Fewer Companies Likely to Emerge From Chapter 11

We’ve warned for some time that this downturn is likely to see more companies entering bankruptcy wind up being liquidated rather than continuing to operate thanks to Chapter 11, which allows companies to hold creditors at bay, renegotiate debt and restructure operations, with the idea that an ongoing concern will be able to provide better recovery rates to lenders, as well as save jobs.

However, this time around, Chapter 11 may not be a viable solution for many companies in trouble. First, in the last wave of private equity deals, not only were the companies highly levered, but the debt was often “cov lite”. Normally, in risky borrowings, banks require that the borrower maintain certain levels of performance, such as keeping a minimum net worth, or having income exceed a multiple of interest expense. If a company violates those restrictions, the lenders can accelerate the debt, meaning demand immediate repayment. Of course, the company can’t cough up the money, so the creditors can force a Chapter 11 filing if the company can’t provide adequate remedies.

In other words, covenants permit lenders to intervene when a company’s condition is starting to deteriorate but has not yet gotten desperate. Weaker covenants mean that many companies are in worse shape when they enter bankruptcy.

In addition, when a company is in the Chapter 11 process, which can take many months, it still needs to keep paying its bills (employees, supplies, taxes, and those pesky lawyers). Debtor in possession financing allows companies in Chapter 11 to borrow the needed funds to keep operating.

We’ve warned that scarce DIP financing could produce considerable collateral damage, since liquidations produce considerable job losses. Yet the Treasury and Fed have made its dubious and costly toxic asset subsidy programs priority and ignored this pressing need.

And credit markets continue to function so poorly (outside those sectors on government life support) that so-called exit financing, the debt companies would raise once they left the courthouse, is also scarce and costly. In fact, some companies that have DIPs are choosing to extend them due to the dearth of exit funding.

From Reuters:

Bankrupt U.S. companies lucky enough to survive a court restructuring are hitting another roadblock created by the economic downturn — finding the money they need to put it all behind them….. But today’s weak markets are not an option now. And like the market for the debtor-in-possession financing that is used to pay for bankruptcy, the outlook is not much better, bankers and lawyers say.

“Exit financing is a pretty tough game right now to be honest with you,” said Brian Trust, a partner at Mayer Brown in New York.

“I’m not saying that you are going to see exit finance markets break open. I think they are going to be subject to the same issues, concerns, constrictions and tightness of credit that we have seen in the current DIP market — although we have seen a crack in the general credit markets.”

Many companies are preparing for continued weak credit markets, renegotiating debt and planning debt-for-equity swaps and rights offerings that put more equity into the company instead of debt. They are also doing prearranged bankruptcies more often, which can help keep debt down and decrease the amount of exit financing needed….

The issues for bankruptcy financing is that, when the credit markets tightened up last year, loans to bankrupt companies — even the DIP loans that were once coveted by lenders because they are repaid first — dried up.

“Liquidity right now in terms of fresh loans to distressed companies is very low. It’s the lowest point I’ve ever seen it, which is forcing people to be creative in terms of how they structure DIP and exit financing,” said Kris Hansen, co-chair of the nationwide financial restructuring group at Stroock & Stroock & Lavan LLP in New York.

Some companies have managed to find small amounts of exit financing. U.S. restaurant chain Buffets Holdings Inc, for instance, lined up a $120 million exit loan earlier this month….

“Because of the current disruptions in the syndicated loan market, most companies will find it more challenging to raise exit financing and instead may attempt to reinstate existing debt or, if there is hard asset collateral, turn to asset backed financing instead,” said Bruce Mendelsohn, co-head of Americas Restructuring at Goldman Sachs.

“But doing a traditional syndicated term loan is going to be very difficult and it’s going to be very expensive

Some companies have tested the exit finance market and decided a better choice is to wait it out. Frontier Airlines Holdings Inc arranged a $40 million DIP earlier this month to refinance one that would have expired next month.

Marshall Huebner, co-head of Davis Polk & Wardwell’s restructuring group and Frontier’s lead counsel, said the company met lenders and discussed both an extension of its bankruptcy financing and exit financing before deciding to extend

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  1. David

    Is this really a bad thing? Perhaps we have too many weak companies. For example, the lack of Circuit City and Linen’s n Things makes Best Buy and Bed Bath and Beyond stronger companies. Since consumer demand is shrinking and needs to shrink, we need fewer retailers. Part of the recovery process from recession is the weeding out of the weak, poorly managed companies so that profit margins for the survivors can increase and support growth and new hiring. The job losses in retail is unfortunate but necessary as our economy needs to rebalance and become less dependent on consumer spending.

  2. eh

    Unfortunately these companies did not have the foresight to become ‘too big too fail’, like. e.g. GM. If they had then they would not be allowed to go into Ch 11 in the first place.

  3. Gringcorp

    I don’t agree. I think there are two weaknesses with this theory. The first is that outside retail, which for reasons unrelated to the availability of DIP financing, I’m struggling to find many examples of lack of DIP availability forcing a liquidation. Now admittedly some of the bigger DIPs I’ve seen recently have involved asset-heavy outfits such as Semgroup and VeraSun, which are much more attractive to DIP lenders. If you want to make an argument that the economy and/or credit committees have raised the threshold of what DIP lenders need as collateral, go for it, but like any other debt market the DIP one is not a binary on/off affair. I’m also not sure that there’s much of a proven link between cov-lite loans and asset recoveries. The most we can say is that they probably affect the timing of bankruptcy filings.

