Focus Abroad The Retail Sector: Restructuring Options in the Current Climate in the U.K., France, and Germany
The United Kingdom
Retail is a very important sector of the U.K. economy, employing over 3 million people, equal to one in 10 members of the workforce (more than the whole of the manufacturing sector). However, many retailers are struggling with a triple hit of falling sales, crushed margins, and rising costs. Consumers have been adversely affected by the collapse in property values, the weak state of the labor market, the lack of job security, and the prospect of future tax increases.
Over the past 12 months, the U.K. has witnessed a continuing trend of collapses in the retail industry, which has been one of the sectors hardest hit by the volatile financial climate and falling customer confidence. There are, however, some signs of recovery after what has been a turbulent year. In the third quarter of 2009, according to Begbies Traynor’s Red Flag Alerts, there has been a decrease of 4 percent in county court judgments and winding-up petitions compared to the same period last year. This contrasts with the first quarter of 2009, which, according to PwC research, saw a jump of 60 percent in retailer insolvencies over the same period in 2008, from 440 to 705. Nevertheless, some big names are still adding to the roll call of the fallen, including Birthdays, the greeting card chain (in which Jones Day acted for the administrators); Bay Trading Clothing; and the bookstore chain Borders. Over the course of 2009, however, an overall rise of retail sales occurred through the second and third quarters, with an increase of 2.8 percent in September compared to the same period last year.
Some commentators say that the recent rise in sales is merely the calm before the next storm, and they predict that we are in the middle of a W-shaped recovery. The year-end brings with it some significant costs for retailers, including the need to pay suppliers, VAT liabilities, and the final quarter’s rent. The expected Christmas-fueled rise in sales may not be enough to keep some in this sector from joining the list of casualties.
High rent obligations remain problematic for the retail sector, despite the fact that a large number of landlords have agreed to reduce rents and/or accept monthly rent payments. Retail insolvencies in the spring were given a reprieve because many retailers had made it clear to their landlords well in advance that quarterly rent was not feasible. Fortunately, many landlords agreed. One thing for certain is that retail businesses will continue to struggle in the current environment. Those for whom the strain becomes too great will likely seek survival through a formal insolvency procedure or a consensual out-of-court restructuring.
There are a number of vehicles for restructuring a distressed retailer, including a company voluntary arrangement (largely under the U.K. Insolvency Act of 1986), pre-packaged administration, trading administration, divestiture of an underperforming business or division, and purchase of distressed debt. We address each of these in turn below.
Company Voluntary Arrangement
If a company and its creditors can reach agreement on a plan to deal with the company’s debts, an appropriate means of implementing such agreement may be a company voluntary arrangement (“CVA”). Under this process, the debtor makes a proposal to its creditors to repay a certain percentage of their claims over a specified period of time. If at least 75 percent in value of the debtor’s creditors taking part in the creditors’ meeting to consider the proposal vote in favor of the proposal, then, subject to certain safeguards, the proposal becomes binding on all creditors, including those who voted against it (although secured creditors need to consent specifically to a CVA in order for it to be binding on them). As we shall see, CVAs are becoming more acceptable in the retail sector, presumably because landlords would prefer to discount their rent claims rather than hazard the risk that the tenant will be forced into administration or liquidation with the consequent risk that the premises will become vacant and non-income-producing.
There have been a number of high-profile pre-packaged insolvencies in the retail sector, such as Whittard of Chelsea, USC, and The Officers Club. Pre-packaged administrations generally involve the sale of an insolvent company’s assets, which is pre-arranged before the company goes into a formal insolvency process. The purchaser is identified and the terms of the sale are agreed upon in advance. The sale takes place immediately following the appointment of an administrator, who will execute the necessary documents. “Pre-packs” often involve the sale of the business to the existing owners or management.
Pre-packs have been praised as providing a lifeline to companies whose businesses would not survive a formal insolvency. They enable customer-facing businesses to avoid the brand devaluation and stigma of being in a lengthy insolvency process and to carry on trading seamlessly, with a transfer of staff (whose jobs and rights are protected by law) and salvageable assets to a new corporate vehicle.
Criticism is often leveled at pre-packs due to their lack of transparency. The process is often perceived as a vehicle whereby a failing company is supplanted by a new entity overnight, leaving creditors, such as landlords and suppliers, to suffer financial losses because the old company is an assetless shell. In many cases, the same management and owners who presided over the failing company bought the new businesses, which has led to anger and widespread criticism of the pre-pack procedure. A report by the Business and Enterprise Committee found that unsecured creditors fare worse during a pre-pack, recovering 1 percent of their debts on average, compared with 3 percent in a standard business sale. However, independent research by Dr. Sandra Frisby of the University of Nottingham has established that in over 90 percent of pre-packs, all the jobs in the business are saved, compared to only approximately 60 percent in other insolvency business sales. Pre-packs can also reduce the risk of value destruction as a result of the insolvency process—they often realize more than simple liquidation, and they almost invariably cost less than a period of trading followed by a business sale.
