The Changing Face of Chapter 11

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 pre-arranged 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 sky- rocketing, 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 ([email protected]) is the CEO and co-founder of Donlin Recano & Company, a information services and bankruptcy management, claims and noticing consultancy based in New York. Scott Y. Stuart ([email protected]) is a former practicing bankruptcy attorney and now Managing Director responsible for business development and case oversight at Donlin Recano.

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 pre-arranged 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 sky- rocketing, 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 ([email protected]) is the CEO and co-founder of Donlin Recano & Company, a information services and bankruptcy management, claims and noticing consultancy based in New York. Scott Y. Stuart ([email protected]) is a former practicing bankruptcy attorney and now Managing Director responsible for business development and case oversight at Donlin Recano.