To remember a time when the economic climate was drastically different people do not need to peer back years, just months. And because thoughts of the high times are still fresh in the minds of most, the downed economy stings even more.
The perfect-storm financial chaos of the last several months has affected nearly every area of law, but none probably more than bankruptcy. There are more bankruptcy petitions being filed, grander companies filing them, and possibly a ripple effect of unprecedented proportions.
As the country continues to mull through – or possibly sink deeper into – a recession, every aspect of law touches upon insolvency and bankruptcy issues. Whether attorneys are representing a major manufacturer, a small business down the street, or a company owed money by an insolvent one, each should have a basic understanding of the law, what the current economic condition means, and when to call in an attorney who specializes in insolvency.
“Everything has changed,” said Jean Robertson ’90, a partner at Calfee, Halter & Griswold LLP in Cleveland and specialist in business reorganization and bankruptcy matters. “Lenders who were willing to work with borrowers a year ago now are not. Lenders are not even working with businesses that have a good core business and a product that a lot of people need. In fact, they’re throwing them out on the street. They’re saying, ‘we don’t care if you have to let 200 people go. Our priority is to get repaid and we’re going to get repaid at the expense of everyone else in this process.’ Things are so much different.”
Where We Stand
Business bankruptcies skyrocketed 54 percent higher in 2008 than in 2007, according to the American Bankruptcy Institute (ABI). In 2007, 28,322 business bankruptcy filings were made compared to 43,546 recorded in 2008. However, there are still fewer business bankruptcies being filed than in the 1990s, when filings consistently surpassed 50,000 a year, according to the ABI.
These bankruptcies not only are coming in high quantity, they are also some of the largest and most storied institutions in the nation’s history. Lehman Brothers, which filed for bankruptcy in September 2008, was by far the largest corporation to file in the country’s history. The investment bank had more than $691 billion in assets, which dwarfed the next largest filing (WorldCom Inc. in July 2002).
In fact, five of the country’s top 10 largest bankruptcies have occurred since last September.
Shortly after Lehman Brothers, Washington Mutual, which at the time had more than $328 billion in assets, filed and represented the nation’s second largest bankruptcy. More recently, General Motors and Chrysler represent the country’s largest bankruptcies by manufacturers.
“These are companies that would have historically never filed Chapter 11,” said Robertson, who represents corporations that supplied materials to many auto manufacturers, including Chrysler Motors and GM. “That’s because there were lenders out there that would have propped them up. Banks would have provided liquidity and capital so that they could ride the storm. They could have refinanced their debt. In today’s environment, that is just not happening.”
The grandest bankruptcies – for obvious reasons – absorb much of the media coverage regarding the topic. But the aftershocks of these massive filings – as well as the thousands of other business that have filed bankruptcy in the last 15 months – should have all businesses and the attorneys who represent them cognizant of how this economic landscape has changed.
“The credit markets have contracted,” said Eric Kaup ’95, general counsel at Hilco Trading in Chicago, a firm specializing in asset valuation, disposition, acquisition, and financing. “There is less money for borrowers, and companies that are in distressed situations are generally not prime borrowers.”
Kaup, who practiced bankruptcy law at Skadden, Arps in Chicago before moving to his current position, emphasized that in the slowing economy of 2008-09, companies that normally would be inching toward bankruptcy are slipping at a faster rate.
“The speed with which companies are going into a downward spiral is faster and harsher than in past years,” he said. “There is very little reorganizing going on anymore in bankruptcy. It is either a sale or liquidation. The companies that are reorganizing are often doing so only with substantial government financial support.”
Bankruptcy Background Basics
It’s helpful to understand how bankruptcy has evolved in the country: starting with a mention by the Founding Fathers in the U.S. Constitution to a handful of thorough legislative revisions. The provisions the United States currently uses are vastly different than other countries and far more lenient on business and consumers who can’t pay their debts.
“You have to step back and say, ‘what is bankruptcy really here for? Why did the drafters of the Constitution consider bankruptcy so important that it needed to be mentioned in the Constitution?’” said Timothy Barnes ’95, a partner in the Restructuring and Insolvency Group of Curtis, Mallet-Prevost, Colt & Mosle LLP in New York City. “A lot of people just think of bankruptcy as another area of law, but it is really not. It is really essential to capitalism. In a capitalistic society you want to encourage people to take economic risks; that is the essence of capitalism. It is, in a sense, the economic rehabilitation that we would hope our penal system would be able to provide in a social sense.”
The U.S. Constitution gives Congress the power to create laws on the subject of bankruptcies. Congress passed its first permanent bankruptcy law in 1898, although it passed several temporary statutes earlier (in 1800, 1841, and 1867) that were repealed shortly after the financial situations that caused their passage were resolved. The 1898 act withstood several changes and amendments, including those for business reorganizations (Chapters 10 and 11), real estate partnership reorganization (Chapter 12), and consumer compromise cases (Chapter 13).
