Recent Bankruptcy Trends

So, have borrowers become more efficient in the last few years, able to withstand increasing interest rates and commodity prices? Hardly. For the past several years, as the U.S. economy has expanded, interest rates have remained low, which has kept down corporate borrowing costs. At the same time, the lending market has become much more competitive. The number of potential lenders and investors has increased, with the proliferation of hedge funds, private equity firms and other types of non-traditional investors now providing liquidity. This has created an abundance of liquidity in the marketplace, thereby causing lenders to lower the cost of credit, loosen covenants or otherwise ease up on borrowing terms. Lenders also are eager to find investments in order to put their money to work in a competitive lending environment. This has allowed companies facing either a credit crunch or a potential default under their credit documents to refinance obligations or obtain additional credit.

'Easy Money'

Recent market indicators suggest however, that the era of 'easy money' may be winding down. Interest rates have been steadily creeping higher, thereby increasing the cost of new loans. Similarly, inflation concerns and rising commodities prices such as oil and other fuels have increased sharply. This has increased borrowers' production costs, and also increased concern on the part of lenders and investors. As companies find their cost of credit and production rising, lenders are becoming more discriminating and increasingly, tightening covenants and lending requirements for new borrowers. Some experts think all it will take is one market shock, or an incremental increase in interest rates, before certain companies will be forced to restructure, or even seek bankruptcy protection.

Increase in Default Rate

A decline in the quality of new high-yield issues over the past few years also should contribute to an increase in the default rate. Traditionally, there has been a lag time of a few years between when a high-yield bond is issued and when it experiences its greatest chance of default. This bodes well for an upturn in default rates, since a large number of lower-quality high-yield issues have been offered over the past few years. The odds are that at least some portion of these new issues will default within the next year or so. The growth of the second-lien loan market also is likely to have an impact on default rates. Standard & Poor's has estimated that the second-lien market has grown from over $3 billion in 2003, to over $16 billion in 2005. Many of these second-lien loans have a floating interest rate feature, and therefore will be more sensitive to interest rate increases than traditional high yield bonds. The availability of new lending and refinancings, together with pressure on borrowers from increased commodity and other costs, has lead to narrower margins and missed performance projections. That means, sooner rather than later, companies are bound to be bumping up against covenants and potentially defaulting on their obligations.

Leveraged Buyouts

An additional form of pressure on corporate borrowers may be the widespread amount of leveraged buyout/highly leveraged purchases that have been taking place in the last few years. These transactions often have involved companies taking on high levels of debt to facilitate the deal. The aggressive use of leverage could leave former LBO target companies with little room for error if there is a price shock on any critical commodity or a downturn in a company's sector. This could trigger a need for negotiations with creditors and/or a formal restructuring.

When Credit Tightens

And exactly what sectors can we anticipate as being most likely affected when credit tightens? First, and not surprisingly, the automotive sector remains under stress ' and therefore, remains most at risk to any overall market downturn. This sector has been one of the largest recent issuers of high-yield paper and second-lien debt. Major players such as Delphi Corp., Dana Corp., Collins & Aikman and Tower Automotive already have commenced Chapter 11 proceedings. These and other automotive suppliers' lifeblood is selling to the major American automotive manufacturers such as General Motors Corp. and Ford Corp. But, with the combination of deteriorating market share, pressure to cut production costs and retail prices, the stress on automotive parts suppliers is mounting. These factors, compounded by high gas prices and continuing high labor and pension costs, mean that many industry experts expect at least a few more auto sector participants to enter Chapter 11 sometime soon.

Other sectors to which experts point as being particularly subject to anticipated upcoming market stress include the consumer products, media and telecommunications industries, all of which have issued large amounts of high yield bonds. Each of these is heavily dependent upon discretionary spending by consumers for much of their revenue. If there is a general economic downturn or some market instability in the near future, consumers may be less inclined to continue spending on non-essentials. Further, to the extent that these companies have taken advantage of the easy financing available in the past, they may find that maintaining the covenants and other requirements under that financing is not so easy in a market downturn. In addition to these industries, some experts anticipate slowdowns in sectors as diverse as real estate (which is highly dependent upon interest rate levels), retail and technology. We will have to stay tuned to see if all of these various predictions come true, although at this point, market conditions appear to be in the prognosticators' favor.

