With a pandemic temporarily closing many businesses and stifling consumer demand, whole industries, especially those that recently leveraged their balance sheets to take advantage of near-zero interest rates, are seeing their profits disappear virtually overnight, leaving too little cash flow to cover debt payments owed to creditors.
This could set up the perfect storm for a huge wave of bankruptcies in the weeks and months ahead, says Stuart C. Gilson, the Steven R. Fenster Professor of Business Administration at Harvard Business School.
“There is a realistic probability that we could indeed see a ‘pandemic’ of bankruptcy filings in the near future,” Gilson says. “The pandemic analogy is particularly apt, in that if the number of new filings is sufficiently high, the bankruptcy courts, like hospitals treating COVID-19 patients, could be overwhelmed.”
Several US businesses have already filed since the coronavirus started rocking the US economy in mid-March, including Neiman Marcus, J. Crew, Dean & DeLuca, CMX Cinemas, and Gold’s Gym. The latest: JCPenney on May 15 filed for Chapter 11 bankruptcy protection after 118 years in business.
As Gilson explains in this Q&A, bankruptcy doesn’t necessarily mean the death of a company, and in fact, it can actually be the very thing that saves a business, assuming the courts can handle the flood that is likely coming.
Dina Gerdeman: What impact do you expect COVID-related bankruptcies to have on the bankruptcy system? And what does that mean for business owners who are seeking protection?
Stuart Gilson: The global economic impact of the pandemic has already been catastrophic in terms of lost output, employment, and financial wealth. But many expect this to be followed by significant aftershocks in coming weeks and months, as quite possibly record numbers of businesses (and individuals) default on their debt, restructure, or go bankrupt. The number of US business bankruptcy filings in the first quarter of this year is already up substantially over prior years, and some believe the number of filings over the next couple of years could top what we saw during the 2008-2009 Global Financial Crisis, when there were more than 100,000 business bankruptcies. Some analysts are forecasting that by the end of 2021 up to 20 percent of high-yield corporate bonds could be in default.
“IT IS CERTAINLY CONCEIVABLE THAT IF TOO MANY NEW CASES ARRIVE AT THE SAME TIME, COMPANIES COULD BE MUCH LESS WELL-SERVED BY THE BANKRUPTCY REORGANIZATION PROCESS.”
What makes the current financial crisis unique is that the economic harm caused by forced shutdowns is being felt by broad swaths of the economy and the population—large public companies to be sure, but also small- and medium-sized businesses, individual households, and cities and states. And all of these entities (with the exception of US states) can in principle file for bankruptcy protection. But all such cases, whether corporate, personal, or municipal bankruptcies, are processed through the same United States Bankruptcy Court system, and are overseen by the same pool of federal bankruptcy judges, who currently number about 350 only. The bankruptcy process also requires the active participation of skilled legal and financial professionals, who are also available in only limited quantities.
So it is certainly conceivable that if too many new cases arrive at the same time, companies could be much less well-served by the bankruptcy reorganization process, and emerge in much less sound financial condition (or not emerge at all). Overcrowding would cause cases to be processed more slowly, leading to longer stays in the bankruptcy “hospital.”
Not only would professional fees go up (especially burdensome for smaller businesses), but process delays would force companies to wait longer to obtain new financing or sell off assets, and delays in paying critical vendors could disrupt supply chains, further hurting the business and destroying value. This potential problem is troubling to a number of bankruptcy scholars, including my colleague Mark Roe at Harvard Law School.
So, is this bleak scenario inevitable? Optimistically, a number of things could happen to “flatten the curve” and reduce the number of bankruptcy filings, at least by enough to allow the existing system to function effectively. Massive financial support available to distressed businesses under the CARES Act and various recently enacted Federal Reserve programs might, if properly directed, allow significant numbers of businesses to avoid bankruptcy.
There are also massive amounts of private sector capital potentially available to support businesses in need. Bank balance sheets are generally sound, and hedge funds that specialize in investing in distressed companies and private equity firms have billions of dollars of investible cash—although whether any of these investors have the appetite to risk their capital in the present environment is yet to be determined. And of course, an effective cure or vaccine for the virus could be found, fueling a faster-than-expected economic recovery.
Will any of these positive developments materialize? The fact is, forecasting the number of bankruptcies presents the same modeling challenges as forecasting the number COVID-19 cases. Absent any such relief, it may be necessary to invest in expanding the capacity of the bankruptcy courts to prepare them to handle an unprecedented volume of new cases, should the worst case come to pass.
Gerdeman: Many view a bankruptcy filing as the death of a company, but you’ve said it can actually revive them. And we’ve seen examples of companies that continue to hum right along after filing. Do you think filing for bankruptcy might help some companies survive now?
