“Bankruptcy filings are mounting. And that’s just the tip of the iceberg” – – – A Dissection & Analysis

[Editor’s Note: This article was originally published on LinkedIn on September 20, 2020.]

There has been a significant uptick in the number of articles appearing in mainstream media (e.g. newspapers) about the wave of bankruptcies that has already started to appear.

One article (linked here), authored by Matt Egan for CNN Business and published about a week ago, caught my particular attention. It is well-written but there were a few things about it that were wrong or, at least, not entirely right. And, so here I am with my thoughts…

In Statistics, Population Size Matters

First, the spike of 244% in bankruptcy (Chapter 11) filings by “large” companies cited in the article, with respect to the two-month period in July and August 2020 as compared to July and August 2019, doesn’t really mean all that much. This is so for three reasons:

• First, the sampling size is very small. A “large” company for the purpose of the research cited in the article is one that had at least $500 million of liabilities as of the date it filed for bankruptcy.
• Second, the article itself later states that once August 2020 is factored in, the rise in bankruptcy filings among large companies was only 120% as compared to the same three-month period in 2019. For a sense of the absolute numbers, I point out that the article states the number of large company bankruptcies in May and June was 34.
• Finally, the article goes on to state that total number of bankruptcy cases among all companies (regardless of size) is down 14%.

My bottom-line points? One, 244% is more headline-grabbing than is the number 34, 68, or whatever the actual number of large bankruptcy cases there were in July and August of 2020. Two, the fate of 34 or 68 companies isn’t really that meaningful in an economy comprised of more than five million companies.

Chapter 11’s Cost Is Not the Main Reason More Cases Haven’t Been Filed

Second, the article cites a Jefferies’ (an investment bank) client communication that stated its view for the disparity between the number of bankruptcy filings of large companies as compared to those by smaller companies to be due to “[i]nadequate cash/liquidity on hand for bankruptcy lawyer retainers.”

While this may factor in at the margins, it misses three important data points:

• One, a company with $500 million or more of liabilities is not necessarily more likely to have the cash on hand needed to pay a law firm retainer than is one that has $400 million or, for that matter, $40 million of liabilities. The amount of debt a company has is just one factor among many that determine how much a Chapter 11 will cost in attorneys’ fees and whether the company at issue is likely to have the necessary cash on hand to pay a retainer.¹
• There are other very good reasons why a financially distressed company may not elect to file bankruptcy sooner rather than later – or at all. The article’s failure to address this is, perhaps, its most important failure because that failure has the potential to mislead the owner of a financially distressed business into thinking that bankruptcy is the only available solution for that financial distress. More on this below in the section titled “Chapter 11 Bankruptcy is Not a Panacea.”

The Most Problematic Sentences of the Article

While the article, as I write above, is generally good, it contains these consecutive sentences that bothered me enough to write this commentary. They are:

• “Reorganization costs money. Some small businesses figure, [u]ntil someone starts taking my stuff away, I’ll just keep going.”
• Struggling businesses that need to go through bankruptcy must pay for an attorney to go to court and compile a reorganization plan.
• You can’t use PPP funds to file for bankruptcy.”

(Internal quotation marks, attributed to Dorsey & Whitney partner, omitted).

The first two sentences could be interpreted to suggest that the strategy to ‘keep going until someone starts to take your stuff away’ is always bad. It is not.

The first part of the third sentence could be interpreted to suggest that the only medicine for a financially troubled business is Chapter 11. It is not.

The second part of the third sentence could be interpreted to mean that the goal of every Chapter 11 is to confirm a reorganization plan. It is not.

The fourth sentence suggests the law is clear in its prohibition of a company from using PPP funds to pay expenses related to filing bankruptcy (e.g. paying filing fees and professionals). It is not.²

It is true that a company which intends to file for bankruptcy cannot obtain PPP funds for that purpose. It is also true that a company which misleads the SBA in an application for PPP funds is committing fraud. And it is also true that SBA guidance on its face does not name bankruptcy filing expenses as a permitted use of PPP funds. However, a lot of gray area remains as to whether a business is strictly prohibited from using PPP funds to pay for bankruptcy filing expenses or to use PPP funds for general bankruptcy purposes.

