RadioShack faces the choice of seeking bankruptcy protection or accepting financing from a lender that helped drive it there. Photo: Mike Mozart via Flickr.

Bankruptcy is coming for RadioShack (NYSE: RSH). The electronics retailer, which has been bleeding red ink for years, is likely to file for Chapter 11 protection early next month, according to a report in the Wall Street Journal.

Last week the company reached an inflection point. Under the conditions of a lifeline financing package thrown together last October, RadioShack had to prove it could maintain at least $100 million in liquidity, but as of November it only had $19 million in available borrowing capacity and another $43 million in cash. The likelihood it would be able to meet that condition was already pretty bleak.

Further, hedge fund Salus Capital Partners had extended a $500 million debtor-in-possession financing offer should RadioShack need to take the Chapter 11 route, but since the offer expired on Thursday January 15, 2015, the retailer needed to make some very quick decisions. 

Where every road is a dead end
Unfortunately, there were no good options. Because the DIP plan would give Salus significant sway over the retailer once it enters bankruptcy, one has to wonder if the roadblocks the hedge fund erected in RadioShack's path weren't designed to get it into this position all along.

  • Salus loaned RadioShack $250 million knowing its precarious financial condition.
  • It then thwarted its reorganization plan to gain control over costs.
  • It also tried to block RadioShack's refinancing efforts by declaring the company in default on its loans.
  • Now it is encouraging RadioShack to file for bankruptcy by promising new financing that will give the hedge fund substantial leverage over the retailer.
In this situation, RadioShack's choices seem to be between the devil it knows (Salus) and the one it doesn't (bankruptcy).

Walking on thin ice
After nearly three straight years of quarterly losses, RadioShack has appeared on the verge of closing its doors several times. The company warned in September it might need to seek bankruptcy court protection if it could not raise new money or get relief from lenders.

The retailer secured $250 million in financing from Salus in late 2013 to stay afloat, but said it wanted to close as many as 1,100 stores to bring costs under control. Salus, however, blocked the plan, asserting the loan covenants didn't permit RadioShack to close any more than 200 stores.

While Salus worried that closing too many stores would limit the revenue RadioShack could generate, thus endangering the hedge fund's ability to recoup its financing, the retailer was left with too many underperforming stores remaining open, causing it to further spiral down.

By limiting its maneuverability, the hedge fund placed RadioShack on the course to bankruptcy.

A hedge fund rides to the rescue
Yet it was temporarily saved from that predicament by hedge fund Standard General, which refinanced RadioShack's $535 million credit facility in exchange for authorization to convert a new $120 million cash infusion into equity if the retailer managed to stay afloat through January. As that deal supplanted Salus as lead lender, it declared RadioShack in default of its loans.

Under its loan agreement with Salus and Cerberus Capital Management, RadioShack agreed not to borrow money from an "affiliate," or some entity with a greater than 10% stake in the business. While Standard General owns less than 10% of RadioShack's stock, the equity it will receive if the retailer survives would amount to 25% of the company. That, Salus contended, put the retailer in default.

RadioShack won a small victory last month when the International Swaps and Derivatives Association ruled the refinancing wasn't a default event. The panel said sellers of derivatives designed to protect against a default don't have to pay holders of these contracts based on what transpired.

Fruit of the poisonous tree
Now Salus is fighting to get back on top by offering RadioShack the financing it needs to keep operating if it declares bankruptcy. While the aid package would replace the retailer's existing $585 million financing agreements, it would also give Salus Capital Partners significant control over RadioShack as the new debt would be considered senior to all other debt or equity.

Debtor-in-possession financing allows companies to use the funds to keep the business going and avoid disruptions while under court protection. Without it, RadioShack might actually have to shut down. But that end result just might be OK with Salus because as senior lender it would have first dibs on RadioShack's assets and could use them to recoup its investments.

Salus has also followed this program before with troubled retailers. After loaning Delia's money in 2013, it arranged for DIP financing when it declared bankruptcy last year. It arranged similar financing for discount clothing retailer Dots, National Envelope, HMX Group, Kids Brands, and others. The $250 million RadioShack financing, however, would be its biggest deal.

Salus Capital might not have been so Machiavellian as to see the end game from the get-go, but it seems at some point it saw the risks involved in its investment and realized the opportunity it had. But having apparently made the choice to pursue bankruptcy, RadioShack may find the freedom to negotiate with other lenders, particularly if Salus's deadline was not carved in stone, as is often the case.

Still, RadioShack's investors must be wondering, with friends like these, who needs enemies?