Reflecting on Business Bankruptcies From the Pre-Code Era into the New Millennium
When future economic historians look back upon the U.S. economy during the last quarter of the 20th century, they will no doubt recognize that this was a particularly volatile period, marked by rapid changes in the economic landscape. The mid-1970s found an American economy in recession, characterized by high levels of inflation, precipitated by numerous causes, most notably rising petroleum prices, rising unemployment, high interest rates and a high number of business failures. It was during these bleak years that the need for a revised system of bankruptcy laws that would promote the reorganization and rehabilitation, rather than liquidation, of companies was conceived and ultimately brought to fruition in the form of the Bankruptcy Reform Act of 1978 (Bankruptcy Code), replacing the long-standing Bankruptcy Act of 1898 (Bankruptcy Act).
Setting the Stage for the Bankruptcy Boom
America's economic woes continued throughout the late 1970s and early 1980s, reaching a climax in 1981, when the prime interest rate reached the unprecedented level of 21.5 percent. At the same time, a major transformation of the American economy began to take place. The new administration identified inflation as "Public Enemy Number One" and initiated a process through which the inflationary pressures that had plagued the American economy for nearly a decade started to be brought under control. Tight monetary policy contributed to the severe 16-month economic recession that occurred during 1980-81. Although the process of flushing inflation out of the economy would take many years, it finally helped lead to the strong economic growth that the country still enjoys today. During the mid- to late-1980s, we witnessed an increase in speculative activity, facilitated in part through widespread downsizing at large corporations, which in turn resulted in large numbers of highly leveraged management buyouts (MBOs) and leveraged buyouts (LBOs), many of which were financed through the use of asset-based financing, as well as financial innovations such as the use of high-yield, "junk-bond" financing. During this period, we also witnessed the the rapid growth of the real estate syndication industry and widespread use of high-yield financing to support a record number of start-up companies and to finance hostile corporate takeovers.
In the mid-1980s, Congress amended the tax laws relating to the so-called "passive loss rules," which in turn had a profoundly negative impact on the real estate syndication industry. In addition, during this period the savings and loan crisis began to spread throughout the United States, which also had a negative impact upon the value of real estate nationwide. Throughout the 1980s, the impact of deregulation that had been imposed upon the American airline industry in 1978 and the trucking industry in 1980 began to be felt as more and more airlines and truckers struggled to remain viable. While the stock market crash of October 1987 did not immediately have the debilitating impact on the general economy that many had feared it would, it did impair asset values, causing many lenders to view loans as less secure, and it was one of many factors that helped set the stage for a deluge of business bankruptcy filings.
The level of bankruptcy filings by middle market-sized companies increased throughout the 1980s. It was not until the late 1980s, however, that a surge in the number of bankruptcy filings by large, publicly traded companies began. In 1987, Texaco, one of the largest corporations in the United States, filed a voluntary chapter 11 petition in order to stay the execution of a multibillion-dollar judgement that had been awarded in favor of Pennzoil in state court litigation. Although other large corporations such as Johns-Mansville Corp. and W.T. Grant & Co. had previously filed for bankruptcy, never before had such a large, visible and ostensibly healthy American corporation voluntarily sought bankruptcy protection. The Texaco case opened the eyes of corporate America to the possibility of utilizing the liberal, pro-debtor bankruptcy laws available under the 1978 Bankruptcy Code as a legitimate business strategy.
The "Golden Age" of Bankruptcy (1987-1994)
During the 1980s, various factors combined to help cause a surge in corporate bankruptcies to historically unprecedented levels. These factors included the failure of leveraged buyouts, the collapse of the junk-bond market and real estate prices, the savings and loan crisis, turmoil in the airline and trucking industries, overdevelopment in the retail sector and the aftermath of the October 1987 stock market crash. The problems and trends that had been developing throughout the late 1980s came to a head during the economic recession of 1990-91. In retrospect, the period beginning in 1987 represented a virtual "Golden Age" for lawyers, accountants, consultants and other professionals who made their living in the bankruptcy and restructuring industry, which lasted until 1994. Although the level of consumer bankruptcies has soared throughout the 1990s, after 1994 the number of middle-market and large capitalization commercial chapter 11 filings, including filings by publicly traded companies, significantly declined. Those who foresaw the transitory nature of the Golden Age downsized their practices where possible and/or diversified into counter-cyclical practice areas that allowed them to remain less intensively involved in, and dependent on, the insolvency field.