Gilson: In many countries, “bankruptcy” does mean the death of a company, because it’s synonymous with liquidation. When a company defaults on its debt, and is unable to renegotiate terms or obtain an extension from creditors, filing for bankruptcy in the courts often results in a forced wind-down of the business. Management is replaced by a trustee or administrator (who is often an accountant or lawyer by training), the firm’s assets are sold off, and proceeds from asset sales are distributed to creditors until the money runs out. Importantly, there is no surviving, ongoing business.
In the US, in stark contrast, bankruptcy law serves a much different purpose. Under Chapter 11 of the US Bankruptcy Code, the goal is to give distressed companies the opportunity to reorganize, by giving them breathing room to fix the problems that afflict the business—for example, by cutting expenses, selling non-core assets, or making needed capital improvements—and put in place a new, less debt-heavy capital structure that the business can support going forward.
During this process—which typically might last one or two years for a large publicly traded company (although much faster prepackaged or prenegotiated bankruptcies are sometimes possible) —creditors are temporarily held at bay, and are not able to exercise remedies normally available to them when there is a default, such as calling in loans or seizing company assets.
Of course, this moratorium on creditor actions, called the “automatic stay,” may appear to disadvantage some creditors. But if it ultimately allows the company to fix the business and emerge from bankruptcy as a viable company going forward, then all creditors are potentially made better off, if the alternative is liquidation. In other words, Chapter 11 assumes, at least initially, that a live business—one that sells products and services to customers, employs people, invests and grows and innovates—is worth more than a dead business.
If this assumption is true, then it’s in everyone’s interest to find common ground on a plan that restructures the company’s debts and allows the business to continue. Even though creditors will typically be asked to make some financial sacrifices, such as accepting a reduction in what they are owed, waiting longer to be repaid, or exchanging their debt for company stock, they will nonetheless receive more value than they would have had the business been shut down.
Chapter 11 doesn’t give companies a free pass, however. Cases can be converted to a liquidation under Chapter 7 of the Bankruptcy Code if continuation of the company’s business doesn’t make economic sense. And Chapter 11 can be expensive. For large, complex companies, professional fees paid for legal, financial, and other advice can amount to hundreds of millions of dollars (over $1.5 billion in the Lehman Brothers bankruptcy).
Finally, Chapter 11 is also costly for company management. My own research shows that approximately 70 percent of CEOs are replaced when their companies go bankrupt, while those who remain take significant pay cuts.
“MY OWN RESEARCH SHOWS THAT APPROXIMATELY 70 PERCENT OF CEOS ARE REPLACED WHEN THEIR COMPANIES GO BANKRUPT, WHILE THOSE WHO REMAIN TAKE SIGNIFICANT PAY CUTS.”
Gerdeman: So, if Chapter 11 is costly and risky, why would a distressed company ever voluntarily check itself into the Chapter 11 “hospital”?
Gilson: The answer is that Chapter 11 gives distressed companies a number of powerful tools to fix the business. One of these is the automatic stay, discussed previously. Companies in Chapter 11 can also reject unfavorable leases and supply agreements (under Section 365 of the Bankruptcy Code); sell assets in a competitive auction without fear that the sale will be legally challenged (so-called “Section 363 sales”); and obtain new debt financing that ranks on par with or ahead of the firm’s existing debts (“debtor-in-possession” or “DIP” financing, covered by Section 364 of the Bankruptcy Code). And Chapter 11 generally relieves a company from having to pay (or even accrue) interest due on its unsecured debt after the filing date.
The upshot of all this is that Chapter 11 is designed to give distressed companies access to significant amounts of cash when it is most needed. It buys them valuable time to fix what ails the business. And so, to return to your original question, filing for Chapter 11 bankruptcy is by no means a death sentence. If anything, it can provide troubled businesses with a fresh start and a path to future profitability.
But Chapter 11 is also not a panacea for every problem that a company may face. Companies become sick for a variety of reasons: poor management, industry disruption, economic recessions, technological change, uncontrollable external shocks, including the current pandemic. And when the underlying problem is severe enough, even the remedies available in Chapter 11 may not be enough to save the patient.
It’s also important to note that the costs and administrative demands of Chapter 11 impose a proportionately heavier burden on smaller companies, sometimes so much so that they have no realistic option other than to liquidate in Chapter 7. Although professional fees paid in the Lehman Brothers bankruptcy might appear eye-popping, in relative terms they represented only 0.3 percent of the value of Lehman’s assets. For smaller companies this percentage is significantly higher.
