News

Lawyers for the Canadian division of struggling U.S. retailer Circuit City Stores Inc. had some explaining to do this week when they asked an Ontario Superior Court judge to approve a bankruptcy protection plan.

At the same time that lawyers for Richmond, Va.-based Circuit City sought protection under Chapter 11 of the U.S. Bankruptcy Code on Monday morning, its Canadian division, InterTan Canada Ltd., dispatched a team before Mr. Justice Geoffrey Morawetz in Toronto to seek protection under the Companies' Creditors Arrangement Act.

In the United States, analysts cheered that the money-losing Circuit City had been lucky enough to land a special $1.3-billion (U.S.) working capital line, known as a debtor-in-possession or DIP loan, during a global credit drought. The lifeline meant that the struggling retailer had bought time to survive what is shaping up as a grim Christmas retail season and draft a survival plan to trim its debts and operations.

In Canada, Judge Morawetz, an experienced former insolvency lawyer, balked. According to affidavits and reports submitted to his court, Circuit City had landed the life-saving DIP loan by effectively allowing a cross-border raid on its profitable InterTan division.

Before handing over a penny to Circuit City, a syndicate of banks led by Bank of America insisted that the Canadian subsidiary pledge as security all the assets and property owned by its chain of 772 stores, known as The Source by Circuit City. On top of that, Circuit City was given the right to demand cash advances from InterTan, while banks were given extraordinary powers to “sweep the cash” of the Canadian branch at their whim after only five days advance notice.

How can this be? Judge Morawetz asked a clutch of lawyers in his court.

The answer, InterTan lawyer and Osler Hoskin & Harcourt LLP partner Edward Sellers told the judge, is that outrageous bank demands are the new normal for companies caught in the vise grip of an emerging recession and paralyzed credit market.

“We're doing the best we can with the hand we've been dealt in this very difficult environment. It's the best we could do; in fact, it was the only thing we could do,” Mr. Sellers explained.

After a number of sharp questions, Judge Morawetz was apparently persuaded. He approved InterTan's request for bankruptcy protection, sending a painful message to embattled Canadian companies about the harsh new economics of restructurings.

To fully comprehend how onerous credit conditions have become for struggling companies, consider the borrowing rates banks are tossing around for a second “junior” $350-million DIP loan that Circuit City is negotiating with its banks. According to people familiar with the discussions, banks are demanding that Circuit City pay between 10 and 15 percentage points over the London interbank offered rate, a base lending benchmark known as Libor that currently stands at about 2.2 per cent. That means Circuit City would be paying at least 12.2 per cent or $42-million a year in interest alone on a junior loan.

At these rates, the math is very simple. Many companies that might have qualified for loans during what we can now call the great credit rush of the past few decades are probably out of luck. Faced with crushing financing terms and a shortage of buyers that can afford to snap up distressed assets, experts predict a return to old-fashioned restructurings. In that world, many struggling companies that run out of cash likely will be left with no option but to shut their doors, petition for bankruptcy protection and sell their assets at liquidation prices.

That's what happened to the Canadian and U.S. operations of retailer Linens 'N Things and a host of other U.S. retailers. And it may be the only option for a growing group of Canadian companies that are rapidly slashing employees and operations to conserve dwindling cash.

“We're going back to the old days,” said Rick Orzy, a restructuring expert with Bennett Jones LLP.

For seasoned practitioners such as Mr. Orzy, the old days are the dreary, grinding time 30 years ago when banks ruled the bankruptcy world and corporate borrowers had little recourse when loans were called and pledged assets seized. The pendulum started to swing in favour of borrowers in the early 1980s when amendments to bankruptcy acts in the U.S. and Canada gave companies more rights to seek protection from their creditors in court to allow struggling businesses time to draft workout plans.

The changes were so revolutionary that Joe Freeman, the chief executive officer of distressed U.S. graphics equipment maker AM International Inc., appeared on Phil Donahue's talk show in 1982 and declared bankruptcy “is fun.”

That was then. Today, the easy bank loans and private equity funds that stoked many of the restructurings are gone, taking with them many of the makeover strategies that troubled companies had come to take for granted.

“There wasn't any problem that couldn't be solved with more money in the good years,” said Kevin McElcheran, an insolvency specialist with McCarthy Tétrault LLP. Today, he said, “companies in need of bank financing to restructure can expect banks to hold them to a very tight leash.”