Circuit City's move was meant to stave off lawsuits from anxious suppliers and creditors and let it restructure with a court's help. If it had filed for bankruptcy protection a few years ago, it might have emerged successfully with better supply agreements, cheaper debt and lower property leases.
Instead, the retailer is going out of business for good, taking 34,000 jobs with it. Its website, which used to ply brand-name flat-screen televisions, is stripped of content bar news on the liquidation and a link to a jobs site, where people looking for temporary work can apply to help empty shelves and chain the company's doors shut.
Just as it was for Circuit City, bankruptcy protection is expected to prove lethal for more companies than usual in this downturn, as they struggle to handle a financing drought and their creditors' own financial problems, as well as legal changes that can force a more precipitate slide into liquidation. “There is a lot less confidence that issuers are going to make it,” says Steven Miller, managing director at S&P's Leveraged Commentary & Data, a debt commentary and information service.
Below: credit derivatives. How hidden agendas on insolvency mean work for lawyers at leastThe modern US bankruptcy code, which recently marked its 30th anniversary, was created to give struggling companies a chance to shed the shackles of debt and get a fresh start. Many well-known companies – including most major US airlines – have resurrected their operations while under Chapter 11 legal protection from creditors, often saving tens of thousands of jobs at a time. Entering bankruptcy protection remains a possibility for General Motors if the carmaker fails to reach agreements with unions and bondholders on restructuring.
Most US corporate restructurings take place outside the bankruptcy courts, when companies sit down with lenders, bondholders and suppliers to redraft agreements on more manageable terms. Companies fearful of having to file for bankruptcy are employing those efforts today more than ever.
But with lenders and bondholders much more risk-averse than before, the era of “clean” restructurings appears to be over. The continued existence of throngs of struggling companies – defaults in the US are soon expected to reach their highest levels since the Great Depression – will therefore depend on whether their stakeholders and advisers can treat restructuring more as a rough-and-tumble art than a science. In turn, that will help determine the severity of the recession – and the amounts of job losses – in the world's biggest economy.
“I think there's going to be a premium on creativity to crack very difficult nuts,” says James Sprayregen, a partner at Kirkland and Ellis, the law firm. “The fact that there's less money to go around is unfortunate but it doesn't have to spell disaster.”
Frantic out-of-court debt negotiations and asset sales have recently failed at companies such as Tribune, the newspaper publisher, and Station Casinos, the Las Vegas gaming company. Even those that convince lenders to swap debt either for cheaper debt or for equity have seen their health worsen.
Yet bankruptcy experts say companies have more out-of-court options today than during the last restructuring cycle, from 2001 to 2003. They point to the flexibility that was written into capital structures in recent years, the growing prevalence of minority investments by private funds and an increase in investors' willingness to consider alternatives. There are a myriad new distressed investing funds, some started as offshoots of the biggest private equity groups and hedge funds, all trying to make a fortune in distressed debt at a time when it is difficult to make significant returns on much else.
The biggest investors in distressed debt include Cerberus Capital Management, Oaktree Capital Management, Angelo, Gordon & Co, Silver Point Capital, Avenue Capital Group and billionaire Wilbur Ross, with a long list of others beneath.
The greater peril arises when those efforts fail and filing for bankruptcy protection becomes a company's only option. Restructuring in court is expensive and a growing list of companies are competing for scant financing. That is leading to a more pronounced divergence than usual between companies that can justify their existence, securing sufficient financing to stay afloat until they can restructure, and those that cannot and are forced to liquidate.
As a case in point, a financing package that was arranged to allow Lyondell Chemical to stay in business while it tries to restructure under court protection used a relatively novel technique to convince pre-bankruptcy lenders to commit $3.25bn in new money. For every $1 committed, those lenders can take $1 of their old exposure and roll it into debt that would have a higher repayment priority – a strategy that is already being mimicked by other loan-starved companies.
Many companies will still struggle to secure financing for far more basic reasons. Loans made to bankrupt companies are usually backed by collateral. Many companies have already pledged most of their assets to lenders, however, in response to a recent shift in the financing market away from unsecured lending. Without enough collateral, these companies would have to win court approval for controversial loans in which new lenders gain priority over other secured creditors. “We've ended up in a situation where many of the assets are already committed,” says James Bromley, a partner at Cleary Gottlieb Steen & Hamilton.
Restructuring advisers expect to see more bankruptcy loans granted by non-traditional investors, as existing lenders try to minimise losses and third parties such as the many distressed debt investors see opportunity. Aladdin Capital, which includes former bankers from Goldman Sachs, has set up a fund to invest in that market.
Equity holders are often wiped out by bankruptcy restructurings, leaving those who are owed money to fight over stakes in the restructured company or its assets. Years ago, when bank loans accounted for the majority of corporate debt, banks ruled these discussions. Today, the talks can also include bondholders ranging from pension funds to “vulture investors”, who buy distressed senior debt and aim to influence the debate.