One trend that emerged during the Golden Age was a shift in chapter 11 practice, particularly with regard to the representation of debtors. Previously, even large corporate debtors had traditionally been represented by small, bankruptcy boutique law firms. Under the prior Bankruptcy Act, the standard for compensation of professionals was discretionary and based on notions of conservation of the bankruptcy estate and economy of case administration. Fearing that talented bankruptcy specialists would be driven out of the field, and that the bankruptcy field would be occupied by those who could not find other work, Congress added §330 of the Bankruptcy Code, establishing a standard for the compensation of professionals based on the customary rates charged by comparably skilled practitioners. This change caused the practice of bankruptcy law to become much more attractive, and potentially lucrative, to large, general practice law firms that had traditionally avoided bankruptcy work out of a fear of less-than-full realization of the fees incurred. A natural consequence of this process was to demystify the chapter 11 process for a large number of corporate lawyers and commercial litigators and allow them to begin to shape a chapter 11 process in ways that drew upon the methods of a corporate transaction-based practice.
Many of the high-profile cases that occurred during the Golden Age years could in retrospect be classified as financial restructuring or "balance sheet cases," in which the underlying business and assets were fundamentally sound but encumbered by an onerouslevel of indebtedness. In such cases, transaction-minded professionals began to view chapter 11 as a means for rapidly effectuating a financial restructuring, similar to an exchange offer outside the bankruptcy context. As a result, the pre-packaged and pre-arranged chapter 11 bankruptcy emerged as an efficient method for rapidly engineering a financial restructuring.
There has been considerable debate about whether the abuses of the bankruptcy process under the 1978 Bankruptcy Code called for reform of the laws governing business reorganizations. For example, prior to the Golden Age, management sought to utilize chapter 11 to reject collective bargaining agreements as executory contracts under §365 of the Bankruptcy Code. In response to the Supreme Court decision in NLRB v. Bildisco & Bildisco, 465 U.S. 513, 79 L.Ed. 2d 482, 9 C.B.C2d 1219 (1984), Congress added §1113 of the Bankruptcy Code, pursuant to the Bankruptcy Amendments and Federal Judgeship Act of 1984. Section 1113 established the procedures and standards that govern the rejection of collective bargaining agreements in chapter 11 and attempts to balance policies that promote debtor rehabilitation with the labor policies that protect employee rights. Unfortunately, even after the passage of §1113, the issues involved were by no means fully resolved, and as a result, there was extensive litigation during the Golden Age regarding the interpretation of §1113 and its relationship to other provisions of the Bankruptcy Code, as well as to applicable non-bankruptcy laws.
The tension between management and labor expanded beyond the scope of §1113. Both prior to and during the Golden Age, management attempted to utilize the chapter 11 process to avoid obligations to pay health, life and disability benefits of retirees. In 1988, Congress passed the Retiree Benefits Bankruptcy Protection Act, adding §§1114 and 1129(a)(13) to the Bankruptcy Code and making this more difficult to accomplish. The range of issues in chapter 11 cases that generated litigation during the Golden Age extended far beyond the labor arena. Congress attempted to address the concerns of various constituencies when it amended numerous provisions of the Bankruptcy Code in the Bankruptcy Reform Act of 1994. Congress continues to consider further revisions of the Bankruptcy Code.
In any event, whether because of or in spite of the bankruptcy system, the U.S. economy that emerged from the Golden Age has been extremely healthy. However, the role of the bankruptcy process for corporate America was forever transformed.
A New Economic Paradigm—Future Failures
Since the 1991 recession, the United States has enjoyed an unprecedented peacetime economic boom in a rapidly evolving world economy. Recognizing the growing significance of interrelated world financial markets, the growth of multi-national business organizations and the widespread dissemination of information technology, economists sometimes refer to this environment as the "New Economic Paradigm."
Some optimistic economists have theorized that in the New Economic Paradigm, the benefits of rapid increases in productivity have eliminated the traditional business cycle. The more conservative view advises that the manifestation of the business cycle's nuances in the New Economic Paradigm is not yet fully recognized nor understood. In this new environment, we should expect business failures of all types to continue to occur, although perhaps less frequently then during the Golden Age. However, we should also expect that many future workouts and bankruptcies will present far greater challenges than the multitude of balance-sheet cases that occurred during the Golden Age.
One result of the thriving economy has been the ability of many companies to raise capital in both the public and private equity markets. To a large extent, private equity has replaced the leveraged markets as the financing device for speculative activity. Many public companies have seen their market capitalization increase dramatically in a rising bull market. Often, such behavior has been predicated on extremely optimistic financial projections, as has been the case of some Internet companies with no prior history of earnings. Such an environment will prove tempting to those wishing to manipulate the prices of stocks. The thriving American economy of recent years and high levels of liquidity have allowed many companies to easily finance away their problems, often merely until a future date. While a reliance on greater levels of equity financing as opposed to debt financing will tend to place management under less pressure, we can nevertheless expect that business failures will still occur.