Regardless of which industries fall prey to the anticipated increase in restructuring activity, the next round of restructurings and bankruptcies is sure to be more complex and to raise issues not seen previously. The first reason for heightened restructuring complexity will be due to the sheer increase in the number of players in the restructuring industry. The creditors in restructurings are not just traditional asset-based lenders anymore. Now, hedge funds have proliferated to such great numbers that they could prove to be the dominant force in the next round of restructurings. Indeed, more and more funds specializing in distressed investments are either raising additional money or opening new funds. For example, Oaktree Capital Management, LLC recently began marketing its fourth control-oriented fund focusing on distressed investments. Recent news reports have noted that KKR is raising $1 billion for a Strategic Capital Fund, that Blackstone launched a $500 million distressed debt hedge fund last year, and that the Carlyle Group recently formed a $1 billion fund. Reports also note that Cerberus is starting a new $6 billion distressed debt fund. There also has been action by other financial institutions to move into the distressed sector with their proprietary money, in an attempt to capitalize on what they see as a potentially active sector. Finally, there has been consolidation and expansion by traditional distressed investors, in order to give them access to even more capital in anticipation of increasing opportunities in distressed and bankrupt companies. An example of this is the recent sale by Wilbur Ross of his boutique distressed investing firm to fund management group Amvescap. While some of these parties preparing for renewed activity in the bankruptcy arena are sophisticated and experienced distressed players, others are new to the field. Despite these differences, however, the sheer numbers of institutions looking at ways to get involved in the upcoming wave of workouts and bankruptcies promises to make those new restructurings even more complicated.

Distressed Deals

The complexity caused by the increase in parties will be magnified by the new issues that are expected to arise in upcoming distressed deals. As previously discussed, second lien financings have grown exponentially, and it is anticipated that this form of financing will give rise to its own unique issues within a restructuring. The addition of an extra layer of secured paper in a bankruptcy proceeding will add a layer of complexity to issues such as the right to receive post-petition interest, whether adequate protection is appropriate, and the debtor's ability to obtain debtor-in-possession financing, just to mention a few. The inter-creditor agreements that often are a feature of second lien financings will be tested in bankruptcies, and as a result, inter-creditor disputes are anticipated to be the focus of many future restructurings. We can expect to see disputes among creditor groups, as well as disputes over the interpretation and enforceability of inter-creditor agreements, taking up much of the bankruptcy courts' time in the future. The case law on second lien financings and inter-creditor arrangements has only started to develop, so the first few cases will set the parameters for those to follow.

What About the Bankruptcy Reform Act?

As a result of the recent slowdown in Chapter 11 filings, since the implementation of BAPCPA the number of 'mega cases' filed has been relatively small. The principal filings that many are watching to see the effects of BAPCPA include the Chapter 11 cases of Dana Corp., Calpine Corp., Oneida Ltd., and a few others. One of the big issues under BAPCPA that has yet to be tested and analyzed fully by the courts is the modification to Bankruptcy Code ' 1121(d), regarding the debtor's exclusive right to file a plan of reorganization. Under the amended version of ' 1121, while the court retains the power to extend the debtor's ability to file and propose a plan of reorganization beyond the original 120-day exclusivity period, any extensions to that period may not exceed 18 months beyond the date the Chapter 11 petition was filed. 11 U.S.C. ' 1121(d)(2)(A). Further, the debtor's exclusive period for solicitation of acceptances on a plan will terminate if the debtor's plan is not confirmed within 20 months of the date the case was commenced. 11 U.S.C. ' 1121(d)(2)(B). This amendment will end the multiple, sometimes years-long extensions of exclusivity that previously were seen in large, complex Chapter 11 cases.

This new 'drop dead date' on exclusivity may force parties to commence plan discussions sooner, and perhaps reach a consensus on a plan earlier, in order to avoid the cost and delay that could result from a fight over competing plans. In extremely complex cases, it remains to be seen whether any constituency outside of the debtor (other than perhaps the official creditors' committee) will have sufficient information to be able to propose a viable plan of reorganization just after the automatic termination of exclusivity. It is more likely that aggrieved individual creditors or other constituents will seize upon the automatic termination of exclusivity to propose plans that, while not being viable or to the benefit of all constituencies, still will have to be considered by the court. However, given that the number of recent, large Chapter 11 filings has been relatively small, it still may be too early to see the effects of BAPCPA's amendments to ' 1121(d). These issues are working their way through the mega cases now in Chapter 11. But one thing is clear ' BAPCPA's changes to the Bankruptcy Code, particularly with respect to exclusivity, will add to the number and complexity of issues arising within the next wave of restructurings.

