. The new RadioShack operates approximately 1,700 stores, down more than 75% from its pre-bankruptcy high of 7,500. The majority of the surviving stores will be co-branded with Sprint cell phones and accessories and will continue RadioShack’s focus on that sector. But the fact that RadioShack survived at all is proof of the brand’s continued strength. Many other well-known retailers — Circuit City, Borders, Filene’s Basement and Linens’n’Things — were all liquidated in Chapter 11, victims of changing consumer tastes and the harsh realities of bankruptcy. Whether the new RadioShack template will be successful — or just the most recent attempt to revive a once-thriving retail mainstay — remains to be seen. Thus, RadioShack’s Chapter 11 experience has lessons for lenders and investors about the difficulties of restructuring retailers in the 21st century.

RadioShack’s History

RadioShack was founded in Boston in 1921 by brothers Theodore and Milton Deutschman, who serviced the growing ham radio industry. “RadioShack” referred to a wooden cabinet that was used to protect and store a commercial ship’s radio equipment. Over the years, RadioShack built its business by supplying original and replacement parts for radios and other electrical devices; its target audience was hobbyists. By 1960, although it operated nine stores and a mail-order business, RadioShack was destitute, and it was acquired in 1963 by Tandy Corporation for a mere $300,000.

Tandy closed unprofitable stores, shuttered the mail-order business and reduced the number of items sold from 40,000 to 2,500. Tandy also made another management decision with long-term repercussions: it pursued a strategy of opening many small, leased stores. The idea was that the stores would be close to customers, and if a location didn’t work out, it could be quickly closed. From an existing nine stores when Tandy acquired RadioShack, the chain steadily grew until it operated 7,000 company-owned stores and 1,000 franchise locations at its high-water mark. At its peak, RadioShack claimed that more than 90% of its customers lived within five minutes of the nearest store.

During the 1970s, RadioShack began expanding internationally, opening in the UK, Australia, Mexico, Canada and other markets. In its heyday, RadioShack was an innovator, selling its first electronic calculator in 1972, the first mass-marketed personal computer in 1977, its first laptop computer in 1983 and the first mobile phone in 1984. It also sold house-brand computers under the TRS brand and Realistic brand audio equipment. But in recent years, RadioShack lost its position as an industry innovator. It failed to recognize the threat from online retailers such as Amazon, and its own website was slow to take off. In the late 1990s, customers could not even buy products online. Instead, the website provided store locators and directed customers to make purchases at brick-and-mortar stores. This never improved. Despite numerous makeovers, RadioShack’s e-commerce sales actually declined from $65.1 million in 2003 to $51 million in 2012.

Diversification: A History of Failure

During the 1960s, RadioShack targeted electronics hobbyists. The stores were small, but carried a large assortment of small parts and accessories that were indispensable to its customer base of tinkerers and do-it-your-selfers, such as cables, clips, batteries, antennas and fuses. The stores had knowledgeable salespeople. If the store didn’t stock the item the customer was looking for, staff might suggest a workaround. When all else failed, the product could be ordered from RadioShack’s enormous catalog. RadioShack manufactured many of the items it sold, generating healthy mark-ups and consistent profitability.

In the 1970s, CB radios boomed in popularity, creating the first monster product hit for RadioShack. At one point, CB radios and accessories represented 30% of its sales. When the boom subsided, RadioShack required a new product to replace lost sales volume. Fortunately, the decline in the CB market coincided with the rise of the personal computer. In 1977, RadioShack introduced the first consumer personal computer, the TRS-80. True to its roots, the TRS-80 was manufactured by RadioShack. The first TRS-80 was primitive: it had a 12-inch square monitor, its display was limited to black and white, and there was very little software and no hard drive. Its operating system was designed by an unknown start-up called Microsoft.

Selling the TRS-80 was a gamble for RadioShack. There was no existing market for personal computers, and its $600 price point was higher than any product RadioShack had ever sold. Recognizing the risk, RadioShack’s first production run was just 1,000 units. To its delight, the product was hugely successful, selling as fast as RadioShack could build them. Between 1977 and 1979, RadioShack sold more than 100,000 TRS-80 units. As a sideline, RadioShack started manufacturing OEM hardware for other computer companies, including AST, Digital Equipment and Apple. RadioShack continued to update its line of computer products through the 1980s and 1990s, but as the world moved to adopt the IBM PC as the standard, RadioShack products were increasingly viewed as technologically inferior. Sales dwindled. By the early 1990s, RadioShack’s personal computer business had run out of gas. The company sold its manufacturing business and stopped selling the TRS line.

