Chapter 11 of the U.S. Bankruptcy Code is a legal process for the rehabilitation, restructuring or orderly liquidation of troubled business enterprises. With the economic decline following the Great Recession of 2008-10 and the resulting tightening of commercial credit in the United States, business Chapter 11 filings should be at an all-time high.
Instead, the filing statistics maintained by the Administrative Office of the U.S. Courts illustrate a different trend. In 2008, 9,272 business Chapter 11 bankruptcy cases were filed; in 2009, business Chapter 11 filings increased to 13,683. See www.uscourts.gov/Statistics/BankruptcyStatistics.aspx. However, in 2010, business Chapter 11 filings dropped to 11,774. For the first quarter of 2011, filings fell to 2,605 from 3,293 for the same quarter last year. These filings remain down everywhere, including the popular Delaware and Southern District of New York venues. An analysis of the business cycle and Chapter 11 filings yields reasons why businesses are not seeking Chapter 11 relief now and an informed basis to consider what to expect in the future.
Upon the filing of a voluntary Chapter 11 petition, the operations, assets and liabilities of the business, referred to as the debtor, are subject to the control of the bankruptcy court, consistent with the provisions of the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure. These provisions are intended to preserve the status quo, permit the continued operation of the business in the ordinary course and protect the interests of creditors.
To preserve the status quo, the filing of the Chapter 11 petition operates as an automatic stay of almost all actions against the debtor and its property, including lien enforcement by secured creditors and repossession by lessors of real or personal property, whether such actions are taken in or out of court. 11 U.S.C. 362(a). Another feature of preserving the status quo is the general prohibition of payment of obligations and debts incurred for goods received or services rendered before the Chapter 11 petition. Unless the court orders otherwise, the management of a Chapter 11 debtor is authorized to conduct business in the ordinary course. 11 U.S.C. 363(c)(1), 1107, 1108. This authorization permits the payment or satisfaction of obligations or debts for goods received or services rendered (other than by professionals) after the commencement of a Chapter 11 case. The usual goal of a Chapter 11 case is the financial rehabilitation of the debtor and the satisfaction of creditor claims through confirmation of a Chapter 11 Plan. 11 U.S.C. 1123, 1124.
During the peak of the Great Recession, commentators often remarked that Chapter 11 practitioners must be experiencing a huge surge in Chapter 11 filings. Practitioners would respond that business Chapter 11 filings tend to be a lagging economic indicator and that, based on prior experiences during business down cycles, the peak of business Chapter 11 filings would not occur until the start of an industry or general business recovery.
Each business Chapter 11 filing is unique, and many factors bear on the rate of these filings. As a general rule, when an industry or the economy is in decline, there is less incentive for lenders and creditors to force a liquidation of a business and its assets because the value of the enterprise and its assets are most depressed. In many cases, lenders and creditors will wait until an industry or business shows signs of improvement before taking action to enforce their claims or to liquidate a business debtor and its assets. However, once business prospects begin to improve, many debtors will seek remedies, including a Chapter 11 filing, to preserve their business operations and assets with the expectation that the recovery will allow them to survive, or at least liquidate at a better price.
The disincentives to a Chapter 11 filing remain relatively constant in good times and bad. The process is often expensive, burdensome and embarrassing, and in many cases comes with no certainty of result. Thus the most successful cases are those filed with a specific business plan or objective in place and that seek to use the Chapter 11 process to implement, or allow debtors to implement, a business recovery plan. However, many Chapter 11 filings are for businesses “in free fall,” filed to prevent or delay the enforcement of creditor and lender collection remedies including foreclosure, asset seizure or appointment of a receiver in the hopes that time will provide a sufficient recovery.
Because the fundamental factors that lead to business Chapter 11 filings do not change, why has there not been a substantial increase in Chapter 11 cases since the start of the recession? There are several factors that account for this anomaly.
First, there are now recognized alternatives to Chapter 11 that may be more attractive to distressed businesses, their creditors and lenders. Some creditors and commercial lenders are more savvy about what a Chapter 11 filing will produce for them and are more willing to consider an out-of-court consensual resolution to the problems of a troubled enterprise, especially if that resolution will produce a better and more certain recovery and result.
Second, while conventional commercial bank lending has been contracting for most businesses, venture capital firms, hedge funds and other opportunistic investors are willing to fund or provide acquisition financing for prospects promising high returns. Azam Ahmed, “Bank Said No? Hedge Funds Fill Loan Void,” N.Y. Times, June 9, 2011, at A1.
Third, the Chapter 11 process has become more burdensome and costly for business debtors as courts and creditors have sought to expedite cases via quick enterprise or asset sales instead of allowing time for the business to reorganize its operations in Chapter 11 and to fund a Chapter 11 plan via a longer-term earnout or a recapitalization. Fourth, as noted above, the current mediocre rate of recovery has reduced the incentives and opportunity for lenders, creditors and enterprises to benefit from Chapter 11 in a market that does not offer the prospect of rapidly increasing enterprise and asset values.
There are still Chapter 11 cases being filed during the Great Recession but not at the rate to be expected. These business Chapter 11 filings tend to be exceptions or forced filings, due to creditor action to enforce claims or liens, unanticipated adverse economic events, special or opportunistic situations like General Motors or the need to facilitate the sale of an enterprise, which can best be accomplished via a bankruptcy court-approved transaction.
What, then, does the future hold for business Chapter 11 filings? The basic principles of the competitive marketplace remain in place; some businesses will continue to suffer from self-inflicted or external financial and operational distress or from business misjudgments by debtors, lenders and creditors that will require business reorganization and debt and capital restructuring. Chapter 11 remains a valuable tool to deal with such circumstances and thus, for distressed enterprises, the old rules still apply, and an improving economy is likely to lead to a return to increased business Chapter 11 petition filings.
Penn Ayers Butler (email@example.com) and Elizabeth Berke-Dreyfuss (firstname.lastname@example.org) are partners at Oakland, Calif.-based Wendel, Rosen, Black & Dean. Butler has three decades of experience related to bankruptcy, corporate restructurings and Chapter 11 reorganizations, and Berke-Dreyfuss has more than two decades of such experience.