TO: Supervisor FROM: Jillian Piccione DATE: May 18, 2011 SUBJECT: Borders Group Inc.

Bankruptcy Analysis

I. INTRODUCTION The purpose of this memorandum is to discuss and analyze the recent Borders Books Bankruptcy proceedings. Borders Group Inc.,

(hereinafter known as BGI) filed for Chapter 11 bankruptcy in the United States Bankruptcy Court in the Southern District of New York on February 16, 2011. As will be discussed below, BGIs choice to

reorganize under Chapter 11, as opposed to liquidation under Chapter 7, a private workout, or a pre-packaged bankruptcy, will have broad implications for the company and shareholders alike.

II. EVENTS LEADING UP TO BGIS BANKRUPTCY PROCEEDINGS

Founded in 1971, BGI is a forty (40) year old bookstore chain that, as of January 29, 2011 has operated 639 stores throughout the United States and three additional stores in Puerto Rico. BGI

operates through its subsidiaries, Borders Inc., and Walden Book Company Inc., which operate stores selling books, music and movies. In addition to the stores, BGI operates a proprietary e-commerce website, launched in March 2008, that includes both in-store and online e-commerce components. As will be further discussed below,

BGIs common stock was, at one time, publicly traded on the New York Stock Exchange (NYSE). 1

For the fiscal year ending January 29, 2011, BGI recorded net sales of approximately $2.3 billion, but nevertheless as of December 25, 2010, BGI had incurred net year-to-date losses of approximately $168.2 million. BGIs Chapter 11 filing stated that

it held $1.28 billion in assets and $1.29 billion in debts, many of which are owed to book publishers. Prior to filing for bankruptcy,

BGI attempted to mitigate some of its losses and increase profitability by closing 219 retail stores in 2009, and an additional 45 stores in 2010.1 BGIs bankruptcy filing has been a long awaited next step for the company as it has faced declines in discretionary consumer spending and fierce competition from Barnes & Noble and the online bookseller Amazon.com.2 In addition, while Barnes & Noble developed

the nook and Amazon.com developed the Kindle, BGI did not develop its own line of e-readers, causing the company to lag behind with respect to the rapid increase in e-book sales. As a result, BGI

missed payments to publishers for books shipped throughout the past holiday season. As of the filing of BGIs February 16, 2011

bankruptcy petitionf, approximately $178.8 million was past due to vendors and publishers, and approximately $18.6 million was past due to landlords. While BGI asked publishers to accept IOUs for In

missed payments, publishers eventually rejected the idea.

1

Joseph Checkler and Jeffrey A. Trachtenberg, Bookseller Borders Begins a New Chapter ... 11, February 17, 2011, http://online.wsj.com/article/SB100014 24052748703373404576147922340434998.html. 2 Julie Bosman and Michael J. De La. Merced, Border Files for Bankruptcy, February 26, 2011, http://dealbook.nytimes.com/2011/02/16/borders-files-forbankruptcy/.

addition, BGI has been forced to lay off nearly 20,000 employees. BGIs CFO Scott Henry stated in the companys Chapter 11 filings that BGI plans to stay viable throughout the bankruptcy proceedings and that the filing will allow the company to access new capital and reorganize its operations. In order to fund its operations

while in bankruptcy, BGI secured a $505 million debtor-in possession loan from GE Capital. III. CURRENT STATUS OF REORGANIATION While BGIs proposed reorganization plan is not due to the bankruptcy court until June 16, 2011, the company has undergone many changes in preparation of formal reorganization under Chapter 11. As part of these changes, BGI determined that many

unprofitable stores should be eliminated, and that in order to maximize the value of the property at the closing locations, all inventory, fixtures and equipment should be liquidated instead of transferred to any of the other remaining locations.3 As such, BGI underwent discussions with liquidators and began a bidding process, which culminated in the selection of a stalking horse bidder. Generally, a stalking horse bid allows a distressed

company to avoid low bids on its assets by securing an initial bid on the companys assets from an interested buyer chosen by the bankrupt party. Throughout the past three months, BGI has closed

hundreds of its 639 stores, leaving just about a third of its

3

Declaration of Scott Henry Pursuant to Local Bankruptcy Rule 1007-2 In support of First Day Motions, http://www.scribd.com/doc/48963204/Chapter-11Affidavit-of-Borders-C-F-O.

stores in operation.4 for the entire chain.

