In most industries, bankruptcy provides a refuge from lenders and suppliers in which struggling companies can reorganize before emerging to compete again. Indeed, about 19 of 20 non-retail corporate bankruptcies result in a successful reorganization, according to Fitch Ratings.
In retail, however, things are very different. A recent AlixPartners study shows that a staggering 55 percent of retail bankruptcies over the last 10 years ultimately ended in liquidation. Why?
One of the primary reasons retailers struggle in bankruptcy is that, in contrast to other industries, their primary asset base — their inventory — is easy to liquidate and has relatively predictable recoveries. For example, liquidators paid 97 percent of cost for Coldwater Creek’s inventory in its recent bankruptcy.
However, while the ease of liquidating inventory has long been a challenge for bankrupt retailers, changes made to the U.S. Bankruptcy Code in 2005 are perhaps most responsible for the high level of retail liquidations in the past decade. Prior to 2005, retailers often spent 18 to 24 months in bankruptcy — time that they were able to use to test merchandizing changes, turn around marginal stores, and prove new concepts over a holiday season.
The 2005 code changes dramatically altered this timeline, effectively giving retailers only a few months to put in place a company sale or reorganization before they are forced into liquidation.
Today, bankruptcy law provides companies with a maximum of just 210 days before unexpired store leases are deemed “assumed,” absent individual landlord approvals. Given that rejecting leases before they are assumed creates general unsecured bankruptcy claims that sit below claims of senior lenders, while rejecting leases after they are assumed creates “administrative” claims that are above those of senior lenders, senior lenders typically enforce a timeline that ensures all unwanted leases must be rejected well in advance of the 210-day deadline. What’s more, because it typically takes 90 days to run in-store going-out-of-business sales, senior lenders frequently attempt to mandate a decision on whether to liquidate or reorganize in as little as 120 days.
Another change in the code was to give “administrative priority” status to the claims of vendors for the value of goods sold in the 20 days immediately preceding a bankruptcy filing. This effectively means that a retailer must pay for such goods in their entirety if it ever wants to leave bankruptcy because administrative priority claims must be paid in cash upon the effective date of a bankruptcy-reorganization plan.
As a result, this creates a significant hurdle for many retailers hoping to emerge from bankruptcy. For example, Circuit City’s 2008 slide into liquidation was widely thought to be hastened by its $350 million of such claims.
If a retailer in bankruptcy has only three or four months before liquidation becomes almost inevitable, then pre-bankruptcy planning is imperative. Retailers should create as much liquidity as possible to provide them with time to plan and the flexibility to choose the best time to file — possibly before the winter holidays — to maximize the ease of selling excess inventory, or after the holidays, when the retailer is likely to have more cash on hand.
The next step is to develop a feasible plan in advance. Failed retail bankruptcies share a predictable sequence of missteps: First, a company believes it can avoid a bankruptcy filing through amendments to its existing debt facilities, a debt refinancing, or a pick-up in sales that never materializes; then it enters bankruptcy with the intention to close only its lowest-performing stores; finally, it announces that a quick company sale couldn’t be orchestrated and it begins liquidations at all stores.
To maximize the chance of achieving an out-of-court turnaround, retailers should focus on implementing a strategy based upon a realistic and conservative view of their business. If a filing becomes unavoidable, preserving cash and focusing on proactively engaging potential buyers and investors is required.
Indeed, almost every retailer in our study that avoided liquidation entered bankruptcy with either a pre-negotiated bankruptcy plan with its creditors or a stalking-horse bidder for a company sale. Retailers that entered bankruptcy without either one of these invariably liquidated.
A final critical step for retailers contemplating bankruptcy is to take full advantage of the valuable and otherwise-unavailable tools that the bankruptcy process offers. The ability to reject store leases is perhaps the most valuable of these. In fact, underperforming store closures were a substantial part of almost every successful restructuring in our study.
Long after the Great Recession has ended, labor-cost increases, declining mall traffic, spotty consumer demand, and the continued growth of e-commerce ensure that retail remains a tough business. Retail bankruptcies have been on the rise in recent years, and as many retailers filed for bankruptcy in the first six months of 2015 as in all of 2014.
The key for retailers looking to manage the challenges associated with a restructuring of any type is planning. As tough as retail bankruptcies can be, almost half of all retailers in our study did emerge as going concerns. Retailers that want to do the same in the future should begin planning long before lack of liquidity forces a bankruptcy, and then if they have to file, do so with either a stalking-horse bidder or pre-arranged plan in place.
Holly Etlin is a managing director and James Hogarth is a director at AlixPartners LLP, the global business-advisory firm, alixpartners.com. The opinions expressed are those of the authors and do not necessarily reflect the views of AlixPartners LLP, its affiliates, or any of its or their respective other professionals or clients.