The Bankruptcy Reform Act of 1978 was a sweeping revision of the 80-year-old act that was urged by a number practitioners and scholars. Criticisms of the new code were aplenty, mostly from creditor groups that felt the law was too generous and from the federal judiciary, which believed too much power had been given to bankruptcy courts.
Significant amendments were made to the code in 1984 after the U.S. Supreme Court ruled that the jurisdiction given to bankruptcy judges under the new law was unconstitutional.
The Court delayed implementation of its ruling to give Congress time to fix the problem. Although the court granted Congress time to make the changes, there was a period of time in 1984 when the country had no bankruptcy judges.
The next major revision of the U.S. Bankruptcy Code came when Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.
What is referred to as the “New Bankruptcy Law,” includes changes for both business and consumer bankruptcies, specifically making it more difficult for consumers to file under Chapter 7 (under which most debts are forgiven or discharged). The new law set income requirements for consumers that either allowed them to file under Chapter 7 or directed them to a “means test” that determines under which chapter they can file.
The laws governing corporate bankruptcies also underwent vast changes as a part of the 2005 legislation. Included were the addition of Chapter 15, which specifically addresses cross-border insolvencies, and a host of new provisions for large- and small-business debtors.
Probably most significantly for corporate debtors, the new law included tougher time restrictions for reorganizing under Chapter 11. Kaup said that this change affected retail stores more acutely than any other sector. The law now states that retailers must decide whether to reject or assume leases within a maximum 210 days after filing for bankruptcy. Previously, debtors were able to extend the deadline “for cause” for well beyond 210 days.
“It’s pretty difficult to get a full holiday selling season within that 210 days, and a holiday shopping season is normally needed by retailers to gauge how well they are doing,” Kaup said.
Since the 2005 passage, Kaup said that few retailers (that have not received government support) have entered Chapter 11 bankruptcy and successfully reorganized. One of them, Goody’s Family Clothing, emerged from Chapter 11 reorganization in October 2008. However, it took fewer than three months after it emerged from Chapter 11 for it to enter Chapter 7 bankruptcy and liquidate the business. “You hardly can count that one,” he said.
What Every Attorney Should Know
If attorneys are representing a company that they believe may even be approaching a point that it could be underwater, they should immediately contact a solvency professional, said Barnes, who has handled some of the world’s largest and most complex restructurings.
“People think that because they are good lawyers they can do bankruptcy,” he said, “and it just doesn’t work that way. They need to consult someone who knows the lay of the land. I am a bankruptcy professional, and I wouldn’t touch consumer bankruptcy with a 10-foot pole without talking to someone who knows what they are doing. That should explain how serious I am about the complexities of the law.”
Barnes warned that as companies – no matter their size – approach what is referred to as “the zones of insolvency,” every action taken by the organization and its counsel could be detrimental to the financial situation of the company.
“The Bankruptcy Code is a very complex set of statutory strictures,” he explained. “Some of it is grounded in federal statutes and some in state. But attorneys are smart and they know that black letter law can be read and understood. They think that they can read the statute and understand it and follow Supreme Court guidelines, and they’ll be all right. It’s just not that way in bankruptcy law.”
Although there are surprisingly few hoops to jump through to actually declare bankruptcy – file a petition, pay a fee, and effectuate a schedule of statements – determining if bankruptcy is the best choice and preparing to file are equally important steps, experts agreed.
Robertson said that because bankruptcies occur so quickly it is necessary to know and understand the nuances of the law. “If you don’t talk to someone who does this for a living then you are likely to make a mistake,” she said. “That mistake could be the difference between you getting paid and you not getting paid.”
Attorneys may fail to realize all the consequences that commence as soon as the bankruptcy petition is filed, experts said. Once a petition is filed, banks will bounce checks that are outstanding, freeze cash management systems, and restrict how employees are paid, among other actions.
It’s also important to know that if a company an attorney represents is owed money from one that goes bankrupt, what may seem like a normal measure now may be restricted. The “creditor” company now must follow an entirely new set of guidelines.
“When you think it is fine sending out a letter that says ‘I hear you filed for bankruptcy, we’d like to remind you that you owe us X amount.’ You can’t do that any more without carefully considering the new playing field,” Barnes said.
Other nuances can be tricky as well. As a bankruptcy moves forward, each of the creditors that are owed money from the bankrupt firm are prioritized by who will get paid first (secured debtors are paid before unsecured debtors, etc.). But, as an attorney representing a company that is owed money by a soon-to-be-bankrupt company, it’s not as simple as finding a method to secure the debt owed.
