Burned by Toys R Us, will suppliers ever trust a bankrupt retailer again?
Vendors gave the toy retailer hundreds of millions of dollars in trade credit to help it rebound from Chapter 11. Then the unthinkable happened.
In mid-March, attorneys for Toys R Us described a "perfect storm" of circumstances that they say forced the company to request court approval to wind down its U.S. business in bankruptcy.
Toy makers and other suppliers, many of which had in the months leading up to that announcement supported the retailer by shipping to it on credit, weathered the brunt of that storm, along with the company's employees and other stakeholders who didn't hold secured debt.
Along with losing the last national retailer dedicated to toys, suppliers to Toys R Us also lost, collectively, hundreds of millions of dollars when the retailer moved to shut down in Chapter 11.
Bad things happen in business, of course. That's why bankruptcy exists. However, many suppliers feel they were burned not just by poor luck — whether in the form of customer whimsy or the vagaries of the toy market — but by the actions of Toys R Us and its lenders.
Major suppliers in July forged a settlement agreement with the retailer to pay a fraction of the money they are owed, which effectively resolves the legal dispute many dozens of vendors had with the retailer. But suppliers still have their memories of what happened in the Toys R Us case, and they may not be so quick to trust — or ship to — a company in Chapter 11 that asks for their financial support.
"In 30 years, I've never seen anything remotely close to this, no hint of it."
CEO, Learning Resources
"In 30 years, I've never seen anything remotely close to this, no hint of it," Rick Woldenberg, CEO of educational toy company Learning Resources, told Retail Dive in an interview. "What happened in Toys Us is shameful in every way, and very damaging," he added, saying he and other vendors could be reluctant to extend trade credit to retailers in Chapter 11 in the future, which could be a disaster for those companies.
A spokesperson for Toys R Us told Retail Dive in an email that no one from the company was available to comment on this story.
'They explicitly hide it from you'
Where there is anger toward the retailer and the backers of its bankruptcy financing — i.e., what was designed as a $3.1 billion debtor-in-possession (DIP) loan package led by JPMorgan and meant to carry the retailer through Chapter 11 and beyond — much of it has to do with transparency during the case.
From the beginning, Toys R Us said it planned to use Chapter 11 to reposition itself for the future. Things worked out differently. Describing the series of events that led to its move to liquidate in March, attorneys for the retailer said that the company fell dramatically short of what were "conservative" financial performance targets attached to its loan for the all-important fourth quarter.
"Because of the poor holiday earnings performance, what [Toys R Us] had viewed as conservative covenants that they could reasonably satisfy became, within months of the holiday season, a major roadblock to continued operations," attorneys for the retailer said in court papers in March. They went on to say that, by Jan. 31, the retailer's revised budget couldn't meet the liquidity requirements set forth in a covenant on the DIP loan. A creditor group dubbed the B-4 lenders extended the covenant timeline to March 3, then March 12, then March 15.
While Toys R Us was negotiating with its lenders on extending its covenants and holding off default, many suppliers had little idea of the dire financial and legal position the retailer was in. The company filed monthly operating reports in bankruptcy court, but their structure was such that gleaning information about the whole of the retailer's U.S. and North American business was difficult. In late January, days after announcing it would close 180 stores, Toys R Us broke form and said it would not file holiday sales results with the Securities and Exchange Commission. CEO Dave Brandon indicated they were not good due to "operational missteps" made during the period. It also delayed one of its monthly Chapter 11 operating reports until March.
But even if suppliers had seen the figures for Toys R Us' holiday sales and profit, few if any of them knew what they meant for the retailer's standing with its DIP lenders, and in turn the company's ability to pay for the goods vendors shipped.
"Many of us are toy entrepreneurs ... This is what we do for a living — we're not finance majors, we're not Wall Street guys, we're not lawyers."
CEO, Basic Fun!
"Nobody shared it, and even if they shared it, I'm not sure any of us would've been sophisticated enough to understand it," Jay Foreman, CEO of the toy company Basic Fun!, told Retail Dive.
"Many of us are toy entrepreneurs," Foreman added. "This is what we do for a living — we're not finance majors, we're not Wall Street guys, we're not lawyers. However, the guys at Hasbro and Mattel are, or at least they should have a whole bunch of those people employed over there, and they got hustled as badly as anybody else."
As Woldenberg put it: "If I knew that they were going to not pay me, I would not have extended credit." He added, "They explicitly hide it from you."
Some bankruptcy lawyers see these events as a reminder to suppliers to be vigilant and proactive when dealing with a bankrupt retailer. "The key thing for a trade creditor — you have to pay attention to what's happening," David Tatge, a Washington, D.C.-based attorney who specializes in commercial finance, bankruptcy and business law, told Retail Dive, also noting the importance of following a bankrupt company's operating reports. "You have to be very closely in touch with the debtor," he added.
