Lessons Learned Before Bankruptcy

 

In a bankruptcy, “The basic question is, are they worth more alive or dead?” said Joshua Freidman, global head of Debtwire, in an interview earlier this summer.

In this particular case, he was referring to Charming Charlies which was about to file for Chapter 11 for the second time in a little over a year following the first one.

This time around, the apparel and accessories retailer plans to close all of its remaining 261 stores and wind down its business in bankruptcy.

Over the course of 15 years, Charming Charlie was founded, grew to 400 stores, filed for bankruptcy, failed again and now its second trip through Chapter 11 marks the end of the company’s life.

Founded in 2004, the retailer made its name by its approach to merchandising, grouping products together by color. It had a pricing structure that positioned itself between department stores and teen retailers. Its core customers were women between 35 and 55 who made up 38% of its base.

 

ASSET BECAME A LIABILITY …

To execute this merchandising plan required a sophisticated inventory system” to position products by color and theme. But that system, which was the company’s calling card eventually became a liability.

“Although this inventory approach provided Charming Charlie with a strategic benefit and engendered significant brand loyalty, it eventually caused the company to be saddled with excess merchandise in under-performing color offerings.” Stated Alvaro Bellon, Charming Charlies CFO.

The pending demise of Charming Charlie is a virtual checklist of everything that can go wrong in retail and other companies with sophisticated business operations and a significant work force.

Over time, the company became caught in a death spiral. Before its first Chapter 11, the company grew its brick and mortar too quickly, built out an over-broad vendor base and was subjected to broad structural changes in the industry as customers turned away from malls and other physical retail outlets.

 

TO SAVE MONEY …

To save money, the company hacked away at its workforce, sometimes only having one associate to run a store for hours.  That hurt the retailer’s ability to convert traffic and led to poaching of remaining employees.

Numerous factors including “onerous leases” and liquidity problems made it “increasingly difficulty” to pay expenses, including $47.4 million in annual rent costs and $81 million in debt, according to court documents quoting the CFO.

To help with the liquidity issues, the company “hastily” expanded its inventory to boost the money available under its asset-based loan. But that created piles of merchandise that was either off-brand or not of the quality their customers expected.

Following the initial Chapter 11, suppliers didn’t ease the terms they demanded from the company until several months after it exited. That made it harder to get better quality merchandise on to the shelves.

Finally, after experiencing all of this, the company finally brought in financial advisors to review its business plan and its options.

With the help of the advisors, the company refinanced a loan. But it was too little, too late and Debtwire reported that the company was still facing a “liquidity crisis”.

As the company prepared to file for Chapter 11 again, it was clear that the Charming Charlie would not make it.

 

IN OUR BANKRUPTCY SYSTEM …

So, how does this happen?   In our bankruptcy system, it is difficult to distinguish a company in financial distress from an economically failed enterprise and it is doubtful that the current reorganization system is very accurate at making the distinction.

Once in Chapter 11, the decision to reorganize or not is made by a bankruptcy judge rather than the market. 

Also, the decision of whether to file is made by the debtor and the debtors management staff that have a vested interest in pushing for reorganization and preserving their jobs and ownership.

Secured creditors will generally accept a reorganization only if the company is worth more alive than dead. But unsecured creditors, who have no hope of recovery if the company is killed, have an incentive to push for reorganization, even if there is a tiny probability that reorganization will work.

 

GET INDEPENDENT ASSISTANCE …

The economic cost of inefficient reorganization can be substantial. The direct costs of bankruptcy, even for smaller companies, can run to hundreds of thousands of dollars in professional fees. If the chances of success are small, the costs to the estate can be prohibitive.

The time to get independent assistance from experienced advisors with expertise in operational restructuring is when the true economic viability of the company can be determined, and the value of assets can be maximized.

This is where the difference between operational or just financial help can make the greatest difference.

And that assistance should be requested long before bankruptcy is considered. The lessons of Charming Charlie are those for every company, even in slight economic risk, to consider.

 

Revitalization Partners is a Northwest business advisory and restructuring management firm with a demonstrated track record of achieving the best possible outcomes for our clients. And now, we’ve written a book to help our readers understand the issues facing their businesses. You can find this compilation of our business thoughts at: https://revitalizationpartners.com/we-could-write-a-book/ or on Amazon.