  4. charles monneron

    DIP is only available when the company can clearly demonstrate that its operational margin (I.e. without the debt burden) is positive. In a recession led by depressed consumer consumption, this hurdle is indeed a tough one, but I don’t see why covenants lite is going to worsen or brighten this reality.

  5. Anonymous

    Is this really a bad thing? Perhaps we have too many weak companies.

    That is the main thing. Many leveraged companies are in sectors that need to reduce capacity through liquidation. Cov lite loans let bad managements destroy enterprise value for a longer period of time before creditors can force restructuring or liquidation, but that’s not the main reason a lot of companies need to be shrunk, recapitalized with debt/equity conversions, or liquidated.

  6. Anonymous

    No need to worry, just call Uncle Ben and have him print up some cash for your failing business. Use this coupon code to bypass the usual verification process: “SYSTEMIC_FAILURE”

  7. Anonymous

    This really drives me crazy. There is just this completely unshakable sense of entitlement to debt. Why does everyone feel entitled to debt? I don’t get it. Why in the world should some investor (i.e., the lender) cap his return when the risks involved with the lending are obviously (given recent bankruptcies) on par with equity risk? This just makes no sense to me. If DIP replacement financing were *so attractive* to an investor (lender), then we would see it in the marketplace. The plain fact is (and I am surrounded by people and funds with a lot of cash that are buying loans at 50 cents on the dollar but won’t buy higher) that no one is going to make a loan with any risk unless the interest rate is in the teens or above twenty percent. If you want something close to risk free, buy Treasuries. In *every* other case, there is a good deal of risk and uncertainty, and I am going to get compensation for taking the risk and entering into a transaction with that uncertainty.

    You want to run a business? Find equity.

  8. Thoreau

    It is laughable that many decry the bankrupt U.S. system yet those who run it are tax cheats. Interesting, the malfeasance of the government knows no bounds. Palin is a tax cheat yet gets to live in the lime light and have continued substantive impact on the lack of justice system that exists in the U.S. Of course obviousness of Palin’s thievery on taxes is irrefutable just review her tax returns wherein she not only stole from the government she helps run by under reporting income and taking false tax deductions but she cheated the state of Alaska by filing phony expense reimbursement reports (and was actually compensated by the state for staying at her own home). Though Palin’s thievery is nothing in the context of Geithner or Mike Hamersley the high level government tax shelter lawyer who goes around confiscating income from honest citizens. Hamersley is perhaps the worst offender of all as he is a nationally renowned tax crusader who based on his own definition of tax fraud to the U.S. Senate purveyed massive tax fraud against the government he now works for utilizing sham foreign paper transactions to generate 100s of millions of phony tax deductions for his clients at KPMG. Of course KPMG, committed massive corporate tax fraud for its clients like the now bankrupt Citi. Though in defense of KPMG, the massive corporate tax fraud it purveyed pales in comparison to the financial statement fraud it engaged for its banking clients like Citi by falsely clearing balance sheets with Tier 3 sham investments and intentionally misevaluating sham derivative contracts such that the financial system crumbled and the costs to the citizens will run into the Trillions while all the while those that run KPMG like Tim Flynn earn their multimillion salaries from the high audit fees paid by their banking clients for issuing fraudulent financial statements which effectively the American people are now funding since if Citi was allowed to fail, KPMG would be out of business and Flynn would end up in the poor house instead of making millions. It is an awesome system if you are one of those like Flynn pulling the strings and defrauding the American people. Ask Flynn about his fraudulent Bermuda captive insurance company, Park, which is a sham paper company used to generate 100s of millions in phony tax losses for KPMG partners (just like it does for its corporate clients) and cheat future partners out of profits by deferring settlement payments for years through sham contracts devised by Claudia Taft of KPMG.

  9. Tax Partner

    Thoreau, please help me out here. I am a bit confused by your statements about Hamersley. I read Travails in Tax and personally observed Hamersley’s testimony before the Senate Finance Committee. He seems like an exceedingly honest guy to me. Didn’t KPMG say Hamersely had absolutely no involvement or knowledge of tax shelters in its press release to the Senate Finance Committee after Hamersley testified in October 2003? I read that KPMG press release on the PBS Frontline website. http://www.pbs.org/wgbh/pages/frontline/shows/tax/interviews/release.html

  10. I Concur with Tax Partner

    Whistlewhat (aka Thoreau, Angry Citi Invetor, Angry Citi Shareholder–I have to admit it is difficult to keep track of all the liases you are using to post identical comments while appearing to be different bloggers.):

    Surely your comments about Hamersely are an April Fools joke, right? Otherwise, they just don’t make any sense at all. I too am highly skeptical that your bold statements about Hamersley could be based on any reliable evidence at all. I too read Travails in Tax and personally observed Hamersley’s testimony before the Senate Finance Committee. He seems like an exceedingly honest guy to me too. Yeah, isn’t it a fact that KPMG said Hamersely had absolutely no involvement or knowledge of tax shelters in its press release to the Senate Finace Committee after Hamersley testified in October 2003? I read that KPMG press release on the PBS Frontline website. http://www.pbs.org/wgbh/pages/frontline/shows/tax/interviews/release.html
    See also Hamersley Senate Finance Committee Testimony 003 TNT 204-35 online at http://finance.senate.gov/hearings/testimony/2003test/102103mhtest.pdf

    Are you suggesting Hamersley and KPMG are in cahoots? Wow, that would be a bold strategy seeing as Hamersley sued the crap out of them. Case No. BC 297209, Los Angeles Superior Court (June 23, 2003.), also reported in Tax Notes Today full copy of complaint 2003 TNT 124-5

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