In September 2017, Toys R Us (TRU) filed Chapter 11 Bankruptcy. While most large toy makers had already shipped orders directly from China to TRU, many smaller toy manufacturers had to decide whether to ship their products to TRU (and possibly not get paid) or not to ship at all and lose out completely on TRU sales for the 2017 holiday season. For the manufacturers that had to make that decision, it probably wasn’t an easy one.
While considered a mass market merchant, Toys R Us’ focus on toys differentiated them from Walmart, Target and Kmart. With enough shelf space to showcase full lines of merchandise from toy companies large and small, they placed high volume orders, and, in some cases, these orders helped smaller manufacturers meet the minimums required by their factories. Even for toy makers who developed toys primarily for the specialty market, TRU often played a key role helping them survive.
This is a two part article. In Part I, we will examine the differences between Chapter 11 and Chapter 7 Bankruptcy. In Part II, we will review some best practices for companies to follow to help ensure they minimize the risk of customers defaulting on payment for any reasons.
What Happens During a Chapter 11 Filing vs Chapter 7 Filing?
When a company cannot pay its debts and intends to close and stop doing business, the company can file a Chapter 7 bankruptcy.
- When a Chapter 7 is filed, the bankruptcy judge appoints a case trustee to take ownership of all the assets in order to liquidate them (sell them) in an attempt to repay creditors as much as possible.
- The Trustee will also examine the records of the company to locate any payments that were made prior to the filing to make sure that no creditors were given a preference for payment. If it is found that a preference was given, the trustee will use the power of the court to get the funds back in order to distribute them to all creditors in a fair manner.
- To collect anything, creditors must file a claim. Even after filing a claim, creditors often do not receive the full amount they are owed or may receive no payment at all.
On the other hand, companies that plan to go forward after the bankruptcy process file Chapter 11.
- Businesses that file a Chapter 11 petition do so when they intend to make changes that will allow them to get through the bankruptcy process and operate profitably when the Chapter 11 is complete. The company creates a Plan of Reorganization. TRU announced in September when they filed Chapter 11 that they were reorganizing, making changes and that they expected their financial issues to be addressed in a “long lasting and effective way.”
- In some cases, companies file Chapter 11 voluntarily; other times, creditors ‘force’ the company to file. TRU entered bankruptcy voluntarily. TRU stated they filed Chapter 11 because many of their worried suppliers were demanding prepayment for goods for the 2017 holiday season.
- The moment a Chapter 11 is filed, protection (referred to as an “automatic stay” or “stay of protection”) prevents further collection action being initiated against the company. The automatic stay also halts any actions that are already in progress. The automatic stay continues throughout the duration of the case unless it is modified by the Judge, typically at the request of a creditor. TRU continues to operate through mid-March 2018.
- In order to emerge from Chapter 11, the company must create a Bankruptcy Plan of Reorganization that must be approved by the Court and also by a majority of creditors.
TRU announced as part of its restructuring that it expected to close up to 200 stores in early 2018. TRU assumed they would be in a good negotiating position to renegotiate all of their leases citing “most landlords today do not want to lose another tenant.” They also expected to have strong sales during the 2017 holiday season. TRU believed that all of these factors along with changes to their structure would allow them to emerge from bankruptcy and continue operating.
- In order for the Plan of Reorganization to be accepted by the Court, known as “confirmation,” it must be voted upon by the creditors. For that reason, prior to submitting the Plan for a vote, the company will usually negotiate with the larger creditors in order to assure that they will vote for the Plan’s confirmation. Often times, smaller, unsecured creditors will face a “cramdown” (lowering in value) on their debt because they don’t have the votes necessary to stop the confirmation of the Plan. However, the final say on a Plan’s confirmation is with the Judge, who can reject a plan that is too unfair to the creditors as a whole. Several major toy companies announced publicly they would “support” TRU, and to continue to ship them new goods.
- However, many companies that enter Chapter 11 protection do not have successful re-negotiations or successful realization of forecasts and expectations. If this happens, the case may be converted to a Chapter 7 Bankruptcy – a liquidation. After lower than expected sales in Fall 2017, news reports indicated that TRU will move to liquidate its assets and cease operations. The exact timing of the liquidation has not yet been determined.
- Just like in a Chapter 7 situation, Chapter 11 creditors will not likely be paid the full amounts owed to them. Some companies owed money by TRU were quoted saying they hoped even to collect 10 cents on the dollar.
- Creditors who hope to make a collection after the Chapter 11 must file a claim with the bankruptcy court. Even with low payment expectations, toy makers who shipped to TRU will have to spend time and even more money filing a claim against TRU just in the hope they can collect a portion of their anticipated sales.
- In some circumstances, certain Chapter 11 plans will provide for asset liquidation and will function much like a Chapter 7 case.
TRU Received $3B at the Start of Chapter 11
In the case of TRU, they received $3 billion dollars from investment firms so they could stay open, pay their employees and continue to purchase merchandise to fill their stores for the 2017 holiday season.
Did the fact that TRU received this $3B mean it was “safe” to ship to TRU – because they had this cash?
The answer is maybe.
- Even if a company is in Chapter 11 and it gets an infusion of cash to operate, the company may not be successful in restructuring or reorganizing, and it may end up shutting down business despite the investment. If this happens creditors may not get paid. TRU indicated they will liquidate assets and close down business. There is no certainty that anyone owed money by TRU will be paid or paid in full.
- Even if a creditor gets paid by a company during Chapter 11, in certain cases the monies can actually be “clawed back”. Sometimes a company in Chapter 11 protection might make payments that they are not authorized to make (including the payments made before the bankruptcy filing.) The courts overseeing the payment process can intervene and it is possible that a supplier who was paid, might be required to give the money back. Before deciding to ship to any company in a Chapter 11 it is best to have an attorney verify that the company is authorized to make a payment to your company. This can help to prevent a claw back.
- If you do ship, it is important to invoice the Chapter 11 Company properly. Typically invoices to a business in Chapter 11 will be to a different company name such as Toys R Us Debtor in Possession (or whatever the Chapter 11 operating company becomes). If a manufacturer decides to take the risk and ship a company in Chapter 11, it is wise to make sure there are no administrative issues that might interfere with collecting on an invoice.
As part of TRU liquidation, it is possible that the Toys R Us name, brand, logo, website, and even some of the profitable assets like the assets of the TRU Canada stores will be purchased and will be used to start a new business. A purchase of TRU assets would not give creditors of the old TRU any claims to the assets of a new business using the Toys R Us name.
By the time a company enters bankruptcy it is often too late for manufacturers to protect themselves against not getting paid. However, good daily business practices can help ensure that your company limits its risks and is in the best possible position to withstand a customer’s bankruptcy or default for any reason.
In Part II of this article next week, we will review some best practices for keeping your business safe.
This article is intended to provide a general overview and is for informational purposes only. It is not legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem.
Dee has been a successful Sales & Marketing executive for the past 30 years in big and small companies and currently works as the Senior Vice President of Neat-Oh! International.
Before Neat-Oh!, she was Director in the Office of President at a global enterprise software vendor where she was responsible for corporate strategy initiatives and measuring the company’s sales and marketing performance. Throughout the years, she built trusted relationships with large retailers and formed long-term partnerships with Fortune 500 companies. As a member of the ASTRA Board of Directors, Dee contributes to finding innovative ways in which all small businesses can successfully navigate the rapidly-changing way consumers look for and buy toys.
Dee holds an MBA from the Kellogg School of Management at Northwestern University and a Bachelor of Music Performance from Northwestern University in Evanston, Illinois.