Why a bankruptcy filing doesn’t necessarily mean your favorite store is going away

Despite popular misconceptions, Chapter 11 can actually mean a retailer's revival.

Why a bankruptcy filing doesn’t necessarily mean your favorite store is going away

The endless headlines lately about this, that, or the other retailer heading toward Chapter 11 bankruptcy protection are enough to give any shopaholic agita.

This week, after J.Crew and Neiman Marcus each filed for Chapter 11 bankruptcy protection, social media was flooded with lamentations about the end of beloved retailers and where they had gone wrong. But the filings weren’t the end of anything: Both companies, choking on debt for years, will continue to operate, with healthier balance sheets now, and no immediate plans for store closings.

There is a popular misconception that Chapter 11 filings mean the end of a business, in retail and beyond. And it’s easy to see why: Many companies like Barneys New York, Toys ‘R’ Us, The Sports Authority, and CIT ultimately liquidated.

But countless others over the years—from General Motors to American Airlines to utility PG&E to retailers like grocer Fairway and even Macy’s (its Chapter 11 filing was in 1992)—have come out of bankruptcy to fight another day. And that’s ultimately the goal of seeking court protection.

“The whole purpose of Chapter 11 is to give a company a chance for a restructuring,” says David Berliner, bankruptcy and restructuring advisor at BDO. “If a company has good prospects for continuing in business, the balance sheet is fixed. The goal is wiping out debt to make it manageable.”

In the case of J.Crew, its debt of $1.7 billion (enormous in relation to annual sales of $2.5 billion) will be converted into equity, so its creditors become its owners. Neiman shed 80% of its debt, giving it a clean slate with which to invest and update its business rather than spend hundreds of millions of dollars on interest.

And for retailers that need to slim down, bankruptcy protection is way to break some contracts, notably store leases, at lower costs.

So chin up: If your favorite store is filing for Chapter 11, it may just be the thing that saves it.

How bankruptcy works

Chapter 11 filings are named for a section of the U.S. Bankruptcy Code. A Chapter 11 filing is a form of bankruptcy that involves the reorganization of a debtor’s business affairs, debts, and assets to give it time to try to fix its business with creditors unable to claim its assets, hence the use of the term ‘protection.’ 

The U.S. government says that “A chapter 11 debtor usually proposes a plan of reorganization to keep its business alive and pay creditors over time.” Most filings are voluntary but occasionally, creditors get together and force a company into bankruptcy proceedings.

This ultimately doesn’t help a company if its business fundamentals are collapsing. Barneys’ massive debt was only one of many problems it had. The Sports Authority missed the boat when it came to e-commerce, and Toys ‘R’ Us’ outdated stores made it irrelevant to shoppers—all factors a bankruptcy filing cannot fix on its own.

In contrast, Neiman Marcus and J.Crew are hardly thriving, but their sales declines have been modest, suggesting there is room for them in the market.

A company under bankruptcy protection has to run everything by the court: the sale of any assets, divisions, property, entering or breaking leases, fees to lawyers. Everything.

Such a company also lines up debtor-in-possession (DIP) financing to have money that creditors can’t try to take that can be used to fund everyday business expenses, such as paying salaries and suppliers.

A pre-packaged plan to emerge from bankruptcy protection is the ideal scenario. Under a ‘pre-pack,’ a filing comes after creditors and the company have agreed on a plan, subject to court approval, as they did in the case of Neiman Marcus. It makes for quicker emergence from Chapter 11 and less conflict and drama.

Survival via bankruptcy auction: Many brands still have a lot of life in them and attract bidders in a bankruptcy auction ready to keep them alive. Earlier this year, Simon Property Group, the largest U.S. mall operator, was part of a group that bought Forever 21, and in 2016, it was in a consortium that bought Aéropostale. Some companies specialized in licensing, notably Authentic Brands, buy intellectual property in bankruptcy court. That is how the Barneys New York name will live on as small sections at Saks Fifth Avenue stores and in stores overseas.

