For distressed retailers weighing bankruptcy, the pandemic complicates what was already a difficult process.
A handful of brands have filed for protection recently, including True Religion, J.Crew Group, Neiman Marcus, John Varvatos and J.Hilburn. More are expected, once retailers are allowed to reopen storefronts, due to expenses accumulated during the lockdown and the need to raise cash through liquidation.
Retailers historically used bankruptcy protection to liquidate inventory to generate cash and reject unprofitable store leases once those liquidation sales are complete, said an industry source, who requested anonymity due to the sensitive nature of negotiations they are involved in. That’s not easy to do when stores are either shuttered or experiencing significant declines in traffic.
Lenders basically have two choices now, the same source said: liquidate and then go through a poor recovery based on the current environment or take ownership and manage the operations until the economy recovers.
As a result, two trends in retail bankruptcy are beginning to emerge. The first sees retailers that have filed for Chapter 11 asking the court for a deferment of administrative expenses such as rent, or effectively asking for a suspension of the case. The second is to swap debt for equity, with the lenders not only taking ownership but also providing debtor-in-possession (DIP) financing, which is typically provided for companies in financial distress, in place of traditional banks.
“There’s sort of two categories of bankruptcy cases now,” said Kenneth Rosen, partner at law firm Lowenstein Sandler. “There are the cases where there’s a lot of institutional debt and then the cases where the company has more traditional bank financing.”
National retailers with well-known names, such as Neiman Marcus or J.Crew, are swapping debt for equity. J.Crew’s Chapter 11 filing on May 4 is the first example of such a debt restructuring under bankruptcy protection since the pandemic began. The lenders are exchanging $1.65 billion of debt for equity in the company.
The two apparel retailers are likely to be joined by others. “We’ve been seeing loads of bondholder groups organize to talk to the bond issuer,” said Rosen.
Among these bondholders as well as holders of the loans are distressed investors eying opportunistic defaults, purchasing pieces of the debt at a steep discount with the idea of eventually taking ownership of the company. Not only do these debt holders stand to gain for essentially buying a company at a bargain, with distressed investing the stand-in for mergers and acquisitions during the pandemic, they also benefit from the interest generated by the financing they end up providing.
These deals are triggered in part because the retailer needs to deleverage so it can reinvest, Rosen said. As is the case of J.Crew and Neiman Marcus, the latter of which is exchanging $4 billion of debt for equity, the lenders are providing the DIP financing to fund operations through the bankruptcy reorganization and beyond.
Such distressed exchanges demonstrate that lenders are confident there will be a business when commerce begins to normalize again, said George Angelich, partner with a specialty in bankruptcy at law firm Arent Fox.
“Bankruptcy affords parties a venue to adjust the rights of creditors and maximize value,” Angelich said. “Bankruptcy is not a destination; it’s a doorway.”
Both Neiman Marcus and J.Crew declined to comment beyond their public statements.
On the other hand, the more likely path for chains with traditional bank debt, particularly regional retailers, is to file for bankruptcy with the intent of liquidating and closing at least some, if not all, of the stores. Modell’s and Art Van Furniture are recent examples of this.
“In the tier below the mega, we will probably see an uptick in bankruptcies in June,” Rosen said. Even though by then a number of retailers and restaurants will have likely reopened, they will have also reached a point with their lenders where they will have to file, he continued.
In these situations, some retailers are asking for a stay of the process and deferment on the payment of certain administrative expenses normally required under Chapter 11.
Brewery and restaurant operator Craftworks was the first to receive court approval of a stay of its bankruptcy, while Modell’s and Pier 1 Imports also received suspensions of their cases. True Religion, the latest example, filed for bankruptcy after restrictions on retailers considered nonessential were put in place. The premium denim brand also requested a stay.
But suspension has its risks. Art Van Furniture was denied a stay, and its attempt at a Chapter 11 reorganization was consequently converted into a Chapter 7 liquidation.
Even with a suspension, bankruptcy remains expensive, and costs such as rent are merely deferred. Expenses for retailers that have filed recently, such as Toys “R” Us and Barneys, piled up during the bankruptcy process to the extent that they weren’t able to pay their vendors post-petition, resulting in substantial administrative insolvency, said Angelich.
Finally, suspensions are also temporary and need to be reapproved. Modell’s, after an initial stay, got the bankruptcy judge to extend it until the end of May.
Complications with the process
Bankruptcies are complicated by so many unknowns of the pandemic, regardless of whether a suspension of the bankruptcy is granted. Even when stores reopen, while liquidation sales may be possible, they still may not be realistic.
“Just because the economy reopens, I don’t think that the spigot will be suddenly turned on,” Rosen said, asserting that the initial reopening of stores will not automatically trigger a surge of filings.
Consumers may not immediately return to physical stores, and it is uncertain if or when they might resume spending at levels similar to before the pandemic, Angelich said. Once chains begin liquidation sales, they will likely be competing with other liquidations, driving down valuations and recoveries. If the public is either not showing up or inundated with liquidations, there could be further suppressed pricing for going-out-of-business sales, Angelich explained.
The merchandise to be liquidated will be out-of-season, too. And summer months are hardly ideal for such sales, with the months leading up to the holidays in the fall the best time to conduct liquidations.
Because of all these factors, retailers in some situations may have difficulty even obtaining a firm to conduct the liquidation, Rosen said. Liquidations can be a risky proposition because bidding firms pay up front. Not all firms are profitable after conducting a liquidation because they bid more than what the inventory ends up selling for.
With the pandemic and the uncertainly around how consumers will behave once stores reopen, liquidators will have a difficult time assigning a value that they believe will be profitable, Rosen explained. In addition, the bids from the liquidators may be so low, as to provide little to no recovery to the creditors.
The path forward
With those factors in mind, retail bankruptcies are likely to heat up beginning in late May and stretch into late summer, particularly if retailers have resumed operations. Rosen said that retailers will likely be given between 60 and 90 days to find a liquidator, with the aim of launching liquidation sales in the fall leading up to the holidays when foot traffic is at its highest.
Even so, industry sources caution that the U.S. is still in the early days of the pandemic, with uncertainty around both whether Covid-19 will be contained by the fall and the economic fallout as a portion of furloughs shift from temporary to permanent layoffs.
Any change for the worst economically or in the spread of Covid-19 could once again upend well-laid plans.
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