If time and financial resources permit, a failing retailer may decide to appoint administrators who will allow the company to continue operating pending a sale or liquidation of the business. This course of action gives the administrators time to identify and negotiate with prospective buyers and to arrange an orderly disposal of the business or its assets. Trading administrations may facilitate an easier reduction in the workforce before the sale of the business. Pre-packs do not have this advantage.
Divestiture of Underperforming Businesses or Divisions
If stakeholders of, or lenders to, a failing business are able to identify an underperforming subsidiary or part of the business, one option is to sell that part of the business and keep the core business going. Doing so will lead to better financial performance of the overall retail business by removing the loss-making part. A clean departure from the underperforming division may also avoid insolvency if the buyer has the will and resources to turn the distressed business around.
Purchase of Distressed-Debt Positions
When a business is distressed, the lender or stakeholder may wish to crystallize its exposure by selling its debt and any associated security. A secured-debt sale occurs when the bank believes it will realize more value by the sale of its debt to a third party than through a formal insolvency procedure.
Set forth below are three examples illustrating how CVAs, pre-packs, and trading administrations have been used recently to try to protect the core Businesses of retailers.
Stylo was an Alternative Investment Market-listed footwear retailer based in Bradford that acted as the holding company of a number of subsidiaries which sold high-street branded footwear such as Barratts, Dolcis, and Priceless. The company had a high cost base due principally to high rent obligations. Following losses of £12.5 million in 2008, the company appointed administrators in February 2009 over each of its operating subsidiaries and proposed a CVA to its creditors and landlords. The CVAs proposed that, in compromise of their claims for rent arrears, the landlords would receive 3 percent of shop turnover for three months beginning in June 2009, increasing to 7 percent for the remaining 11-month period of the CVA.
The proposed CVAs were ultimately voted down by the landlords because the proposal would have put them in the undesirable position of subsidizing Stylo’s other creditors, who would be paid with the money the landlords would concede. They also believed that it was likely, even if the CVA had been approved, that under continuing pressure, they would ultimately lose their tenants in the following few months. However, commentators believe that the key reason for the rejection was that the landlords were concerned about setting a precedent that other struggling retailers might follow. It appears that the commercial-property industry intended to send a clear message to the retail sector—that CVAs were not going to be an easy way out.
Following rejection of the CVA proposal, administrators were appointed over the listed parent company, Stylo, and the core profitable elements of the business were “pre-packed” to an entity owned by the chairman of the Stylo group, with the unprofitable stores closing.
JJB Sports plc
JJB Sports, a sports equipment retailer, was struggling with a combination of a high cost base and low sales. In contrast to the rejected CVA proposed by Stylo, the CVA proposed by JJB to its creditors provided that the landlords of closed stores would be able to claim distributions from a fixed pot of £10 million on two payment dates in September and December 2009 and that the terms of the leases for the open stores would be varied to permit monthly, as opposed to quarterly, rental payments. The CVA was approved by 99 percent in value of creditors, saving the retailer from administration. Early engagement with the landlords and other creditors was arguably the determining factor for the success of the JJB CVA. The success of the CVA also showed that most landlords are beginning to realize that CVAs will not be rejected out of hand.
Birthdays owned more than 330 stores nationwide selling greeting cards and related products. A combination of high rentals and reduced trading made its business uneconomical, although many individual stores were profitable and viable. Birthdays had to reduce its store base, but the cost of doing so outside insolvency was prohibitive, and so it entered into administration. The administrators operated the business for a month and sold a significant proportion of the stores as a going concern.
The current financial downturn has crept into every sector of the French economy, including the retail sector. Of 60,000 formal insolvencies in the past year in France, about 13 percent of the total have arisen in the retail sector.
France’s insolvency law provides for the following procedures for restructuring a distressed retailer.
New Money Under the Ad Hoc Mediation (Mandat ad hoc) and Conciliation Procedures (Conciliation)
The ad hoc mediation and the conciliation procedures are two out-of-court confidential pre-insolvency proceedings that are widely used to restructure distressed businesses in France. In each case, a company’s management has the right to request that the president of the commercial court appoint a mediator to help the debtor reach a voluntary agreement with its creditors or investors. In practice, the conciliation procedure can be extremely effective in distressed M&A transactions, because new-money investors benefit from a “super priority” (privilège de conciliation) over the debtor’s other liabilities if the French court publicly approves (homologué) the conciliation agreement entered into by the debtor, its creditors, and the new-money investor. An important example of this was seen in June 2009 in the case of SIA, a leading European retailer of interior decoration products. Here, Vermeer Capital, a distressed investment fund, will be able to claim super priority for a shareholder loan it will make once it has completed its acquisition of the company.
Restructuring Plan Under a Safeguard Procedure (Sauvegarde)
The recently introduced safeguard procedure is also a very useful restructuring tool in France. This highly regulated procedure is a court-driven process available to companies facing financial difficulties. The safeguard procedure can result in the court approval of a restructuring plan involving the rescheduling of the company’s debt over a maximum period of 10 years if there is no agreement between the debtor and the creditors. If there is an agreement between the debtor and the creditors, the debt restructuring can include a write-off, a debt-equity swap, or the rescheduling of the debt over a longer period than the statutory 10-year maximum.
