The Dog That's Not Barking

I've been increasingly mystified, now bordering on troubled, by a new case of "the dog that didn't bark."  Here's my question:  Given that we've been slogging through this subprime/Alt-A/Bear Stearns/Freddie & Fannie financial quicksand for a solid year, where is all the restructuring and insolvency work?

Just a few days ago The Times (UK)  reported:

"The huge increase in the number of empty retail premises in central Southampton dominated the regional television news on the South Coast on Monday. The next morning a headline in The Times business pages cautioned: “Disastrous reports now pour in from every sector.”

"In other words, the parlous state of the economy is now top of everyone's agenda. So that is the bad news but, by the same token, are the good times starting to roll once again for the insolvency and corporate recovery lawyers around the City?

"Strangely enough the answer is “no”. A straw poll of a cross-section of City law firms with strong insolvency practices produced a remarkably consistent result. “It's extraordinarily quiet - it's actually rather spooky. We seem to be in a strange twilight zone,” Stephen Gale, head of corporate recovery at Herbert Smith, said."

Likewise, The American Lawyer reported a few days ago:

"Since the economic downturn hit about a year ago, lawyers lamenting the decline in deal-making have been waiting for an expected spike in bankruptcy work. So far, they've been mostly disappointed."

(To be sure, the piece goes on to notice signs of "hope"—using that term advisedly—in the restructuring pipeline at Weil Gotshal.)

But this doesn't answer the fundamental question:  With so many economic indicators down, and the supply of the water of economic life, credit, essentially shut down since last fall, why no more firm failures? 

My theory:  We're in the land of the walking dead.

And only the unprecedented lending and financing practices of the most recent period have enabled these zombie companies to forestall their imminent demise.    I don't believe creditors are being more "humane," forbearing, or patient than in past downturns, and I don't believe debtors are being more creative, quick on the trigger, or resourceful in conserving cash and staving off the day of reckoning than before.

I believe that the prevalence of "covenant light" deals is having this unintended consequence:  With fewer covenants, fewer firms are in violation.  Some will be in violation later, and some will only surrender when they flat run out of cash.

For an inside look at the latter situation, consider the bizarro case of Steve & Barry's, as recounted in the WSJ "based on interviews with current and former employees, including senior executives."  (As a privately held company, Steve & Barry's is required to disclose very little, and the more temperate Journal uses the term "most unusual blowup" as opposed to "bizarro.")

Start with the dog not barking:  "The 276-store chain [was] regarded just weeks ago as one of America's fastest-growing retailers."  In other words, very little warning.

Next, let's review the financial engineering Steve & Barry's performed on itself.   To understand the dynamics of this particular Erector Set, a brief excursion into the sui generis economics of retail malls is required.  In Mall Land, anchor tenants such as major department stores—or Steve & Barry's—are viewed as the marquee names that attract shoppers and traffic and feed all the little stores.  Indeed, non-anchor tenants typically receive a meaningful discount in their rent if an anchor spot becomes vacant. 

Conversely, given the parlous state of the department store industry, companies that can fill an anchor spot are in an exceedingly strong bargaining position.  According to Frank Natanek, President of Cullinan Properties, Ltd., a large mall owner:

"Because Steve & Barry's was often the only retailer willing to occupy large, vacant stores, it didn't often budge on its demands. "They go into a market and say, 'This is what we're going to pay...There's not a lot of negotiation.""

And what Steve & Barry's negotiated for were multimillion-dollar upfront tenant "allowances" paid by mall owners for—so the kabuki dance had it—improvements to the leasehold.  Here are the numbers:

"For the 2003 fiscal year, which ended Jan. 31, 2004, when Steve & Barry's had 31 stores, tenant-improvement payments totaled $17.5 million, according to documents reviewed by The Wall Street Journal. The payments jumped to $58.6 million the next year, the documents say. The peak came in the 2006 fiscal year, when the company received $122.3 million in payments, but spent only about $59 million to build out new stores, leaving about $63 million in unused cash, the documents indicate. From fiscal years 2004 to 2007, the company received $380 million of payments."

Can we now see the freight train coming at us down this tunnel?

As mall owners began having their own problems, they encountered more and more difficulty in making, and honoring, promises to Steve & Barry's for upfront improvement allowances—which, as we've seen, Steve & Barry's was not using exclusively for improvements, but largely to dress up cash-flow.  And as the pace of new store openings at Steve & Barry's slowed, two nasty realities intersected:  Inventory purchased in anticipation of new store openings sat warehoused and unsold, and the cash infusions typically generated by new store openings slowed. 

What evidently happened last week was simple:  Cash run through, lights out.

Interestingly, in what seems a tossed-off aside, the article notes casually that "Earlier this year, the company defaulted on its $200 million credit facility with its main lender, the commercial-lending unit of General Electric Co."  But that is the sum and substance of any allusion to defaults or covenants.

Is this, then, the "new normal?"  Does it take flat running out of cash to trigger restructuring and insolvency?

If so, we probably won't have to wait too much longer for the bankruptcy pipeline to begin to fill.  Which will be good news for firms with these practices—or with underutilized M&A lawyers who can be retooled into restructuring practitioners.   And lest we forget, the sooner we can lance these boils, the sooner the economy itself can regain its footing.