Not my local RadioShack, I don't think.

Photographer: Craig Warga/Bloomberg.

Not Everyone Is Happy That RadioShack Ran on Derivatives

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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If you could choose to either operate RadioShack, or not do that, which one would you choose? I suppose financial analysis might inform your choice. Being pretty generous to RadioShack, here are some numbers:

Once upon a time, operating RadioShack was a profitable business. But for the last two years, give or take, it has been a terrible business. For the first 10 months of 2014, just operating the stores has lost RadioShack something like $920,000 a day; for the last quarter for which we have results, it was about $1.1 million a day. Every day that RadioShack's managers opened up their stores, they lost the company more than $1 million. But every day they did it anyway.

So, I mean, just don't do that then.

Or that is the argument that RadioShack's Official Committee of Unsecured Creditors is making in RadioShack's bankruptcy process. Actually they're making a slightly different argument; they think that RadioShack should have stopped running its stores -- or, at least, so many of them -- months ago:

Despite predictable (and indeed, foreseen) losses, RadioShack decided in very late 2013 to borrow as much money as it could on a senior secured basis and attempt a turnaround. Within a few months of borrowing, however, RadioShack’s crisis managers and restructuring professionals found themselves pleading with their secured lenders for permission to liquidate almost half its operations so they could start to operate a sensible business. In the spring of 2014, the secured lenders refused unless certain demands were met, citing a contractual prohibition on closing more than 200 (or 5%) of the stores. Faced with extraordinary demands in exchange for making a rational business decision, RadioShack simply chugged along, and continued to lose $1 million a day.

Every time I write about RadioShack I feel compelled to mention that 2007 Onion article, but it keeps being relevant. RadioShack has been baffling for years, and it's just kept on going. Being baffling didn't stop it. Losing money for 11 straight quarters didn't stop it. Going bankrupt certainly didn't stop it: RadioShack filed for bankruptcy two weeks ago, and its stores are still going strong. (In the midst of writing this paragraph I got up and went to my nearest RadioShack to check on this and, yep, it was open, not particularly busy, playing lite reggae.) And there's no end in sight; the stalking-horse bankruptcy plan calls for up to 1,750 combination RadioShack-Sprint stores, and leaves untouched something like 1,000 franchise stores

Why? Nostalgia? The unsecured creditors have another theory. Or a couple of theories. One theory is that RadioShack's secured lenders prevented it from closing a lot of stores when it wanted to do that in the spring of 2014. This theory is uncontroversially true: RadioShack announced that it wanted to close a bunch of stores, then closed many fewer than it wanted to; it said at the time that the secured lenders blocked its more aggressive proposal, and it said it again when it filed for bankruptcy.  Closing the stores would have been good for the company, its shareholders and its bondholders, who would all benefit from losing less money. But it would have been bad for a secured lender: "Fewer stores would mean fewer assets left to secure the loan, and that could reduce any recovery it would get in a bankruptcy reorganization." This situation leaves the unsecured lenders sad, but there's not much they can do about it. That's the point of secured lending; you get to block things that put your security at risk, even if no one else likes it.

The juicier theory is that credit default swaps were to blame for the delay in RadioShack's bankruptcy. The theory goes like this. RadioShack signed up two groups of secured lenders in late 2013. There was a GE Capital group that provided $585 million in mostly revolving asset-based lending, and there was a $250 million term loan from Salus Capital Partners and Cerberus Capital Management. In October, the GE Capital lenders sold their loan to a new group of lenders led by Standard General L.P., a hedge fund that had bought a big chunk of RadioShack's equity. The Standard General group then agreed to modify the loan agreements, giving RadioShack more borrowing capacity in exchange for a pile of fees and the right to buy a majority of the company's stock if the 2014 holiday season went really ridiculously well for RadioShack.  (It didn't, so here we are.)

But the unsecured creditors argue that the Standard General group had another motivation:

Several of the Participating Investors, including BlueCrest Capital Management LLP, DW Investment Management LP, Mudrick Capital Management, and Saba Capital Management LP (and/or any funds managed by or affiliated with the foregoing), had reportedly sold CDS protection on RadioShack bonds, betting that the company would not default on its bonds -- at least not before December 20, 2014. If the company did default before that date, the Participating Investors who had sold that CDS protection would have suffered massive losses. The October 2014 Transaction however, enabled the Participating Investors to avoid such losses and keep the Debtors out of bankruptcy until after December 20, 2014. This way, the Participating Investors that had previously sold CDS on RadioShack bonds could pocket the upfront payments received from the purchasers of that protection and actually prevent their own losses by orchestrating when RadioShack would default. 

We talked a little about this back in December, just before that CDS deadline, when Bloomberg News reported the lenders' CDS positions. At the time I was tickled by this trade, which kept a struggling company alive through the magic of derivatives. On the other hand, the unsecured creditors have a point: Maybe that struggling company shouldn't have been kept alive. Maybe the magic of derivatives was actually a dark necromancy. Maybe it was used to animate a horrible zombie that then roamed the countryside laying waste to assets that properly belonged to RadioShack's unsecured creditors.

Anyway, now those unsecured creditors want to poke around and see what they can find out. (That's the point of their motion, which seeks information about RadioShack's pre-bankruptcy deliberations.) For instance: Did RadioShack's directors breach their fiduciary duties by agreeing to that October loan modification, which kept RadioShack alive to lose more money? Did the CDS writers who also bought into the term loan somehow commit insider trading?  Did they, even more nefariously/delightfully, have simultaneous bets that RadioShack would not default before Dec. 20, but would default shortly thereafter?  

