With a pandemic temporarily closing many businesses and stifling consumer demand, whole industries, especially those that recently leveraged their balance sheets to take advantage of near-zero interest rates, are seeing their profits disappear virtually overnight, leaving too little cash flow to cover debt payments owed to creditors.
This could set up the perfect storm for a huge wave of bankruptcies in the weeks and months ahead, says Stuart C. Gilson, the Steven R. Fenster Professor of Business Administration at Harvard Business School.
“There is a realistic probability that we could indeed see a ‘pandemic’ of bankruptcy filings in the near future,” Gilson says. “The pandemic analogy is particularly apt, in that if the number of new filings is sufficiently high, the bankruptcy courts, like hospitals treating COVID-19 patients, could be overwhelmed.”
Several US businesses have already filed since the coronavirus started rocking the US economy in mid-March, including Neiman Marcus, J. Crew, Dean & DeLuca, CMX Cinemas, and Gold’s Gym. The latest: JCPenney on May 15 filed for Chapter 11 bankruptcy protection after 118 years in business.
As Gilson explains in this Q&A, bankruptcy doesn’t necessarily mean the death of a company, and in fact, it can actually be the very thing that saves a business, assuming the courts can handle the flood that is likely coming.
Dina Gerdeman: What impact do you expect COVID-related bankruptcies to have on the bankruptcy system? And what does that mean for business owners who are seeking protection?
Stuart Gilson: The global economic impact of the pandemic has already been catastrophic in terms of lost output, employment, and financial wealth. But many expect this to be followed by significant aftershocks in coming weeks and months, as quite possibly record numbers of businesses (and individuals) default on their debt, restructure, or go bankrupt. The number of US business bankruptcy filings in the first quarter of this year is already up substantially over prior years, and some believe the number of filings over the next couple of years could top what we saw during the 2008-2009 Global Financial Crisis, when there were more than 100,000 business bankruptcies. Some analysts are forecasting that by the end of 2021 up to 20 percent of high-yield corporate bonds could be in default.
“It is certainly conceivable that if too many new cases arrive at the same time, companies could be much less well-served by the bankruptcy reorganization process.”
What makes the current financial crisis unique is that the economic harm caused by forced shutdowns is being felt by broad swaths of the economy and the population—large public companies to be sure, but also small- and medium-sized businesses, individual households, and cities and states. And all of these entities (with the exception of US states) can in principle file for bankruptcy protection. But all such cases, whether corporate, personal, or municipal bankruptcies, are processed through the same United States Bankruptcy Court system, and are overseen by the same pool of federal bankruptcy judges, who currently number about 350 only. The bankruptcy process also requires the active participation of skilled legal and financial professionals, who are also available in only limited quantities.
So it is certainly conceivable that if too many new cases arrive at the same time, companies could be much less well-served by the bankruptcy reorganization process, and emerge in much less sound financial condition (or not emerge at all). Overcrowding would cause cases to be processed more slowly, leading to longer stays in the bankruptcy “hospital.”
Not only would professional fees go up (especially burdensome for smaller businesses), but process delays would force companies to wait longer to obtain new financing or sell off assets, and delays in paying critical vendors could disrupt supply chains, further hurting the business and destroying value. This potential problem is troubling to a number of bankruptcy scholars, including my colleague Mark Roe at Harvard Law School.
So, is this bleak scenario inevitable? Optimistically, a number of things could happen to “flatten the curve” and reduce the number of bankruptcy filings, at least by enough to allow the existing system to function effectively. Massive financial support available to distressed businesses under the CARES Act and various recently enacted Federal Reserve programs might, if properly directed, allow significant numbers of businesses to avoid bankruptcy.
There are also massive amounts of private sector capital potentially available to support businesses in need. Bank balance sheets are generally sound, and hedge funds that specialize in investing in distressed companies and private equity firms have billions of dollars of investible cash—although whether any of these investors have the appetite to risk their capital in the present environment is yet to be determined. And of course, an effective cure or vaccine for the virus could be found, fueling a faster-than-expected economic recovery.
Will any of these positive developments materialize? The fact is, forecasting the number of bankruptcies presents the same modeling challenges as forecasting the number COVID-19 cases. Absent any such relief, it may be necessary to invest in expanding the capacity of the bankruptcy courts to prepare them to handle an unprecedented volume of new cases, should the worst case come to pass.
Gerdeman: Many view a bankruptcy filing as the death of a company, but you’ve said it can actually revive them. And we’ve seen examples of companies that continue to hum right along after filing. Do you think filing for bankruptcy might help some companies survive now?
Gilson: In many countries, “bankruptcy” does mean the death of a company, because it’s synonymous with liquidation. When a company defaults on its debt, and is unable to renegotiate terms or obtain an extension from creditors, filing for bankruptcy in the courts often results in a forced wind-down of the business. Management is replaced by a trustee or administrator (who is often an accountant or lawyer by training), the firm’s assets are sold off, and proceeds from asset sales are distributed to creditors until the money runs out. Importantly, there is no surviving, ongoing business.
In the US, in stark contrast, bankruptcy law serves a much different purpose. Under Chapter 11 of the US Bankruptcy Code, the goal is to give distressed companies the opportunity to reorganize, by giving them breathing room to fix the problems that afflict the business—for example, by cutting expenses, selling non-core assets, or making needed capital improvements—and put in place a new, less debt-heavy capital structure that the business can support going forward.
During this process—which typically might last one or two years for a large publicly traded company (although much faster prepackaged or prenegotiated bankruptcies are sometimes possible) —creditors are temporarily held at bay, and are not able to exercise remedies normally available to them when there is a default, such as calling in loans or seizing company assets.
Of course, this moratorium on creditor actions, called the “automatic stay,” may appear to disadvantage some creditors. But if it ultimately allows the company to fix the business and emerge from bankruptcy as a viable company going forward, then all creditors are potentially made better off, if the alternative is liquidation. In other words, Chapter 11 assumes, at least initially, that a live business—one that sells products and services to customers, employs people, invests and grows and innovates—is worth more than a dead business.
If this assumption is true, then it’s in everyone’s interest to find common ground on a plan that restructures the company’s debts and allows the business to continue. Even though creditors will typically be asked to make some financial sacrifices, such as accepting a reduction in what they are owed, waiting longer to be repaid, or exchanging their debt for company stock, they will nonetheless receive more value than they would have had the business been shut down.
By Stuart C. Gilson