Creeping back: US bankruptcy filings on the up

July 2022  |  COVER STORY | BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

July 2022 Issue

Although remaining below last year’s numbers due largely to government support packages provided in response to the coronavirus (COVID-19) pandemic, bankruptcy filings in the US have started to increase over the first half of 2022. In February there were 26,985 new filings across all chapters, up 3.2 percent on January’s 26,155 filings, according to Epiq. But in March, the total number of new commercial and consumer bankruptcies filed jumped 33.5 percent over the previous month, with consumer filings rising by 34 percent and commercial cases by 26 percent.

Anaemic

Globally, many companies were able to survive the COVID-19 crisis thanks largely to government assistance programmes enacted since early 2020, with trillions of dollars issued in support. The US was no exception. 2021 saw a 42 percent decrease in the number of Chapter 11 bankruptcies, according to Reorg research. Legal and regulatory forbearance and a focus on out of court workouts to resolve business distress also helped drive down the number of corporate bankruptcies.

Indeed, despite the initial shock from the impact of COVID-19, the market was flush with liquidity. Companies, even those in distress, had ready access to capital, in no small part because of the massive amount of liquidity the federal government provided to the economy.

“During the last 12 months, low interest rates and an influx of liquidity from the federal government have permitted distressed businesses or those with unmanageable capital structures to stave off Chapter 11 by refinancing their debt on favourable terms or obtaining fresh capital that likely would not be available in a normal market environment,” says Justin Bernbrock, a partner at Shepard Mullin. “This has contributed to a historically low number of Chapter 11 filings – indeed, far fewer filings have occurred in the last year than in any other 12-month stretch during my career as a restructuring lawyer. It will be interesting to see how the situation changes as the Federal Reserve continues to raise rates and the conflict in Ukraine persists.”

According to Peter Antoszyk, co-head of the private credit restructuring group at Proskauer Rose LLP, ‘anaemic’ is the best word to describe bankruptcies in the US over the last 12-18 months. “As a reference point, we track the rate of default in the active deals we maintain on behalf of private credit clients and publish a Private Credit Default Index on a quarterly basis,” he says. “For the fourth quarter of 2021, 867 active deals met the criteria for inclusion in our Default Index, representing companies across all major industry groups with EBITDA from $0 to more than $1bn.

“Based upon this data, default rates peaked at 8.1 percent in the second quarter of 2020 but gradually declined to 1.04 percent by the fourth quarter of 2021 – a bit more favourable than the institutional syndicated loan default rate for the same period,” he continues. “The correlation of the default rate of private credit and institutional syndicated loans has been consistent since Q1 2020, notwithstanding the fact that our definition of a defaulted loan is significantly broader than the definition of default by S&P. This represents a historical low rate of defaults.”

For those organisations struggling, the ability to renegotiate existing debt can offer a lifeline. In recent years, lenient lenders and healthy investor appetite have made it easier for companies to achieve attractive terms in the debt market, which in turn has made it simpler to renegotiate existing debt if additional liquidity is needed down the track.

“We saw the fallout from covenant-lite loans in 2008-10, yet there are fewer lender protections in loan documents than ever,” points out Jennifer Marines, a partner at Morrison & Foerster LLP. “One of the more troublesome trends from a lender’s perspective is collateral leakage. Borrowers have more flexibility to transfer assets to unrestricted entities outside of the credit group, which gives borrowers more financing options, as well as greater leverage when negotiating with existing lenders that are scrambling to recapture value.”

Right-sizing

Some companies took the opportunity in recent months to reorganise and right-size their operations, and some are making higher margins today on lower sales volumes. The retail space, for example, was proactive in closing non-viable locations. Most notably, struggling drug, clothing and department stores announced efforts to scale back their footprint.

In April, Rite Aid released the results of its fiscal fourth quarter earnings and said it planned to generate $170m in cost savings during the next fiscal year through, among other things, the closing of 145 unprofitable stores. At the end of 2021, CVS announced plans to close 300 stores per year between 2022 and 2024 as part of a shift to e-commerce. In the apparel space, American Eagle said it planned to close 225 stores. Department store chain Century 21 revealed in September 2020 that it would be shutting all 13 of its stores on the US east coast, saying that it was filing for bankruptcy after its insurance provider declined to pay a $175m claim to cover interruption to business triggered by the pandemic.

Gap, Banana Republic, Disney, Macy’s, Best Buy and many others also closed physical locations during the first two years of the pandemic. According to UBS, between 40,000 and 50,000 retail stores will close in the US over the next five years, the majority being clothing and accessories retailers, consumer electronics businesses and home furnishing chains.

Notable cases

For Mr Antoszyk, the most noteworthy cases over the last two years have involved the liability management or ‘lender on lender’ violence reflected in such cases as TriMark and Westco. “In each of these cases, lenders, relying upon the flexibility afforded borrowers in their credit documentation, layered new tranches of debt and up-tiered existing pari debt senior to the debt of existing co-lenders – in some cases, without providing all lenders the opportunity to participate in the up-tier transaction,” he points out. “In these cases, primed lenders have cried foul on the grounds that the up-tier transactions violated fundamental principles underlying the relationship between co-lenders.

“One court has taken the position that the transactions can stand so long as the transactions do not violate the express provisions of the credit agreement. Another court has held that such a transaction may in fact violate certain fundamental principles of good faith and fair dealing. We expect more of these situations to arise, particularly given the flexibility afforded borrowers under credit documentation over the past five years,” he adds.

