It is no mystery that certain (mostly smaller) traditional brick-and-mortar retailers in the United States have been under fire in recent years owing to the rapid emergence, and acceptance by consumers, of pure-play online retailers such as Amazon and the embrace of e-commerce by traditional market leaders such as Wal-Mart, Target, and Staples.
Not surprisingly, this trend has also hit the private equity (PE) community hard, with more than 30 PE-backed retailers having filed for bankruptcy protection in recent years according to the PitchBook platform, including such well-known names as H.H. Gregg, Eastern Mountain Sports, and Gordmans Stores. In many cases, these retailers were originally acquired by their PE owners using significant amounts of debt to help finance the purchase price, in what is known as a leveraged buyout (LBO) transaction. The lesson, of course: declining businesses and piles of debt are, generally speaking, a poor combination.
Earlier this year, in a possible case of more self-inflicted wounds, the creditors of one PE-backed retailer alleged that a common strategy employed by private equity firms to return capital to their investors after an acquisition – namely, the dividend recapitalization, or dividend recap transaction – was to blame for prematurely pushing the company into bankruptcy. Dividend recaps result from using borrowed money to issue a special dividend to a company’s shareholders.
In 2012, several PE funds partnered to acquire Payless ShoeSource from publicly traded Collective Brands in an LBO deal. In the years that followed, the company paid its PE owners a total of roughly $350 million in cash dividends via two separate dividend recap transactions that were financed through additional borrowings backed by the assets and cash flows of the business. However, once the business started to go south (Payless has announced plans to shutter nearly 10% of its over 4,000 stores globally), the company was no longer able to support its increased debt load, and it filed for bankruptcy protection earlier this year.
An official committee of Payless’ unsecured creditors alleged that the additional borrowings used to fund the dividend payments hastened the company’s decline into bankruptcy, and asked the bankruptcy trustee to hire a financial expert to review the company’s pre-bankruptcy transactions, including the extraordinary cash distributions to its shareholders. Ostensibly, the creditors were seeking to determine whether the distributions represented prohibited transactions pursuant to the fraudulent conveyance provisions of the Federal Bankruptcy Code as well as general state laws (e.g., the Uniform Fraudulent Conveyance Act). These laws cover not only intentional fraud by a borrower that is intended to financially benefit secured creditors or shareholders at the expense of unsecured creditors, but also “constructive” fraud. The Federal Bankruptcy Code defines constructive fraud as occurring when a debtor either: 1) was insolvent on the date the transfer was made or becomes insolvent as a result of the transfer; 2) was left with unreasonably small assets or capital as a result of the transfer; or 3) made the transfer with the intent to incur (or reasonably should have believed that it would incur) debts beyond its ability to repay them.
If the dispute had moved forward and the bankruptcy court had ultimately found that a fraudulent conveyance had occurred, the Payless dividend recap transactions could have been unwound and the PE sponsors (and possibly other beneficiaries of the dividend recap transactions, such as executives who may have received bonuses based on the payments) could have been forced to return the transaction proceeds to the bankruptcy estate for redistribution to the company’s creditors. In addition, the court could have imposed penalties, including judgments against an individual’s personal assets, on the principals that were involved in approving the transaction (i.e., board members) had they been found to have engaged in the fraudulent transactions, regardless of whether there was any malicious intent by the parties.
Ultimately, however, Payless agreed to settle the dispute with its creditors over payment of the dividends. Pursuant to the settlement, the company agreed to pay $25 million to its unsecured creditors (i.e., primarily creditors that it deals with in the ordinary course of business, such as trade vendors) as part of its bankruptcy reorganization, which corresponds to a recovery of roughly 20 cents on the dollar for these parties. This is substantially in excess of the amount that these creditors otherwise stood to recover in the bankruptcy, but it allowed Payless to put the dispute behind it and move forward with pursuing the financial restructuring with its senior secured creditors to which it had previously agreed. Payless did not admit to any wrongdoing as part of the settlement agreement.
It appeared, at first blush, that the Payless board of directors followed standard protocol in assessing the financial impact to the company of the additional debt funding the dividend payments at the time these payments were made to the shareholders. However, the fact that these transactions came under a high level of scrutiny by multiple parties – and an independent board member investigated whether the payments contributed to the company’s current ills – highlights the importance of ensuring that these types of leveraged recapitalization deals are subjected to a rigorous level of review by qualified, highly experienced professionals prior to their approval.
Of principal importance is the engagement of an independent financial advisor to render a solvency opinion on the deal. While such an opinion offers no guarantees, of course, it can assist a board of directors in fulfilling its fiduciary duties by not knowingly or recklessly approving a transaction that leaves a business insolvent. It can also go a long way in helping the company, the directors, and the shareholders fend off later challenges to the deal, such as the one mounted by the Payless creditors.
A previous version of this article was published in June 2017.