April 2020 – The following are some observations by Chaffetz Lindsey partner Alan Lipkin based on his long-term experience as a bankruptcy lawyer and what he now sees and hears in the bankruptcy world:
- Contrary to popular belief, the current economic crisis as it applies to many businesses has less to do with the COVID-19 virus than most people think. Historically, whatever the immediate precipitating event causing a financial crisis (here the pandemic), the primary cause of most business bankruptcy filings is management’s prior decisions. Hence, while the coronavirus has created unanticipated health and financial difficulties of enormous magnitude, eventually (and probably sooner than later) the current magnitude and poor credit quality of U.S. corporate debt were leading towards a severe recession in the U.S. even without the pandemic. In effect, it was unsustainable to have the current amount of U.S. corporate debt at $10 trillion and the current amount of high-yield debt (a/k/a junk bonds) more than 20 times greater than the amount of such debt less than thirty years ago. Thus, while the suddenness and enormous impact of the pandemic caused economic disruption that threatens many businesses, the consequences will be far more problematic to the extent a management’s prior decisions left a business with insufficient working capital, an inadequate or no line of credit, too much debt, and no rainy day back-up plan. Nor does the pandemic excuse a management that recently engaged in substantial stock buy-backs or unwarranted dividend distributions.
- The current financial crisis will not impact all businesses the same. Even putting aside the influence of government interventions and subsidies, which vary by industry, in the business world there are likely to be groups of “haves” and “have nots.” In a financial crisis, cash is king as cash is the lifeblood of any business. Hence, industries whose cash flow has been drastically reduced or cutoff entirely by the pandemic will suffer. Those industries include airlines, cruise lines, car rental companies, and other travel related businesses, entertainment and sports businesses, restaurants, retailers, gaming enterprises, mining companies, and oil and gas firms. Meanwhile, businesses whose cash flow remains relatively steady notwithstanding the pandemic should be stable or even thrive. Some examples include businesses selling groceries and staples (in the broader sense including Amazon, Walmart, etc.), streaming companies such as Netflix, pharmaceutical and healthcare companies, and most utilities. Accordingly, those companies not lucky enough to be in industries that remain flush with cash will be severely challenged.
- Don’t be misled by the absence to date of a wave of commercial bankruptcy filings; such a wave is coming. Some of the delay is typical for any businesses in financial difficulty. First, there is denial of the magnitude of the problem from both the management and creditor perspective. Second, even once a problem is acknowledged, managers (and creditors) often defer directly dealing with the problem. Third, management is generally reluctant to talk with bankruptcy professionals due to a misplaced fear that just having such conversations creates a self-fulfilling prophesy in which a bankruptcy filing becomes inevitable. Fourth, conflicts frequently arise, both within management and between the debtor and its creditors, when trying to reach consensus on the debtor’s financial problems’ causes, magnitude, and solutions.
The current delay in many commercial bankruptcy filings is also due to factors unique to the COVID-19 pandemic. First, the pandemic created a sudden crisis that takes time for decision makers to absorb and process. Second, there remains significant uncertainty regarding the length, depth, and commercial impact of the pandemic. Such uncertainty makes generating reliable financial projections quite difficult and, therefore, interferes with a prospective chapter 11 debtor’s ability to obtain DIP financing (i.e., financing typically needed to fund a chapter 11 case) and to make progress on or even reach agreement with key creditors on a business plan and the proposed recapitalization of the debtor. Yet, when a debtor files for chapter 11 the debtor wants to have a positive story to tell about having locked in DIP financing and having an exit strategy as to which substantial progress (or even an agreement incorporated in a prepackaged chapter 11 plan) has been achieved. Third, progress now on many debt restructurings is being hindered because most bankruptcy professionals and many hedge funds that are key creditors are involved in multiple potential chapter 11 cases and, therefore, are stretched quite thin. Fourth, the fact so many people are working from home and busy with multiple potential bankruptcies also signifies bankruptcy courts are often overwhelmed and only dealing with emergencies. Thus, there is less urgency to make an immediate chapter 11 filing because it probably would not be followed by much progress in court during the near term. Still, as the logjam starts to clear many chapter 11 filings should follow.
With all of those considerations in mind, now is the time to evaluate the economic circumstances of your business and those of key counter-parties as well as to utilize advisors to make sure you understand your legal rights and best determine how to survive and even thrive in these challenging times.
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