The Harsh Reality of Bankruptcy

RAPAPORT… A combination of the economic downturn, weak consumer spending and lack of available financing is driving more companies into bankruptcy faster, as well as increasing the number of retail liquidations. According to the American Bankruptcy Institute, for the 12-month period ending March 31, 2009, business bankruptcy filings soared 59.7 percent from 2008. The wave that pummeled industry leaders from Lehman Brothers to Circuit City and General Motors is now slamming through the jewelry industry.

Jewelry Sector Woes
Paralyzed by poor liquidity and the termination of credit lines, a host of well-known and well-established jewelry names joined the casualty list of companies filing for bankruptcy this summer. That list includes retailers Finlay Enterprises, Robbins Brothers, Gottschalks, which liquidated, and the upscale David Webb, as well as high-end wholesalers Henry Dunay and Michael Beaudry. “Everyone goes through their time. It’s now the jewelry industry’s time,” says Michael Enright, a partner with Robinson & Cole, a law firm that represents institutional lenders to the jewelry sector.

“Obviously, jewelry is at one of the extreme ends of discretionary spending,” says Tim Shimotakahara, vice president in investment banking for D.A. Davidson & Co., an investment banking firm. “It always represents a luxury purchase, regardless of where you buy it. Other than as an accessory, there is no utility to it.”

Crippling Credit Crunch
The near-freeze of the credit markets is cutting off critical funds needed to support operations in businesses already strained by weak sales from tepid consumer demand. Henry Dunay, for example, cited the bank termination of credit lines as one factor that pushed the company into bankruptcy. “There is little appetite for lending,” explains Gilbert Harrison, chairman and founder of boutique investment firm Financo. “The banks and other financial sources that have been the lending source in many cases…have lost faith in the companies and, as a result, their only concern is getting all or part of their money back as quickly as possible.”

In the current business climate, lenders are no longer just unwilling to take on a risky loan but, in some cases, unable to do so. “Banks need to meet certain equity and capital requirements,” states Shimotakahara. Due to the fallout in the financial markets, the losses they are taking from existing assets “are eroding their capital base; hence, they have neither the money nor the ability to lend,” he points out. “You have extreme need, and extreme dearth.”

The credit crunch has also dried up the market for Debtor-in-Possession (DIP) financing, the type of loan that provides operating capital to sustain a company while it is reorganizing under Chapter 11 to regain its financial footing. The lack of DIP financing has resulted in bankruptcies devolving more often into liquidations. A prime example is Fortunoff, which began liquidating in late February, less than three weeks after it filed for bankruptcy protection for a second time.  

“A lot of the DIP financing was securitized into the secondary market, made up primarily of institutional investors, and that has all dried up,” says Craig Johnson, president of Customer Growth Partners, a research and consulting firm. “That is why bankruptcies are going more frequently to liquidation.”

Even when lenders do provide DIP financing these days, “they make it available at much more aggressive rates and with more stringent covenants so that it is financially punitive,” points out Robert Dangremond, managing director of business advisory firm AlixPartners.

Bankruptcy Law Burden
A 2005 revision in the bankruptcy code that forces retailers to decide which leases they will keep and which they will reject within 210 days after filing for Chapter 11 also has resulted in more companies calling it quits, particularly retailers. Industry trade groups, such as the National Retail Federation (NRF), are urging Congress to overturn the rule.

It takes time to do a rigorous “location-by-location analysis” of a retailer’s store base, agrees Enright. As a result, he says, merchants in Chapter 11 “have made hasty decisions” that backfire, such as was the case with Circuit City, “which turned into a massive liquidation quite quickly. It used to be that as long as you were able to pay the post-petition rent for leased space, you could take a long time to decide whether to get rid of, or hold on to, the lease.”

Another 2005 change in the law requires that a bankrupt company scramble together a reorganization plan in 18 months, whereas previously, “it was open-ended,” adds Dangremond. “It has forced some decisions to be made much quicker, instead of allowing companies to take their time in operationally fixing their business.”

The Private Equity Factor
In recent years, private equity firms, flush with cash, were on an acquisition binge, buying up all types of companies. Not so today. Firms like Henry Dunay, in search of a buyer or equity investment, are finding such help hard to come by. As lending tightened and the economic climate soured, private equity firms also fell on hard times. And many businesses that were initially scooped up by private equity firms, from Fortunoff to Linens ’n Things, ended up liquidating.

As a general proposition, private-equity-owned companies are more susceptible to bankruptcy and liquidation because they’re highly leveraged, and their owners are squarely focused on ultimately selling the business to recoup their investment. Shimotakahara notes, “theirs is inherently a higher risk situation.” These firms typically also do not have an emotional attachment to the companies they acquire. “It’s simply about money so they are more likely to be open-minded about filing Chapter 11, as opposed to somebody who has been running their family’s business,” Enright says.

Warning Signs and Safeguards
In general, a company opts to declare Chapter 11 when its “equity values are so far under water, and when its cash flow is so negative, that it can’t afford to pay its bills,” says Harrison. In light of what is happening, “the best retailers and consumer goods executives are putting a magnifying glass to cash management,” Pippa Wicks, a managing director at AlixPartners, was quoted as saying in a press statement detailing the results of a survey the company conducted on bankruptcy reforms. “However, only half of those we interviewed are looking at their cash on a weekly basis. In today’s environment, relatively healthy companies can suddenly find themselves in a liquidity crunch if they don’t keep a close eye on the cash.”

Both David Webb and Robbins Brothers blamed sharp cash flow declines as contributing factors to their filings. “What’s going on in this business environment is that the decline in revenues of these companies has been too sharp, too quickly, so they couldn’t restructure their debt,” explains Shimotakahara.

A red flag for vendors that retailers are in trouble is missed payment deadlines. Faced with that occurrence, a vendor should stop shipping merchandise until payments are up to date, Enright advises. Merchandise “is the only leverage you have, ultimately.” But, adds Enright, “Vendors are extremely reluctant to do that because they don’t want their sales to crumble, and they don’t want to lose the relationship with the retailer and lose sales to their competitors.”

Another warning sign for vendors is if their factors, who advance suppliers money until a retailer pays, give a merchant’s creditworthiness a thumbs-down. “Factors are intimately familiar with the financials of these companies,” Johnson says.

The current economic crisis is forcing both jewelry wholesalers and retailers to reexamine ways to cushion themselves in the event a business partner slips into insolvency. Retailers can best protect themselves by making sure all their vendor eggs are not in one basket. “The need to diversify supply is critical,” Dangremond says.

Vendors selling goods via a memo transaction, or consignment, also need to protect themselves. In a series of seminars and a published guide, “The Essential Guide to Memo Transactions,” the Jewelers Vigilance Committee (JVC) recommends filing certain documents with the Uniform Commercial Code (UCC)  — the body of laws that regulate sales of personal property. If a memo transaction meets the UCC’s criteria for a consignment, a security interest — or property interest — in the goods, such as a parcel of diamonds, for example, is created. If this security interest is “perfected” with a UCC-1 filing, and if the supplier has a consignment agreement signed by its merchant partner and has also notified that merchant’s other secured creditors, then the supplier has a higher priority for payment over other debtors if its retail partner files for Chapter 11, says Cecilia Gardner, president and chief executive officer (CEO) of JVC.

If a vendor fails to take these steps, the bankruptcy court can decide that a bankrupt retailer has title to the vendor’s merchandise simply because it’s in the retailer’s possession on memo. And the proceeds from the sale of those goods can then be used to pay back the retailer’s debts and secured creditors, while the vendor is left empty-handed.