Shock and disappointment
But the opaque wall hiding Toys R Us' abysmal holiday performance, along with the frenetic negotiations with creditors around the breached DIP covenants, wasn't the worst part of the situation for suppliers.
Even worse was that, amid all this, Toys R Us kept buying from its suppliers, and buying on extended terms (i.e., on credit), from its vendors. In some cases, it bought a lot from its vendors in the months following the holidays.
In a scathing court filing, attorneys for Crayola said in March that the retailer began "rapidly accelerating" orders from the handicraft maker after the holiday season, beginning in early January and through much of February. In January alone, Toys R Us ordered and received $1 million in Crayola products, attorneys said. By the time of Crayola's March 23 filing, which came about a week and a half after Toys R Us moved to liquidate, the retailer owed the company nearly $2 million for goods shipped since Jan. 10.
Attorneys for Crayola pointed to a March 20 hearing in which Toys R Us' financial adviser acknowledged, in their words, that the retailer and its advisers were "aware well before the end of January 2018 of impending covenant defaults" under their DIP loan and would run out of money in North America by mid-May as a result.
In short, Toys R Us kept ordering product that it knew, or certainly should have known, it might not fully pay for. Crayola went so far in court as to call Toys R Us' behavior "irresponsible and potentially illegal."
Crayola wasn't the only one. Munchkin Inc. attorneys said Toys R Us was ordering up until March 6 and by the end of March had $1.7 million past due on $3.4 million in orders made since the retailer filed for Chapter 11. Attorneys for Munchkin said in a March 29 filing that the company believed that Toys R Us had "knowledge at some juncture of their impending liquidation" and "negotiated in bad faith in order to induce Munchkin to continue to ship goods."
Why? Munchkin attorneys said that by continuing to order product from suppliers, Toys R Us "increased the collateral available to pay secured claims and certain administrative claims." Vendors also decried Toys R Us' attempts to prioritize certain claims over others when divvying up the pot from liquidation sales.
In April, J.P. Morgan responded to the vendor objections in court papers. The bank acknowledged the "shocking and disappointing" nature of the retailer's liquidation, as well as the "frustration" of vendors. But J.P. Morgan also disputed their legal case and described as "absurd" Crayola's "attempts to depict the payment of secured debt with the proceeds of collateral liquidations as 'highly inappropriate.'"
'You need to keep shipping'
After filing for bankruptcy, Toys R Us didn't just send in orders to its vendors. Company officials actively applied pressure and persuasion on suppliers, according to vendors Retail Dive spoke with. "The whole deal was, the management of Toys R Us came around to all the vendors and said, 'You need to keep shipping,'" Foreman said.
"Everybody said, 'Well, how can I keep shipping? You owe us money,'" Foreman added. "And they said, 'Well if you don't keep shipping, we certainly can't help you. We got this DIP, and we'll work through it, and we'll get you on a critical vendor list, which will help you get a bigger chunk return … but you need to keep shipping.'"
Foreman, along with many others, had already been burned by Toys R Us because of shipments made before the retailer filed in September and was owed $1 million, he said. In April 2017, the retailer asked his head of sales for extended terms until October for spring shipments, payments for which ordinarily would have been collected in June and July, according to Foreman. At the time, few analysts and other observers saw the company as an immediate bankruptcy risk, as it didn't have any major loan maturities coming due. "We knew then Toys R Us had some challenges, but they were our biggest account, had been our best customer. How could I say no to that? Not on everything but on some things," Foreman said.
Toys R Us then asked Foreman's company to speed up shipments in the mid-summer, only to ask him in late summer to hold off shipments, he said. On Sept. 19, just a few weeks after initial bankruptcy rumors emerged, Toys R Us filed. The timing of the shipments he made, and their pause at the behest of the retailer, affected how and if they would be paid in the Chapter 11 case, Foreman said.
"They were pushing us, pushing us, pushing us very hard to ship."
CEO, Epoch Everlasting Play
Foreman and another supplier Retail Dive spoke with, Michael Varda, CEO of Epoch Everlasting Play, both negotiated with Toys R Us to be added to the retailer's list of critical vendors, which would have given legal priority to their claims on unpaid goods shipped before Toys R Us filed for bankruptcy. Both say they were pressured to ship to the retailer in exchange for critical vendor status. Varda said he was told by Toys R Us employees, "'In order to sign this agreement, you have to be shipping.'"
Foreman said negotiations with the retailer on its critical vendor status were protracted, as one point of contact left the company and he had trouble reaching the next in line until he finally caught the executive in person in Hong Kong, and then the paperwork process stalled.
