Surge of Bankruptcies Will Be Next Virus Curve to Flatten

The U.S. bankruptcy system risks being overwhelmed by a wave of previously healthy companies hurt by the coronavirus seeking relief all at once in the months ahead.

So far, only a handful of big companies like Frontier Communications and LSC Communications have sought bankruptcy protection since the pandemic shut down much of the U.S. economy. Many more are expected to follow.

Just as public health officials tried flattening the curve of Covid-19 to avoid straining U.S. hospitals, bankruptcy practitioners are thinking of ways to slow the spread of financial distress to ease the burden on the U.S. bankruptcy system.

“The bankruptcy process wasn’t designed for problems of this order of magnitude,” said Jonathan Lipson, a professor at Temple University Beasley School of Law. “If there are suddenly scores and thousands of filings, it’s just going to flood the system.”

The bankruptcy system needs new tools to respond to today’s unique challenges, bankruptcy lawyers said.

Among the ideas they are considering: standstill agreements for stressed businesses, better lender incentives, and perhaps even federal bankruptcy loans.

Not if, When

The uptick in bankruptcy filings could be two to three months from now, or as many as nine months off, said American Bankruptcy Institute Executive Director Amy Quackenboss.

Small business are most likely to file first, followed by larger companies seeking reorganization under Chapter 11, Quackenboss said.

Chapter 7 and Chapter 13 filings from consumers are likely to come much later, after stimulus checks run out and bills pile up.

“The question of when the deluge is going to happen is just unclear right now,” Quackenboss said. “But we’re certainly expecting it.”

Unique Challenges

Companies that had already filed bankruptcy when the pandemic hit are showing signs of the unique challenges ahead.

Michigan-based retailer Art Van Furniture LLC filed for Chapter 11 protection in March with plans to sell off some of its stores and liquidate the rest. The company had bankruptcy financing and a willing buyer for 44 of its 169 stores.

Eleven days later, after stay-at-home orders forced the company to close all stores, stop its going-out-of-business sales, and halt furniture deliveries, the buyer backed out of the deal. Art Van went into default and attempts to renegotiate financing failed.

Now, less than a month after filing for bankruptcy, Art Van is in Chapter 7 liquidation.

As a result, more than 1,000 employees have lost their jobs and health care, and customers who paid in full for undelivered furniture have been left to fight with their banks to get deposits back.

Companies that file while the economy is on hold may have trouble selling assets or getting bankruptcy loans, said Edward R. Morrison, a law professor at Columbia Law School. And many won’t have enough time or money to put together a pre-packaged bankruptcy, in which companies speed up the process by prenegotiating a reorganization plan with their lenders and getting shareholder approval before filing.

“It’s like a reshuffling of the deck,” Morrison said. “The conventional tools have become blunted, become less useful, or have been taken off the table.”

Stopping Time

A lot of the financial stress surrounding the coronavirus could be alleviated if contracts were put on hold and everyone could agree not to sue, said Temple University’s Lipson.

“The real issue behind bankruptcy is going to be breach of contract,” Lipson said. “Everybody is going to be in breach.”

Lipson and Norman M. Powell, a partner at Young Conaway Stargatt & Taylor, LLP, worked with the American Bar Association to publish a model standstill/tolling agreement that sole proprietors, landlords, business owners, and vendors could use to hit “pause” until the virus emergency has passed.

The agreement essentially would replicate the automatic stay that happens in a bankruptcy without anyone having to go to court, Lipson said.

Priming Liens

For companies that do end up in bankruptcy, increasing incentives for lenders to provide more bankruptcy financing could help free up liquidity, said Kenneth Ayotte, a professor of law at U.C. Berkeley.

The bankruptcy code allows for “priming liens,” meaning a lender that offers a company new money for its debtor-in-possession financing could get it paid back ahead of existing secured creditors as the bankruptcy process unfolds.

Priming liens are uncommon, however, and usually a company’s existing secured lenders are the only realistic source of bankruptcy financing.

If it were easier for a new lender to move to the front of the repayment line, especially in the early stages of a case, “there might be more competition for such loans and longer runways for companies to evaluate their restructuring options,” Ayotte said.

Federal loan facility

The federal government also could help the liquidity shortfall with an emergency loan facility during the pandemic, according to Peter DeMarzo, Arvind Krishnamurthy, and Joshua Rauh of Stanford University.

Under their proposal, the Federal Reserve and U.S. Treasury would create a temporary Debtor-in-Possession Financing Facility (DIPFF) to provide bankruptcy financing to companies in Chapter 11 during the pandemic.

The facility would offer loans with a low interest rate equal to the Federal Reserve Discount Rate, and the DIPFF loan would take priority over others and get paid back first.

The objective would be to give a company enough funds to survive the Covid-19 shutdowns until it could get back to a normal Chapter 11 restructuring process and emerge from bankruptcy, DeMarzo told Bloomberg Law.

By making such financing only available to companies already in Chapter 11, federal dollars “would be flowing to a place where it will have the most impact,” Krishnamurthy also told Bloomberg Law.

“This is the time to start thinking about risks that may emerge over the next few months,” he said. “If we get started now, these bankruptcy risks can be mitigated.”

For additional legal resources, visit Bloomberg Law In Focus: Coronavirus.