During the same period, RadioShack saw growth in the consumer electronics market and experimented with a number of formats to try to capture that business. Instead of concentrating on its RadioShack brand and expanding offerings, it created specialty stores: Computer City (computers), Energy Express Plus (batteries), Famous Brand Electronics (refurbished electronics), Macduff and Video Concepts (audio and video) and the Incredible Universe (a Best Buy alternative). None was successful, and all were either closed or sold off by the late 1990s, generating huge losses.

As the personal computer and big-box retail businesses faded, RadioShack benefitted from the next boom product: the cell phone. Selling a technology-based product was a natural fit for RadioShack, and in those days many customers needed sales help to use the phones. At a time before the major cell phone carriers had established their own retail outlets, RadioShack’s broad store base was well positioned for making sales. The original deals that RadioShack had with cell carriers were lucrative. In addition to a per-customer sales fee, RadioShack received a percentage of the monthly fee that each customer paid. As the cell phone market grew, RadioShack increasingly concentrated on selling cell phones, service plans and accessories. The strategy worked for a long time: cell-related sales grew steadily until 2011, when they represented 51% of RadioShack’s $4.4 billion in sales.

Once again, changes in the cell phone market eroded RadioShack’s sales and profitability. As the industry grew, carriers became less dependent on RadioShack and its retail network. Many opened their own dedicated stores and retooled their agreements with RadioShack, cutting its fees and commissions. Finally, around 2010, as smart phones became more of a commodity product, their profitability declined. This time, RadioShack didn’t have the next hot product as a backup.

There were other problems with RadioShack’s dependence on cell phone sales. Selling cell phones and signing customers to service plans was a lengthy process, which tied up store staff and led to customer frustration. And, as more of the store inventory became dedicated to cell phones and accessories, the stores stopped carrying its legacy products — the wide assortment of consumer electronics parts — further alienating the customer base. Ironically, the shift in inventory mix also led RadioShack to miss the renewed trend toward do-it-yourself electronics. And RadioShack’s sales staff, which had been trained to sell cell phones, didn’t have the knowledge about the remaining electronics component inventory to help the DIYers who did come to the stores.

From 2000 to 2015, RadioShack continued to confuse its customers and employees with constant changes in marketing focus and management. The various schemes trotted out failed to stop the reverses, and included such forgettable efforts as branding the chain as “The Shack.” The tags lines, “You’ve got questions, we’ve got answers” and “Radio Shack: Let’s Play,” also failed to resonate and contributed to customer confusion.

The chain also suffered from a high level of management turnover. Between 2006 and January 2016, RadioShack had six different CEOs, including David Edmondson, who resigned in 2006 after admitting his college degrees were fake.

Financial Decline

The constant efforts to reorient the merchandising paralleled RadioShack’s financial decline. In 1998, RadioShack reached its peak, calling itself the largest consumer electronics and communications retailer in the world. Its financial decline began shortly after, accelerating in 2010, when it had a net income of approximately $200 million on sales of $4.2 billion. By 2013, RadioShack had losses of $344 million on sales of just $3.4 billion, and in the first nine months of 2014, it lost an additional $216 million, while overall sales slid by 16%. Its overall losses in the four years prior to Chapter 11 were nearly $1 billion.

As its finances declined, RadioShack incurred substantial debt to try to boost liquidity. In 2011, RadioShack issued $325 million in high-yield bonds. In 2013 it entered into a $585 million revolving and term loan facility with GE Capital. In 2014, GE Capital sold its loans to a hedge fund known as Standard General. In connection with that transaction, RadioShack’s revolving facility was reduced to $140 million. During the five years prior to Chapter 11, RadioShack’s debt as a percentage of its capitalization ballooned from 33% to 78%. When it entered into the Standard General facility, RadioShack also borrowed a $250 million term loan from Cerberus and Salus Capital Partners. But the Salus loan contained a covenant that came back to haunt RadioShack: it prohibited more than 200 store closings per year without Salus’ consent. When it filed for Chapter 11, RadioShack had approximately $830 million in outstanding long-term debt, and it owed vendors an additional $125 million for merchandise.

Chapter 11 Filing

By 2014, RadioShack was struggling. Because it was a public company, RadioShack was required to file periodic reports with the Securities and Exchange Commission, thus revealing the extent of its deepening financial distress. As a result of its gloomy financial disclosures, the companies’ vendors began to reduce the amount of trade credit available. Covenants in the Salus term loan facility blocked RadioShack from implementing all of its planned 1,000 store closings in 2014. Salus objected because it feared that many store closings would erode the collateral base backing its loan. The combination of reduced vendor credit and liquidity and declining sales led RadioShack to file for Chapter 11 on February 5, 2015.

