British fashion retail is expected to roll out major post-lockdown discounts to drive footfall and clear SS20 stock now that the lockdown is easing. However, this discounting may have wider legal implications for fashion brands. In this article, we look at turnover-based rents, the impact of discounting on existing finance arrangements, what fashion retailers should do and how lenders are responding.
1. Turnover -based rents.
Many brands, such as New Look and Frasers Group, are reported to be seeking to renegotiate a move to turnover-based rent models with their landlords. The rationale for such a move from retailers is entirely logical. But there are a number of challenges with turnover-based rents in retail leases:
a. What items should form part of the physical store’s gross turnover? And, how should the turnover rent to be paid to the landlord be calculated?
Retailers will look to limit the definition to those sales which originate from the physical store and are completed through the tills. For landlords, particularly given multi-channel retailing, it is preferable to adopt a wide definition of gross turnover, as a means by which to capture, for example, click-and-collect sales and other sales which although originating online, are completed in the physical store.
b. How much rent will landlords receive?
A key challenge for landlords is the uncertainty in the amount of rent they will receive. This is particularly relevant in the wake of the current economic downturn and discounting by retailers. Such uncertainty may have consequences in terms of property valuation if the landlord’s future income stream is unclear. The position can be contrasted with the traditional upward-only open market rent model, where the overall rent is more readily ascertainable. Turnover-based rent models are typically comprised, however, of a fixed base rent, reflecting current market conditions, and a turnover element, representing a percentage of the total turnover generated by the premises (a figure between 5% and 12% is usual). The major balance to be struck is therefore in the negotiation of the respective base and turnover elements.
c. What is the administrative burden of a turnover-based lease?
Turnover-based rents require the retailer to provide accounting information to the landlord at regular intervals during the lease term, from which the turnover rent is calculated. This additional procedural element has potential issues for both landlords and brands. From the landlord’s perspective, the primary issue is having accurate turnover data on which to rely, and for the retailer, there is the need to preserve confidentiality in the context of disclosure of sensitive financial data.
Despite the challenges inherent in turnover-based rents, the model provides a flexible basis for landlords and retailers to share in the risks and rewards of the tenant’s trading performance. But with multi-channel retailing, however, the lines between online and bricks-and-mortar retail are becomingly increasingly blurred. Much will therefore depend on clear lease drafting and careful consideration of what items to include in the calculation of turnover rent.
2. The impact of discounting on existing finance arrangements
Heavy discounting will have an adverse impact on a fashion retailer’s profit margins and eat away at the bottom line. But such a strategy has the potential to lead to a breach of a borrower’s obligations in its debt financing arrangements.
For a fashion retailer which is a borrower, the retailer’s facility agreement will contain financial covenants setting out the parameters within which a business has to operate during the term of a facility agreement. Testing typically occurs on a quarterly or annual basis. Drops in cashflow will affect EBITA measures and may lead to a breach of the covenants. Breaches of covenants tend to act as an early warning sign for lenders that a borrower may be in financial distress and a breach is often the first event of default to be triggered.
A borrower will also usually give several information undertakings which requires it to keep lenders informed of material contracts and potential breaches. It is likely that loss of trade, excess stock and supply shortages could trigger breaches or termination rights in material contracts which borrowers would be obliged to disclose to lenders.
Seriously heavy discounting as a strategy on a longer-term basis also indicates general financial difficulties such as deteriorating cashflow, operational issues, and wider issues that may represent a material adverse effect on the financial position of the business. Financial agreements often include a representation and warranty from the borrower that there are no circumstances that have a material adverse effect on the business or assets or condition of the group and the less ‘borrower-friendly’ a material adverse effect clause is, the more likely it is to be triggered.
3. What should fashion retailers do?
Generally, borrowers should always keep their finance documents under review, in particular the financial covenants, information undertakings, material adverse change clauses and any relevant grace periods and potential penalties for breaches of representations and warranties, covenants and notice requirements. It would be prudent for a fashion retail borrower which has any concerns to have advance discussions with lenders to procure waivers or amendments where necessary and generally maintain open communication with lenders.
4. What are lenders doing?
A breach of financial covenant may entitle a lender to exercise its rights to accelerate the loan, act as a stop on the utilisation of the facility, seek repayment and/or enforce its security. The manner in which lenders choose to respond will vary on a case by case basis. Lenders may be more likely to waive breaches in the current climate, but the best course of action is for fashion retailers to be proactive in discussions with their lenders – this may result in a lender issuing a waiver letter in respect of any specific breaches. Such waivers are likely to be worded narrowly and limited to a specific time. It may also be possible to agree a pause on financial covenant testing.
Generally, given the competitive environment in which fashion retailers operate, retail brands should consider the longer-term impact of heavily discounting products. As well as the negative impact of reducing profit margins and the potential for breach of financing arrangements in place, there is also the risk that extensive promotional offers will reset customers’ value expectations. This adverse impact on brand perception may cause lasting financial impact, beyond the realms of the current recession.