The recent proliferation of hedge funds adds further complexity. Hedge funds under pressure to give back investors' money are focused on bringing in cash, even at a loss. Others are willing to hold positions longer in hope of a recovery. That can put funds at odds when a company is trying to restructure out of court. Investors with long-term views may be willing to amend terms or swap debt for equity, while cash-thirsty investors would rather receive pennies on the dollar or, if they have hedged their positions, push the company into bankruptcy.
When a company files for bankruptcy, its chances of liquidation can also be greater if key debtholders would rather cash out than take an equity stake in its possible recovery. “There has been a flight toward cash recoveries by hedge funds, and that's just natural,” Mr Bromley says. “That kind of pushes you away from a reorganisation model, because they'd rather get $10 in cash now than a note for $50 in six months. They might not be around in six months.”
Debtholders can be tough to identify and even more difficult to unite around one solution. A hedge fund, for example, might own several types of debt issued by the same company, each with a different repayment priority. A company's top bank lender could also be a key bondholder. Bondholders may also own insurance in the form of credit default swaps, which means they could profit from this insurance if the company fails (see below). “Intelligence about who owns the debt has become very, very important,” says H. Jeffrey Schwartz, a partner at Dechert.
Some creditor committees have barred cross-holders or asked them to recuse themselves from discussions, and frustrated creditors have considered suing others for not negotiating in good faith. But experts play down the debate over whether debtholders should fully disclose their other holdings to provide transparency.
Bruce Mendelsohn, who co-heads Goldman Sachs' restructuring group, says complications among cross-holding creditors rarely push debtholders into accepting an unnatural result. “More often than not, the reality is that parties that own multiple tranches in the capital structure want to maximise their overall returns,” he says. “There is a convergence to rationalism that ultimately happens.”
Amendments to US bankruptcy laws in 2005 are also making it harder for some companies, retailers in particular, to avoid extinction. They now have less time to accept or reject property leases, which can mean an inescapable time crunch for retailers such as Circuit City or Linens 'n' Things that had hundreds of separate landlords.
The confluence of obstacles for struggling companies has prompted speculation that the US government may step forward as a bankruptcy lender of last resort in certain cases. The Treasury has already committed $17.4bn to help GM and Chrysler restructure out of court, which could be converted into bankruptcy financing if necessary.
The government would probably consider such a move only in cases involving financial companies or other national interests, experts say. Judges may occasionally bless unconventional arrangements to preserve the financial system or to keep the country from sliding into a depression.
As Dechert's Mr Schwartz puts it: “Bankruptcy is a collective proceeding – and one of the considerations in any case is public interest.”
CREDIT DERIVATIVES: HIDDEN AGENDAS ON INSOLVENCY MEAN WORK FOR LAWYERS AT LEAST
Aspiring bankruptcy lawyers have in recent weeks been undergoing a crash course in advanced finance, writes Aline van Duyn.
In order to win the coveted annual Duberstein Moot Court competition – awarded by St John's University in New York next month – they will need to address a question on the $30,000bn market in credit derivatives, the financial instruments used to provide insurance against corporate default.
“Credit derivatives can, in theory, have an enormous influence on a company's financial situation if they have to restructure,” says Joel Telpner, partner at Mayer Brown. “They are a relatively recent phenomenon, however, and exactly how the existence of this market will affect companies in this economic downturn is still very unclear.”
The hypothetical situation with which the lawyers must grapple is as follows. A company on the verge of bankruptcy tries to reach agreement with its bondholders to reduce its debt. After months of negotiations, some investors vote against the proposal. The restructuring fails, the company goes under and bondholders lose more than they would have done under the proposed deal.
It later emerges that those bondholders who voted against the restructuring made a lot of money from the company's demise. They owned credit derivatives, which paid out when the company went under.
“One key assumption underlying debt restructuring negotiations is that creditors generally want to keep a solvent company out of bankruptcy and want to maximise the value of an insolvent company,” says Henry Hu, professor at the University of Texas School of Law, who last year testified before Congress about this issue. “These assumptions can no longer be relied on.”
Companies have no say over the types or number of derivatives linked to their creditworthiness. Because it is a privately traded, self-regulated market, there is no public information about who owns credit derivatives, nor is there any legal requirement to make holdings public. This opacity has been a focus for regulators in the current financial crisis, especially as fears have grown that the tens of billions of dollars in such contracts could be a source of a systemic financial collapse. Such concerns were a key reason for the rescue of Bear Stearns last March and have influenced many interventions since then.
So far, there are few concrete examples of credit derivatives positions hampering, or helping, a company in trouble. However, bankruptcy lawyers and bankers say they now always try and find out as much as they can about the number of credit derivatives outstanding and who owns them, usually through placing phone calls to traders and other types of intelligence-gathering.
Due to pressure from the regulators, who are pushing the industry to set up a centralised clearing house for these contracts, there is at least some information available, such as the net value of credit derivatives outstanding on any company or bank. But there is still no requirement for any disclosure on who is taking such positions.
One thing, at least, is clear: the lawyers currently honing their understanding of credit derivatives are likely to find themselves in demand in the coming years.