At some point in every restructuring of a consumer products retailer, the company and its advisors will be called upon to analyze the importance of the company's key asset groups to its future success. Assets will be evaluated based on anticipated returns on future investments, anticipated carrying costs and an assessment of the opportunities that could be created from the redeployment of invested capital into other assets or asset classes. Inevitably, this analysis will lead to the identification of underperforming or excess assets, followed closely by the development of a strategy designed to maximize the recovery value from the disposition of such assets.

Experience suggests that every retailer, even well-run healthy retailers, carry under-performing and excess assets on their balance sheets. For instance, it is an axiom of retailing that, when taken as a whole, every inventory can be segmented into quintiles from the best, fast-turning, high-recovery and high-margin items to the worst, slow-moving items that require significant markdowns to move, if at all. Moreover, all stores are not created equally. The characteristics that define whether a store is a good, positive contributor or a drain on precious cash flow may not be readily apparent at the time the retailer commits to an expensive build-out and 10 years of rental obligations. Just like its inventory, the real estate portfolio of a mature retailer will contain winners and losers and many levels in between.

For retailers restructuring under the protection of chapter 11, there is a well-defined strategy available to address the drag of underperforming inventory and real estate assets. This strategy calls for the liquidation of the inventory by selling it directly to the consumer through the medium of a "going-out-of-business" or "store-closing" sale (GOB sale) coupled with a real estate disposition program designed to utilize the leverage created by the trustee's power to assume, assume and assign, or reject a lease under §365 of the Bankruptcy Code. Properly orchestrated, these strategies will allow the retailer to maximize the recovery value of its inventory while minimizing the liabilities associated with its real estate, the key phrase here being "properly orchestrated." The premise of this article is that the traditional paradigm for the orchestration of the inventory and real estate disposition strategy may not always lead to the best result for the estate, the debtor's managers, vendors and other parties in interest.

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The choice of which service provider will conduct a liquidation event can have a material impact on the results achieved during that project.

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The Liquidation Paradigm

Over the past 10 years, the model for driving the liquidation process has essentially become institutionalized. The stores to be closed are identified, the excess inventory is earmarked for sale and segregated on the company's books, and an information package describing the characteristics of the store leases and the inventory is created and disseminated. Typically, the company and its legal and financial advisors drive this process. If there is a lender with a collateral interest in the assets, it will also be injected into the process together with other institutional constituents such as the creditors' committee. Recently, a new entrant into this process is the consultant who on behalf of the lender or the company is retained specifically for the purpose of assisting and in some cases managing the process of developing the disposition strategy and dealing with the service providers that provide the expertise necessary to effectively execute a disposition project.

Once the process is underway, the company will identify a service provider and enter into an agreement with that service provider setting forth the terms and conditions for the disposition project. That agreement is circulated among interested parties, and an auction typically ensues. Bankruptcy lawyers and judges like the fact of the auction, because bankruptcy jurisprudence suggests that a sale following a properly noticed auction is entitled to a finding of "good faith" and the protections of §363(m) of the Code. The financial advisors to the respective constituencies also seem to like the auction dynamic. To the extent the auction results in an increase from the stalking-horse price, they can take comfort in the view that the process has resulted in added value. Finally, the secured lenders like the auction since they perceive that it provides a certain, market-tested result. The one key constituent remaining is the merchant/debtor. Is it satisfied with the results of the auction? More often, it seems that the answer is no, especially in those instances where the liquidation project involves a subset of non-core assets with a debtor focused on reorganization and looking to maximize the recovery on its non-core assets in as painless (i.e., non-disruptive) a fashion as possible.

To understand why this happens, one must examine the dynamics of the sale procedures. Following the identification of the "stalking horse," that service provider and the debtor will have many days, if not weeks, to work through the underlying contract, iron out issues and generally get onto the same page in terms of how things should work. Then, the day before the §363 hearing, the auction takes place and additional bids are received. Very often, the stalking horse goes home, and a new service provider (the "winner") steps in. This new party has not had days of conversations with the company. Moreover, having just paid a higher price for the liquidation opportunity, this party will be unwilling to make concessions or reach interpretations with respect to contractual provisions that might have a negative impact on its ability to recoup its investment. Reconciliation may become a problem, and ultimately the bargain the company thought it had struck disappears.

Alternative Strategies

There are alternative strategies that can be utilized to address this problem. The first is to structure the arrangement with the service provider as a consulting arrangement. Under this type of structure, the service provider's compensation can be structured around a "soft" guaranty. Most often this is done by putting the service provider's fees at risk unless certain recovery thresholds are satisfied. Once the recovery threshold is met, the service provider can earn a base fee with an incentive fee designed to align interests as the parties seek to maximize every dollar.

A second type of arrangement is a "hard" guaranty at a leveraged-down threshold with upside sharing to the company after the threshold is met and the service provider's base fee is paid. Sharing can be weighted in favor of the company so that it obtains the lion's share of any upside produced. For example, if 80 percent of the upside generated in a project automatically flows to the company, there would seem to be little or no benefit derived from an auction where the guaranty is likely to move only a few percentage points.

In either circumstance, the company gets its pick of service provider without the risk of a subsequent upset. Indeed, if there is to be an auction at all, it would seem to make more sense to conduct it with sufficient time to allow the company to get comfortable with its service provider and to make sure they are on the same page before the court is asked to approve the service provider's contract. Indeed, in a few recent cases, prospective debtors have run their selection processes and conducted an auction prior to commencing the bankruptcy case. Thereafter, the case and the sale motion are filed with the selection of the service provider a fait accompli.

Consideration of Alternative Structures May Avoid Unintended Results

The choice of which service provider will conduct a liquidation event can have a material impact on the results achieved during that project. Different service providers have different strengths and weaknesses, as well as different outlooks on the way problems should be solved and opportunities realized. It seems strange that a decision so vital to the success or failure of a reorganization should be left to chance at an auction on the eve of the approval hearing. There are several strategies that can be used to avoid unexpected results while permitting the company to achieve results it and other constituencies will be happy with. In all cases, a careful consideration of these options should ensue before the liquidation process gets underway. At the end of the day, your clients will thank you.