The CARES Act and SBA guidance on permitted use of PPP loans are inconsistent. The CARES Act suggests that using the funds for a non-Allowed Use (as defined in the Act) will revert to an unsecured loan. This suggests a company isn’t violating law when it uses PPP funds to pay bankruptcy filing expenses, it may simply be receiving less favorable terms (i.e. the obligation will not forgivable and will be treated as a loan) than if it uses the funds to pay expenses for a category specifically named in the CARES Act. On the other hand, SBA guidance suggests using PPP funds for a non-Allowed Use may constitute fraud. The SBA’s position suggests a company using PPP funds to pay for bankruptcy expenses would be breaking federal law. The SBA’s position, however, is merely a position and it has yet to be fully tested in the courts.

Moreover, legislation currently pending before Congress would vitiate the SBA’s position. The bi-partisan Continuing Small Business Recovery and Paycheck Protection Program Act (Bankruptcy Access Bill), proposed in July 2020, would modify the Paycheck Protection Program to allow for PPP funds to be applied for and used by Chapter 11 debtors subject to certain additional conditions – in particular, granting the SBA a superpriorty claim in the event that the loan is not forgiven. While the legislation remains pending, it serves to demonstrate that SBA’s position is at odds with that of Congress. The SBA and the CARES Act are silent on other issues relating to use of PPP funds in a bankruptcy case. For example: If a company receives PPP funds and files bankruptcy immediately after, is it implied that it used PPP funds to pay for filing bankruptcy expenses, and thereby they were used for a non-Allowed Use? And can a debtor use PPP funds for general purposes in a bankruptcy case, or only for the limited purposes listed by the SBA in the PPP regulations?³ Bankruptcy court rulings have yielded mixed results on these issues.

Enough said about the fourth sentence. Let’s look at the other three in turn…

Bankruptcy is Usually (and Should be) Triggered by Something

Companies typically file (or should file) bankruptcy for a reason – a specific purpose. That is, to achieve a specific goal. In other words, Chapter 11 is a means to an end, it is not the destination. And, while corporate restructuring attorneys should start to prepare a company for a potential Chapter 11 filing as early as possible once it becomes apparent that a Chapter 11 may be advisable or even unavoidable, the decision to actually pull the trigger and file the bankruptcy petition is based on a multitude of factors.

Many companies received a lot of government aid in the Spring and Summer of this year. At the same time, collection efforts grounded to a halt, or at least to a trickle. Many landlords, for example, were prevented by government mandates from evictions. More broadly, the “wheels of justice” (i.e. collection efforts by creditors of all kind) largely stopped, as white-collar bankers, attorneys, and other professionals who make up the spokes of the wheel figured out how to work from home. Courts slowed to a snail pace, as well, and, even if none of this happened, collection efforts would have overloaded the legal system. In other words, by way of examples, (a) lenders don’t typically want to operate the businesses they loaned funds to, let alone at a time when those businesses have no customers or revenue; and (b) liquidation auction firms can only sell so much restaurant equipment before the bottom falls out of the market.

Under these circumstances, with less pressure from creditors and flush with government cash (with hope for more), why not “just keep going?” Sometimes, there is a reason why that is not a viable (or at least the best) option. But sometimes it is – and I’ve been advising my clients accordingly.⁴

Things are calming down now, however. Barring more (and greater) civil unrest and a tremendous upsurge in the pandemic, the time of reckoning is getting closer. How much closer is hard to say and there certainly won’t be a single answer across all of corporate America (or even within a single industry). However, until things open up and it is clear they will stay open, entire industries will remain on their knees. This, in turn, will make it difficult for classic restructurings to take place in those industries because valuation will be an ever-moving target.

Chapter 11 Bankruptcy is Not a Panacea

“Struggling businesses that need to go through bankruptcy must pay for an attorney to go to court and compile a reorganization plan.”

It is true that a struggling business must hire an attorney if it wants to file Chapter 11. It is not true, however, that Chapter 11 or (any chapter of bankruptcy) is the only answer. Bankruptcy isn’t even usually the best answer. Moreover, when Chapter 11 is the optimal solution, a reorganization plan is not necessarily the goal. Many Chapter 11 cases are considered relatively successful without the confirmation of a plan.

