The economy, stupid. -James Carville 1
The corporate restructuring profession has become, much like the broader economy, increasingly a world of few “haves” and many “have nots.” This is not by accident, and it is not going away.
Those who see and accept the industry for what it is—and pivot accordingly—will continue to be winners.
Those who possess a limited repertoire of moves and simply hope for economic downturns will continue to fight for limited market share.
The Bankruptcy Code is a technology2 that was adopted — successfully — for corporate restructuring. The pace of its adoption increased between enactment in 1978 up to the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) in 2005.
Adopted by whom?
Chief among the earliest adopters were a small number of law firms that, right around the Code’s enactment, jumped into the relatively vacant space with both feet.
Have you read Outliers by Malcolm Gladwell?
In Outliers, Gladwell writes about people who might have been successful in any event, but, because they were at the right place and at the right time, became successful at a very particular thing.
One example: in Outliers, Gladwell discusses how Bill Gates became, well, Bill Gates.
Gates happened to grow up in a prosperous area of Seattle. His private school was one of the only schools in the United States that, in 1968 (when Gates was 13), provided its students with access to computers.
Gladwell did not suggest that Gates’ success is attributed only to the luck of being in the right place at the right time. His point, rather, was to show there is an undeniable relationship.
Compare Gates to acclaimed restructuring attorney, the late Harvey Miller.
Miller was 46 years old in 1978. He joined Weil Gotshal & Manges nine years earlier as the firm’s 14th partner. If he had been 20 years younger or older, or perhaps if he did not happen to be at Weil, or perhaps if any number of other variables had been different, Harvey Miller would be known as a giant in some other legal specialization.
Nevertheless, Miller was in the right place at the right time. This allowed him to understand the potential of the new Bankruptcy Code. And he mastered it.
The Bankruptcy Code of 1978 (which replaced the old Bankruptcy Act) brought many changes to bankruptcy, but perhaps most important was the change regarding professional compensation.
In a nutshell, the Bankruptcy Code established that attorneys and other professionals working on bankruptcy cases are entitled to be paid the same hourly rate they command outside of bankruptcy.
This was simply not the case pre-Code. Consequently, most of the largest and most sophisticated law firms had little-to-no interest in a bankruptcy practice prior to 1978. With about 116 attorneys in 1977, Weil was considered a large firm.3
Miller was among the first to understand the new Code’s potential for clients, as well as the lucrative opportunity it presented for those attorneys who could master it to achieve their clients’ objectives. Miller’s head start (and, of course, his widely acknowledged brilliance and drive, among other attributes) helped him rise to the pinnacle of the profession.
Miller was not alone, of course. Whereas no major law firm had a significant corporate restructuring practice prior to 1978—and the very concept of the “restructuring firm” did not yet exist (the first was likely AlixPartners, founded in 1981)—the industry exploded starting almost immediately after the passage of the Bankruptcy Code.4
Supply ≥ Demand ≠ Lower Cost
Countless professionals followed in the footsteps of Harvey Miller, Jay Alix and the other early pioneers of modern corporate restructuring.
In time, the complex Chapter 11 bankruptcy industry saturated. Competition for work became—and remains—fierce.
Nevertheless, for those of us fortunate to work in the space, average hourly rates rose steadily. These high rates, together with the sheer number of professionals involved in any given case, make Chapter 11 an increasingly expensive solution for troubled companies and their constituents.
If there are relatively more professionals than work, why would hourly rates keep rising?
Is something amiss?
Should you call the U.S. Trustee?
No. It’s not that simple.
Consider that there have been significant peaks and valleys of Chapter 11 work since 1978. The mid-to-early 1990s, for example, were grueling years for the profession. During such times of famine, heaps of bankruptcy lawyers changed focus—some became real estate lawyers (especially in states like Arizona), where others fled to various alternative practice areas.
Sure, some lawyers return with the “good” times (or bad, depending on where you sit). But, without consistent practice5, those who leave and come back are not—and cannot be expected to be—as expert as those who continuously practice.
There are thousands of restructuring professionals in the United States, but only a handful of us had the good fortune (and laboring chore) of honing our skills over the course of 2,000 – 3,000+ hours a year, year after year, without interruption.
