Forever 21 Turns 22

Forever 21, the store known for its trendy fashions among teens and young adults turned 22 today when the company filed for its second Chapter 11 bankruptcy since 2019.  During the 2019 bankruptcy, the company closed 150 of its 534 stores and was brought out of bankruptcy by label owner Authentic Brands and mall operators Simon Property and Brookfield Asset Management. This time, Forever 21 is not as lucky as the company has announced liquidation plans.

It Was In My Other Pocket

Have you ever been short on money and gone through your clothes, only to find a $20 bill that you had forgotten about? We are sure that you were relieved. The same thing just happened to cryptocurrency exchange FTX, which filed for bankruptcy back in November. FTX attorneys announced that the company had found $5 billion in cash, liquid cryptocurrency, and other liquid investments! Of course, it appears that there may be other pockets to check as the total value of missing customer assets is $8 billion.

Liquidity and Bankruptcy

As investors have learned, like any other investment, cryptocurrency is subject to volatility. The recent bankruptcy filing of crypto exchange FTX shows, this volatility can be extreme. For example, the Ontario Teachers' Pension plan wrote down $95 million due to the collapse. As you probably know, bankruptcy occurs when liabilities are greater than assets. However, bankruptcy can result from a finer distinction between liabilities and assets, namely liquidity. In the case of FTX, the company had $8.9 billion in liabilities and $9.6 billion in assets. So was the company forced to declare bankruptcy? Liquidity. When you look at the balance sheet, FTX had $900 million in liquid assets, $5.5 billion in less-liquid assets, and $3.2 billion in illiquid assets. Think about it like way: You owe $10,000 at the end of the week but your only asset is a $100,000 house. Yes, your assets are greater than liabilities, but you likely won't be able to sell the house and receive the cash for the sale by the end of the week, so you could be forced into bankruptcy. But FTX had other problems as well. John Ray, who was appointed to oversee the FTX bankruptcy and has overseen other large bankruptcies such as Enron, stated "Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here."

COVID-19 Bankruptcies

As we mentioned in the textbook, financial leverage is a double edged sword. With the COVID-19 lockdowns, the economy slowed dramatically and the effect on highly leveraged companies was immediate. During 2020, 244 U.S. companies with liabilities over $50 million filed for bankruptcy. This was a 70 percent increase from 2019, and the most since 2009's 293 filings. In what may be more telling, during 2019, 62 percent of companies reported being a net investor. However, by the fall of 2020, only 52 percent of companies reported being a net investor.

Wirecard Turmoils

Creditors of German digital payment processor Wirecard, which advertised "Beyond Payments," may find that the company's debts are beyond payment. Wirecard also proved that accounting fraud is unfortunately worldwide when it filed for bankruptcy yesterday. The company said that €1.9 billion ($2.1 billion) in cash that was on its balance sheet probably never existed in the first place. Now, things have gotten bad for the company's auditors as the German shareholder association SdK announced that it had filed a criminal complaint against the company's auditor Ernst & Young (EY). SoftBank, a major investor, also announced that it planned to file against EY. In its defense, EY stated there were "clear indications that this was an elaborate and sophisticated fraud, involving multiple parties around the world at different institutions, with a deliberate aim of deception" and that "even the most robust and extended audit procedures" were not enough to uncover the fraud.

Hertz SEO

We had previously discussed the Hertz bankruptcy filing. In an indication that the current economic conditions caused by the COVID-19 lockdown are unique, Hertz is planning a secondary stock offering while in bankruptcy. An SEO in the middle of a bankruptcy filing has never been attempted before. The company has warned prospective shareholders that it is unlikely that they will receive anything in bankruptcy, and barring a rapid improvement in the company's prospects, will almost certainly be wiped out. Based on the current stock price, Hertz hopes to raise $500 million. Hertz currently owes about $2.3 billion. This is certainly an SEO we are not trying to jump in line to buy.

Oil And Gas Bankruptcies

As we discussed in the textbook, financial leverage is a double-edged sword, increasing shareholder returns in good times, but causing financial distress in downturns. Since companies in an industry tend to have similar leverage ratios, a wave of bankruptcies can occur in that industry. The high leverage in the oil and gas industry appears to be reaching a tipping point as 26 oil and gas producers have filed for bankruptcy this year, almost matching the 28 for all of 2018. There is still a way to go to match the 70 bankruptcy filings in 2016, which was caused by low oil and gas prices.

