The financial repercussions of Covid-19 are in full swing. Neiman Marcus, JC Penney, Gold’s Gym, to name a few, all filed bankruptcy cases in the last two weeks. Nationally, commercial bankruptcy filings for the month of April are up 26% from a year ago.
Many other companies will soon file, including stalwarts in the hotel, rental car, air transportation, cruise line, energy, entertainment and retail sectors.
In the coming weeks and months, management and boards of directors will struggle with a critical decision – whether to seek Chapter 11 protection in an effort to save their companies. The decision is not an easy one.
Once made, more difficult decisions follow – including where to file and how to formulate a feasible blueprint to successfully emerge from bankruptcy.
Like the catchy lyrics from Hamilton portend, in-house counsel and their outside advisers will be in the room where it happens and all eyes will focus on attorneys to provide sound, unequivocal advice to executives and board members who have no experience navigating the high risk and uncertain waters of Chapter 11.
Retaining Bankruptcy Counsel
For a company in financial distress, the decision to engage restructuring advisers often creates anxiety among company executives and its board. It is an admission, both internally and often externally, that the company’s future is in doubt. It is a decision that companies are loath to make. However, it represents an important first step to protect the company and prepare it for a possible bankruptcy filing.
If an organization is new to the restructuring universe, the determination of who will represent the company may require in-house counsel to select outside advisers with whom there is no previous or ongoing relationship. Given the critical role played by restructuring counsel and the mammoth responsibilities placed on their shoulders, it is a critical determination. Trust in these advisors is paramount.
The calculus of the hiring decision is not easy. Large corporate bankruptcies benefit from the vast resources that national law firms afford their clients.
However, to be colloquial, “bigger is not always better.”
The bankruptcy bar has a deep bench and there are highly skilled lawyers at smaller firms. Even if a company decides to hire a national firm, most bankruptcy cases require a cadre of restructuring counsel with specialized skill sets, such as pension plan termination and labor contract relief.
File Before It Is Too Late
Chapter 11 of the bankruptcy code is a powerful business tool and the decision to file resides exclusively with a company’s board of directors. To make that decision, boards rely on management’s representations regarding the company’s financial outlook and prospects for a successful reorganization. It is an area ripe for disagreement and conflict.
Company executives are often reluctant to file because a filing by its very nature is fraught with risk and the outcome is uncertain. Typically, creditors, employees and shareholders suffer significant adverse economic consequences – large numbers of employees lose their jobs, unsecured creditors receive a fraction of what they are owed and equity holder claims are most often extinguished.
The effort to keep the company afloat at all costs, while noble, is often misguided and does not necessarily comport with fiduciary obligations.
Executives and board members must keep in mind the first commandment of bankruptcy: “Thou shalt not wait too long.”
Frequently, companies leverage assets to offset negative cash burn in the months or years before a filing, leaving little collateral to use for Debtor in Possession (DIP) financing. Without sufficient assets for a DIP loan, companies risk potential liquidation. Faced with dim prospects for recovery, company boards of directors must act decisively to preserve the long-term interests of the company and its creditors.
Once a company decides to file, the next important hurdle is where to file. Under current bankruptcy rules, a debtor is authorized to file in its state of incorporation, its principal place of business, or where one or more of its affiliates conducts business. Under these rules, a debtor need only have a tangential relationship to its preferred venue.
A disproportionate number of companies elect to file in a jurisdiction far from its principal place of business, most often Delaware or New York.
The arguments in favor of filing in these locales often turn on three factors:
- that courts in these jurisdictions are more sophisticated and better able to manage large and complex corporate restructurings;
- that the case law is much better developed and more favorable to a debtor; and
- that the vast majority of attorneys, financial advisors, and bankers are located on the East coast, thereby affording the debtor greater efficiency and reduced travel costs.
While one can argue the merits of filing in a “mature” jurisdiction, there is little evidence to support the notion that judges and practitioners in other jurisdictions are less sophisticated or less able to handle complex Chapter 11 reorganization cases, or that there is a meaningful disparity in case law from one jurisdiction to the next.
In fact, both the Neiman Marcus and JC Penney bankruptcies were filed in Texas. With the likelihood of a substantial increase in the number of Delaware and New York filings, boards should be wary of getting stuck in a “conga line” of Covid related filings in those jurisdictions.
In the meantime, long-overdue legislation has been introduced in Congress that would amend the bankruptcy code and eliminate the affiliate loophole, largely restricting filings to a company’s principal place of business.
The Covid-19 Challenge to Feasibility
After a company decides to file for protection under the bankruptcy code, the difficult work begins.
Most people assume that the most important aspect of a bankruptcy case is the ability to shed liabilities, dispose of unwanted leases and contracts, modify labor agreements, etc. While these tools are critical elements of most restructuring cases, the single most important feature of a bankruptcy case is the development and acceptance by creditors of a feasible plan of reorganization.
Given the extraordinary drop in consumer demand as a consequence of the Covid-19 pandemic, putting together a feasible business plan will prove extraordinarily difficult and, in some cases, virtually impossible.
Using the airline industry as a proxy, with a near 90% drop in passenger air traffic resulting in hundreds of grounded aircraft, an airline could not today formulate an acceptable business plan. There is simply no way to determine when passenger traffic will return to the skies in sufficient numbers, and whether potential capacity restrictions will limit airline profitability.
The same will be true of hundreds, likely thousands, of businesses severely damaged by the economic fallout of the pandemic.
The country will witness an unprecedented number of bankruptcy filings in the months ahead. Companies that were otherwise healthy 90 days ago or at least had a fighting chance of avoiding a trip through the bowels of bankruptcy are now faced with the grim reality of a Chapter 11 filing.
Many of those debtors will be unable to formulate feasible business plans and liquidation will follow. Others will successfully emerge from bankruptcy. Time will tell whether their business plans will work or whether they too will succumb to the economic consequences of the pandemic.
Gary Kennedy is the former General Counsel of American Airlines and led the company through its 2011 bankruptcy filing. He is the author of Twelve Years of Turbulence, the Inside Story of American Airlines’ Battle for Survival.