“You may think that you are being smart by saying to the debtor ‘don’t pay my debt, I’ll just go back and file a lien to become a secured debtor,’ which, we know, will get paid first when the bankruptcy is filed,” Barnes said.
But that lien – if made within 90 days before the bankruptcy petition is filed –may be recoverable by the debtor during bankruptcy. The provision in the Bankruptcy Code prevents debtors from making a “preference” to certain creditors before filing for Chapter 11.
Companies acting as creditors to a potentially bankrupt firm could also risk being sued after the bankruptcy is filed, said Judge R. Guy Cole, Jr., a former bankruptcy judge in the U.S. Bankruptcy Court, Southern District of Ohio, and an adjunct professor at the Moritz College of Law. Cole teaches a course at Moritz on bankruptcy and corporate reorganization.
“The court could determine that, as a creditor, you were telling the debtor how to operate its business. The debtor could claim that you caused it to go into bankruptcy,” said Cole, who is currently a judge in the U.S. court of Appeals for the Sixth Circuit. “This could lead to the company you represent being sued or their claim on equity being subordinated.”
But before bankruptcy discussions even arise, it can sometimes be difficult for the leaders of a business to recognize or admit that the company they are operating is nearing insolvency. The amount of time and money vested in the venture sometimes makes the reality a difficult one to swallow.
Attorneys representing those businesses must be able to accurately and independently evaluate the company’s balance sheets as well as expected cash flows to make the proper recommendations.
Clients will oftentimes show balance sheets that prove that they have more assets than liabilities and question how they could not be a solvent company, Robertson said. “But if you are measuring your solvency on your ability to pay debt as it comes due, it’s a different story,” she said. “If you can’t pay your obligations as they come due you are likely going to be insolvent. I say likely because every case is different. But if you have invoices due in 30 days and you are unable to pay them until 60 or 90 days, this is the first symptom of this chronic disease.”
Attorneys should have a “complete and total understanding of the capital structure” of their clients, Robertson said. If a client begins to approach bankruptcy, it is necessary to identify all the parties that have a stake in the company.
Bankruptcy attorneys must also determine whether firms have a reorganization plan and the financial resources to emerge from what can be a costly process. That’s especially true in today’s economic climate, Kaup said.
“The attitude used to be that a company would file bankruptcy, earn a respite, and use that time to formulate a plan,” Kaup said. “Now you have to have a plan and use a bankruptcy as just one part of that plan, as opposed to bankruptcy being the plan.”
A paramount part to any restructuring plan is ensuring that the business operation presented is a viable one, said Creola Johnson, a professor at The Ohio State University Moritz College of Law who specializes in bankruptcy. In a Chapter 11 reorganization, creditors must approve a plan submitted by the bankrupt company before moving forward. “In this economy, if you don’t have a solid plan then you might as well just close up and consider liquidation,” Johnson said. “If your business is selling cassette tapes and you go into your creditors’ meeting with a plan to start selling CDs, your creditors are never going to sign off on that plan. They know the business. They know your history. They know this plan isn’t going to work.”
Creditors – which, for larger bankruptcies, now include not only secured debtors and unsecured debtors, but hedge funds and their varied interests – are becoming more stringent regarding what type of projects in which they would like to fund.
For smaller companies, creditors who traditionally would have provided debtor-in-possession financing to help insolvent companies stay in operation during a restructuring are no longer doing so. The largest bankrupt companies in the country have been assisted by the U.S. government. For instance, the United States provided General Motors with $30 billion in debtor-in-possession financing so that it could operate while in bankruptcy. But other, smaller businesses are finding it nearly impossible to secure similar debt in order to restructure, according to Karen Hopper Wruck, a professor of finance at The Ohio State University Fisher College of Business. In fact, the credit businesses enjoyed for so long is increasingly scarce, she said.
“I really think that advising companies about the value of liquidity and access to capital is going to be more important than ever before. We have taken these credit markets for granted for too long. They worked so well we hardly talked about them,” she said. “I think we are going to see a whole bunch of rethinking about how firms should restructure to include more liquidity. It is tragic to see a good firm fail just because they don’t have liquidity.”
Unfortunately, experts agreed, the ability for many businesses that normally would have filed bankruptcy to restructure the organization are more likely headed to liquidation. The types of businesses showing up in U.S. Bankruptcy Courts are different than those a year ago; and they’re ones that many people never imagined would have been there.
“Bankruptcy used to be for the low-life and now it is the tool for the Mercedes of business and capitalism,” Robertson said. “The middle market company – those that have $100 to $500 million in assets – can’t file for bankruptcy because they don’t even have enough money or access to credit to go through the process. They are just shutting down or filing for Chapter 7. Chapter 11 is now like a restructuring tool for the elite, and it has never been like that before.”
Tags: Eric Kaup, Jean Robertson, Timothy Barnes