Bankruptcy filings by retailers in the first half of 2017 were on a record-setting pace, with 15 Chapter 11 filings in just the first six months of the year (Figure 1). This exceeds the number of retailers that have filed for bankruptcy in any full year since 2009, and there is a significant possibility the Great Recession record of 20 filings in 2008 will soon be eclipsed. First-half sales have been soft in most categories, and with many retailers moving into the most capital-intensive period of the year, there is even the possibility that filings will accelerate.
For the most part, the challenges facing traditional retailers are obvious to any shopper: the rise of e-commerce, the overexpansion of brick and mortar, and the self-perpetuating spiral as more stores close, leaving consumers with fewer and fewer reasons to venture into malls. Even some of the strongest retail management teams have struggled to respond, hamstrung by the challenges of adapting store portfolios and supply chain infrastructure at a rate that can keep pace with the rapidly evolving buying habits of shoppers.
For a number of years the authors’ firm has actively tracked retail bankruptcies. Starkly, the research shows that since 2006 almost half of all retailers that filed for bankruptcy ultimately liquidated (Figure 2), compared with less than 10 percent across nonretail industries. With no signs of retail headwinds abating, it is worth exploring the causes of this high liquidation rate, as well as steps that can be taken to save today’s distressed retailers from the same fate.
In 2005 significant changes were made to the U.S. Bankruptcy Code. These changes dramatically altered the timeline for retail restructurings, effectively giving companies only a few months to obtain approval for a sale or reorganization before being forced into liquidation. The specific driver of this accelerated timeline was modifications to Section 365(d)(4) of the code, which limited the period for rejecting leases to a maximum of 210 days, absent individual landlord approvals.
This accelerated timeline is most clearly visible in the 17 full retail reorganizations since 2006 (the other 45 going concern reorganizations took the form of asset sales). Of these 17 examples, only five debtors took more than 200 days between filing and plan confirmation, and the remaining 12 debtors took on average only 130 days to secure a confirmed plan.
Given that rejecting leases before they are assumed creates a general unsecured claim that sits below senior lenders, but that rejecting leases after they are assumed creates an administrative claim above senior lenders, it is typical for lenders to enforce a timeline that ensures all unwanted leases are rejected well in advance of the 210-day deadline. And because it can take up to 90 days to run in-store going-out-of-business sales, lenders frequently attempt to mandate a decision on whether to liquidate or reorganize a debtor in less than 120 days.
As an example, when hhgregg filed for bankruptcy in March 2017, the terms of its debtor-in-possession (DIP) financing required the company to file a motion approving bidding procedures for a sale process within three days, to select a stalking horse bidder (an initial bidder chosen by the debtor to buy its assets ahead of a possible auction) within 14 days, and to conduct an auction within 49 days.
Before the 2005 changes to the Bankruptcy Code, retailers often spent several years in bankruptcy—time they could use to test merchandising changes, turn around marginal stores, and try out new concepts during a holiday season.
In contrast to many other businesses that hold a substantial amount of fixed assets, retailers typically have significant capital tied up in easy-to-sell inventory. Inventory can make up as much as 50 percent of a typical retailer’s assets and can usually be sold rapidly and at attractive prices. For example, liquidators paid 111 percent of cost for Anna’s Linens’ inventory in 2015 and 97 percent of cost for Coldwater Creek’s in 2014. This is problematic for a retailer looking to reorganize, because to emerge from bankruptcy, a debtor must pass the best-interests test, proving that each class of creditor does better under a plan of reorganization than it would if the company were liquidated.
When a liquidation can be accomplished easily and with good returns, it can be difficult for debtors to achieve consensus for a recapitalization or sale that delivers results superior to the recovery hurdle implicitly set by the liquidation value of the debtor’s inventory. The challenge is even greater when restructuring timelines are as short as 120 days.
For retailers, the challenges of effectuating a successful restructuring are further compounded by another 2005 change to the Bankruptcy Code—the introduction of Section 503(b)(9), which gives “administrative priority” status to vendor claims for the value of goods sold in the 20 days leading up to a bankruptcy filing. Administrative priority claims must be paid in cash on the effective date of a plan of reorganization, which means a retailer must pay for goods subject to Section 503(b)(9) to emerge from bankruptcy as a reorganized going concern.