Conclusion

For many people, the anticipated upcoming economic downturn will not be good news. For those bankruptcy professionals who have been sitting out the most recent bankruptcy drought on the sidelines, this downturn will come none too soon. Along with the upcoming wave of restructurings will be the test cases for the new issues created by second lien financings and other recent developments, such as the increased use of credit insurance. Add to this the number of highly leveraged buyouts that have been taking place recently and the rise of the new players in distressed investing, as well as the recent changes to the Bankruptcy Code, and you have what many agree will be one of the most interesting periods in bankruptcy and restructuring. It is too early to predict the effects of all of these changes, and what the outcome will be for those companies already tackling some of these issues in Chapter 11. But, there is one thing on which most of the experts agree ' all the signs are ripe for a significant increase in activity in the distressed, restructuring and bankruptcy arenas in the near future. For bankruptcy players, it seems hope is indeed just over the horizon.

Ingrid Bagby is a partner in the Financial Restructuring Department in the New York office of Cadwalader, Wickersham & Taft LLP. She concentrates her practice on corporate reorganizations and has represented debtors, creditors and bondholders in Chapter 11 proceedings and restructurings. She may be reached at [email protected]. Sheryl Saleeby, a financial analyst in the department, assisted with the article.

As many bankruptcy and restructuring participants are all too aware, the recent expansion of the United States economy has created a significant decrease in financial restructurings, defaults and Chapter 11 filings. Based on Standard & Poor's estimates, corporate default rates were just 1.6% last year, compared with a recent high of 10.51% in 2001. Relatively low interest rates, relaxed lending terms and the increasingly competitive financing environment created by the proliferation of new, non-traditional funding sources have kept many companies afloat that, just a few years ago, surely would have found themselves either negotiating with creditors or heading into Chapter 11. But the era of 'easy money' may be coming to an end soon, as there are signs of increasing economic pressure in certain sectors of the economy. At the same time, the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), the principle provisions of which became effective in October 2005, is fundamentally changing certain aspects of the Chapter 11 process. Although no one is able to predict with certainty what will happen in the restructuring field in the near future, below are some of the signs that the bankruptcy field is about to undergo a substantial change.

Increased Chapter 11 Activity

The current buoyant market conditions have led to a lull in Chapter 11 filings, particularly filings by companies with large market capitalizations, ie, the 'mega cases.' Statistics from the Administrative Office of the U.S. Courts indicate that Chapter 11 filings are down approximately 9% for the year ending March of 2006, compared with the same period last year. Even more startling, the number of filings so far this year is down about half from the number 5 years ago. Indeed, since the start of 2006, there have only been a handful of significant filings, such as the Chapter 11 cases of Dana Corp., Pliant Corp., Riverstone Networks, Integrated Electrical Services, Inc., and J.L. French Automotive. As the current downturn has been going on for some time, the causes and long-term effects of this lull in Chapter 11 filings now has become clear.

So, have borrowers become more efficient in the last few years, able to withstand increasing interest rates and commodity prices? Hardly. For the past several years, as the U.S. economy has expanded, interest rates have remained low, which has kept down corporate borrowing costs. At the same time, the lending market has become much more competitive. The number of potential lenders and investors has increased, with the proliferation of hedge funds, private equity firms and other types of non-traditional investors now providing liquidity. This has created an abundance of liquidity in the marketplace, thereby causing lenders to lower the cost of credit, loosen covenants or otherwise ease up on borrowing terms. Lenders also are eager to find investments in order to put their money to work in a competitive lending environment. This has allowed companies facing either a credit crunch or a potential default under their credit documents to refinance obligations or obtain additional credit.

'Easy Money'

Recent market indicators suggest however, that the era of 'easy money' may be winding down. Interest rates have been steadily creeping higher, thereby increasing the cost of new loans. Similarly, inflation concerns and rising commodities prices such as oil and other fuels have increased sharply. This has increased borrowers' production costs, and also increased concern on the part of lenders and investors. As companies find their cost of credit and production rising, lenders are becoming more discriminating and increasingly, tightening covenants and lending requirements for new borrowers. Some experts think all it will take is one market shock, or an incremental increase in interest rates, before certain companies will be forced to restructure, or even seek bankruptcy protection.

