It is legend in American retail restructuring. In 1974, Interstate Sales files for Chapter 11, and its money center commercial banks (before the repeal of Glass Steagall) provide the debtor-in-possession (DIP) financing to run an orderly bankruptcy process. In 1978, Toys R Us emerges from the ashes of the Interstate bankruptcy under the leadership of Charles Lazarus. Long before “loan-to-own” is on anyone’s lips, the original Interstate lenders convert substantial debt into new public equity of the spun-off enterprise, and over the next decade Toys R Us becomes the original big-box “category killer,” growing to over $13 billion in revenue. Even accounting for “time value” during the long bankruptcy process, many of the original lenders get more than their principal returned with a decent return on investment. It’s a testament for old school bank workout themes of “all play/no play” and “share the pain.”

Question: Could the Toys R Us story be replicated under today’s economic climate and bankruptcy rules?

Be Careful What You Wish For

Several amendments were made to the U.S. Bankruptcy Code in 2005,1 and two in particular dramatically changed the prospects for retailer restructuring. In hindsight, many parties that lobbied hard for these amendments rue the adaption today — instead of undergoing a reengineered recovery like Toys R US, retailers like The Bombay Company, Sharper Image, Levitz, Wickes Furniture, Circuit City, KB Toys, Linen N Things and others, ended up vanishing in a rapid liquidation. In these cases, while losses for creditors may be substantial, the other stakeholders — customers, vendors, landlords, employees, etc. — lose everything.

In the first example, landlord constituents pushed for Bankruptcy Code §365(d)(4) revisions, forcing the debtor lessee to assume or reject leases within a maximum 210 days of the filing unless express consent is received from each individual landlord for a further extension. Before this amendment, these decisions often took considerably longer, as troubled retail management evaluated its core business strategy along with geographic considerations and four-wall contribution. That strategic assessment often took priority, and while real estate was critically important, it was usually on the top of the second tier of issues resolved.

Many troubled retailers, in fact many troubled companies, have been forced to rapidly reject leases on a “wholesale” basis, causing many landlords to ask debtors to reconsider and offer more time to renegotiate leases instead. With the national vacancy for regional and super regional malls across the U.S. hovering around 8.8%, and with mixed sentiment as to whether the market has reached a stabilized level,² many landlords would rather see a more deliberate, albeit slower, process than a fast one in the hopes that the property remains cash flowing as opposed to vacant.

This tightened timeframe has had perhaps the most dramatic impact on the terms of the DIP financing that retail debtors have recently received. Lenders are no longer assured of sufficient time to conduct store closing sales that would serve to maximize the value of their collateral or market the leases in the event the reorganization fails. Instead, they are opting to “fast track” the cases to permit sufficient time to liquidate inventory, if necessary.

Traditionally a lender’s willingness to provide post-petition financing was rooted in part on the value of the debtor’s inventory and its commercial leases that could be liquidated and monetized in the event of a failed reorganization effort. Prior to the 2005 amendments, lenders were far more willing to finance a debtor’s reorganization, partly because the Bankruptcy Code essentially provided them with an indefinite period of time to a.) liquidate the debtor’s inventory in the event of a failed reorganization and b.) assign the debtor’s below-market commercial leases to third parties at a premium in the course of a subsequent liquidation.

Since the 2005 amendments, however, lenders often encourage/force going out-of-business (GOB) sales prior to expiration of the 210-day period to assume or reject leases to ensure a sufficient time to liquidate the inventory in the store locations before the debtor loses the leases. As a result, retail debtors have minimal time to attempt to reorganize. Post-petition financing arrangements regularly dictate that inventory must be liquidated well in advance of the expiration of the 210-day period in order to have sufficient time to administer GOB sales. Further the residual value of a debtor’s commercial leases is lessened because lenders are left without sufficient time to market those leases in the event the reorganization stalls.