As part of its Chapter 11 filing, RadioShack immediately obtained bankruptcy court approval to close approximately 2,100 stores and conduct going-out-of business sales at those locations. Those store closings opened the door to RadioShack’s restructuring. RadioShack sought bankruptcy court approval to market and sell the balance of its business in a section 363 sale process.

In electing that course, RadioShack was following the recent trend to use Chapter 11 to sell a debtor’s business, in whole or in part, through such sales. In a section 363 sale, the debtor typically has an initial bidder who establishes the first bid, called a “stalking horse.” The bankruptcy court then sets rules for the debtor to market its business in bankruptcy to determine whether a better offer can be located. The sales process is typically conducted by the debtor’s investment bankers.

In RadioShack’s case, the stalking horse was General Wireless, an affiliate of Standard General. The auction began on March 23, 2015 and lasted four days. At its conclusion, five separate bidders were declared winners for various groups of RadioShack’s assets, but General Wireless was the buyer. General Wireless agreed to buy 1,700 store locations and the inventory and fixtures at those sites. The initial purchase by General Wireless, which included cash and a credit bid of a portion of its debt claims, was valued at approximately $150 million. The bankruptcy court approved the General Wireless deal, and the transaction closed in early April 2015.

RadioShack also sold its Mexican, Latin American and Middle Eastern businesses, and its legacy antenna business for approximately $40 million. RadioShack used the Chapter 11 process to sell off unwanted store leases. In three separate sales, RadioShack sold 219 leases for approximately $3.3 million. The fact that RadioShack was only able to sell 219 of the approximately 2,200 leases from stores marked for closing demonstrates that the majority of its locations were unappealing.

The auction in which General Wireless acquired the bulk of RadioShack’s operating business did not include RadioShack’s trademarks, patents and other intellectual property due to creditor disputes as to who owned those rights. The auction of those rights was delayed until May 2015, when General Wireless also acquired those assets for approximately $26.2 million. In all, the total value of the cash and credit bids for RadioShack’s assets was approximately $220 million. While that figure is certainly not insignificant, it contrasts sharply with the pre-bankruptcy values. In its last 10-Q filing with the SEC in December 2014, RadioShack reported assets of $1.2 billion.

Gift Card Litigation

One of the controversies in the RadioShack case was the treatment of unredeemed gift cards. When the Chapter 11 case began, RadioShack estimated that it had approximately $46 million in unredeemed cards outstanding. Legally, the cards represented unsecured claims, meaning that the holders of those cards had a right to goods (or cash back) in the amount of the balance of the cards. In June 2015, the Attorney General of the State of Texas began litigation to improve the position of the gift card holders. The Attorney General contended that gift card holders should be paid ahead of general unsecured creditors, such as vendors and landlords. The states of Virginia and Florida filed similar claims, as did a purported class action claimant. RadioShack responded by moving to dismiss the various gift card claims, but when the bankruptcy court denied the motions, RadioShack negotiated a settlement under which most holders were paid their card balances in cash or retained the right to continue to use the gift cards at RadioShack stores that continued to operate.

The victory was clearly important for the affected consumers, but should also stand as a cautionary note for lenders to retail businesses. It clearly shows how the gift card holders’ are viewed relative to their rights as creditors. Certainly no other RadioShack creditor group was paid in full in cash. In assessing future Chapter 11 cases involving retailers, lenders should consider whether a borrower’s cash in Chapter 11 will be required to be used to pay such claimants.

Standard General Litigation

In August 2015, the unsecured creditors committee, which represented RadioShack’s vendors, landlords and the holders of its $325 million of unsecured bonds, sued Standard General, former CEO Joseph Magnacca and lender, Wells Fargo. According to the lawsuit, RadioShack could have sold its assets and liquidated in early 2014, which would have yielded a payout to unsecured creditors of approximately 20 cents on the dollar. But Standard General was a shareholder at that time and would have been wiped out. To prevent that, the action alleged, Standard General acquired the GE Capital loan, thus moving to the most senior position in the capital structure. But the resulting delay and continuing loss in the value of the business wiped out any chance for unsecured creditors to receive a distribution in the Chapter 11 case. The lawsuit also alleged breach of fiduciary duty claims against the officers, directors and Magnacca, and claimed that certain payments of fees and interests to the Wells Fargo lender group were fraudulent conveyances.