During the relative decline of bankruptcies over the last two years, there have been efforts in the US, particularly among federal courts and Congress, to remedy certain perceived abuses of the Chapter 11 system. “Much of this reform effort has grown out of recent mass tort cases,” says Mr Bernbrock. “In the Purdue Pharma cases, for example, the district court overturned the bankruptcy court’s order confirming the company’s Chapter 11 plan because, at least in part, it included non-consensual, third-party releases in favour of the Sackler family from sizeable opioid claims.

“In years past, these types of releases were not uncommon. In the LTL Management cases, Johnson & Johnson has attempted to shed its talc liability in bankruptcy without subjecting the entire business enterprise to the burdens of Chapter 11. Members of Congress have proposed legislation to outlaw this practice, which is responsive to a growing desire to reform Chapter 11,” he adds.

Coalescing challenges

The unpredictable nature of the global economy over the last two and a half years has made forecasting difficult. However, the prevailing economic circumstances, including high demand and product shortages, are driving double-digit inflation, which Russia’s war in Ukraine has intensified. Businesses that cannot keep up with rising costs will be under pressure to cut costs where possible or seek restructuring alternatives. As governments roll back the aid packages which helped keep businesses afloat, and remove relief on winding-up and ‘wrongful trading’ liability, more companies are seeking debt relief via formal bankruptcy.

Amid rising interest rates, growing inflation, worker shortages and supply chain disruption, companies are feeling the pinch. “The reported macroeconomic trends in the US include inflation, continuing supply chain issues, rising labour costs, employee retention challenges and a volatile geopolitical environment, to name just a few,” notes Mr Antoszyk. “These trends create challenges for businesses as they look to meet demand while maintaining margins. Of particular note are those businesses with limited ability to pass on these and other contributors to rising costs. Going forward, we expect to see weaknesses in healthcare, certain manufacturing sectors and information technology.”

The real estate market is also looking choppy, especially the commercial and office space segments. “While analysts have been predicting a real estate slump for the past 18 months, the market seemed to be holding its breath amid government incentives, rent deferrals and low interest rates,” suggests Ms Marines. “Until recently, real estate lenders have been unwilling to mark-to-market because regulators have not been forcing action with respect to defaulted loans, and also because price discovery was virtually impossible.

“But that seems to be changing with inflation, rising interest rates, and a marked shift to working from home,” she continues. “I think it is only a matter of time before banks will have to begin properly valuing their loans, which will have a deep ripple effect into the commercial real estate space.”

Distressed deals

Strategic buyers and equity sponsors that sat on the sidelines during the early phase of the pandemic have since demonstrated a keen interest in acquiring viable but underperforming or overindebted businesses, including those sold out of bankruptcy. Private equity dry powder and capital raised by the procession of special purpose acquisition company (SPAC) initial public offerings (IPOs) have contributed to a buoyant M&A market, which has helped limit restructuring activity. There is a strong argument to suggest that M&A involving distressed or insolvent businesses will increase going forward, with opportunities likely to arise in those sectors hit hardest by COVID-19.

“The federal government is now taking actions that will have the effect of significantly tightening market liquidity,” warns Mr Antoszyk. “Nonetheless, there remains an abundance of dry powder in the private sector among private equity and private credit firms to support distressed businesses.

“However, valuations, even for healthy companies, have in some sectors contracted signifcantly, and capital providers are and will continue to be in a stronger position to demand more to support distressed companies and finance restructurings. These demands will take the form of higher cost of capital, more equity dilution, and an overall reversal of the trend of sponsor-favourable credit documentation terms,” he adds.

Rising restructurings

According to Mr Bernbrock, restructuring activity is likely to increase incrementally throughout the rest of the year and into 2023. “Rising interest rates will make it more difficult for borrowers to access capital and refinance their indebtedness, and continued conflict in Ukraine may increase the cost of doing business in certain sectors to an unmanageable degree.

“The question in my mind is not if we will see more restructurings in the future, but how widespread the forthcoming distress will be,” he continues. “The interest-rate effect will likely increase the number of financial restructurings – that is, through the need to remedy debt-laden balance sheets – but the war in Ukraine could lead to a fundamental shift in input costs that may lead to more operational restructurings.”

Indeed, the anticipated rise in restructurings is starting to manifest. “We are already experiencing an uptick in restructurings and are fielding more calls from parties flagging credits that are troubled or are anticipated to have issues within the next 12 months,” notes Mr Antoszyk. “Certainly, those companies with covenant-lite loan structures will have greater flexibility to address macroeconomic challenge before triggering issues under their credit facilities. But even these companies may require liquidity support.

“I would anticipate that, unlike the short-term jolt initially caused by COVID-19, the sustained macroeconomic headwinds will challenge both lenders and private equity sponsors to make harder choices about which distressed portfolio companies to support. For the most part, for a number of reasons, I expect most of these issues will be resolved in the virtual conference room, as opposed to the courtroom. On the other hand, these situations also present opportunities for distressed investors, so we will likely see increased activity in distressed deals,” he adds.

Bankruptcy filings and restructuring activity are set to climb over the coming months, particularly in comparison to the last two years of relative inactivity. Whether the tidal wave of distress which many predicted comes crashing down remains to be seen. However, the growing geopolitical and economic difficulties facing the global economy will almost certainly push more organisations into bankruptcy.

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Richard Summerfield