Beware of the ABL Trap: The Challenges of Retail Chapter 11 Debtors and Asset Based Lending
An asset-based loan (“ABL”) is often the financing of choice for retail borrowers – and for good reason. In its simplest form, an ABL is a credit facility, usually in the form of a revolving line of credit, the availability of which is based exclusively on the value of a company’s “eligible” assets. In the retail context such eligible assets are, for the most part, the company’s accounts receivable and inventory. There are numerous advantages of an ABL over a traditional loan: an ABL is typically easier to obtain since it is based on a company’s assets and not cash flow; an ABL provides ready cash to support liquidity needs; an ABL often includes flexible borrowing and repayment terms and less restrictive financial covenants; and, particularly beneficial to retailers, an ABL commonly accounts for seasonality and allows more borrowing during periods of slower sales. The borrower in the ABL is required to submit a “borrowing base certificate” on a monthly or even weekly basis, which details the current inventory levels (and accounts receivable), deduct certain amounts such as letters of credit, applies the applicable borrowing percentage (usually a percentage of the net orderly liquidation value (“NOLV”) of their inventory), and the result is the amount of cash available. In addition to borrowing base certificates, the company is also subject to field examinations and inventory appraisals conducted at least once a year, if not more often, which determines the percentage applied to their borrowing base calculation.
When retail sales are booming, the company and the ABL seemingly work like a well-oiled machine: inventory is rapidly converted to cash, which is then used to pay the loan and fund purchases of new inventory, which, in turn, increases the amount the company can borrow at any time, commonly known as the “borrowing base”. A difficulty arises, however, when one of these necessary steps is obstructed – which is exacerbated in the bankruptcy context. There seems to be an inherent conflict between the fluid nature of retail inventory flow and the fixed nature of a borrowing base. It would certainly be maddening if American Express restricted my credit limit on a weekly or daily basis depending upon what was, or was not in my closet at any given time.
When the amount you can borrow depends upon your inventory levels, the retail company is incentivized to keep inventory levels high through new inventory purchases, which, in turn, often requires drawing cash from the credit facility. This vicious circle illustrates what is colloquially referred to as the “ABL Trap”. Even when it may be in the company’s best interest to reduce or hold off on inventory purchases, the selling of inventory without replenishment will lower its borrowing base and increase the risk of an over advance – that is, when the amount borrowed exceeds the calculated availability.
The filing of a chapter 11 bankruptcy transforms the ABL Trap from a pothole to a house-swallowing sinkhole. After facing months of slower sales, the distressed retailer usually enters bankruptcy with serious cash flow issues and inventory accumulation. The straight forward solution to this predicament is the rapid selloff of inventory via “going out of business” or similarly themed sales, the closing of stores to reduce overhead, and the restructure of various other obligations to increase liquidity. The difficulty with this approach is that it runs fundamentally contrary to the ABL structure – rapid reduction of inventory concomitantly reduces the debtor’s borrowing base leading to, or increasing, an over advance. Making the matter more difficult for the debtor is the fact that most ABL structures involve a “lockbox” account – a blocked account controlled by the lender wherein all the debtor’s sales are deposited, with funds only later distributed to the debtor based on the pesky borrowing base calculation (which is, of course, tied to inventory that is (or should be) rapidly depleting). The net result is the more cash the debtor generates in inventory liquidation sales, the less accessible its cash becomes due to a shrinking borrowing base.
The ABL Trap is only one of the many challenges faced by practitioners in retail insolvencies and the issue should be tackled early and thoroughly before the bankruptcy filing to ensure a successful reorganization in a presently unforgiving retail environment. The trap is by no means an insurmountable barrier to reorganization, but it requires meticulous inventory management and extensive negotiations with an ABL lender. The rescue ladder from the ABL Trap is an acknowledgment by all parties that a full liquidation is often the least favorable option for the debtor, lenders, landlords, consumers and all parties with a connection to the distressed retailer.