Is There Too Much Corporate Debt?

A common refrain among policy experts is that the corporate debt level is too high. In fact, from 2008 to 2018, corporate debt rose from $2.3 trillion to $5.2 trillion, debt-to-EBITDA has risen, and there has been an increase in the number of companies with junk-rated bonds. So is there really too much corporate debt? A recent article from McKinsey indicates that current debt levels may not be as dire as many would lead you to believe. For example, even though the number of companies with debt rated below BBB- has increased, it appears that the reason is not a general lowering of credit rating, but rather an increase in the overall number of rated companies and companies that previously issued unrated debt now being rated. And while the debt-to-EBITDA ratio has increased, the EBITDA-to-interest ratio for most industries has remained stable over the past 10 years.

In short, it may be that the fear of too much leverage in corporate America is overblown. However, as the article notes, companies should still undertake stress testing to exam the risks associated leverage. If you are not familiar with stress testing, it is similar to scenario analysis in capital budgeting, except we focus on the worst case analysis. Stress testing can indicate scenarios that would place a company in financial distress, allowing for prior preparation if these circumstances should arise.

Bankruptcy Contagion?

Brazilian airline Avianca Brasil filed for bankruptcy restructuring in December, which is not an unusual event. However, Avianca Brasil licenses its name from Avianca Holdings SA, a Colombian airline. Avianca Holdings is a larger company, although the companies are owned by brothers. In a recent SEC filing, Avianca Holdings stated the close association between the companies “could generally result in an overall decrease in customer confidence, any of which could lead to a significant loss of business.” Whether this loss of costumer confidence occurs to Avianca Holdings occurs is yet to be seen, but Avianca Holdings also may be forced to take on four airplanes that it subleased to Avianca Brasil.

Defaulting On Bond Covenants

Windstream Holdings, a rural telecom company, is expected to file for bankruptcy after the company recently lost a lawsuit filed by Aurelius Capital. The lawsuit stems from Windstream's 2015 spinoff of the company's Uniti Group. Aurelius filed the lawsuit arguing that the spinoff violated protective covenants in the company's bond indentures. Windstream was forced to pay Aurelius $310 million. Since the ruling legally means the company has defaulted in its debt, other bondholders can now force immediate repayment on the bonds they hold.

PG&E Files Bankruptcy

Several weeks ago, we discussed the possibility that PG&E might file for bankruptcy. Yesterday, PG&E made it official with its bankruptcy filing. PG&E listed assets of about $71 billion and liabilities of about $52 billion in its filing. The advantage of bankruptcy for PG&E is that it will slow down lawsuits that have been filed or will be filed in relation to recent wildfires in California. It is estimated that the company faces about $30 billion in claims from these wildfires. PG&E may take up to two years to emerge from bankruptcy.

Lehman's Bankruptcy Tally

The Federal Reserve Bank of New York released a final (hopefully) estimate of the cost of the Lehman Brother's 2008 bankruptcy filing and the numbers are staggering. Compensation and benefit costs amounted to $1.97 billion, professional and consulting fees were $2.56 billion, and other operating expenses were $1.37 billion, for a total of $5.9 billion! This does not include the $1.36 billion paid out for the Security Investors Protection Act (SIPA)claims. While the bankruptcy costs (excluding SIPA claims) were about $6 billion, the number appears to be in line with other bankruptcies. Research indicates that bankruptcy costs are generally 1.4% to 3.4% of a company's pre-bankruptcy value. For Lehman, which had $300 billion in assets, bankruptcy costs were about 2% of assets.

Sears Bankruptcy

Sears survived the Great Depression and two world wars, but couldn't survive internet shopping. As a result, the company was forced to file bankruptcy and now it is going to get expensive. Lehman Brothers 2008 bankruptcy cost more than $2 billion, while the Toys R Us bankruptcy in 2017 has cost $375 million to date and still counting. In the Sears bankruptcy, at least 36 lawyers are charging more than $1,000 per hour. The company has employed six law firms, three investment banks, two financial advisors, and seven others who are providing tax, real estate, and other bankruptcy services. One law firm has already billed more than $5 million in the first two weeks of bankruptcy. 

