Why retailers are filing for bankruptcy when they aren't yet broke

Nathan Bomey | USA TODAY

Show Caption Hide Caption Retail industry has had a miserable 2017 A multitude of retailers have filed for bankruptcy this year as the industry continues to struggle. Here are some of the big names.

If you only looked at its profit statement, you might have thought teen-fashion retailer Rue21 was a raging success. After all, it earned $54 million in 2016.

But instead of waiting to fall into serious red ink, Rue21 abruptly filed for bankruptcy in May. And it's not alone.

Rue21 is part of the trend of retailers that are filing for Chapter 11 bankruptcy reorganization while still profitable. It's a survival strategy that could play out during the next couple months among retailers that fared poorly during the critical holiday season.

Several national chains survived their brush with death by filing for court protection from their creditors in 2017 even though they might have otherwise looked financially healthy. The trend illustrates the importance of pre-emptive action for retailers that foresee impending doom.

"If you see a retailer that is at least nominally in the black" that files for bankruptcy, it's "almost always going to be because they have a balance sheet that no longer works for the company," said Jude Gorman, an insolvency expert and general counsel of Reorg Research.

In other words, they're making money on their actual operations, but they're broke because they can't make their debt payments.

More: 15 retailers that went bankrupt in 2017

Naturally, there's a question of whether companies that are still in the black should be allowed to declare bankruptcy, which often hurts financial creditors, landlords, retirees and product suppliers.

Melissa Jacoby, a University of North Carolina bankruptcy law professor, said some companies "with no real financial problems" that have filed for bankruptcy seeking only to use the legal process as a "bludgeon" for creditors have had their cases thrown out of court.

But it's more common for companies to wait too long to file for bankruptcy, Jacoby said.

"It would be a shame if people took away that filing earlier suggests any sort of abuse, when that is not necessarily the case," she said.

Besides Rue21, national fashion brands Payless ShoeSource and True Religion embraced bankruptcy in 2017 and made it out alive, albeit with fewer stores. All three were turning a profit before taxes, interest and other special items shortly before they filed for bankruptcy.

Chapter 11 allows retailers to break leases on money-losing stores and slash loans — critical elements to reducing potential losses. Rue21, for its part, announced it would close up to 400 of its 1,179 stores a month before its filing.

More: True Religion to close 27 stores after bankruptcy filing: See the list

More: Payless emerges from bankruptcy court protection after closing more than 673 stores

More: Rue21 files for Chapter 11 bankruptcy as shopping mall stores suffer

More: Will your store credit card survive 'retail apocalypse'?

The lesson for retailers in the doom-and-gloom age of Amazon-Walmart dominance and the demise of shopping malls is clear: The goal of Chapter 11 is to create a reorganized, often-smaller company that can get a new start.

"It’s a refresh — it’s a chance to start over if you use it that way," said Martin Wade III who was appointed as interim CEO of Payless when the company emerged from bankruptcy in August, in an interview.

Time to invest

Of course, there are other plausible routes to restructure that don't involve publicly declaring insolvency. Ailing women's fashion retailer Charlotte Russe announced Dec. 15 that it had negotiated debt cuts with lenders by giving them full ownership of the company.

That route makes sense for retailers that can convince creditors to make steep concessions. But often lenders won't willingly provide enough breathing room for retailers to invest in the kind of digital infrastructure they believe they need to compete with Amazon, Walmart and others.

Thus, bankruptcy has provided companies like Payless the opportunity to begin spending to try to shift to more online sales and not be so dependent on stores, said Peter Cohan, a Babson College professor, investor and author of the book Disciplined Growth Strategies.

"They need a lot of cash to be able to reinvent themselves," Cohan said.

Payless CEO Wade cautioned that the process of restructuring in bankruptcy court is not for the faint of heart. It's costly, uncertain and embarrassing.

"If you think going through bankruptcy is an easy thing, you should try going through a root canal without an anesthetic," he said.

Still, Payless has a second chance at life after it closed about 900 stores and shed debt that private equity investors had piled onto the company several years earlier.

The company turned a pretax profit of $95 million in its 2016 fiscal year. But red ink loomed on the horizon.

With some 22,000 employees and nearly 4,400 stores in 30 countries at the time of its bankruptcy, Payless had built a powerful global brand, but several missteps undermined the company's operations. It had a limited digital presence, prices that had crept too high over time and the company had fallen behind competitors.

But with significantly less debt following the company's bankruptcy, Payless is set to reinvest in digital infrastructure and launch a global expansion with hundreds of new stores in underserved markets in Africa, Mexico, rural Brazil and India, Wade said.

The company has also taken steps to gradually lower prices in recent months, Wade said, while making plans to adopt the "treasure-hunt nature" of successful physical retailers T.J. Maxx and Marshalls.

Wade said Payless also envisions an opportunity in servicing other retailers by handling their shoe inventory or sales.

"We’ve got to redesign our model so we can make all that happen," he said. "We can execute on our strategy."

Bankrupt but profitable

Others that now have a second chance include mall retailers many observers had left for dead, such as True Religion and Rue21.

Much like Payless, both were profitable not long before bankruptcy. Besides Rue21's respectable 2016 earnings, True Religion reporting a pretax profit of $7.1 million in the first five months of 2017 before the company filed for court protection.

Both fashion brands tumbled into bankruptcy as their respective debt loads became too unmanageable and unprofitable stores weighed them down.

The outcomes of their respective bankruptcies suggest that retailers can survive their brush with insolvency, unlike Circuit City, Borders and Sports Authority that liquidated shortly after filing. About one in five True Religion locations closed in bankruptcy, while Rue21 shuttered about one in three of its stores.

True Religion declined to comment, and a Rue21 representative did not respond to a request seeking comment.

Each came out of court with more affordable debt payments and, critically, a chance to reconnect with consumers who had stopped considering them because of fashion missteps.

One reason why many retailers end up needing bankruptcy to survive is because as soon as there's a whiff of financial trouble, their vendors — the companies they sell them the products that line their shelves — worry about keeping up their shipments without receiving cash immediately as soon as their goods are delivered.

Without products to sell or without the upfront cash to pay, companies like Toys R Us can't survive without the legal auspices of bankruptcy, which allow debtors to guarantee certain payments.

"If suppliers are getting skittish about shipping on credit to retailers, suppliers actually get better legal protection once the retailer is in bankruptcy," said Jacoby, the North Carolina professor. "To the extent that leads the company to have a chance to be saved, it’s not necessarily a bad thing."

Follow USA TODAY reporter Nathan Bomey on Twitter @NathanBomey.