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An Epilogue to Chapter 11

Bankruptcy sales rise as the credit crunch makes reorganization more difficult.
Avital Louria Hahn, CFO Magazine
May 1, 2008

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.


But to delay filing while losses accelerate is akin to being "an ice cube on a griddle," says David Powlen, a restructuring adviser with Western Reserve Partners. In Fortunoff's case, the equity owners — Trimaran Capital Partners and Kier Group — bought a 75 percent stake from the founders in 2005 when the retailer had already been losing money. But those losses jumped to $10 million in 2006 and $30 million by the end of 2007. "By the time they filed, there was no more money to make payroll," says Watros.

The equity owners were able to tap senior secured lender Bank of America for $12 million, which allowed Fortunoff to keep operating but didn't cover such expenses as customer gift cards. For that and other expenses, NRDC had to invest an additional $35 million. Still, the damage of the late filing continues to be felt. Because Fortunoff delayed throughout the fall of 2007, it had to skip payments to vendors, which stopped shipping. In fact, many vendors now refuse to ship unless they receive cash on delivery or a letter of credit.

Holding the Bag
As the Fortunoff case illustrates, 363 filings come as a relief for sellers. But acquirers are often left with damaged goods. NRDC is now dealing with a limping business that has been losing market share for years in areas like bridal registry. It has had to eliminate 190 jobs so far. And since getting merchandise flowing is the most immediate challenge, Watros is in constant negotiations with vendors, who collected nothing from the sale.

The former Saks Fifth Avenue executive hopes to lower losses to $5 million to $7 million in 2008 and be in the black in 2009. One tactic: NRDC, which owns Lord & Taylor, plans to place Fortunoff's jewelry stores inside its 20-plus locations. For now, while Watros admits NRDC got a bargain, he also says "every day we bleed cash the purchase price is going up."

Avital Louria Hahn is a senior editor at CFO.


Find Your Stalking-Horse
A postbankruptcy sale is no easy ride.

Finding a prospective buyer during the bankruptcy process may offer relief to companies in distress, but it promises no guarantees.

Under Section 363 of the Bankruptcy Code, the newly found acquirer serves only as the stalking-horse — a buyer that provides a floor price. Because the court wants the company's value maximized, it allows competing bids and at times even orders an auction. As compensation for agreeing to be the stalking-horse, the company guarantees the suitor a breakup fee if another buyer ends up with the assets.

Even after negotiating with Fortunoff for months, NRDC Equity Partners nearly lost its bid for the New York retailer when Harbinger Capital swept in with a bid that was $1 million above NRDC's. Luckily for NRDC, Harbinger withdrew. But the original bidders don't always end up with the coveted deal. In late March, Holy Family Home's $40 million stalking-horse bid for Victory Memorial Hospital was handily topped by Victory Center of New York LLC, which paid $45 million for the Brooklyn, New York, long-term-care facility in an auction. And if Victory Center failed to produce the necessary documents on time, alternate bidder Dervall LLC was waiting in the wings with a $44.9 million offer.

Without a stalking-horse offer, bidders are at the mercy of the courts. Minnesota resort Izatys Group LLC went into bankruptcy last fall without having a stalking-horse bidder. In a court-ordered auction in April, the top bid was $2.8 million from J&C, another resort. But Commerce Bank objected because it would fail to collect the full $3.1 million it was owed by Izatys. The judge canceled the sale, clearing the way for new buyers to step in. "It is better to have a stalking-horse and then conduct an auction," says Mikels. "Going in without one is a lot more speculative." — A.L.H.


Die Another Day
Notable bankruptcy acquisitions in Q1 2008
Date
Target Acquirer
Value ($mil)
2/27
Federal Mogul Thornwood Associates $900
1/18
Marcal Paper Mills NexBank Capital 160
2/4
Fortunoff NRDC Equity Partners 100
2/14
SCO Group Stephen Norris & Co. Capital 100
1/31
Trend Homes Najafi 65
1/30
Summit Global Logistics TriDec Acquisition 56.5
2/1
Bayonne Medical Center IJKG 40.1
2/29
Nichols Bros. Boat Builders Ice Flow (and partners) 24.2
3/10
Delphi–Ride Control Tenneco 19
3/18
Victor Plastics River Bend Industries $17.4
Source: Thomson Financial


Rescue Rising
Section 363 sales are climbing.
Date Announced
Value ($mil)
Deals
Q1 '07
$888
21
Q2 '07
14,153*
15
Q3 '07
305
19
Q4 '07
1,208
20
Q1 '08
$1,568
32
*Incl. $13 billion in debt restructuring for Delta and Northwest Airlines
Source: Thomson Financial



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