This article is already longer than I planned, and my wife is waiting for me so we can watch Gilmore Girls, so I am not going to elaborate here on the many alternatives to traditional bankruptcy that may be better for the company in trouble, its owners, and/or its creditors, and other constituents.

Instead, I hope it will suffice to state simply and clearly that traditional Chapter 11 is just one type of bankruptcy and, far more importantly, the various types of bankruptcy (whether Chapter 7, 11, or Subchapter V of Chapter 11) that most businesses may file are not the only tools available for the financially troubled business, its owners, its creditors, and other constituents.

These bankruptcy alternatives include assignments for the benefit of creditors, composition agreements, and friendly foreclosure under Article 9 of the Uniform Commercial Code (one well-known proponent of friendly foreclosure under Article 9, Aaron Todrin, believes Article 9 sales should generally be the option of choice in most situations – a proposition I don’t agree with, though I do agree with his view that they should be used far more often than they are. This Bloomberg article goes into his view more).

Here is a short list of some excellent (humble I am not) resources you may want to look at to understand the various options better:

RISE OF THE ALTERNATIVES: the increasing use of alternatives to chapter 11 bankruptcy for selling an insolvent business in the United States

Strategic Alternatives For And Against Distressed Businesses, 2020 ed.

Opportunity Amidst Crisis Webinar On-Demand Recording (if you are a business person who knows nothing about this topic but have a situation that is demanding that you learn fast, this is your best bet and the best $50 you will ever spend. If you are an attorney you can purchase it for CLE credit, you can do so here.)

Double-downing: Avoid Double Trouble Structuring Alternatives for Additional Rounds in Troubled Portfolio Companies

Dealing with Corporate Distress 01: Hello Darkness, Our Dear Friend

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1. The amount of a company’s revenue and the value of its assets are both, to the extent size does matter, better metrics to consider when deciding whether to file Chapter 11 and whether it is likely to have enough cash-on-hand to do so.

Revenue (that is, the reason to preserve or acquire it) is one reason parties want to restructure or purchase a company, and it is the fuel with which to accomplish a restructuring. (yes, I know that by picking revenue I am opening myself up to criticism thata more bottom-line metric would be better, but I think we can agree that without revenue those other metrics being more than $0. If you do not agree then I suggest you read ‘Know Thy Numbers’ Installment #1 – Welcome to the Jungle, an Introduction to the Series. In any event, the amount of debt is less relevant to whether a company will have the cash-on-hand necessary to file bankruptcy than are other metrics. Indeed, asset value is also more relevant since a cash-poor company can often borrow the funds necessary to fund a Chapter 11 if it has sufficient assets to pledge to a lender. This page on cash collateral and DIP financing makes available several excellent articles about how a chapter 11 debtor can finance its bankruptcy case.

2. Thanks to my colleagues, Mark Melickian, Elizabeth Vandesteeg, Michael Brandess, and Jeremy Waitzman for their invaluable assistance with the discussion relating to whether PPP funds can be used to pay bankruptcy expenses. Thanks generally to my colleague, Hajar Jouglaf, for all her more holistic input.

3. See BARFLY VENTURES, LLC., et al., No. 20-01947-jwb (Bankr. W.D. Mic.). My law firm represents the official committee of unsecured creditors in this case.

4. See also “Your Distressed Company & COVID-19- A Simple Restructuring Playbook for the Great Cessation,” published in April (“I am generally advising my clients to hold off on trying for the very short term to seek formal relief from lenders and other creditors. The other reason is a very practical one: when you are going 75 MPH in a 60 but all the cars around you are also going 75, what’s the odds of getting pulled over? In other words, for example, if a landlord has 150 (to pick a random number) of tenants and 149 of them are not paying their rent, the landlord’s first reaction is not likely to begin eviction proceedings against all of them (and even if that was the desire, courts and sheriffs aren’t exactly prioritizing on that sort of thing right now). I don’t mean to be cavalier, but I do mean to suggest that attorneys who do what I do for a living really need to remember one more maxim: don’t be the solution in search of a problem.”).