An Epilogue to Chapter 11

Long Island–based retailer Fortunoff had already been losing money in September 2007 when the company began discussing a sale with NRDC Equity Partners. But as losses accelerated, the parties could not agree on a price and broke off negotiations in January. Two weeks later, Fortunoff filed for bankruptcy.

As it turned out, that move was key to rekindling the deal with NRDC. Thanks to filing Chapter 11, the suitor had to bid only $80 million for Fortunoff's assets, sidestepping some $120 million in unsecured debt discharged by the filing. "We would have liked to buy Fortunoff without taking the brand through bankruptcy," maintains Fortunoff's new vice chairman and NRDC managing director Donald Watros. "But it was not economically feasible."

Fortunoff's fate is an example of what many small-to-midsize companies filing for Chapter 11 can expect these days. Like Fortunoff, which had $306 million in debt and $267 million in assets when it failed, many distressed companies are using bankruptcy as a vehicle for a sale rather than a reorganization. Having amassed heavy debt burdens during a period of easy credit, many companies are now entering bankruptcy with financial cushions too thin to bear the costs of reorganization. Such sales, which are governed by Section 363 of the Bankruptcy Code, are attractive to buyers because they can purchase assets at fire-sale prices and with the court's blessing.

It's no wonder then that the number of Section 363 sales is rising. In the first quarter of 2008, 32 such sales, worth $1.6 billion, were announced, versus 21 deals, worth $888 million, in first-quarter 2007. Included on the list were clothing manufacturer Pacific Marketing Works Inc. and its affiliate Habitual LLC, which were sold out of bankruptcy to New Fashions Inc. for $475,000; Lexington Jewelers Exchange, which was acquired by Tiger Capital Group and Gordon Co. for $13.1 million; and Trend Homes, which was sold to Najafi Cos. for $65 million. The cycle is just warming up. "In the upcoming months and in the next couple of years we are going to see more of these sales," predicts Rick Robinson, a partner with Reed Smith in Delaware.

Blackhawk Down
While bankruptcy sales occurred long before the current downturn, recent legal and economic developments have fueled the trend. Thanks to the 2005 Bankruptcy Reform Act, companies have a narrower window of opportunity to file their own reorganization plan. Called the "period of exclusivity," that time is now limited to 18 months; the previous 120-day window could be extended indefinitely.

In addition, multilocation sectors such as retail have lost one of their main reorganization tools: the right to accept and reject leases for the duration of the bankruptcy. The new rules restrict the period to 120 days, with one 90-day extension. That means companies have to decide earlier which locations to keep, a process that could lead to misjudgments.

At the same time, banks are shunning loan workouts and demanding speedy debt recovery. "Lenders are demonstrating that they do not have the policies or the practice to work through problems," says Dominic Aversa, a managing director at turnaround specialist MorrisAnderson & Associates. He is currently serving as chief restructuring officer at auto-parts maker Blackhawk Automotive Plastics, which resorted to a 363 sale in March. "They pressure companies to foreclose immediately."

Blackhawk, whose business had been teetering along with the ailing auto industry, could not keep up with vendor payments despite a healthy business backlog. With vendors demanding cash on delivery, CFO Mike Martell projected a severe liquidity shortfall, and the company filed for bankruptcy. The intention was to reorganize or sell, but Blackhawk was not able to secure exit financing ("We asked many lenders," says Martell) and sold its main business to Canadian auto-parts maker Flex-NGate Corp. for $13.5 million. "For us, the best way to pay down debt and get the best return was to sell the company," says Martell.

One bright spot for Blackhawk was the $36 million in debtor-in-possession (DIP) financing it secured, says Martell. The continued availability of that type of financing — another trait of the current cycle — is tied to lenders' desire to protect their senior position as creditors. But DIP loans are not always enough. "Secured creditors are willing to fund for only a certain length of time," says Robinson. Consequently, he adds, "we are seeing a lot of cases where the company's intention is to sell within 30 to 60 days of filing because it is losing lots of money." Any longer and they might be forced to liquidate.

Timing Is Everything
The other bright spots for Blackhawk were its strong niche in the appliqué business (the firm makes the plastic wood grain used on car dashboards) and its early filing for bankruptcy. Blackhawk, which filed when it still had cash on its balance sheet, had a number of interested buyers and sold within four months, says Martell. The same cannot be said for Fortunoff.

The retailer, in fact, filed only when its cash nearly ran out. That's not uncommon at small-to-midsize private companies, whose founders often view bankruptcy as a last resort. "During periods when Chapter 11 is not favorable to debtors, it should be expected that debtors will attempt out-of-court solutions rather than Chapter 11 filings," writes Richard Mikels, a partner at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, in a recent article.

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