Sears' Financial Distress Costs

We mentioned in the textbook that there are indirect financial distress costs, which, unfortunately, Sears is experiencing. Because of Sears' financial problems, suppliers are not willing to sell to Sears, or are tightening credit terms. Part of the reason is that suppliers continued to sell to Toys R Us, but then only received 20 cents on the dollar. A poll indicates that 66 percent of suppliers are demanding cash payment or payment on delivery and 26 percent were on regular terms, but not longer than 30 days. In fact, more than 200 suppliers have quit selling to Sears at all. This can create a "death spiral" as Sears cannot order goods to sell at a time when sales are already low, meaning fewer customers even go to Sears' stores. 

Sears Bankruptcy

It appears that Sears, once the world’s largest retailer, may file for bankruptcy as soon as this weekend. One alternative being explored is a Section 363, or stalking horse, filing. In a Section 363 filing, the company would sell some of its assets, but the sale would still have to be approved by the bankruptcy court. For example, CEO Eddie Lampert has already offered $480 million for the company’s Kenmore appliance and home improvement division. If successful, the company would exit the bankruptcy with fewer assets, but less debt as well.

Toys R Us Joins Retailers In Bankruptcy

With $5 billion in debt, Toys R Us becomes the second largest retailer in U.S. history to file bankruptcy, following only KMart. The bankruptcy filing is at the worst possible time for the company as it is ramping up inventory for the fourth quarter, which typically accounts for about 40 percent of the company's revenue. Overall, 2017 has been a bad year for retailers as 35 retailers have filed for bankruptcy, including Wet Seal and Radio Shack, who filed Chapter 22 bankruptcies.

The (Partial) Effects Of Tax Reform

With the U.S. corporate tax rate being among the highest among developed economies, there is discussion of corporate tax reform that would reduce the corporate tax rate from 35 percent to 20 percent, as well as the possibility of eliminating the deduction of interest expense entirely. So how would this affect corporate finance? A cut in the corporate tax rate on interest would reduce the attractiveness of debt as a form of financing, thereby reducing the amount of debt in the optimal corporate capital structure. One estimate is that the U.S. average debt-to-EBITDA ratio would drop from 4.1 to about 3 times, which would also affect the other financial leverage ratios. And the non-deductibility of interest expense would affect the calculation of the weighted average cost of capital. And, finally, at least for now, the decline in corporate debt will likely increase the credit rating for the remaining debt, driving the yield down on debt that does remain. All in all, major changes to U.S. based corporations.

Sears' Financial Distress Costs

When a company is in financial distress and bankruptcy is possible, it may be forced into actions that it would not like to undertake. For example, Sears, which has been has been faced with declining sales and mounting losses, recently announced that it was selling its iconic Craftsman tool brand. The sale of Craftsman to Stanley Black & Decker is for $900 million. Under the terms of the agreement, Sears will be able to sell Craftsman tools for 15 years royalty free. Sears also announced that it will close an additional 150 stores.

Financial Distress Costs For Sears

For several years, the performance of Sears Holdings has been declining. Now, it appears that the company's suppliers feel that the company may be headed toward bankruptcy. JAKKS Pacific announced last month that it would stop shipping toys to Sears' Kmart stores, fearing Sears would file bankruptcy, making collection on the receivables problematic. Now it appears that other suppliers have reached the same conclusion as at least six suppliers have reduced shipments to Sears for the same reason, including at least one supplier who stopped shipping to Sears entirely. Chairman and CEO Eddie Lampert had extended credit to Sears three months ago to stop speculation by suppliers and some Sears suppliers have been paid in 30 days rather the typical 60 to 90 days. Given that Sears is headed into the Christmas season, the biggest sales season for retailers, problems with suppliers could signal a spiral into bankruptcy for the company.

High Yield Bond Defaults Expected To Rise

Standard & Poor's Ratings Services expects default rates on high yield bonds to increase to 5.6 percent over the next 12 months, which implies that 99 issuers will default. The increase is due in large part to the decline in oil prices, although a delay in an interest rate increase by the Federal Reserve could offset the increase risk. However, in large part due to the low and negative interest rate environment, investors are pouring money into high yield investments resulting in a decline in the yield spread of high yield bonds dropping from 815 basis points in February to 560 basis points in July.