To date, BGI has been unable to find a bidder While Barnes & Noble offered to buy about 10

of the stores, the deadline for going-concern bids that would keep the company operating was May 6, 2011. However, BGI has

alleged that it is still negotiating with an undisclosed party that has put in an expression of interest to retain the remaining bookstores.5 IV. EVALUATION OF BGIS DECISION TO ENTER CHAPTER 11 PROCEEDINGS

Generally, companies deal with financial distress in a variety of ways including selling major assets, merging with other companies, reducing capital spending, issuing new securities, negotiating with banks and creditors, exchanging debt for equity, and finally, filing for bankruptcy. While financial distress is often not an

ideal state of affairs, it can sometimes work to force a company to change its behavior and dispose of unnecessary or unrelated business ventures. In BGIs case, prior to any indication that

bankruptcy was imminent, the onset of financial distress forced BGI to close many of its less profitable United States stores. Additionally, in 2009, BGI was encouraged to dispose and sell off its overseas branches in the U.K., Singapore, Ireland, Australia and New Zealand, which it had initially financed through millions

Border Chapter 11 Store Closures List, Last Updated March 2011, http://www.bordersreorganization.com/pdflib/Reorganization_Closure_Listupdate d3-24.pdf. 5 Associated Press, Report: Borders Has Possible Bidder on Some Stores, May 14, 2011, http://www.forbes.com/feeds/ap/2011/05/14/business-specializedconsumer-services-us-borders-bankruptcy_8466887.html.

of dollars in debt offerings.6 Alongside these responses and indicators of financial distress, in July 2010, Altmans Z-score predicted that BGI would face bankruptcy. Altmans Z-score is a model that uses financial

statement ratios and multiple discriminant analyses to predict bankruptcy in publicly traded companies. A Z-score of less than

2.675 indicates that a firm has a 95% change of becoming bankrupt within one year, but in actual use, bankruptcy would be predicted if the Z-score is less than or equal to 1.81, and non-bankruptcy would be predicted if the Z-score was greater than or equal to 2.99. In BGIs case, its Z-score for 2009 was 1.67, indicating

that the company would likely be headed for bankruptcy.7 Rather than choosing to restructure under Chapter 11, BGI could have chosen to liquidate under Chapter 7. Liquidation is the

complete termination of the firm, which involves the sale of the assets of the firm and the distribution of the proceeds to creditors in accordance with the absolute priority rule. In BGIs

case, it held a large amount of debt, indicating that after administrative expenses, employee wages and benefits, and tax claims were paid, secured creditors would be entitled to the bulk of the funds recieved from the liquidation of BGIs assets. Rather than liquidate, BGI chose to file for corporate
6

The Street, The Borders Story: Is This the Final Chapter?, January 20, 2011, http://www.newsweek.com/2011/01/20/the-borders-story-is-this-the-finalchapter.html. 7 Retail Highest Risk, July 6, 2010, http://www.etgcapital.com/blog.asp ?blog_id=1000018.

reorganization under Chapter 11.

Presumably, the present value of

BGI was greater than its liquidation value, making reorganization the better option. The general objective a Chapter 11 proceeding

is to devise a plan to restructure the corporation with some provisions for the repayment of creditors. Generally, a federal

judge must approve a voluntary petition that is filed by the corporation.8 The judge will set a time for filing proofs of claims

of creditors and of shareholders, and in most cases the corporation, which becomes known as the debtor in possession, continues to run the business. As is often the case, BGI, as the

debtor in possession, has continued to run the business and has sought to borrow money to pay off secured creditors and to continue operation of the company until its reorganization plan is approved. BGI has 120 days to file a reorganization plan, and has 180 days from the filing of this plan to gain acceptance of the plan from creditors. Acceptance must come from creditors and shareholders, A reorganization plan is

who are divided into two classes.

accepted if two-thirds of the class of creditors (in dollar amount) and one-half of the class (in number) have indicated approval. As of April 2011, BGI is expected to report to its unsecured creditors committee that it has secured more than $30 million in rent reductions, managed fifty (50) of the 226 superstores planned for closure, and that it will move out of its Ann Arbor, Michigan headquarters for cheaper office space in the general Detroit metro
8

An involuntary petition alleging that the corporation is not paying its debts may also be filed by three or more creditors.

area.9

BGI has also expressed that it would like to exit bankruptcy

as soon as possible in order to avoid more legal costs and to rebuild its brand without the stigma of bankruptcy attached. Rather than enter into formal bankruptcy, in reality BGI did have a different option, namely to come up with a private workout plan. Both bankruptcy and private workouts involve exchanging new financial claims for old financial claims, but successful private workouts often lead to greater benefits than formal bankruptcy. fact, history has shown that firms that emerge from private workouts experience greater increases in stock prices than those emerging from bankruptcy, and that the direct costs for private workouts are much less than bankruptcies. In BGIs case, an increase in stock prices would have meant the difference between being able to continue to list and trade its securities on the NYSE, and being delisted. As it turned out, the In