Circuit City’s 2008 slide into liquidation offers a prime example of the potential downside of administrative priority claims for retail debtors. The retailer’s winddown was almost certainly hastened by the $350 million of 503(b)(9) claims that were filed with the Bankruptcy Court in its case.
If experience demonstrates that the best-case scenario for a retailer filing for bankruptcy is that it has only three or four months before liquidation becomes almost inevitable, then prepetition planning is imperative. Accordingly, distressed retailers should consider the following to improve their prospects for a successful turnaround:
1. Buy Time
Distressed retailers need the longest runway possible to achieve an out-of-court turnaround or a successful bankruptcy. A critical first step is to develop a detailed understanding of the business’s liquidity position, debt covenants, and other potential filing triggers. At the same time, to maximize the runway available, the company should urgently implement a variety of liquidity generating initiatives, such as the curtailment of capital expenditures, reductions in general and administrative expenses, and actions to optimize its borrowing base.
Additional runway is important because it affords both time to negotiate a turnaround or planned restructuring and the flexibility to choose the best time to file—for instance, possibly before the winter holidays to maximize the ease of selling excess inventory, or after the holidays when retailers are likely to have more cash on hand.
2. Be Realistic
In the same way that retail turnaround successes have advance planning in common, retail turnaround failures share a predictable sequence of missteps. First, a company believes it can avoid a bankruptcy filing through an amendment to its existing debt facilities or a debt refinancing, or through a pickup in sales that never materializes. Then it files for bankruptcy, planning to close only its lowest-performing stores. Next, it announces that a reorganization couldn’t be orchestrated in the time available and going-out-of-business sales begin at all stores.
Perhaps the most important element of a successful turnaround is the development of a truly feasible plan from the start. If there’s a prospect of achieving an out-of-court turnaround, then a strategy based on store closures, marketing optimization, and merchandising transformation may be right. But if a filing seems unavoidable, then preserving cash may provide the best footing for an in-court turnaround, reducing the reliance on lenders for DIP financing and thereby limiting the leverage lenders can exert to mandate an unrealistically aggressive bankruptcy timeline.
3. Understand the Market
An understanding of viable capital-market options is an essential pillar of any sound plan. There are relatively few distressed retail investors, so once a retailer has a realistic and credible restructuring plan in-hand, it’s vital to begin a dialogue with the capital markets well before a bankruptcy filing becomes necessary. Retailers should also make sure they consult existing lenders, both to explore their lenders’ appetite to support a reorganization and to evaluate alternatives and pricing for potential DIP financing. The goal is to secure either a stalking horse bidder or support for a prearranged plan prior to the point of filing. The authors’ firm’s research illustrates the importance of this. Since 2006, all but one successful reorganization of a retailer with more than $500 million in liabilities was based on either a prearranged or prenegotiated plan.
4. Focus on Operations
Even though retail bankruptcies have become tougher to navigate successfully since 2005, the bankruptcy process still offers valuable and otherwise unavailable tools for retail turnarounds. The ability to reject store leases is perhaps the most valuable of these, and store closures have been undertaken in the vast majority of successful restructurings since 2006. Of the store-based retailers that emerged from bankruptcy as going concerns (some were online or catalogue-based retailers), four out of every five closed stores in bankruptcy, and more than half closed more than a quarter of their prefiling store bases (Figure 3).
A retailer should conduct a four-wall profitability analysis well in advance of a filing. In many cases, a retailer should also initiate rent negotiations with landlords against the backdrop of a potential filing, both to achieve rent savings and to inform store closure decisions with an understanding of likely go-forward lease expenses. In addition to store closures, the ability to reject other executory contracts is a powerful tool for renegotiating marketing, logistics, transportation, and other third-party agreements, and can provide leverage with vendors, even before a filing.
Against a backdrop of a more restrictive Bankruptcy Code and increasingly challenging retail conditions, successful retail restructurings are arguably more difficult than ever. But, viable restructuring alternatives that can preserve significant value still exist. This is evidenced by the other half of retail Chapter 11 filings that resulted in successful reorganizations rather than liquidations.
The good news for management teams, sponsors, and lenders is that the ultimate success of a retail restructuring largely rests in the hands of the key stakeholders. In many cases, acting early, strategically, and decisively can make all the difference.
The authors would like to thank Alvaro Corletto Costa and Deborah Rieger-Paganis for their assistance preparing this article.
All data included in this article is based on AlixPartners analysis and information sourced from TheDeal.