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Boston College Law School

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Wednesday, September 5, 2007

Movie Gallery's Death Spiral

Movie Gallery, Inc. yesterday announced that the holder of a majority of principal amount of its 11% Senior Notes, had agreed to forbear until September 30, 2007 from exercising its rights and remedies arising from MG's cross-default under its indenture for these notes.  The cross-default had occurred due to MG's prior default on its first lien credit facility.  MG had previously signed a forbearance agreement for its default under its financial covenants contained in its first lien credit facility.  But, because of this default, MG has now cross-defaulted on its $175 million second lien facility.   MG is now in default on all three of its major debt financing instruments.  And to make matters worse, because of MG's non-compliance with the covenants contained in the first lien facilities, MG has disclosed that its liquidity is now threatened since "many of our significant vendors have discontinued extending us trade credit, requiring us to pay for product before it is shipped, and we have experienced additional tightening of terms with other vendors."  In light of these problems the stock is now a penny one, and MG is no longer in compliance with Nasdaq Marketplace Rule 4450(a)(5), which requires a minimum bid price of $1.00 per share.  MG is about to be relegated to the small-cap market in a best case scenario; bankruptcy court is also now a possibility.

This mess all started on July 2 when the nation's second-biggest video rental chain announced that it was unable to meet financial covenants due to "significantly" weaker-than-expected second-quarter results.  Specifically, the company disclosed that it blew through the Interest Coverage Ratio set forth in Section 6.7(a) and Leverage Ratio requirements set forth in Section 6.7(b) and Section 6.7(c) under the First Lien Credit and Guaranty Agreement.  This default set off the chain-reaction described above.  And it took Movie Gallery only four months to breach these covenants, the first lien credit facility was signed on March 8.  A review of the 10-Q for MG's second quarter shows a deterioration of MG's results but one that appears at quick glance to be expected.  The quick timing between the execution of the first lien agreement and the event of default appears just a bit too quick, particularly since MG was a troubled business even at the time the facility was executed.  This is just an educated guess, but perhaps MG lost the ball here and unwittingly agreed to covenants it could never meet.  I hope not, but there is a story here -- hopefully a diligent reporter will find it so we can all learn from it.  This is beside the obvious one of the perils of cross-default provisions.  In the meantime, MG continues its death spiral. 

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