This is a real concern right now given how severely small businesses have been impacted by the economic shutdown. In an accident of good timing, last Fall Congress passed the Small Business Reorganization Act of 2019, which is designed to reduce the financial and administrative burden of Chapter 11 on small- to medium-sized businesses (those with non-contingent debts under $2,725,625, temporarily raised to $7.5 million under the CARES Act).
Gerdeman: You say the quality of US bankruptcy law (Chapter 11) enabled us to get through the 2008-2009 crisis much more quickly and successfully than might have been expected. Can you provide an example of a company that made it through that crisis with the help of Chapter 11? And are there any lessons learned from that period that might apply if a new wave of bankruptcies comes?
Gilson: One example that I like to cite in my classes, and the subject of one of my HBS case studies, is LyondellBasell Industries, (“Lyondell”) which filed for Chapter 11 in January 2009, only four months after Lehman Brothers’ collapse ushered in the Global Financial Crisis. Lyondell was the world’s third-largest diversified chemicals company, with $55 billion in annual revenues and operations in 25 countries. Hit by a one-two punch of falling oil prices and the global economic recession, Lyondell suffered massive losses and was on the verge of defaulting on $23 billion of debt. Because almost all of the debt was secured, a default would have allowed creditors to seize company assets, almost certainly forcing the business to shut down.
With the Chapter 11 filing, however, Lyondell’s US subsidiaries were protected from asset seizures by the automatic stay, buying the company valuable time. In addition, relieved of having to pay interest on its debt while in Chapter 11, Lyondell gained access to millions of dollars of additional cash that could be invested in the business or used to fund the reorganization plan. And, critically, it was able to raise over $8 billion in new DIP financing—a remarkable feat, given the timing. Funded by a consortium of commercial banks, investment banks, private equity firms, and hedge funds, the new loans were awarded a senior position in the company’s capital structure, as permitted under the Bankruptcy Code.
In general, this is how Chapter 11 gives new lenders the incentive to lend to a financially distressed business; even if the company ultimately fails and is liquidated, the senior DIP lenders are still likely to be repaid in full. In Lyondell’s DIP financing, existing lenders were also incentivized to lend additional money to the company by letting them convert (“roll up”) a dollar of their existing debt into the new senior DIP loan, effectively jumping ahead in line, for every dollar of new money that they lent under the facility, $3.25 billion in all.
Sixteen months later, Lyondell emerged from Chapter 11 on April 30, 2010. Under the plan of reorganization, total debt outstanding from before the bankruptcy was reduced from $26 billion to $7 billion, while the DIP loans were repaid in full. The company also raised $6 billion in new debt and private equity financing. With its debt burden significantly lightened and $2 billion of cash in the bank, Lyondell emerged from the bankruptcy with a much healthier balance sheet and a fresh start for the business.
And how did the business ultimately fare? Over the course of the following four years, Lyondell’s total operating profit increased by 90 percent, while its stock price increased by 413 percent (over 50 percent a year, on average). By the end of 2014, Lyondell’s total enterprise value (the market value of the business) was $50 billion. Of course, Chapter 11 was but one of many things that helped produce this happy outcome. But had Chapter 11 not been available, and the company been forced to liquidate, only $4 billion would have been realized from that process, according to one estimate.
Gerdeman: Are there other lessons to be drawn from the 2008-2009 crisis?
Gilson: I think the lessons for management that one draws from this and other cases from the 2008-2009 crisis are still very much applicable to today’s crisis.
Whatever the specific cause, if a business becomes financially distressed and is at risk of defaulting on its debt, it needs a transfusion of cash—often, lots of it—to be able to survive. In the US, the bankruptcy laws are designed to do exactly that. That, and the community of skilled lawyers, investment bankers, investors, judges, and others who apply these laws, gives US companies an enormous competitive advantage over their competitors in other countries, where bankruptcy often has a much different purpose, to shut down rather than support the business. Based on all this—my earlier concerns about the limited capacity of the US courts notwithstanding—I expect that US companies will in general fare much better than businesses in other parts of the world in dealing with the financial damage that the pandemic has wrought.
One other takeaway from the 2008-2009 crisis, just as relevant today as then: Hedge funds and private equity investors have dramatically transformed the restructuring of financially distressed businesses. These investors, sometimes called “vultures,” have raised vast sums of money for the purpose of investing in distressed companies. As I write about in my book Creating Value Through Corporate Restructuring, they employ a variety of strategies to invest in the debt, equity, and assets of bankrupt or near-bankrupt companies. Often they are a financial lifeline, and source of new ideas, to companies in need. Their role in the current unfolding crisis, although still to be determined, will undoubtedly be critical.
