long before they seek bankruptcy relief. During that time, it
is common for them to experience either technical or financial defaults under their lending agreements. The default
gives a lender the opportunity to reconsider the terms under
which it is doing business with its borrower, to anticipate the
possibility of still further defaults and to develop an overall
strategy for being paid in full. Deciding which responses
are appropriate will depend on many factors, including the
length of the relationship with the borrower, the lender’s
assessment of management and the lender’s assessment of
recovery in full in the event of a bankruptcy.
A loan default is the best opportunity for a lender to
reconsider the core terms of its lending agreement. Do the
financial covenants make sense at their current levels? Are
there other positive or negative covenants that need to be
added? On a structural level, the lender needs to consider
the nature of the default and the likelihood of additional
defaults in the near term. The lender should consider trends
in the borrower’s sales and profitability and how the debtor
compares with peer retailers. The lender should assess
the quality of the borrower’s market strategy and management team. In addition, lenders need to analyze their likely
payout from an orderly liquidation of the borrower’s business. Another key variable is the remaining tenor of the loan.
How likely is it that the borrower will be able to refinance its
debt when due?
Because each retailer faces its own market, customer
base, vendor base and geographic footprint, there are no
cookie-cutter solutions. A loan default is the best opportunity for a lender to reconsider the core terms of its lending
agreement. Do the financial covenants make sense at their
current levels? Are there other positive or negative covenants
that need to be added? On a structural level, the lender
needs to consider the nature of the default and the likelihood
of additional defaults in the near term. For more troubled
companies, lenders can require that a borrower retain a
chief restructuring officer acceptable to the lender or that the
borrower retain an investment bank and begin the process
of marketing the company for sale. Lenders need to calibrate
their responses to the facts of each case; a minor covenant
failure does not necessarily mean that a lender should seek
a change in management. But if the borrower has shown a
pattern of declining sales and/or profitability, good lending
practice suggests that the lender act to protect its interests
before the borrower experiences an irreversible decline. abfj
S TEPHEN SELBS T is the chair of Herrick Feinstein’s Restructuring
& Bankruptcy Group.
for approximately $170 million in cash and credit bid.
Standard General will operate approximately 1,700 stores.
• Caché: Sold its inventory to Great American for $18
million, closed 218 stores and sold some leases
• Aeropostale: Sold its assets to a consortium of inventory
liquidators and two of its major landlords for $243 million.
Prior to Chapter 11, operated approximately 800 stores in the
U.S. and Canada. New owners may operate as many as 500
stores, but they are still in the process of evaluating locations.
Challenges to Reorganization
Retailers experience high rates of liquidation because they typically
have very little time to execute a reorganization or sale. Prior to the
2005 amendments to the Bankruptcy Code, retailers often spent two
or more years in bankruptcy. During that time, they used a variety of
strategies to fix their businesses, including merchandising changes and
evaluation and/or closure of marginal stores. They typically had one or
more holiday seasons in which to test the changes. But the 2005 amendments to the Bankruptcy Code substantially shortened that timeline,
effectively giving retailers only a few months to obtain approval for a
sale or reorganization before getting forced into liquidation. Coupled
with the changes in the Bankruptcy Code was an increased willingness
of bankruptcy judges to approve DIP financing agreements that had
strict timetables for retailers to confirm a plan or commence liquidation.
The biggest change to the code came in §365(d)( 4), which now
provides a maximum of just 210 days before unassumed store leases are
deemed assumed — absent individual landlord approvals. Rejecting a
lease before it is assumed creates a general unsecured claim, whereas
rejecting a lease after assumption creates an administrative claim.
Thus, senior lenders will typically impose a timeline in cash collateral
or DIP financing orders that ensures all unwanted leases get rejected
well in advance of the 210-day deadline. Because it can take up to 90
days to run store going-out-of-business sales, senior lenders frequently
attempt to mandate a decision on whether to liquidate or reorganize a
debtor within 120 days of the filing.
Lenders have another incentive to push liquidation: strong results
from inventory liquidations. Inventory can make up as much as 50%
of a typical retailer’s assets. In several recent cases, the inventory liquidation values were at or above 100% of the debtor’s cost. Lenders are
aware that liquidators have achieved these returns, lessening the fear
that a liquidation will adversely affect them. Because liquidation offers
lenders a high probability of a good result and the certainty of an accelerated timeline, they are less likely to give retailers time to reorganize.
Negotiating and obtaining confirmation of a plan of reorganization can
be time consuming, and if the pre-petition lenders are not cashed out,
they remain exposed to the debtor. Thus, lenders have incentives to
Another important 2005 change to the Bankruptcy Code was the
introduction of §503(b)( 9), which gives administrative priority status
to vendor claims for the value of goods sold in the 20 days immediately preceding a bankruptcy filing. Unless trade creditors agree to
less favorable treatment, a retailer has to have cash at confirmation to
pay for those goods in full to confirm a plan of reorganization because
administrative-priority claims must be paid in cash on the effective
date of a plan. This change significantly increases the cash cost of a
Lender Strategies for Struggling Retailers
Given the ongoing forces that are affecting the retail sector, lenders
may face exposure to one or more troubled borrowers. Retailers rarely
experience catastrophic failures; they typically struggle financially
A loan default is the best opportunity for a lender to reconsider
the core terms of its lending agreement. Do the financial
covenants make sense at their current levels? Are there other
positive or negative covenants that need to be added? On a
structural level, the lender needs to consider the nature of the
default and the likelihood of additional defaults in the near term.