With the context above, I introduce you to the parable of the three tenors. It is not my creation; I read about this years ago and tried, to no avail, to locate the source for attribution.6
Here is my paraphrasing, based on memory:
Who are the “Three Tenors?” They are Luciano Pavarotti, Plácido Domingo, and José Carreras.
But who is fourth?
That is, after the first three, who is the next “best” tenor of his time?
Assuming any of the three tenors would be paid $10 million for a performing at Carnegie Hall, how much less would the fourth tenor receive? $9 million? $8 million?
No. Probably a lot less.7
This reminds me of the Sprint commercials featuring Paul, who used to be with Verizon, asking us why we would pay so much more for Verizon when Sprint is 99% as good.
Sprint’s logic may work, depending on how you use your phone. But, if you are a highly compensated professional working on high-stakes matters, you may very well be willing to pay much more money for a very small improvement in service. Does this analogy make sense?
Let’s try another…
If you were the owner of a financially distressed company, would you settle for the fourth best restructuring attorney to help save the business?
Would your answer change if I told you that you could pay 10% less for the fourth best than you would for the first best? What if I told you could pay 20% less?
Clearly, these are not simple “yes or no” questions.
As the creator of this presently unattributed parable went on to explain (again, solely my imperfect paraphrasing), the demand for the “best” was exacerbated by the revolution in communication and transportation technology—together with the phenomenon of specialization—over the past 100 years or so.
Imagine, if you will, it is 1908. You own a large manufacturing concern located in a suburb of Columbus, Ohio. Imagine further that the business is experiencing extreme financial distress. Whom will you hire?
You will, gosh-darn-it, spare no expense to hire the best attorney in all of Columbus, that’s who! Indeed, if there is a better attorney in Cincinnati, you will even consider that.
What about today? If this happened today, who would you want?
Maybe even the world.
This is why, despite the high cost, the system is not broken. It is working exactly as it was meant to. The structure may be imperfect, but pricing is determined by the market—exactly as Congress intended.
Speaking of something not being broken…
Chapter 11 cases have become exceedingly more complex and expensive to run in the past decade or more, thanks to the BAPCPA, or Bankruptcy Abuse Prevention and Consumer Protection Act.8
BAPCPA was the most significant overhaul of the Bankruptcy Code ever made, and it was driven by a host of special interest lobbying.
In the Spring of 2005, I co-authored a five-part series of articles for Dow Jones’ Daily Bankruptcy Review titled The New Bankruptcy Code – A Solution In Search Of A Problem with a bright young attorney named James H.M. Sprayregen (I think the kid may have a future in this business).9
In the Dow Jones series, we analyzed major aspects of BAPCPA and concluded that those aspects were an attempt to give certain groups more leverage in Chapter 11.
It could be accurately characterized as “anti-general creditor” and “pro-special interest.”
Among other things, BAPCPA resulted in the following changes:
These—and other changes—made Chapter 11s more expensive and less predictable. These, in turn, created a regime about which some (including me) previously called “one-size fits all.”
It was far less attractive—particularly to smaller businesses and those in need of the operational fixes that Chapter 11 can facilitate.
Again, BAPCPA is not the only reason Chapter 11 is not as attractive an option as it once was for troubled companies. An even more significant problem is that, just as BAPCPA changed the game board in significant ways, the players experienced significant changes, too.
Once upon a time, long ago (measured in the way restructuring professionals measure time. Meaning not so long ago), when companies in need of a loan went to a bank. The owner or CEO of a company and the management of a bank would get to know each other. They might even become friends.
And, when the company experienced problems, that personal relationship mattered.
This might have meant extracting a little less in exchange for permitting use of cash collateral, allowing the company more time to formulate a plan, agreeing to more favorable plan terms or any number of other things that might increase the likelihood of a successful reorganization.
The number of commercial banks and thrift holding companies, independent banks and independent thrifts declined by about 50% since 1984. Most of the decline is attributable the community bank sector—especially among the smallest of them.10
For example, suppose Company X runs into trouble and looks to its historic relationship with the good folks at tiny Bank Y? How helpful can those folks be when Bank Y was previously sold to Bank Holding Corp Z?
Another major shift, at least equally harmful to incumbent equity of distressed businesses, began roughly at the same time: the “loan-to-own” era began.
The concept of a holder of debt taking over a delinquent company is not new. Article 9 of the Uniform Commercial Code is not new, after all, and the practice predates Article 9 by many centuries.