Increase in Default Rate

A decline in the quality of new high-yield issues over the past few years also should contribute to an increase in the default rate. Traditionally, there has been a lag time of a few years between when a high-yield bond is issued and when it experiences its greatest chance of default. This bodes well for an upturn in default rates, since a large number of lower-quality high-yield issues have been offered over the past few years. The odds are that at least some portion of these new issues will default within the next year or so. The growth of the second-lien loan market also is likely to have an impact on default rates. Standard & Poor's has estimated that the second-lien market has grown from over $3 billion in 2003, to over $16 billion in 2005. Many of these second-lien loans have a floating interest rate feature, and therefore will be more sensitive to interest rate increases than traditional high yield bonds. The availability of new lending and refinancings, together with pressure on borrowers from increased commodity and other costs, has lead to narrower margins and missed performance projections. That means, sooner rather than later, companies are bound to be bumping up against covenants and potentially defaulting on their obligations.

Leveraged Buyouts

An additional form of pressure on corporate borrowers may be the widespread amount of leveraged buyout/highly leveraged purchases that have been taking place in the last few years. These transactions often have involved companies taking on high levels of debt to facilitate the deal. The aggressive use of leverage could leave former LBO target companies with little room for error if there is a price shock on any critical commodity or a downturn in a company's sector. This could trigger a need for negotiations with creditors and/or a formal restructuring.

When Credit Tightens

And exactly what sectors can we anticipate as being most likely affected when credit tightens? First, and not surprisingly, the automotive sector remains under stress ' and therefore, remains most at risk to any overall market downturn. This sector has been one of the largest recent issuers of high-yield paper and second-lien debt. Major players such as Delphi Corp., Dana Corp., Collins & Aikman and Tower Automotive already have commenced Chapter 11 proceedings. These and other automotive suppliers' lifeblood is selling to the major American automotive manufacturers such as General Motors Corp. and Ford Corp. But, with the combination of deteriorating market share, pressure to cut production costs and retail prices, the stress on automotive parts suppliers is mounting. These factors, compounded by high gas prices and continuing high labor and pension costs, mean that many industry experts expect at least a few more auto sector participants to enter Chapter 11 sometime soon.

Other sectors to which experts point as being particularly subject to anticipated upcoming market stress include the consumer products, media and telecommunications industries, all of which have issued large amounts of high yield bonds. Each of these is heavily dependent upon discretionary spending by consumers for much of their revenue. If there is a general economic downturn or some market instability in the near future, consumers may be less inclined to continue spending on non-essentials. Further, to the extent that these companies have taken advantage of the easy financing available in the past, they may find that maintaining the covenants and other requirements under that financing is not so easy in a market downturn. In addition to these industries, some experts anticipate slowdowns in sectors as diverse as real estate (which is highly dependent upon interest rate levels), retail and technology. We will have to stay tuned to see if all of these various predictions come true, although at this point, market conditions appear to be in the prognosticators' favor.

Regardless of which industries fall prey to the anticipated increase in restructuring activity, the next round of restructurings and bankruptcies is sure to be more complex and to raise issues not seen previously. The first reason for heightened restructuring complexity will be due to the sheer increase in the number of players in the restructuring industry. The creditors in restructurings are not just traditional asset-based lenders anymore. Now, hedge funds have proliferated to such great numbers that they could prove to be the dominant force in the next round of restructurings. Indeed, more and more funds specializing in distressed investments are either raising additional money or opening new funds. For example, Oaktree Capital Management, LLC recently began marketing its fourth control-oriented fund focusing on distressed investments. Recent news reports have noted that KKR is raising $1 billion for a Strategic Capital Fund, that Blackstone launched a $500 million distressed debt hedge fund last year, and that the Carlyle Group recently formed a $1 billion fund. Reports also note that Cerberus is starting a new $6 billion distressed debt fund. There also has been action by other financial institutions to move into the distressed sector with their proprietary money, in an attempt to capitalize on what they see as a potentially active sector. Finally, there has been consolidation and expansion by traditional distressed investors, in order to give them access to even more capital in anticipation of increasing opportunities in distressed and bankrupt companies. An example of this is the recent sale by Wilbur Ross of his boutique distressed investing firm to fund management group Amvescap. While some of these parties preparing for renewed activity in the bankruptcy arena are sophisticated and experienced distressed players, others are new to the field. Despite these differences, however, the sheer numbers of institutions looking at ways to get involved in the upcoming wave of workouts and bankruptcies promises to make those new restructurings even more complicated.