Gerdeman: Chapter 11 may not be the answer for every company in trouble, right? Is restructuring debt outside of bankruptcy considered more beneficial for some troubled companies? Can you provide an example of a company that has done this and explain which types of businesses might benefit most from this approach?
Gilson: Some of my research on troubled debt addresses this very question. Chapter 11 can be very expensive. The expense includes not only legal and investment banking fees, but also economic losses suffered by the business as management’s attention and time are consumed by the heavy administrative demands of the formal bankruptcy process. Chapter 11 can also have greater reputational consequences. Before recently filing for Chapter 11, Neiman Marcus had undoubtedly discussed refinancing options with its creditors, but that did not garner the same headlines as the bankruptcy filing.
To avoid or reduce these costs, it may make sense for a financially distressed company to seek to restructure its debt out of court and negotiate with creditors privately. This is exactly the same calculation made by parties in litigation: Is it better to go before the court and accept the judge’s verdict, or save court costs and settle? In principle, it should be possible to restructure debt out of court in less time and at lower cost. But two things can get in the way of this.
First, even if restructuring out of court is less costly, going through Chapter 11 provides distressed companies with a number of benefits, including the ability to reject unfavorable leases, the automatic stay, the ability to sell assets on an expedited basis, and access to debtor-in-possession financing. For some companies, the net costs of Chapter 11 (that is, costs net of benefits) might actually be lower than the costs of restructuring out of court, where the aforementioned benefits are not available. For example, retail chains and commercial airlines, which lease a lot of their assets such as stores and airplanes, might rationally prefer Chapter 11 to restructuring out of court.
The second impediment to reaching a consensual deal out of court is that, even if restructuring out of court is less costly than Chapter 11, creditors may disagree on how the resulting financial windfall should be shared. In that event, obtaining the necessary level of consent may be impossible. Outside of Chapter 11, for example, changing the core terms of a publicly traded bond issue (the interest rate, principal amount, or term to maturity) legally requires the consent of 100 percent of the bondholders. If just one bondholder objects to the restructuring plan, it cannot be implemented. In this case each creditor has a powerful incentive to hold out for better terms, and to block the plan.
“RETAIL CHAINS AND COMMERCIAL AIRLINES, WHICH LEASE A LOT OF THEIR ASSETS SUCH AS STORES AND AIRPLANES, MIGHT RATIONALLY PREFER CHAPTER 11 TO RESTRUCTURING OUT OF COURT.”
In contrast, if debt is restructured in Chapter 11, where each distinct class of creditors votes separately on the plan, only a majority of creditors in a particular class—at least two-thirds in terms of value and one-half in number—has to approve the plan; dissenting creditors in the class must accept the will of the majority. This feature reduces the ability of individual creditors to hold out for higher recoveries, potentially undermining the entire restructuring. And should a class of creditors reject a plan because they feel it pays them too little, the judge can nevertheless compel that class to accept the plan, in what’s called a “cram down,” provided no more junior class of creditors receives anything. In other words, the plan is deemed “fair and equitable.”
Chapter 11 can therefore dominate out of court restructuring when creditors are more numerous, more heterogeneous, or motivated by different goals. This is true for any type of debt, not only debt that’s publicly traded. It’s unlikely that Lyondell could have been restructured out of court, for example, given its 25,000 creditors and breathtakingly complex capital structure.
So, to return to your question, for some troubled companies, restructuring out of court may indeed represent a better outcome for creditors and the business. It really depends on companies’ individual circumstances. Companies that have more complicated capital structures with a larger number of, and more heterogeneous, creditors, might be better served by restructuring in Chapter 11, despite the higher costs. These could include companies that lease a lot of their assets or that have other so-called executory contracts like supply agreements and collective bargaining agreements which receive similar favorable treatment under the Bankruptcy Code; and those that have deeper business problems that might benefit from an extended stay in the “bankruptcy hospital.”
Finally, it’s important to note that distressed companies sometimes get to realize the best of both worlds by undertaking an expedited prepackaged or prenegotiated Chapter 11 bankruptcy. These are hybrid approaches in which the company files for Chapter 11 only after it has first negotiated a restructuring plan with creditors out of court, either formally soliciting their votes or getting them to support the plan in principle prior to filing. In theory, this shortens the company’s stay in bankruptcy court, thus reducing costs, but still allows it to take advantage of Chapter 11’s more favorable voting rules and the cram down option, making it more likely that the plan will be passed. Last year, the technology firm Sungard Availability Services completed a pre-negotiated bankruptcy in just 19 hours, although one to two months is a more common window. Contrast this with the conventional 2014 Chapter 11 bankruptcy of Energy Future Holdings, which lasted for four years.