Private equity players and hedge funds understood early on that Chapter 11 provided a particularly effective means to engage in the practice.
Loans move from one bank to another during bank M&A activity. More and more banks sought to jettison defaulting loans, even at a loss. This created a secondary market in which private funds—and other “master-of-the-universe” type opportunistic players—purchase defaulted loans at pennies on the dollar.
While some distressed debt buyers seek to be repaid cash on the face amount of the loan (plus interest and fees), many do not. Instead, they use their debt position (and may even loan more money to a company) as a means to take over the company.
This can be (and years ago was more commonly done) through a Chapter 11 plan under which their debt position converts to equity, and old equity is wiped out. It can also be done through a 363 Sale in which the debt holder credit bids the debt at an auction of all of the company’s assets.
Either way, these changes in the players work together to make Chapter 11 less predictable and riskier from the perspective of equity than it was in years gone by.
There are other problems. Any very experienced practitioner, if she or he is very honest, will tell you the following:
Still, the system largely works for many debtors because these are exceptions, not the rule. Most Chapter 11 professionals are honest, hardworking people who try their best to do the right thing. Chapter 11 also works, however, because it fosters alternative options precisely because of its limitations.
In other words, the toll to travel down the Chapter 11 road has been raised so high that it is prohibitively expensive for many companies to use it.
Besides that, there are more potholes in this road than before. Hence, other roads have been taken, widened, or built from scratch.
Chapter 11 is never an end to itself. It is a
It is a means to an end; it’s a tool, used to achieve a business goal. Depending on where you sit and where you want to go, another option may be better.
Depending on where you sit and where you want to go, another option may be better.
If your goal is to sell a distressed business so as to maximize proceeds, then two concepts worth considering about Chapter 11 (and certainly over Chapter 7) are assignments for the benefit of creditors (ABCs) and equity receiverships.
An ABC involves a company’s organized wind-down or liquidation through an “assignment” of its assets to a third-party fiduciary for the benefit of the company’s creditors. One can think of an ABC as an alternative to a liquidating Chapter 11 or a Chapter 7.
One can think of an ABC as an alternative to a liquidating Chapter 11 or a Chapter 7.
ABC can be quicker, less expensive and more certain than either those two options. And, as in Chapter 11 and Chapter 7 cases, the equity owners of the distressed company can bid at an ABC sale for the company’s assets.
ABCs have been around since the early 19th century and should be viewed primarily as a tool for a debtor since only the company—not creditors—can commence an ABC. They grew rapidly in popularity in the early 2000s, particularly in California during the 2007 financial crisis.
[Editors’ Note: For more about ABCs, check out The Road to an Assignment for the Benefit of Creditors (ABC): A Case Study and Help, My Business is In Trouble!]
Though not yet utilized as frequently as I predict they will be in the coming years (due to a general unfamiliarity with the tool) equity receiverships are becoming a more common means of dealing with distressed companies.
In stark contrast to an ABC—which can only be initiated by the troubled company itself—a receivership is a creditor’s remedy against further damage of their interests by a troubled company. Where the goal is to take control of and liquidate a debtor’s assets, receiverships can provide a faster, more cost-effective strategy for creditors than bankruptcy.
A receiver, essentially, is a disinterested person or organization appointed by a court to protect property subject to disparate claims by acting as a fiduciary.
Receivers are commonly given wide authority to control all aspects of a debtor business. Both federal and state courts have broad discretion to appoint a receiver at the request of a secured creditor, company shareholders, or a government entity. Factors federal courts commonly consider include:
Once a receiver is appointed, it must typically post bond. The bond value is based on the value of the debtor’s assets to protect all parties involved from gross mismanagement of fraudulent activity. The receiver is then vested with jurisdiction to take control and possession of all real and personal property, regardless of the jurisdiction it resides.
Receiverships also enjoy several clear advantages over traditional Chapter 11 cases.
For example, the doctrine of in pari delicto, a defense similar to “unclean hands,” is increasingly used against bankruptcy trustees and creditor committees, but is inapplicable to a receiver.12
[Editors’ Note: For more information about the in pari delicto defense, read 90 Second Lesson: What is the “In Pari Delicto” Defense?]
In case I was not clear above, my position is not that Chapter 11 is dead or that it should be. Quite to the contrary:
I am not here to bury Chapter 11; I am here to praise it!