NYSE suspended trading in BGIs shares on February 16, 2011, and its stock was delisted on March 21, 2011. The shares traded at a

52-week high of $3.29 in April 2010, but its shares closed at $.23 on March 9 2011. Prior to delisting BGIs stock, the NYSE warned

that the stock would be delisted if Borders could not keep a minimum average closing price of $1 during a consecutive 30-day period.10
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Had BGI pursued a private workout rather than bankruptcy,

Tiffany Kary and Linda Sandler, Borders Files Bankruptcy, Is Closing Up to 275 Stores, February 16, 2011, http://www.bloomberg.com/news/2011-0216/borders-book-chain-files-for-bankruptcy-protection-with-1-29-billiondebt.html. 10 Alexandria Sage, UPDATE 1-Borders receives delisting warning from NYSE, February 4, 2011, http://www.reuters.com/article/2011/02/04/borders-

it may have been able to increase its stock prices and avoid problems with the NYSE. With respect to the costs associated with formal bankruptcy, it is important to consider both direct and indirect costs. Direct

costs include legal (BGI has retained David Friedman of Kasowitz, Benson, Torres & Friedman LLP) and professional fees such as administrative fees and fees for trustees and accountants. Indirect costs include opportunity costs, lost sales, lost profits, and losses stemming from the stigma associated with bankruptcy. Finally, while top management often sees pay decreases in both private workouts and formal bankruptcy, in formal bankruptcy management bonuses must often be approved by a federal judge, rather than approved by the board of a company that is dealing with financial hardship under a private workout. BGI recently faced

this issue, as it was forced to seek judicial approval with regard to employment agreements and bonuses. The approved plan called for

the withdrawal of employment agreements for four executives, including Chief Financial Officer Scott Henry. In addition, ten

participants in the companys bonus plan will be paid a bonus of 40% to 125% of their base salary if BGI achieves certain benchmarks. Specifically, bonuses on the lower range will be paid

if Borders negotiates at least $10 million in annual rent reductions on its store leases, and senior management will get 125% of their base salary if they recover more than $95 million in
idUSN0428122420110204.

funding for unsecured creditors.11

Unsurprisingly, the approval of

large bonuses for the executives of a bankrupt company has caused stark public criticism. While a private workout would have provided many advantages for BGI, it seems that filing for Chapter 11 was not BGIs first choice. It has been reported that BGI initially attempted to put

together a pre-packaged bankruptcy whereby it approached its creditors with a plan for reorganization prior to entering formal bankruptcy proceedings, but that this plan was rejected.12 If

however a plan had been agreed upon, it would have taken effect once BGI entered bankruptcy. In addition, it is rumored that

activist investor William Ackman, whose company Pershing Square Management Co. has a nearly 15% stake in BGI, offered to finance a $16-per-share Borders-led takeover bid for Barnes & Noble in December 2010. While nothing materialized, it is clear that BGIs

first choice may not have been to file for Chapter 11 bankruptcy protection. Nevertheless, while Chapter 11 may not have been the best or first choice for BGI, a private workout would certainly have had its downsides in that (1) BGI would not have been protected from creditors while negotiating towards a private workout plan; (2) it is likely that not all of the equity investors would have agreed to
11

Tiffany Kary, Borders Bankruptcy Judge Approves Bonus Plan for Executives, April 22, 2011, http://www.businessweek.com/news/2011-04-22/bordersbankruptcy-judge-approves-bonus-plan-for-executives.html. 12 Daily News Staff Writer, Borders Files for Bankruptcy, Plans to Close 200 Stores, February 16, 2011, http://articles.nydailynews.com/2011-0216/news/28622348_1_borders-files-borders-express-borders-group.

deal and would have held out for a better deal in bankruptcy anyway; and (3) BGI is a complicated capital structure with a variety of different debt and equity financing, and therefore it would have been challenging to put together a private workout given the array of interests at stake. V. CONCLUSION BGIs decision to enter formal bankruptcy under Chapter 11 was not a surprise when considering the combination of its financial distress and low Z-score. Nevertheless, BGIs choice to file under

Chapter 11, as opposed to arranging a private workout or a prepackaged bankruptcy plan, will likely leave BGI with few options as to its future, and will harm BGIs shareholders, who stand to lose the most under the reorganization.

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