Distressed Deals

The complexity caused by the increase in parties will be magnified by the new issues that are expected to arise in upcoming distressed deals. As previously discussed, second lien financings have grown exponentially, and it is anticipated that this form of financing will give rise to its own unique issues within a restructuring. The addition of an extra layer of secured paper in a bankruptcy proceeding will add a layer of complexity to issues such as the right to receive post-petition interest, whether adequate protection is appropriate, and the debtor's ability to obtain debtor-in-possession financing, just to mention a few. The inter-creditor agreements that often are a feature of second lien financings will be tested in bankruptcies, and as a result, inter-creditor disputes are anticipated to be the focus of many future restructurings. We can expect to see disputes among creditor groups, as well as disputes over the interpretation and enforceability of inter-creditor agreements, taking up much of the bankruptcy courts' time in the future. The case law on second lien financings and inter-creditor arrangements has only started to develop, so the first few cases will set the parameters for those to follow.

What About the Bankruptcy Reform Act?

As a result of the recent slowdown in Chapter 11 filings, since the implementation of BAPCPA the number of 'mega cases' filed has been relatively small. The principal filings that many are watching to see the effects of BAPCPA include the Chapter 11 cases of Dana Corp., Calpine Corp., Oneida Ltd., and a few others. One of the big issues under BAPCPA that has yet to be tested and analyzed fully by the courts is the modification to Bankruptcy Code ' 1121(d), regarding the debtor's exclusive right to file a plan of reorganization. Under the amended version of ' 1121, while the court retains the power to extend the debtor's ability to file and propose a plan of reorganization beyond the original 120-day exclusivity period, any extensions to that period may not exceed 18 months beyond the date the Chapter 11 petition was filed. 11 U.S.C. ' 1121(d)(2)(A). Further, the debtor's exclusive period for solicitation of acceptances on a plan will terminate if the debtor's plan is not confirmed within 20 months of the date the case was commenced. 11 U.S.C. ' 1121(d)(2)(B). This amendment will end the multiple, sometimes years-long extensions of exclusivity that previously were seen in large, complex Chapter 11 cases.

This new 'drop dead date' on exclusivity may force parties to commence plan discussions sooner, and perhaps reach a consensus on a plan earlier, in order to avoid the cost and delay that could result from a fight over competing plans. In extremely complex cases, it remains to be seen whether any constituency outside of the debtor (other than perhaps the official creditors' committee) will have sufficient information to be able to propose a viable plan of reorganization just after the automatic termination of exclusivity. It is more likely that aggrieved individual creditors or other constituents will seize upon the automatic termination of exclusivity to propose plans that, while not being viable or to the benefit of all constituencies, still will have to be considered by the court. However, given that the number of recent, large Chapter 11 filings has been relatively small, it still may be too early to see the effects of BAPCPA's amendments to ' 1121(d). These issues are working their way through the mega cases now in Chapter 11. But one thing is clear ' BAPCPA's changes to the Bankruptcy Code, particularly with respect to exclusivity, will add to the number and complexity of issues arising within the next wave of restructurings.

Conclusion

For many people, the anticipated upcoming economic downturn will not be good news. For those bankruptcy professionals who have been sitting out the most recent bankruptcy drought on the sidelines, this downturn will come none too soon. Along with the upcoming wave of restructurings will be the test cases for the new issues created by second lien financings and other recent developments, such as the increased use of credit insurance. Add to this the number of highly leveraged buyouts that have been taking place recently and the rise of the new players in distressed investing, as well as the recent changes to the Bankruptcy Code, and you have what many agree will be one of the most interesting periods in bankruptcy and restructuring. It is too early to predict the effects of all of these changes, and what the outcome will be for those companies already tackling some of these issues in Chapter 11. But, there is one thing on which most of the experts agree ' all the signs are ripe for a significant increase in activity in the distressed, restructuring and bankruptcy arenas in the near future. For bankruptcy players, it seems hope is indeed just over the horizon.

Ingrid Bagby is a partner in the Financial Restructuring Department in the New York office of Cadwalader, Wickersham & Taft LLP. She concentrates her practice on corporate reorganizations and has represented debtors, creditors and bondholders in Chapter 11 proceedings and restructurings. She may be reached at [email protected]. Sheryl Saleeby, a financial analyst in the department, assisted with the article.