This is all very much a fishing expedition, and none of it is necessarily true, or coherent. For instance, the unsecured creditors blame the Standard General group of creditors for seeking to delay bankruptcy to profit from the CDS that they had sold, but also blame Cerberus and Salus for seeking to accelerate bankruptcy to profit from the CDS that they had bought. The idea here is that the term-loan lenders refused to consent to store closings, and sent (rebuffed) notices of default last year, in order to try to get a CDS payout before Dec. 20.  One problem with this theory is that Cerberus had not bought any CDS, so "the fictitious CDS position could not have been the motivating factor behind any decision on the store closing covenant."  

The other problem is that none of this is necessarily bad. I mean, insider trading would be bad, and breaches of fiduciary duty would be bad, and perhaps the creditors will find some evidence of that sort of stuff. But the thrust of the accusations is that lenders pursued their interests, and that their interests were defined in part by credit derivatives that they had bought or sold. There is not, as far as I know, any rule against that. It makes negotiations more complicated than they would be without credit derivatives -- "It’s very difficult to know where anyone stands anymore because of CDS and because CDS investments are not disclosed" -- but the main source of complexity is people with different interests, not the instruments by which they express their interests. 

Also it doesn't necessarily lead to a worse outcome.  The unsecured creditors' theory here is that CDS sellers gave RadioShack a loan to keep it afloat and make money on their CDS trades, while CDS buyers used their positions in their loans to try to push RadioShack into default. (Though that part of the theory seems to be wrong, at least for Cerberus.) One or the other of those things might be bad, but in combination they sort of cancel each other out. You're left with a company muddling through, trying to please all its lenders as much as possible, but knowing that there's just not enough to go around.

  1. This is super generous: Just revenue minus cost of goods sold and selling, general and administrative expenses. (Divided by the number of days in the period.) RadioShack's operating loss is that, minus (relatively small amounts of) depreciation, amortization and impairment expenses. Its net loss is that, minus interest expense, which has gotten rather large.

    The periods are messed up because RadioShack changed to a Jan. 31 fiscal year starting with this past fiscal year. So there's a one-month January 2014 stub period on the chart, though the y-axis at least is normalized by days.

  2. That link is to a PDF download from RadioShack's bankruptcy docket (Docket No. 304).

  3. See paragraphs 37 and 44 of the First Day Declaration (Docket No. 17).

  4. The Standard General group agreed to convert its loans into RadioShack stock if certain conditions were met. Here are the conditions:

    GRH’s obligation to complete the Sponsor Conversion is subject to (1) the entry into an amendment to, or a replacement contract for, the Company’s current contract with a third party supplier (which expires by its terms on December 31, 2014) on terms that are equivalent or more favorable, taken as a whole, to the Company than the terms of the existing contract, (2) the Company having at least $100 million of available cash and borrowing capacity at January 15, 2015, and (3) Company management developing, reasonably and in good faith, an operating plan and budget for fiscal year 2016 that is accepted by the Company’s board of directors and contemplates earnings (excluding specified cash and non-cash charges) before interest, taxes, depreciation and amortization of at least $75.4 million, as well as other customary closing conditions.

    (GRH is the Standard General vehicle.) RadioShack's EBITDA for the first three quarters of fiscal 2015 was negative $267.4 million. So positive $75.4 million would be quite a swing. I don't really know what the thinking was there.

  5. I don't think so? But here's paragraph 50 of the motion:

    For example, Standard General, LiteSpeed, and the other Participating Investors could have written short-term CDS on RadioShack bonds with a termination date in December based upon their confidential negotiations with RadioShack, knowing that they were going to be in a position to extend the lifeline of the company through to 2015. Or they could have used the confidential information they were privy to in order to make secured loans to avoid substantial losses on their CDS by delaying RadioShack’s bankruptcy beyond December 20, 2014.

  6. Paragraph 46:

    A Rule 2004 investigation is similarly warranted to determine if any of the Participating Investors were executing a “steepener” strategy, betting that RadioShack would not default in the short term (because they were ensuring that that would not happen through the October 2014 Transaction and the Transaction Committee’s consultation rights), but would likely default in early 2015. In this regard, a review of the agreements underlying the October 2014 Transaction reveals provisions that indicate that the Participating Investors may have been executing such a “steepener” strategy. For example, while the October 2014 Transaction may have been specifically engineered to prevent a default in the fourth quarter of 2014, several new events of defaults imposed by the First Amendment would likely be triggered in the first quarter of 2015. If the goal of the October 2014 Transaction was to delay bankruptcy for four months, the benefits that RadioShack and its other stakeholders received for such transaction must be investigated and assessed.

  7. Paragraph 63:

    Moreover, upon information and belief, Salus and Cerberus were purchasers, in CDS transactions, of protection on RadioShack debt. Therefore, their conduct in refusing to consent to RadioShack’s plan to close 1,100 stores in the spring of 2014, as well as their decision to send two notices of default, may have been motivated by these CDS positions.

  8. That's from Cerberus's delightful, brief response (Docket No. 345) to the unsecured creditors' motion.

    Another problem with all of these theories is, I don't know, there was like $550 million of net notional of RadioShack CDS outstanding on Dec. 18 ($26 billion gross), and there's like $476 million net notional outstanding now ($23.5 billion gross), so, what, like $74 million worth of CDS expired on Dec. 20? (Maybe it was more and a lot of people wrote CDS after that? Why?) Someone might have made tens of millions of dollars on these trades, but we're talking about loan positions of hundreds of millions of dollars, so I'm not so sure that the CDS tail really wagged the RadioShack dog here.

  9. Even if it did here! I don't know, you do your own valuation of how much it's worth to you to have RadioShack stay open for a few extra months.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net