We specialize in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations.

Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.

Bankruptcy Help May Be On The Way

 

In a recent blog, we wrote about the high cost of Chapter 11 bankruptcy for small and mid-sized companies (SME).

As we talk with owners and managers of troubled companies, we often hear: “If I can’t work things out, I’ll just declare bankruptcy.”

By bankruptcy, they mean Chapter 11, which allows the debtor to reorganize the company by submitting a plan of reorganization that is acceptable to the creditors and approved by the bankruptcy court.

While Chapter 11 reorganization for a smaller or mid-sized company won’t approach the staggering number of a large company, it is still extremely expensive relative to the size of the business.

 

 

It’s Very Expensive …

The reason a Chapter 11 bankruptcy is so expensive is because it involves two separate elements:
1. a reorganization plan and
2. a debt repayment plan.

The reorganization plan has to convince the court and your creditors that the business can make a profit in the near future. This plan must be supported by reliable data.

Then you have to show a budget where you outline how you can repay your creditors over the next several years.  And then you will have to negotiate the terms of the plan with the court and your creditors. 

While that is going on, your budget has to allow for the payment of your attorney’s fees, your creditors attorney’s fees and for financial advisors on both sides.

 

Success Rates Are Very Low …

The success rate in Chapter 11 bankruptcies is extremely low, meaning that a very low percentage of reorganization plans actually obtain court approval.  Depending on size and financial capability, experts put the number between 20 and 30 percent.  Thus there is a high chance that the company will spend a lot of money putting together the plan and attempting to persuade the court, but fail to do so and end up in Chapter 7 liquidation.

But it appears that help may be on the way. Proposed changes to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) offer significant help for Small and Mid-Sized Enterprises (SME) seeking protection in Bankruptcy.

In the proposed changes, a company is considered an SME if:

1. No publicly traded securities were included in its capital structure or in the capital structure of any affiliated debtor whose cases are being jointly administered with the debtors case.

2. It had less than $10 million in assets or liabilities on a consolidated basis with any debtor or non-debtor affiliate as of the petition date.

3. If a debtor met the above requirements, but had between $10 and $50 million in assets, the company could request that the SME rules apply.

 

What’s The Advantage?

So, what is the advantage to the proposed SME rules?  An SME would have the opportunity to avoid one of the largest costs of a Chapter 11, namely a committee of creditors along with all of the legal and advisory costs that go along with that.

Specifically, unless the court, after a motion from an unsecured creditor that a creditors committee was necessary to protect the interests of unsecured creditors, the default rule for SME’s would be that no creditors committee would be appointed.

A debtor or party in interest could still request the appointment of an estate neutral individual to advise the debtor in possession (DIP) on operation and financial matters and in the negotiation of a plan of reorganization. This individual would be paid by the estate and represent the estate’s interest. This would provide for a much lower cost than the adversarial relationship that exists in the Bankruptcy Code today.

 

One Of The Most Interesting Aspects … 

One of the most interesting aspects of the proposed changes is the ability for SME equity to retain a substantial stake in the debtor under a plan. The proposal envisions an amendment to the Absolute Priority rule in Section 1129 of the Bankruptcy Code to allow existing equity to maintain 100% voting control of the debtor when it emerges from bankruptcy subject to 85% of the rights to receive economic distributions being vested in creditors.

While it is unclear if these proposals will become law in their present form, the intent is to make Chapter 11 less costly and more effective for small to mid-sized companies. 

 

Important To Note That …

It is important to note that even if these changes are accepted, they do not affect secured debt and unsecured creditors can and may object to a plan individually.  With enough objections, a plan may not be approved by the court.

Even with reduced costs, bankruptcy remains expensive and it is always beneficial for companies to deal with problems proactively to avoid the expense and risk of the proceedings.

As this is our last blog of 2015, we thank all of you who read and comment on our writing and want to wish you, family and friends the very best of the Holiday Season.

We look forward to having more to say in the coming year.

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Law Suit Filed: JPMorgan Chase Accused of Fraud in Bankruptcy Filings