In the early 2000s, Harvey Miller, Shai Waisman and, separately, Professors Douglas Baird and Robert Rasmussen questioned the effectiveness of Chapter 11 and its value to the economy overall.13
Miller mourned the demise of the conventional Chapter 11 case, where preservation and rehabilitation of the distressed historic debtor entity are the main goals.
In a nutshell, Miller criticized the increasing use of § 363 asset sales for liquidating debtors.
University of Chicago Professor of Law Douglas Baird and Vanderbilt Professor of Law and Associate Dean Robert Rasmussen published a series of articles (together and independently) on this same topic and around the same time.
In stark contrast to Miller, Professors Baird and Rasmussen called for abandoning traditional Chapter 11 altogether and replacing it with a privatized contract-based system to conduct sales.
They based their position largely on the theory that residual owner(s) of a distressed debtor company will not act rationally with everyone’s interests in mind. Baird and Rasmussen also believed there was a decreasing need for Chapter 11 to preserve debtors. They argued that assets are fungible, and going concern value is illusory or rare.
They argued that assets are fungible, and going concern value is illusory or rare.
I disagreed with portions of what Miller and Professors Baird and Rasmussen argued then—and I still do.
As I countered in a co-authored 2005 article, although saving a distressed business is a factor to consider, another overarching goal of corporate restructuring is to maximize creditor recoveries.14
Regardless, Chapter 11 provides a “Compared to what?” function for out-of-court workouts.
In other words, parties negotiating an out-of-court debt restructuring do so with the knowledge that the alternative to an agreement may very well be a Chapter 11.15
The import of this baselining function, in actual practice, should not be underestimated; I certainly use it with great frequency.
And, even if Chapter 11’s paramount goal is debtor rehabilitation, there is no reason to think of a § 363 sale as antithetical to that goal. Conventional reorganizations, involving debt-for-equity exchanges, and asset sales can get a debtor and its constituents to exactly the same place, given there is no prohibition against old equity holders bidding at asset sales.
Finally, to be clear, the death of a failed business is a natural, if not essential, part of a dynamic economy. It facilitates the recycling of assets to higher and better uses.
Ok, here we go. Prediction time.
North American oil and gas producers—and companies that service them—have been a dominant source of work for U.S. restructuring professionals since crude oil prices began crashing in 2014.
More than 200 North American producers filed bankruptcy in the last two years alone.
Right before the downfall, crude oil was about $110/barrel and dropped rapidly to around $30/barrel in mid-2015 before starting to rebound.
While stabilized prices may save some distressed drillers that would otherwise collapse, it seems that absent an exceedingly sharper oil price rally, oil and gas bankruptcies will continue.
The majority of the 207 senior-level restructuring experts who took part in AlixPartners’ 11th Annual North American Restructuring Survey agree—the oil and gas industry will not stabilize until 2018.
That said, the Intel suggests strongly that the big wave is over. And, pardon the pun, the well of restructuring work in this space is running dry.
The problem with most macroeconomic predictions today, of course, is the uncertainty introduced by a Trump presidency.
These potentially counterweighting levers on supply and demand introduce new variables that simply were not present until Election Night. And this, of course, leaves aside that Trump is the least predictable person to ever sit in the Oval Office.
Aeropostale, American Apparel, PacSun, Sears/KMart, Sports Authority, The Limited, to name a few.
The retail industry kept more than its fair share of restructuring professionals busy the past few years, a trend that will not abate in 2017.17The dominant culprit, of course, is the internet.
Rapidly evolving technology plays a massive role in reshaping consumer shopping behavior. The ease of online shopping shattered traditional brick-and-mortar traffic in the U.S.
If the internet is to blame, an analogy can be made between the radio star and brick-and-mortar retail seller.
Radio stars didn’t go extinct, after all. Some (or even many) evolved.
It may have started with audio and video, with the likes of Amazon, Apple, and Netflix decimating retailers such as Borders, Sam Goody’s and Blockbuster, but it didn’t end there. We now see all sorts of successful e-retailers selling goods that, just a few years ago, one would have thought could not be sold en-mass on the internet.
People want to try on eyeglasses and clothes, after all, right?
We now know that all sorts of goods sell successfully online, and, with advancing technology, the trend will continue.
Want to try eyeglasses on virtually? Just check out Warby Parker, which offers designer eyewear at a revolutionary price and ships up to 5 pairs directly to your home to test for a style.