Varda said he also negotiated a deal with the company in Hong Kong. "They were pushing us, pushing us, pushing us very hard to ship," he said. "Working very hard to get us to ship even though we had no signed agreement" — and even though Toys R Us at the time may have known it couldn't ultimately pay for the goods it was ordering. "It was a couple million dollars they wanted us to ship" from mid-January through mid-February, Varda added.
Woldenberg said Toys R Us managers were asking suppliers (including him) for exclusive deals even at Toy Fair in late February, which ended just a day before CNBC first broke news that Toys R Us may have breached its DIP covenants and could be forced to liquidate. (A spokesperson for the company denied in a USA Today story at the time that Toys R Us had breached its covenants.)
For a company in Chapter 11 facing default on a DIP loan to make "overt requests to suppliers to bring in more product" would be "a breach of their fiduciary duty," Chris Bayley, a partner with Snell & Wilmer's bankruptcy practice, told Retail Dive. "If those buying and ordering decisions are being made in full knowledge of their precarious financial decision ... that's a problem." He added, "The next question you have to ask: Are the lenders directing the debtor to make those purchase requests for the specific intent to bring that product in" for the purpose of liquidating them.
Saving what they can
Whatever case Crayola, Munchkin and many other vendors may have against Toys R Us, it won't be heard. The settlement that arose from vendor objections prevents them from suing the retailer and pursuing their claims in full. The agreement provides a baseline recovery of $180 million on some $800 million owed to vendors, with potential for more.
Vendors can, if they choose, opt out of the settlement and keep their legal options open, but they probably won't. "It would cost so much to litigate these issues, the settlement makes a lot of sense," Jeffrey Schwartz, a principal at Much Shelist who is representing Woldenberg's company, said. Litigating, he added, "would take years and years to resolve."
"It's rare to have full-blown litigation over this that culminates in a ruling from the court," Joshua Friedman, a legal analyst with Debtwire, told Retail Dive, pointing to the costs of litigating claims.
Paul Labov, a partner with Fox Rothschild representing Just Play and who helped negotiate the settlement, said he hadn't heard of any vendor who is planning to opt out. But that's not to say the settlement was the ideal outcome. "The settlement was only able to make the best out of a bad situation, and had it not been for the settlement, it would have been worse," he said. "We were saving a victory from the jaws of total defeat."
'Where is the trust?'
All this might seem moot in light of the settlement. But some suppliers, in their comments to Retail Dive and court papers, clearly were rattled by the Toys R Us case. In similar circumstances today, with a retailer on the brink and in desperate need of supplier support — in the form of trade credit and stock on their shelves — vendors might act differently.
Bankruptcy, like business in general, relies on trust that everybody is acting in good faith. Schwartz said that vendors in general will likely be "more active and aggressive in monitoring their" shipping agreements and credit arrangements with retailers in Chapter 11.
"I think you need to understand who you're selling to in a much more 360 approach," Labov said. "Here's the lesson from Toys R Us: You better start getting your hands on the issues sooner, because admin claims [against bankrupt companies] aren't as safe as they could be."
"It's going to be much more expensive for the debtor-in-possession," Schwartz said. If vendors are reluctant to provide favorable terms to bankrupt retailers, that could mean those retailers will need to come up with more cash, at a sensitive time in the bankruptcy process for a retailer that desperately needs to stock its shelves to survive day-to-day. Altogether, it could force more retailers to liquidate rather than reorganize, Schwartz said.
"Here's the lesson from Toys R Us: You better start getting your hands on the issues sooner, because admin claims [against bankrupt companies] aren't as safe as they could be."
Partner, Fox Rothschild
Woldenberg puts it in even starker terms. "Everyone's going to be touched" by the Toys R Us bankruptcy, he said. "And it's not going to be pretty. We are the suppliers of oxygen to this economy. The credit we extend is the oxygen. We lend a lot of money in the form of our receivables — that's money."
"In the future, how many people like me are going to extend credit to a bankrupt company?" he added. "In Toys R Us ... the fundamental problem was, they didn't pay us in the court-supervised Chapter 11 process. Which means that vendors like us are very likely to change our behavior in the next bankruptcy. We have already done this."
"Where's the trust in the DIP lending system in bankrupt companies?" said Varda, who has been in the business for 35 years. "What is so unusual to me in this, and maybe I'm just naive, is that when you had DIP financing, the bank is monitoring the ability of the company they are providing financing to ensure that vendors would be paid."
Another risk trailing the Toys R Us case is that suppliers become more wary of distressed retailers before they enter bankruptcy. "If the stock prices sink, they are going to start pulling credit," Woldenberg said. "We are the sort of shadow banks to these companies. If we start pulling in our credit, they will go into a tailspin and they will go bust. And none of us will lend to them after they go bust because of Toys R Us."
"So there will be no more Chapter 11s," he added. "They'll just be liquidated."
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