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The Bankruptcy Strategist
The Changing Face of Chapter 11 - From Legal Reforms To a New Down Cycle
By Louis A. Recano and Scott Y. Stuart
The face of bankruptcies in corporate America has changed multiple times since the
reforms of 1978. And it’s going to change once more — probably radically — over
the coming months. Starting about 30 years ago, bankruptcy represented freedom to
restructure without the stigma of failure. It then morphed into a business tool
that some of the largest and most sophisticated companies in America chose to use
to reorganize in specific, strategic ways. Then the era of liquidity, which is now
coming to a close, took hold. During this period, which was activated by hedge funds
and private equity, bankruptcies grew less frequent. They became most useful as
an opportunity to use the process to create quick sales, equity swaps and sophisticated
yet prearranged partnerships among a company’s money players. Following the 2005
Amendments to the Bankruptcy Code, bankruptcies became even scarcer. Now, we move
into a new place, as the good times come to an end. Will this mean we’ll see bankruptcies
the way they existed in the late 1990s and early 2000s? Or will it be something
less traditional as defaults climb, money becomes harder to borrow and Chapter 11
becomes the only way to test survivability of companies that desperately need —
and may have for a long time desperately needed — a traditional restructuring? One
thing is certain: Chapter 11 is once again in play. In this article we look at the
trail of modern bankruptcy — and begin to parse the next phase.
THE RECENT PAST
During the era before the 2005 Amendment to the Bankruptcy Code, Chapter 11 was
a strategic business tool; it allowed management to remain in control of its own
business, made post-filing financing available and created a vehicle with which
to restructure everything from leases to union contracts. At the height of Chapter
11, in 2004 and 2005, some of the largest companies in America used this tool to
navigate away from financial ruin. United Airlines, Fruit of the Loom, WorldCom
and Penn Traffic are just a few examples of filings that set the standard for use
of Chapter 11 as a smart way to right troubled situations. Then the money kept rolling
in — with endless liquidity. Almost simultaneously, the Bankruptcy Reform Act occurred.
Both events altered the corporate restructuring landscape. The era of Chapter 11
as a productive, accepted business tool ended; the way bankruptcy factored into
the way businesses got restructured changed. In short, the highly gracious lending
environment, and the new Code, altered the very definition of bankruptcy.
LIQUIDITY TOOK THE ONUS OFF RESTRUCTURING
Liquidity really changed everything, including how the economy cycled and functioned.
It meant that companies could take another dollar to live another day, and do so
cheaply, with few covenant restrictions. It also meant that companies could avoid
the pain and expense of a Chapter 11 in an unknown world of new laws — and changed
how companies in need of restructuring looked at strategic options. Elizabeth Warren,
Professor at Harvard Law School once commented that "Bankruptcy is less a culture
and more a tool. It’s more a device. It’s more like a knife on a surgeon’s table."
Until 2005, that statement was on target.
WHAT KIND OF PROBLEMS DID ALL THE LIQUIDITY MASK?
Did taking another dollar to live another day mask problems that were better suited
for the surgeon’s knife to fix? We don’t know yet, but we’ll find out soon, given
a probable downturn in the economy. Prior to 1978, bankruptcy was not only a last
resort; it was hardly considered. There was a stigma attached to it. The stigma
resurfaced in the recent liquidity era as it became easier and less expensive to
take advantage of money in the markets, the result was a period with the fewest
corporate bankruptcies in decades. Cheap money, even where corporate failure looked
inevitable and masked deeper issues, became the easy way out of the bankruptcy option.
THE ERA OF THE LIMITED-USE BANKRUPTCY
Where bankruptcies have been used recently, it has been with pinpoint precision,
in a much quicker process. This approach was not only to effectuate very specific
goals, but it also saved money. (Considering that cases such as United Airlines
cost approximately $10 million per month, and most post 2005 filings were not of
the size of United or like companies, the potentially prohibitive cost of Chapter
11 became one important factor in staying as far away from the process as possible.)
Hence, the era of the pre-arranged and pre-packaged case was born. Chapter 11 was
no longer being used to complete a business overhaul from soup to nuts. It has recently
been to bless what was all done on the outside — coming into the federal process
as a blessing mechanism of sorts after the deal had already been done. Costs were
thus kept to a minimum, specific problems addressed and objecting parties negated.
In the liquidity era, this has worked well. Companies like Bally’s, Movie Gallery
and Blue Bird Bus Company, just to name a few, essentially made their restructuring
and recapitalization deals prior to filing a Chapter 11. Once in Chapter 11, the
process has been used to both kosher a deal made on the outside and, in certain
cases, to clean things up a bit by rejecting or selling leases, holding quick sales
or validating creditor trusts. This has kept a stay in Chapter 11 to an absolute
minimum. Make no mistake about it, though, this new approach would not have been
possible if hungry hedge funds and equity players did not have a huge appetite for
distressed assets in an environment where defaults were virtually non-existent.
This most recent face of bankruptcy was either a quick in-and-out process to sell
assets or to validate a deal. Or, it was a face ignored when inexpensive money could
save the day. Did that new face do the business world much good?
THE NEW REALITY
Everything changed in July 2007, when the reality that to every cycle there is an
end slammed our economy in the sub prime market meltdown. Money became tight and,
despite a series of interest rate cuts, the housing market looked frighteningly
distressed. Risk aversion in the debt sector took hold, and corporate America began
to face up to a possible recession. What this means for corporate restructurings
in 2008 and beyond is that Chapter 11 is once again not just an option; but a likely
reality for many businesses. There will be many rough patches. For one thing, traditional
restructuring probably did not occur frequently enough during the liquidity period.
So who knows what shape some firms are in? Further, a cohort of corporate executives
who have never had to navigate a down cycle all of the sudden are thrust into it
front and center. They’ll need to be educated about the importance and value of
the Chapter 11 process for the first time. Default rates are skyrocketing, money
is not as readily available to fix the ills of corporate America and the use of
Chapter 11 may be both a great tool while at the same time the last resort many
have successfully avoided these past several years.
CHOICE OR NO CHOICE?
Will companies again be willing to expend what turnaround specialist Bill Brandt
once indicated was 3%- 4% of their assets to go through a Chapter 11? Perhaps they
don’t really have a choice. Consider a failing housing market, diminishing liquidity
and a retail sector likely to suffer as disposable income, once available primarily
from equity in the robust housing market, shrinks. These are the realities that
many may not want to explore, but may be forced to accept.
CONCLUSION
Now that Chapter 11 is once again in play, we should all hope that leaders play
it right and use it to help corporate America survive the mine field that the liquidity
era has created.
Louis A. Recano (lrecano@donlinrecano.com) is the CEO and cofounder of Donlin
Recano & Company, a information services and bankruptcy management, claims and
noticing consultancy based in New York. Scott Y. Stuart (sstuart@donlinrecano.com)
is a former practicing bankruptcy attorney and now Managing Director responsible
for business development and case oversight at Donlin Recano.
Reprinted with permission from the "January" edition of the "The Bankruptcy Strategist"
© "2008" ALM Properties, Inc. All rights reserved. Further duplication without
permission is prohibited.
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