Want to buy clothes that fit without leaving the comfort of your home? Technology can already assist you with that.
Moving away from predictions about 2017—and peeking around the corner further—it is safe to say that some retailers, with an assist from their mall-operator landlords, will continue to flourish by becoming destination experiences. We already have seen this, but it is a trend that will accelerate.
Bass Pro Shops draws more than 120 million visitors annually.
Each location is extensively customized to reflect the ambiance of the region. They may contain giant aquariums full of live fish and elaborate wildlife mounts and dioramas. Some sites even offer exotic restaurants and nature-themed bowling alleys—perks that no internet retailer can match.
The widely popular grocery store, Stu Leonard’s, continues to thrive. This is, in part, because it creates a fun family experience with a vast spread of samples, animatronics, hayrides and even a petting zoo!
Abt Electronics is a family owned business founded in 1936 that continues to flourish. In addition to providing online services, Abt created a 100,000 square foot showroom to provide a unique shopping experience and house many of the company’s fun attractions. The destination includes a dancing fountain, a collection of specialized shops, kitchen showroom, oversized bubble machine, interactive virtual butterfly exhibit and even a fresh smelling atrium that serves over 250,000 cookies every year!
Taking the unique experience strategy to a whole new level, some mall operators stirred up holiday buzz for youngsters this past Holiday Season by offering an animated trip to the North Pole through DreamWorks DreamPlace. Likewise, Adventure to Santa offered visits with Santa through interactive games and a 15-minute cinematic journey in a pop-up theater of sorts.
An assist to brick-and-mortar arrives from an interesting place.
In 2016, Amazon—a major factor in the decimation of traditional brick-and-mortar stores—opened its own physical bookstores (which sell more than books).
In 2017, Amazon will open its largest store to date in Manhattan’s Time Warner Center (where Borders once operated).
The e-commerce giant also launched an 18,000-square foot convenience store in Seattle called Amazon Go, which employs a blend of computer perception, artificial intelligence and additional high-tech components to eliminate the checkout line.
The line of demarcation between retailer and e-retailer continues to erode.
Amazon, of course, is not alone.
Warby Parker has about 50 retail locations, and there are many other examples of retailers that started online but have since opened brick and mortar locations. We’re going to see a lot more of this. It just makes sense.
People like to get out of the house to socialize. They like to touch (or otherwise tryout) what they may buy.
More traditional retailers will act in much the same way, moving more of their business to the internet while shrinking the number and square footage of their stores. In this way, retailers will reduce their real estate and inventory costs while getting the marketing value of having physical locations and providing customers the chance to touch and try.
And customers can be saved the trouble of carrying out what they buy.
This is not such a new concept, by the way. When is the last time you went to a furniture store and walked out with a sofa the very same day?
Panning the camera back in…
The prediction for retail in 2017 (and for the next few years) is massive decimation.
People keep asking if retail bankruptcy is back, and yeah, I think it’s back.
First, the Intel suggests many firms work with retailers already. Second, many lenders and landlords will want out at the first sign of trouble—if they can get out with limited losses—because certainty is a good thing. And that certainty is likely provided by e-retailers with significant cash in the bank and otherwise clean balance sheets. They’ll look to make land grabs for prime retail space.
Technological change is not, of course, unique to retail. Consider if you will:
Other examples abound.
The point is that all industries face technological change at an increasing speed. We’re going to see massive disruption of virtually every aspect of the economy over the next two to three decades.
Much has been written about the “velocity of innovation.” If you are in business of any kind, you would be well-advised to understand the concept.
Just as few, if any, companies had chief technology officers or chief information officers, say, 30 years ago, few companies today have “chief future officers” or “chief futurists.”
This will change. Those businesses that adapt to coming massive disruptions will survive or even thrive. Those who don’t, well…
They go the way of the dinosaur.
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[Editors’ Note: Jonathan Friedland is a partner at Much Shelist, PC. Schwallier is an associate with Kirkland & Ellis. Friedland is also the founder and publisher of DailyDAC and Financial Poise. This article is generally written in the singular voice on behalf of Friedland, for ease of reading. Friedland thanks James H.M. Sprayregen, for having co-authored many of the articles on which this one is built.
To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can watch at your leisure, and each includes a comprehensive customer PowerPoint about the topic):
©2017. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer” by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…
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