When the creditors committee brought that lawsuit, the defendants not only denied liability, they also made demands for indemnity under the loan agreement. The defendants argued that even if they were liable (which they denied), they were nonetheless entitled to indemnification for their legal fees and expenses, which they estimated could run from $10 million to $20 million. Their claim for indemnification thus imperiled the potential confirmation of RadioShack’s reorganization plan.

The claim was settled in September 2015. Under the settlement, the defendants agreed to pay $9.4 million in cash to the unsecured creditors, to drop their claim for indemnification and, in the case of Standard General, to forego a recovery on the $30 million of RadioShack bonds that it held.
Chapter 11 Plan

RadioShack confirmed a liquidating plan of reorganization on September 30, 2015. Under the plan, Salus’ remaining claims of $70 million were estimated to receive 80 to 90 cents on the dollar, the balance of the Salus claims having previously been paid from asset sale proceeds. Holders of RadioShack’s bonds, an estimated $330 million, and the holders of its unsecured claims, estimated at $200 million to $400 million, were only entitled to receive the proceeds of litigation claims, such as the Standard General litigation previously discussed. If there were no other recoveries in addition to the Standard General settlement, unsecured creditor recoveries would be in the range of one to two cents on the dollar.

Radio Shack’s Survival Bucks the Trend

Changes in the federal Bankruptcy Code, as well as changing trends in bankruptcy practice, have made it extremely difficult for retailers to reorganize, which makes RadioShack’s emergence from Chapter 11, given the depth of its business problems, surprising. According to a recent study by turnaround and restructuring firm AlixPartners, 55% of all U.S. retailers that have filed for bankruptcy over the past 10 years have ended up in liquidation. By comparison, fewer than 5% of non-retail filings over that period have liquidated. And although RadioShack did not emerge as a stand-alone company, its continuation under new ownership is still a departure from the prevailing trend in retail bankruptcy cases.

The 2005 amendments to the Bankruptcy Code made it significantly more difficult for retail businesses to reorganize in Chapter 11. Debtors now have just 210 days in which to decide to assume or reject store leases. Previously, the bankruptcy court had discretion to determine how much time to give debtors to make that determination. In practice, most debtors were at least given one Christmas decision before being required to decide. In the early 1990s, Macy’s spent nearly two years in bankruptcy, evaluating its store mix throughout that period. More recently, Winn-Dixie exited bankruptcy in 2006 after 18 months.

Even the 210-day period is misleading. Because it can take 90 days to hold a going-out-of-business sale, senior lenders often attempt to decide whether they should liquidate or reorganize a debtor in as few as 120 days. Mall landlords led the fight for this change because they were unhappy seeing retail debtors take a year or more to decide whether to assume or reject store leases. When the law was changed in 2005, retailing was still strong, and many mall landlords openly stated that they expected to use the new provisions to recapture low-rent leases and re-lease them at higher rents.

Another change to Bankruptcy Code was the enactment of Section 503(b)(9), which provides priority status to vendors’ claims for the value of goods sold in the 20 days preceding a bankruptcy. Because those claims must be paid in cash, many retailers fail simply because the owners don’t have or cannot borrow enough cash to satisfy those claims.

Other factors have also changed retail bankruptcies. The emergence of a very robust market of inventory liquidators has emerged during the past three years, so firms are competing to run retailers’ going-out-of-business sales and are offering strong bids for retailers’ inventories, sharply reducing the risk of liquidations.

Finally, with knowledge of these changes, debtor-in-possession lenders to retailers have toughened their terms, often giving retail debtors DIP credit loans of 120 to 210 days. That gives a retail debtor little time to evaluate alternatives to liquidation unless it enters Chapter 11 with a strong reorganization business plan in place.

Retail debtors now often have 120 to 150 days to revamp their business, find a buyer, close underperforming stores and convince creditors to take less than full payment. That’s not enough time, the American Bankruptcy Institute has concluded. The ABI has called on Congress to extend the lease-rejection deadline to a full year, though the proposal has yet to be taken up.

RadioShack’s Future

Retail experts are divided on whether the RadioShack that emerged from Chapter 11 can survive. On the positive side, they point to the chain’s long history and its broad customer base as strengths. They also say that many of the surviving stores appear to be solidly profitable. But an equal number are skeptical, given the company’s many missteps in recent years, arguing that RadioShack is still too dependent on cell phone sales and has lost its connection to its customer base. The critics say that — apart from the balance sheet — nothing has changed, and RadioShack’s business is no better than it was before bankruptcy. But whichever side is correct, one conclusion is beyond dispute: the RadioShack case offers a virtual check-list of steps to avoid in seeking to turn around a troubled retailer.