Some might say the change in the real estate provisions has not directly led to the dramatic increase in retail liquidations. Instead, they point to the lack of financing available in the wake of Lehman Brothers and the financial meltdown in the fall of 2008. But the serial financial crisis of the last couple of years has only masked the impact of these provisions. Indeed, once the economy eventually turns and commercial real estate values improve, these provisions will have an easy-to-follow direct impact on the ability of retailers to survive Chapter 11 and enhance values for all constituencies.

The second major change was in §503(b)(9) of the Bankruptcy Code. This change grants administrative priority status to the seller of goods delivered to a vendor within 20 days prior to a bankruptcy filing. Before this amendment, troubled retailers often “gamed” the system to build inventory before the filing, so this war chest would give the troubled retailer goods to sell to gain the time to rehabilitate. The potential substantial increase of new priority administrative claims in bankruptcy has made it harder for retailers to reorganize as administrative claims must be paid in full as a condition to confirmation of a plan of reorganization.

Capital Structure Issues

While not limited to the world of retail, the increasing complexity of capital structures has also had a significant impact on the outcomes of bankruptcies. In the past there would be one primary asset-based lender (ABL) group secured by most assets, while other debt was unsecured in nature. Usually the ABLs were protected by perfected liens on collateral and had sufficient equity cushions based on asset values, leaving equity value to other creditor constituencies.

The growth of junior lean debt in the past decade, sometimes in multiple tranches and oftentimes combined with ownership of significant equity of the underlying retailer, has created complex case dynamics. With this, a key player was created that, in many cases, has become the critical component of the retailer’s capital structure since it may absorb the remainder of a company’s value after senior secured debt. As a result, second lien lenders as the so-called “fulcrum security” often have a greater role in both pre-petition and post-petition restructuring negotiations.

In some instances, especially given the poor values received for assets after the excessive number of retail liquidations in 2008 and 2009, strategies other than forced liquidations have been devised including “kick the can” loan extensions and pre-packs, often converting most of the debt to equity. In many of these cases, fundamentals concerning the nature of the underlying retail operation have not been necessarily fixed, and achieving better valuations in future days may be more ephemeral than real.

Challenges Ahead

The next few months may be challenging ones for American retailers. The Consumer Confidence Index (CCI), measured by the Conference Board, plummeted for the third time in four months in September, dropping to 48.5 — the lowest rate since February 2010. To benchmark this score, in a strong economy, the CCI is typically more than 90.0. Skittish consumers delayed back-to-school shopping until the last second, and many retailers are hunkering down for another tough holiday.

The uncertain economy does not bode well for the upcoming 12 months either. Unemployment, continuing home foreclosures and high consumer debt levels among American consumers making less than $25,000 in annual income have hurt many retailers. Even high income earners — those making $100,000 or more in annual income — may still have “frugality fatigue” and are still reluctant to shop, increasing the consumer savings rate as potentially higher taxes loom ahead.

In fact, the chief financial officers (CFOs) at more than 100 of the leading U.S. retailers anticipate a continuation of stagnant economic conditions, according to a recent proprietary study commissioned by BDO USA.3 From the CFO’s office, unemployment seems to be the linchpin to retailers’ recovery, with 76% of the CFOs citing it as the economic issue having the greatest impact on consumer confidence for the balance of 2010 (a jump from 64% in 2009). The impact of personal credit availability and debt levels (14%), the weak housing market (4%) and market volatility (4%) are also playing a role.

Saving the Brand

America’s retailers may be treading in dangerous waters, and may face significant challenges this fall. In another sea-change, the days of borderline retailers hanging on during the holiday season and filing for bankruptcy protection after the first of the year is also gone, as apprehensive lenders would rather run GOB sales during the holiday to generate a better return than an orderly liquidation in the spring.