Chapter 7: If a Chapter 11 filing doesn’t work out, a company may file for Chapter 7 once things look hopeless that the company can continue. This simply means liquidation and deciding which creditors will get paid in what order when assets are sold off.

Chapter 22: The number 22 is a bit of bankruptcy court humor and refers to any company that has sought Chapter 11 protection twice. That illustrious group in recent years has included Gymboree and Payless ShoeSource.

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The perfect storm: Why the coronavirus market is particularly dangerous for individual investors

Shorting the market could result in unlimited losses.

The perfect storm: Why the coronavirus market is particularly dangerous for individual investors

Individual investors may be about to lose prodigious amounts of money during the COVID-19 pandemic—but it’s not simply due to the overall market drop over the past two months. 

A confluence of factors has come together to bring about some of the worst and most value-destroying behavior by individual investors, also known as retail investors, in history. Newly granted access to high-risk markets, the appearance of zero-cost investing, historic levels of credit extended to nonprofessional traders, and an absence of other outlets for risk-taking behavior have all combined to produce a situation where many retail investors are losing money hand over fist in volatile and opaque markets they don’t fully understand.

We are beginning to see this destructive behavior play out in the data. For futures markets, something normally only accessed until recently by institutional investors, we have seen average daily volume in overnight trading nearly double in the first three months of 2020 for the E-mini S&P 500 futures contract (a security specially designed to attract retail investors due to its lower cost than the total S&P 500 contract). In the equally high-risk options markets, average monthly trading volumes jumped 58% between January and March of this year.

While this is worrisome for the average investor’s portfolio, the news in the U.S. stock market is even worse—namely the severe jump in retail investors short selling, a bet against the market where losses for investors are potentially unlimited. As equities of U.S. companies with high market capitalization (also known as large-cap stocks) bottomed out on March 23, short interest on the SPY (another favorite of retail traders that tracks the S&P 500) sat at $50 billion. Short interest expanded over the next three weeks to $66 billion, but at the same time U.S. large-cap stock rebounded almost 25%. This implies that an additional $4 billion was lost over that period as retail investors rushed to short the position.

How did retail investors gain such broad access to these markets and begin to make such bold bets? Much of this can be traced back to the proliferation of what are widely known as zero-cost trading platforms, which allow individual investors to purchase funds with no fees. Over the past two years, the rise of services like Robinhood has forced traditional players like E*Trade and Fidelity to offer similar plans. 

In addition to zero-cost trades, many of these startup trading platforms offer individual investors higher-than-normal amounts of margin (loans for investing) while requiring little money down, as well as easy access to high-risk options and futures markets. These companies’ apps make trading in these markets as easy as one or two taps on a phone—you can place $100,000 in trades instantly with a balance of just $10,000.

The problem here, aside from the risk taking, is what the investor believes are the costs of trading in these new markets. Unlike traditional investing in stock markets where the costs to trade are explicit (for example, a flat fee per trade placed), in options and other derivative markets the true costs are implicit and hidden to the average investor in things such as the bid-ask spread—something most retail investors don’t factor into their decision making. So even if the explicit costs to trade are zero, investors can lose 10% or more of their investment in implied costs every time they trade a derivative.

The coronavirus crisis has forced most white-collar employees to work from home, leaving many with no outlet for the small pleasures they used to enjoy in everyday life, such as group sports activities, going out for drinks, or betting on sports. Reddit is filled with tales of some investor turning a small investment into a million-dollar gain overnight. This gives that homebound, bored retail investor some hope that they can do it too. Yet the truth is that the more “zero-cost” trades the investor places in these markets, the more fees they rack up and the more they destroy their long-term investments.

It is a scary time for those who have watched the stock market plunge this year, but retail investors need to resist the allure of trading in derivatives markets as a way to make up for portfolio losses. Now more than ever, individual investors need to remember the basics of Finance 101: minimizing costs and resisting the urge to try to time the market is the best thing one can do for their portfolio’s future.

Derek Horstmeyer is an associate professor of finance at the George Mason University School of Business.

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