Articles Tagged with Restructuring

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As we learned during the downturn in 2008, the economic climate can change rapidly. When things are going well, many businesses forget the lessons of the past. No matter what industry your business is in, there may be occasions when you are asked to enter into a relatively long-term contract, i.e. longer than three years. Such agreements are sometimes favorable because of the stability and predictability they can provide. However, before entering into such an agreement, you should consider that the longer the contract, the greater the risk of a change in the contract counterparty’s financial situation. A safe credit risk in 2017 might find itself filing for bankruptcy by 2020.

If your response is: “I am not concerned about the other party filing bankruptcy. I had my attorney include a bankruptcy termination clause in our agreement,” then you may want to think again. The U.S. Bankruptcy Code has a lot to say about the rights of both the debtor and the non-debtor party once a bankruptcy is filed – often to the chagrin of the non-debtor party.

It is true that many business agreements contain clauses which provide that a party filing bankruptcy is deemed to have breached the agreement, and the other party may terminate the agreement (a “Right to Terminate” clause). Or the provision might say that if one party files bankruptcy, that party’s rights terminate automatically (an “Automatic Termination” clause).

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An asset based loan (“ABL”) is often the financing of choice for retail borrowers – and for good reason. In its simplest form, an ABL is a credit facility, usually in the form of a revolving line of credit, the availability of which is based exclusively on the value of a company’s “eligible” assets.  In the retail context such eligible assets are, for the most part, the company’s accounts receivable and inventory.  There are numerous advantages of an ABL over a traditional loan: an ABL is typically easier to obtain since it is based on a company’s assets and not cash flow; an ABL provides ready cash to support liquidity needs; an ABL often includes flexible borrowing and repayment terms and less restrictive financial covenants; and, particularly beneficial to retailers, an ABL commonly accounts for seasonality and allows more borrowing during periods of slower sales.  The borrower in the ABL is required to submit a “borrowing base certificate” on a monthly or even weekly basis, which details the current inventory levels (and accounts receivable), deducts certain amounts such as letters of credit, applies the applicable borrowing percentage (usually a percentage of the net orderly liquidation value (“NOLV”) of their inventory), and the result is the amount of cash available.  In addition to borrowing base certificates, the company is also subject to field examinations and inventory appraisals conducted at least once a year, if not more often, which determine the percentage applied to their borrowing base calculation.

iStock-184621155-1024x682When retail sales are booming, the company and the ABL seemingly work like a well-oiled machine: inventory is rapidly converted to cash, which is then used to pay the loan and fund purchases of new inventory, which, in turn, increases the amount the company can borrow at any time, commonly known as the “borrowing base”. A difficulty arises, however, when one of these necessary steps is obstructed – which is exacerbated in the bankruptcy context.  There seems to be an inherent conflict between the fluid nature of retail inventory flow and the fixed nature of a borrowing base.  It would certainly be maddening if American Express restricted my credit limit on a weekly or daily basis depending upon what was, or was not in my closet at any given time.

When the amount you can borrow depends upon your inventory levels, the retail company is incentivized to keep inventory levels high through new inventory purchases, which, in turn, often requires drawing cash from the credit facility.  This vicious circle illustrates what is colloquially referred to as the “ABL Trap”.  Even when it may be in the company’s best interest to reduce or hold off on inventory purchases, the selling of inventory without replenishment will lower its borrowing base and increase the risk of an overadvance – that is, when the amount borrowed exceeds the calculated availability.

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We asked some of our financial advisor colleagues to give us brief read outs on what they felt 2017 has in store for us now that we have gotten beyond the inauguration and into the first weeks of the Trump administration.  Their thoughts follow:

https://www.southerncaliforniabankruptcylawyersblog.com/files/2017/02/2012-03-31-10.05.15-214x300.jpgWe have been seeing a lot of highly leveraged deals that impact the performance of the business. These deals are leading to reduced spending on capital expenditure, marketing and even experienced management.  Once new ownership is in place, these strictures prevent the company from operating with the same efficiency as in the past, let alone growing.  Another scenario we have been encountering is companies getting beyond the management ability of the founder as the company increases revenues from $25M to $50M and then to $100M or more. In either case, increasing interest rates will cause dislocation, because it does not take much to push these companies into a zone where they are showing significant financial stress.

That being said, we are also seeing that lenders are still being lenient because it’s really hard to get a full recovery in a liquidation, and appraisal firms always seem to be the first to hedge on their ability liquidate inventory en masse.  Also, my sense is that lenders don’t really want to sell their loans to exit a credit as it hurts their reputation.  Still, we are finding that lenders keep getting surprised with over-advances for many reasons.  When we are called in to assist in such situations, we focus our efforts on trying to fix the operating issues of the businesses and make a reasoned re-allocation of limited resources.