Expert Analysis: Steps to Take NOW for Addressing the COVID-19 Crisis
The unprecedented COVID-19 pandemic has thrust many retailers into unchartered territory. With the imposition of social distancing and stay at home orders, non-essential U.S. retailers have been forced to close thousands of stores across the country. Many of these stores may not reopen until May, at the earliest. And when they do, the world may look very different from what it did just months before.
The blunt impact of the COVID-19 shutdowns will force many retailers to grapple with overleveraged balance sheets and exhausted liquidity reserves. Many experts believe that retailers will find themselves undertaking this already daunting task in the midst of a significant global recession. To weather the storm, retailers will need to develop strategies that address both the operational and financial issues they face. Historically, many retailers have done this through formal Chapter 11 proceedings.
Chapter 11 provides retailers with important tools to restructure both their operations and their balance sheets. Critically, it allows retailers to “reject” non-residential real property leases as a means of reducing store counts, and to cap the resulting damages. It also allows retailers to restructure secured debts and to pay them off over time, or alternatively to convert secured debt to equity. Retailers can also utilize Chapter 11 to reject executory contracts (rendering the resultant damages unsecured claims), and to reduce amounts owing to unsecured creditors. And finally, Chapter 11 provides restructuring retailers with an avenue to raise additional capital to fund future operations.
Chapter 11, however, is not just a tool for standalone restructurings. Where a standalone restructuring is not a preferred or viable path, Chapter 11 also allows retailers to divest some or all of their operations through going concern asset sales. And where going concern sales are not an option, retailers can use Chapter 11 to conduct going out of business liquidation sales.
The key to a successful Chapter 11 is adequate planning. The most successful Chapter 11 cases are those commenced after a company has undertaken extensive planning—developing and securing the funding necessary to implement a well-defined exit strategy. Retailers that enter bankruptcy without a well-defined strategy are often overtaken by circumstance, and forced to liquidate.
For this reason, retailers impacted by the COVID-19 crisis and its aftermath would be well advised to begin planning how they might address the impacts when the crisis abates. This, of course, is easier said than done, as the ultimate outcomes are still uncertain. Nobody knows, for instance, how long non-essential retail stores will be closed, and the extent to which store closures will impact retailer revenues. It is similarly too soon to tell if consumers will, in large numbers, embrace e-commerce as an alternative to brick-and-mortar stores during the crisis, or if they will largely forego discretionary spending. And if non-essential e-commerce does gain traction, nobody can know whether consumers will return to stores once the crisis ends—or whether they will continue online shopping for the foreseeable future.
Most critically, nobody knows whether discretionary consumer spending will bounce back after the shutdown ends, or if it will instead continue its decline due to a lasting economic recession.
Given these uncertainties, as a practical matter, it may seem futile for retailers to begin strategizing around a possible restructuring. But even engaging in preliminary planning will allow retailers to act quickly and surefootedly when the uncertainties begin to abate. Some of the steps retailers should consider taking now include:
- Communicating with lenders. Many non-essential retailers have or soon will violate their financial covenants or otherwise default on their credit facilities, and will need to obtain waivers or forbearance from their lenders to remain afloat. Given that COVID-19 has likely depressed collateral values—making foreclosure or forced liquidation an unattractive option for lenders—lenders may be willing to provide limited waivers and short-term forbearance in exchange for increased financial reporting and information (and possibly a fee). This may buy retailers time to develop a better-informed strategy to deal with the impact of the crisis, albeit with increased lender oversight.
- Communicating with landlords and suppliers. Many non-essential retailers will also struggle to pay rent and meet other contractual obligations during the shutdowns. Some landlords and suppliers may agree to short-term deferrals of rent or other contractual obligations. Others—particularly those with cash needs of their own—may be willing to terminate long-term lease or contractual agreements in exchange for immediate cash payouts. Achieving these short and long term arrangements can help a retailer in negotiating with lenders, developing a business plan, and determining whether any necessary restructuring can be achieved outside of a Chapter 11 process.
- Preserving cash. Cash is king. Retailers should conserve cash whenever possible.
- Addressing supply chain concerns. Many retailers now face disruptions in their supply chains. Solidifying supply chains through executory contracts that can be modified depending on future needs will enhance the value of retail businesses.
- Developing contingency plans. While nobody knows when or how the current crisis will end, there are a number of conceivable results. Retailers should promptly develop business plans, fund-raising plans and/or divestment strategies that can be refined and implemented depending on how the crisis plays out. They should engage experienced professional advisors—like financial advisors, investment bankers and restructuring lawyers—to assist in these efforts. Throughout this process, management and the board should ensure that they are exercising good corporate governance, and are acting in the best interest of the company and its relevant stakeholders.
Retailers are facing a one-in-a-generation disruption. Those who engage in proper planning—even in the wake of uncertainty—may be positioned to emerge from the COVID-19 crisis stronger than ever.
Erin N. Brady is a partner at Hogan Lovells. Her practice focuses on complex, time-sensitive challenges inherent in corporate restructurings and liquidations. One concentration of Erin's practice is restructurings in the retail sector. She represented Mattel as the largest unsecured creditor and co-chair of the creditors' committee in the Toys 'R' Us Chapter 11 cases. She represented Fleming Companies in the sale of substantially all of its grocery store distribution business. She also represented American Apparel and its affiliates in its two recent Chapter 11 cases, the first in 2015 and the second in 2016.