The rapid pace of technological innovation suggests that more companies will experience the "horse-and-buggy" phenomenon in which an entire industry is rendered obsolete in a relatively short time. Such changes may be caused by the creation of entirely new industries, as in the case of the high-technology sector, or through the transfer of manufacturing overseas to low-cost labor nations, as in the case of the textile and apparel industries.
One of the central principles of the New Economic Paradigm is that companies must compete in a global economic environment. Increasingly, companies in all industries will find that their operations involve various international components. These may include various degrees of foreign sales, manufacturing, outsourcing, foreign exchange issues, joint-venture relationships, etc. Domestically based companies may be subject to foreign ownership and be indebted to foreign creditors. Continued political upheaval throughout the world will cause management to factor the possible consequences of sovereign risk and political uncertainties into consideration in planning business strategies. In any event, the multinational nature of many contemporary businesses will result in more complex reorganizations than situations in which all of a company's problems can be conveniently reorganized under chapter 11 in a U.S. bankruptcy court.
During the Golden Age, large numbers of corporate managers and institutional lenders developed a working familiarity with the nuances of the reorganization process. Alarmed by the expense and uncertainties of chapter 11, many such businesspeople are now increasingly motivated, where possible, to look to out-of-court solutions. We can expect that where an out-of-court restructuring is not feasible, companies will continue to look to the pre-packaged chapter 11 bankruptcy in a perceived-to-be debtor-friendly jurisdiction such as Delaware, as the means of accomplishing a financial restructuring (i.e., balance-sheet cases).
Notwithstanding the indisputable benefits of the New Economic Paradigm, we might witness a slowing of the American economy during 2000 that could increase the level of activity in the workout field.
As a result of the Golden Age, there are now more lenders and other parties that are familiar with the intricacies of debtor-in-possession lending. Accordingly, as the availability has increased, the pricing for these types of loans has become more competitive and the underlying equity/collateral cushion thinner. Another trend to emerge from the previous bankruptcy Golden Age is the increasingly active role played by the distress-investing community. There are now numerous entities, including hedge funds, claims traders, investment banks and others, that routinely purchase and sell nearly the entire spectrum of debt, equity claims and interests in companies that have sought bankruptcy protection. Such investors have a different view of the reorganization process as opposed to more traditional players such as trade creditors and commercial lenders. Such parties will tend to be less tolerant of the needs and dictates of entrenched management and will tend to steer the chapter 11 process toward rapidly maximizing the return on their investment. During the Golden Age, the market for the purchase and sale of assets in bankruptcy became more efficient. There are now numerous entities that are interested in participating in the disposition of assets in chapter 11, including auctioneers, liquidators and various consultants. It is now not unusual to find numerous entities competing for the right to liquidate a company's assets. Markets now exist for leasehold interests. Given the ready marketplace for the range of a company's assets, yield-hungry, distressed investors will not hesitate to utilize the services of the cadres of turnaround consultants that came into existence during the Golden Age in seeking to achieve their financial objectives.
One might argue that all bankruptcies are ultimately the result of mismanagement. In the future, we believe that chapter 11 will increasingly become the domain of truly troubled companies and that such cases will prove more difficult to reorganize. The recent economic euphoria and technological revolution will no doubt lead to ever more novel types of fraudulent schemes that will manifest themselves in heretofore unforeseen ways. The potential for fraud increases in a global environment where multiple countries, languages, legal systems and currencies are involved. The rapid pace of globalization and technological change will mean that companies will increasingly face the threat of obsolescence. Management will need to be nimble enough to anticipate changing trends and adjust to them. However, we can expect that there will be more horse-and-buggy industries than ever in the future, and that companies in such industries will face a tremendous challenge in attempting to reorganize. More than anything else, however, it seems as if the prosperity of recent years has been the result of a significant drop in nominal interest rates, brought on by an astute monetary policy that began during the 1980s. As the level of inflation slowly rises, as now appears to be occurring, nominal interest rates will likely also rise, and the cost of capital for highly leveraged companies will rise as floating rate loans and debt instruments become more costly to borrowers. Only time will tell whether the increase in nominal interest rates will be large enough to adversely affect corporate profits, cash flows and valuations and to reduce overall economic activity in a significant way.
Notwithstanding the indisputable benefits of the New Economic Paradigm, we might witness a slowing of the American economy during 2000 that could increase the level of activity in the workout field. However, despite the wishful thinking of many, it is unlikely that a new Golden Age is on the horizon.