In this challenging environment, here are a few steps that retailers can take to avoid liquidation:

• Control inventory levels and monitor liquidity — America’s retailers have done a remarkable job over the past five years tightening inventory levels and re-engineering the supply chain. In these uncertain times, a purchasing faux pas or a cash forecasting error might quickly become a catastrophe, as lenders will be more willing to start a liquidation process before the holidays versus after the first of the year.
• Take a proactive role communicating with senior lenders and other stakeholders — The credit crunch crushed a number of senior debt providers, and while most banking professionals and banking regulators think loan portfolios are materially healthier than a year ago, nervous lenders will react swiftly and negatively to “surprises.” Companies need to thoughtfully manage those senior lender, and vendor, relationships in a way so those parties know what’s going on inside of your business; so no one makes a bad assumption. Communicate disappointing news in a straightforward manner to avoid the creation of “credibility gaps” that can be brutal if the pathway points to a formal bankruptcy process. During the holiday season, even daily communications might be appropriate.
• Take advantage of green tax incentives — Retailers need to take advantage of green tax incentives, as “going green” becomes more beneficial to the bottom line. According to the BDO CFO survey, many retailers are taking steps to reduce their carbon footprint by recycling, using less paper and reducing electricity in stores, offices/other facilities and distribution centers. Additionally, retailers should pursue energy efficient lighting, heating/cooling systems, building insulation, state and local green incentives and energy efficient commercial building deductions for new buildings. Many of these initiatives represent minimal capital investment and feature extremely high paybacks, and the tax incentives have perhaps never been so favorable to initiate these programs. The public relations benefit from these initiatives may also play well with the consumer.
• Create a more reasonable Debtor-in-Possession period — The changes to Bankruptcy Code outlined above tightened the timeframe for a company in Chapter 11 to make critical decisions, including the assumption or rejection of leases. Troubled retailers need to push to use all the time the Code allows, and perhaps negotiate for more time, to actively manage and communicate the strategic thinking on a pathway to recovery for the effected stakeholders.
• Negotiate special deals and gather a consortium of supporters — It was widely reported in February 2010 that Blockbuster CEO Jim Keyes told investors that the company would accelerate stores closures, unless the other major studios joined Warner Home Video, 20th Century Fox Home Entertainment and Universal Studios Home Entertainment in delaying new-release DVDs to kiosk vendors. Keyes said that if the “major studios operate a unified retail window, there would remain a strong demand for store-based disc rentals.” There are similar opportunities to negotiate special strategic deals with other retailers facing challenges, as vendors and landlords will help build the case against total liquidation.
• Make tough decisions quickly with a seasoned professional team — The amended bankruptcy rules mean retailers have to make hard and tough decisions (e.g., closing stores and merchandizing targets) quickly before senior lenders start pushing liquidation. Although a self serving recommendation coming from restructuring professionals, retailers need to get good outside advice. Special situations work has become highly specialized over the past 30 years, and while each situation is unique, the shared experience from other companies that have successfully reorganized gives these professionals credibility with stakeholders that may be hugely beneficial. Get a seasoned team of professionals on board to help management make the hard and tough decisions, and be prepared to pay for quality and value.

Jeffrey R. Manning, CTP is managing director at BDO Capital Advisors, LLC, and is the group head of the special situations practice. Over his 30-year career, he has provided a broad range of investment banking services to a number of retailers, including Dial-A-Mattress, Harvey’s Electronics, Avado Brands, Tweeter, Cannondale, USA Floral Products, Sterling Optical, Weathervane and others. For more information, visit www.bdocap.com.

Jay Indyke is the chair of the bankruptcy and restructuring practice at the national law firm Cooley LLP. His practice is concentrated in the area of creditors’ rights and bankruptcy, and he has had significant creditor representations in many retail cases over the past 27 years including Federated Department Stores, Blockbuster, Ritz Camera, Pizzeria Uno, Eddie Bauer, The Sharper Image and many others. For more information, visit www.cooley.com.

Footnotes

1 The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, effective October 17, 2005.

2 Korpacz Real Estate Investor Survey Third-Quarter 2010

3 The BDO USA LLP Retail Compass Survey of CFOs is a national telephone survey conducted by Market Measurement, Inc., an independent market research consulting firm, whose executive interviewers spoke directly to CFOs, using a telephone survey conducted within a scientifically developed, pure random sample of the nation’s largest retailers.