Recently, Autodis, a leading French retailer of car parts to the public, was financially restructured through the conciliation procedure for the operating company and the safeguard procedures for the holding companies. The case may well prove a model for complex restructurings in France because the restructuring of this 5,000-employee company was implemented via a pre-packaged agreement entered into by management, the company’s shareholders, its various classes of creditors, and a third-party investor, contemporaneously with the official commencement of the safeguard procedures.
Sale Plan Under a Reorganization Procedure (Redressement judiciaire) or a Liquidation Procedure (Liquidation judiciaire)
The reorganization procedure is a court-based proceeding available to insolvent companies that basically follows the rules of the safeguard procedure, except that one possible exit route is the sale of the company’s assets under a sale plan. The sale plan is the usual feature of the liquidation procedure. In both cases, a third-party investor will purchase the assets of the debtor following a competitive, transparent, and orderly sale process. The third-party investor will typically also agree to take over all or a significant number of the employees of the debtor. The purchase price for the assets is often less than the amount of the debtor’s liabilities, but this is unsurprising, both in view of the state of the debtor’s insolvency and because the court’s priority is to preserve the continuity of employment of the workforce rather than to enforce repayment of the debtor’s liabilities.
The retail sector in Germany has also been hit by the economic downturn. The German Retail Federation (Hauptverband des Deutschen Einzelhandels, or “HDE”) expects a decline in retail sales of about 2 percent in 2009. The drop in sales may turn out to be even worse due to increased unemployment in the fall. According to the HDE, retail is the economic sector that is suffering most from the general squeeze on credit availability. In addition, rents in the retail industry are considered too high, and due to a change in trade tax rules that came into force last year (arguably at the worst possible time), rent payments up to a certain percentage may have to be included in income when calculating a company’s trade tax liability. The newly elected German government—a coalition of the center-right Christian Democratic Union; its Bavarian sister party, the Christian Social Union; and the liberal, pro-business Free Democratic Party—plans to reduce this percentage. It remains to be seen, however, whether this proposed change in the law is possible, given anticipated opposition from the federal states and municipalities, both of which benefit from trade tax revenues.
According to estimates, roughly 5,000 retail businesses will have to close their doors this year. Small, owner-managed stores will not be the only businesses affected; larger concerns will be victims as well. The sector has seen a number of high-profile insolvencies recently. These include Arcandor, the parent company of the well-known retail chains Karstadt and Quelle (the latter a mail-order company that is now being wound up), and Woolworth (which was independent of the U.K. business). These insolvencies followed the collapse last year of Wehmeyer, Sinn-Leffers, and Hertie.
Insolvency proceedings (Insolvenzverfahren) under the German Insolvency Code (Insolvenzordnung) are the only judicial proceedings in Germany for formal insolvencies of companies. These proceedings are flexible and seek to effect either a liquidation of the company’s business (including a sale of the business as a going concern by way of an asset deal) or a reorganization of the insolvent company itself by means of an insolvency plan.
A sale of the company’s business as a going concern by way of an asset deal is a well-established way of rescuing a business in insolvency proceedings. It has the advantage of being a fairly simple means of realizing value for the estate. To adopt an insolvency plan and leave the debtor in possession has proved to be beneficial in large and complex insolvencies involving groups of companies, by combining the specific restructuring expertise of a reorganization specialist appointed to the board shortly before the insolvency with the knowledge and experience of existing management.
A recent example of a sale of a retail business as a going concern is Wehmeyer. A reorganization by means of an insolvency plan was successful in the case of Sinn-Leffers.
The fashion chain Wehmeyer applied to the German court for insolvency in July 2008. The sale of the business to Indian strategic investor Rajive Ranjan by way of an asset deal was announced by the insolvency administrator at the beginning of November 2008. The transaction involved 23 of the 39 original branches, and about 500 out of 900 employees were retained by the buyer. Although speed is naturally of the essence in every asset deal in insolvency proceedings, the sale in the fall of 2008 meant that the peak of the economic crisis was avoided. It probably would have been much more difficult to achieve the same result six months afterward, as investors have since become cautious.
Another well-known German fashion chain that went into insolvency in 2008 was Sinn-Leffers. In this case, a restructuring expert was appointed to the management board to advise the company and assess its options before the company applied to the court for insolvency. Once the application had been made, an insolvency plan was put together very quickly. The shareholder provided fresh money that enabled the insolvency plan and the restructuring to proceed. When the proceedings were formally opened, the plan was already prepared and the court left the debtor in possession (i.e., it did not appoint an insolvency administrator to take over the company’s affairs). The advantage of an insolvency plan over a sale by way of an asset deal was that the consent of the landlords for the transfer of lease agreements was not required.
Although economists’ predictions for the retail sector remain uncertain, there are likely to be further insolvencies, with more U.K. high-street retailers (and their equivalents in France and Germany) struggling to meet their overheads and rental obligations. It is likely that the formal insolvency procedures and out-of-court restructurings described above will be utilized. We expect the use in the U.K. of CVAs to become more widespread as they become more acceptable to stakeholders and creditors.
A version of this article originally appeared in Accountancy Age. It has been reprinted here with permission.