In 2020, commercial chapter 11 bankruptcy filings climbed to their highest levels in recent years, as COVID-19 disruption sparked sharp declines in GDP and volatile stock market swings. Notably, the pandemic accelerated the restructurings of some companies that were already on the precipice of financial distress, particularly in the retail, energy, travel and hospitality sectors.
Year-on-year commercial chapter 11 filings increased 29% in 2020. The 7,128 filings in 2020 were the most since 2012, which saw 7,789 filings, according to data prepared by Epiq for the American Bankruptcy Institute.
However, after a significant spike in the number of commercial chapter 11 filings in the second and third quarters of 2020, the pace of new chapter 11 filings slowed significantly toward the end of the year.
We enter 2021 with continued exuberance in the capital markets and soaring stock valuations, but also with record levels of US corporate debt. As government support measures wind down and longer-term business impacts from the pandemic are realized in 2021, chapter 11 filings are expected to resume their earlier 2020 pace or perhaps even increase, as many businesses that were spared the worst of the economic fallout may have to right-size their balance sheets and adjust post-pandemic business models. This upward trend in filings would be particularly acute if the current market conditions result in inflationary pressures and a rise in interest rates.
COVID-19 as catalyst and accelerant for 2020 filing increase
In certain sectors, the impact of COVID-19 lockdowns was the catalyst for the spike in chapter 11 volume, and in others—particularly energy and retail—the effects of the pandemic hastened the need for many already-distressed businesses to file. COVID-19 also initially roiled the markets early in 2020, as the S&P 500 fell by more than a third from the beginning of February to the end of March as the pandemic accelerated. In Q2 2020, US GDP fell by a record 31.4% and large numbers of businesses were forced to seek bankruptcy protection.
Market disruption could have been worse and the number of new chapter 11 filings would likely have been higher were it not for wide-ranging stimulus measures. The CARES Act, signed into US law at the end of March 2020, provided more than US$2 trillion of financial support for businesses and consumers, with US$454 billion made available to the Federal Reserve to provide loans and loan guarantees to businesses.
At the same time, banks and other capital providers showed a willingness to modify loans, relax covenants and provide additional liquidity to allow borrowers to survive the pandemic. And, for many large businesses with the ability to raise further funding under their current debt documents, there was seemingly unlimited appetite for additional leveraged loans and high yield debt in the capital markets.
Government action and the resulting abundance of capital paid immediate dividends. The S&P 500 jumped almost 13% in April and ended the year with a total return of almost 18%. US GDP increased by 33.4% in Q3, completely erasing the losses from Q2, and grew by an additional 4% in Q4. The major stock market indices posted all-time highs in early 2021.
More distress anticipated in 2021 and beyond
Although government stimulus funds remain available for certain businesses (and more stimulus measures are expected under the Biden administration), these measures will likely wind down in time, which may lead to more defaults and bankruptcy filings. Moreover, the recent surge in the number of so-called zombie companies—ones for which interest expense exceeds operating income—portends a need for significant de-leveraging.
It is less clear when or if private capital will become less abundant, and how long already over-leveraged issuers will be able to access the capital markets and continue to add more debt to their balance sheets. US leveraged loan default rates were already increasing steadily throughout 2020 to reach 4.5% in December, up from 1.7% at the end of 2019, according to ratings agency Fitch, with further increases anticipated for 2021—particularly if the capital markets become less hospitable to leveraged issuers.
Chapter 11 filings were also kept in check by creditors’ reluctance to enforce remedies and realize losses when asset values were so uncertain due to the pandemic. This has been especially pertinent in sectors such as commercial real estate, travel, leisure and aviation, where businesses often have no obvious alternative operators should lenders opt to foreclose and take control of troubled companies’ assets. As markets stabilize and a clearer picture forms of the longer-term, post-pandemic business landscape, lenders will have a better sense of where the value of their collateral breaks. This, in turn, will lead to more restructuring activity and a likely uptick in the number of chapter 11 filings.
2020 saw fewer freefall cases than 2019
According to the Debtwire Restructuring Database, when companies initiated chapter 11 proceedings in 2020, they were fairly evenly divided between “freefall” cases (where a business enters chapter 11 without an agreement with creditors on the terms of its restructuring) and pre-packaged or pre-arranged cases (where the terms of the restructuring have been agreed upon, and in the case of pre-packaged proceedings, voted on by the creditors prior to the filing).
This stands in sharp contrast to 2019, when there were three times as many freefall cases as pre-packaged or pre-arranged filings. This suggests that, in 2020, companies facing an inability to refinance or take out existing debt—possibly due to the impact of COVID-19—more often chose to address those immediate balance sheet issues through pre-packaged or pre-arranged cases, rather than tinker too heavily with their operations and business models given the business and asset value uncertainties related to the pandemic.
Freefall chapter 11 cases take longer to resolve on average and as a consequence are generally more expensive—more time translates to higher costs in the form of professional fees and other administrative costs during the pendency of the cases. Freefall cases are also necessarily more uncertain, which can be more damaging to the company’s business operations and relationships with customers, vendors and employees. However, debtor-in-possession (DIP) financing is often obtained prior to the filing, providing the company operating capital to fund the case and providing assurance to stakeholders that the company will continue to operate in the ordinary course. DIP financing must be approved by the bankruptcy court and usually ranks higher in lien and payment priority than existing debt.
Although it is often preferable to agree on restructuring terms before the filing, if creditors are unable to agree on where value breaks and how the restructuring should proceed a freefall filing may be the only option. And, despite the increased cost and uncertainty of a freefall, it does allow for more time and latitude to effect a true operational restructuring, which is often not the case in pre-packaged or pre-arranged cases.
Pre-packaged and pre-arranged cases are generally less disruptive to a company’s business but are equally effective in reducing the company’s funded debt. In addition, these cases can last anywhere from a day or two on the extreme short end of the spectrum, to several months, instead of potentially years with certain freefall cases. The shorter chapter 11 process typically results in significantly lower administrative costs than in freefall cases, although it is often the case that more professional fees are incurred prior to a pre-packaged or pre-arranged chapter 11 filing while the terms of the restructuring plan are being negotiated. In addition, to secure consensus from different classes of creditors, pre-packaged and pre-arranged cases sometimes run the risk of not going far enough to restructure the company’s debts, which increases the risk of the business encountering further distress following its emergence from bankruptcy.
Although the data has not yielded a clear trend, as business conditions normalize and stimulus tapers off it will be interesting to monitor the respective levels of freefall and pre-packaged and pre-arranged cases. On the one hand, it is likely that companies in certain sectors will need to undergo a significant reduction in footprint and change in business model due to lasting changes resulting from the pandemic. These companies could likely be better served by a freefall case with a significant operational restructuring component, as well as debt restructuring. On the other hand, many companies have survived COVID-19 by expanding their balance sheets to levels that will be hard to sustain, even if their business returns to pre-pandemic levels. For these companies, the faster and cheaper pre-packaged or pre-arranged routes will likely be more attractive as a means to right-size their balance sheets without the uncertainty and costs associated with a freefall case.
