Liquidation Nation

Circuit City, Linens ‘n Things, and Sharper Image are gone. What company is next to go under?

Earlier this month, Circuit City, the 567-store electronics retailing giant that filed for bankruptcy protection in November, announced it was going to liquidate. It’s closing all its stores and laying off its 34,000 workers.

Circuit City’s suicide is part of an alarming trend in the retail industry. It used to be that companies came out of bankruptcy relatively easily. Chapter 11 was like rehab: a safe place, insulated from the harsh realities of the outside world—like the need to keep current on bills—that gave companies a chance to regroup and relaunch. But these days, companies are simply deciding to end it all. Liquidation is the corporate version of foreclosure. Borrowers and lenders agree that instead of undertaking the hard, time-consuming work of modifying debt and restructuring finances, they should just sell for whatever they can get, take the loss, and move on. Just as more and more homes have wound up in foreclosure, more and more companies are being liquidated.

Virtually every large company that filed for Chapter 11 in the past year intended to reorganize. But Sharper Image, which went bankrupt in February, couldn’t come up with a viable plan for its gadget stores and began to liquidate them in June. (The brand still lives on the Web.)  Linens ‘n Things, which filed for bankruptcy in May, planned at first to close 100 stores. But when it couldn’t find a buyer, Linens ‘n Things decided in October to throw in the towel. Whitehall Jewelers, which filed for Chapter 11 in June, began selling off the family jewels in August. Steve & Barry’s filed for bankruptcy last summer and tried to reorganize before giving up and going for liquidation. Mervyn’s, the California department store chain, filed Chapter 11 in July and in October said it would start liquidating its 149 stores. And so on.

Retailers aren’t the only ones opting for liquidation. Within a week of its Chapter 11 filing, Lehman Bros. sold off its U.S. operations to Barclays and its European operations to Nomura (the latter for the princely sum of $2). AIG, which avoided a Chapter 11 filing by virtue of a massive bailout that effectively transferred ownership to the federal government, is staging a more deliberate liquidation sale. 

These liquidations are signs of significant (perhaps excessive) pessimism and the continuing hangover from the recent era of easy money. From 2001-07, cheap money allowed finance types to make huge profits by flipping assets and refinancing. Investors thrived by wading into distressed situations and doing the difficult work of cutting costs, restructuring balance sheets, and turning businesses around. In years past, companies lingered in bankruptcy for many months, even years, as creditors and borrowers hammered out agreements. Today, few people are willing to pursue this long and winding road toward profits. The preference is to write off the bad debt, take a few pennies on the dollar, shut down, and move on.

This impatience is aggravated by rampant fear on the part of both managers and lenders. Now that consumers actually have to pay cash for what they buy—rather than borrow it on credit cards or through home-equity loans—there’s concern that consumer spending will settle permanently at a lower plateau. And so, the thinking goes, what’s the point of keeping all those Circuit City, Whitehall Jewelers, and Steve & Barry’s stores open?

The credit crisis, which helped push many companies into Chapter 11 in the first place, also explains the trend toward liquidation. The first thing a bankrupt company does is arrange what’s known as debtor-in-possession financing, which enables the firm to keep stores open and pay salaries even as it starts stiffing other creditors. Because the rules (here’s a primer) permit DIP lenders to jump to the head of the creditors’ line, large banks viewed the DIP market as a relatively low-risk business. Now, of course, many of the firms that provided DIP financing are themselves functionally bankrupt. The surviving banks  now regard all types of lending—to consumers and businesses, in bankruptcy and out of bankruptcy—as a highly hazardous activity. Meanwhile, the private equity firms and hedge funds that had been big buyers of bankrupt firms are shying away.

The trend toward liquidation may also be an unintended consequence of government policy. As Kristina Doss reports in today’s Wall Street Journal, recent changes in the bankruptcy code have made it more difficult for companies, especially the types of companies going bankrupt now, to reorganize. For example, the deadline for companies in Chapter 11 to decide whether to assume or terminate store leases has been shortened to 210 days. That means companies that file early in the year can’t wait until the vital Christmas season has passed to make a decision about which stores to keep open.

The inauguration of a new president has inspired a great deal of hope. But none of the factors that created the rush to Chapter 11 and the incentives to liquidate is likely to change much in the first 100 days. Last fall, Noreen Malone wrote a guide to buying Christmas gifts at liquidation sales. In 2009, consumers won’t need to limit themselves to holiday gifts. They may be able to buy everything at going out of business sales.