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Rising Bankruptcy Costs Catch Debtors Off Guard
By Anne Urda, anne.urda@portfoliomedia.com
Portfolio Media, New York (September 18, 2007)
With the mortgage industry in crisis, the much-anticipated wave of bankruptcy filings is finally here. But many debtors are unprepared for mounting costs in the wake of recent changes to the law, experts say.
As every day seems to bring news of another subprime mortgage lender on the brink of collapse, Chapter 11 is quickly becoming the lone option for some as the liquidity in the marketplace begins to dry up.
"In the past year or two years, money was plentiful and Chapter 11 wasn't that much of an attractive option," said Lou Recano, the chief executive officer and co-founder of bankruptcy consulting firm Donlin Recano. "The financial markets are so roiled now, people are less willing to put money into a company that has financial problems, making Chapter 11 a viable option."
But the expenses currently connected with the Chapter 11 process could take many off-guard and force companies to look for new alternatives to the traditional debtor-in-possession financing that was once available to them, he says.
"As capital tightens up, companies that turn to Chapter 11 will have to face the realities of the new law, and those may be more painful than debtors and creditors alike anticipate," said Recano.
Though several large entities like Calpine Corp. and Refco Inc. ducked into bankruptcy following the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005, the code has had relatively little impact on smaller companies up until now.
"I don't think it's been tested with the mid-cap companies because they were able to get money to fix their problems," he said.
Recano believes that many potential Chapter 11 debtors are about to caught flat-footed by the monetary realities connected with entering bankruptcy these days.
"The new law added two requirements—that debtors only had 18 months to retain exclusivity and that creditors were entitled to receive a great deal more information," he said. "You have to really put together your plan [quickly] and notify and keep your constituency informed. A lot of the work is compressed."
Recano recalled how a client was recently forced to pay nearly $140,000 for mailing costs alone in association with sending out 17 notices to an estimated 95,000 creditors during a two-week period.
"Due to the shortened [schedule], we could not use U.S. mail and had to resort to faxing, e-mailing, FedExing," he said. "That kind of fast tracking is very expensive."
The code also changed what kinds of liabilities could be discharged, forcing debtors to classify more claims as administrative rather than as general unsecured claims, leading to greater costs.
"These are more expensive problems, and I don't think anybody is aware of this," he said. "There are so many other problems that they have to deal with and filing is such a hurdle. People still go in blindly and they don't look at what is entailed by filing for Chapter 11."
Karen Ostad, a partner in the bankruptcy and restructuring group at Morrison & Foerster, agrees that preparation is key for companies mulling a move into Chapter 11 in the wake of the law's revisions.
"The amendments to the bankruptcy code have some impact on how debtors will proceed," she said. "They need to go in being a little bit more organized and have planned their restructuring before they go in. They have less time to have an exclusive period to get a plan confirmed."
But while a shorter time frame might seem to suggest that fees would be lower, that is not the case in most bankruptcy proceedings, according to Peter Goodman, a partner in the bankruptcy/restructuring practice at Andrews Kurth LLP.
"If the time periods are truncated, you have to make decisions quickly with respect to leases, etc. and there are commensurate professional fees that go along with it," he said. "While [less time] should theoretically reduce the costs, what you are seeing in some of the current cases is people putting in a lot of hours, working overtime and running up fees. "
But Martin Bienenstock, co-chair of the Business, Finance and Restructuring department at Weil Gotshal & Manges LLP, cautions against making generalizations about the costs associated with Chapter 11 today.
"While I think nothing in the bankruptcy amendments or current market turmoil will make it less expensive, you have to look at the facts of each debtor," he said.
Certain changes to the code are more likely to consume more cash, including the requirements that all goods the debtor has received have to be paid for in full and that debtors must assume or reject leases within 270 days, according to Bienenstock.
"All of these changes can consume cash earlier in the process than before the bankruptcy amendments," he said. "But some of the changes can be dealt with by planning, knowing that you are going to file."
One area that could be out of the debtors' control, though, is their ability to tap into traditional debtor-in-possession financing, especially in the subprime sector, says Recano.
"Generally, debtor-in-possession used to come from banks who are the creditors in the subprime cases," he said. "People who would traditionally provide the DIP are sometimes conflicted out now."
While Ostad concurs that the DIP market is narrowing in light of recent economic changes, she believes that less traditional sources will be ready and willing to step in to provide the funding.
"The DIP market has tightened with the rest of the market," she said.
But Ostad contends that hedge funds with adequate capital and others will continue to look for bargains in the distressed market arena, filling in the DIP void left by bigger financial institutions.
"At the right discount, the hedge funds will be in buy mode, with the objective of running a reorganization and enhancing the return on something that they have bought at a discount," she said.
Bienenstock argues, though, that the lack of DIP financing in the subprime sector may have more to do with the nature of the subprime cases themselves than anything else.
"In the subprime space, most of the subprime debtors lose all their assets before or shortly after their bankruptcy," he said. "The lender doesn't have a reason to lend because there is very little business to protect. The subprime debtors are very much like the dot coms—dead on arrival."
Just because the creditors would also be lenders, though, does not mean that the world of traditional DIP financing is now off-limits to parties like the subprime lenders, said Goodman.
"You do see some of the subprime cases lining up debtor-in-possession financing with potential acquirers," he said. "I believe in some cases creditors have also been lenders both under the old act and the new code. It raises the eyebrows of the court but it hasn't been a deterrent."
But as talk turns to what potential debtors may face upon entering Chapter 11, some professionals caution that, though expected, the bankruptcy surge is not yet a reality.
"We are not seeing a lot of bankruptcies filing now," says Goodman. "But there is a credit crunch that transcends the subprime issue. You are gonna see those companies that have poor credit problems not being able to obtain the funding they [previously] had."
Recano concurs, suggesting that the recent subprime filings are just the start as hedge funds and other lenders begin to adopt a more wary attitude towards the market.
"As the market defines itself again, these lenders may not be willing any longer to take a risk in a market that they have lost confidence in," he said. "The fact that there has been so much capital around and the borrowing cost was so little, people just used it to plaster over any kinds of problems that they had. Now they are not able to do that."
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