The Changing Face of Bankruptcy

A need for speed, a shortage of DIP financing, government bailouts, and a complex web of debt structures are the hallmarks of the most recent crop ...
Marie LeoneAugust 11, 2009

There was a heightened sense of urgency to the Chrysler bankruptcy petition. When the company signed an agreement in May to sell most of its assets to Italy’s Fiat, the clock began ticking. The American carmaker needed to make a quick exit from bankruptcy.

Fiat said it wouldn’t wait past June 15 to ink the deal. Meanwhile, Chrysler was being pressed by dealers and vendors to restart idle factories, as those groups had about three months before they ran out of inventory and working capital, respectively.What’s more, the Obama Administration said it was willing to provide financing to restructure the company, but only for about the same three-month period.

In a notable effort, Chrysler emerged from bankruptcy 45 days after it filed its Chapter 11 petition using what is known as a Section 363 sale. Now other companies that succumb to Chapter 11 protection may want to follow, and in fact many already have. Since the beginning of the year, General Motors, Midway Games, Nortel, and Tropicana Atlantic City Casino and Resort have all initiated 363 sales.

Unlike traditional bankruptcies, a petitioner that files a 363 transaction — which is named for the bankruptcy code provision under which it falls — does not submit a reorganization plan to the court. Rather, the company arranges to sell assets to a buyer in an expedited process that does not require buy-in from the debtor or its shareholders.

Creditors balk at such deals, as the speedy sale process leaves little but unwanted assets and liabilities to be liquidated in a Chapter 7 proceeding. In contrast, buyers love the idea of quickly purchasing assets at fire-sale prices, free and clear of liens and claims.

In some cases, all parties agree that a 363 sale makes sense. The classic time-sensitive example involves a bankrupt vegetable wholesaler that runs out of money to pay its growers for the broccoli, lettuce, and spinach that sit rotting in boxcars while Chapter 11 proceedings drag on. The faster the company emerges from bankruptcy and pays its creditors, the faster the veggies make it to grocery-store shelves.

Of course, Chrysler and GM were not hampered by rotting broccoli. However, industry experts believe no automaker could survive protracted bankruptcy proceedings, simply because of their interdependency with dealers and major suppliers. It was very possible that none of the three would have survived had production lines remained idle for an extended period of time, and it was virtually impossible for the carmakers to ramp up production with demand tumbling and cash dwindling. For them, the fast 363 sales seemed necessary.

While there is no central repository that tracks 363 sales, there is reason to believe these accelerated transactions are becoming more popular. The number of Chapter 11 filings rose 69%, year-over-year, for the 12-month period ending March 31, 2009, according to the U.S. Bankruptcy Courts. That “sheer number of bankruptcies,” combined with the lack of availability of debtor-in-possession financing, probably means that more 363 sales are being completed, posits Douglas Pugliese, managing director at valuation consultancy Marshal & Stevens. “Companies are going straight into liquidation” because there is not enough DIP financing in the market, Pugliese tells

Others agree. Jonathan Carson, managing director and co-founder of Kurtzman Carson Consultants, which specializes in bankruptcy and corporate restructuring, says the rise in 363 sales is due partly to the shortage of “rescue financing.” He says, “That’s probably a trend that is here for a while, at least until the capital markets ease up and it’s easier for companies to obtain rescue financing or DIP loans.” Carson explains that with fewer lenders willing to offer DIP financing, companies are being forced to offload assets to a willing bidder, sometimes through a 363 sale.

“Lenders are extremely reluctant to finance bankruptcy cases, especially when the prepetition lender is undersecured,” noted Scott Opincar, an attorney with McDonald Hopkins, in a report on a recent poll conducted by the Turnaround Management Assn.

Results of the poll “accurately reflect the overall state of the market; not one type of lender is more actively extending credit this year compared to last year,” added Thomas Pabst, chief operating officer with auction and liquidation specialists Great American Group, who also participated in the TMA survey.

Another reason for the increase in 363 sales is lender impatience. Tight credit markets have forced lenders to be stingy with respect to giving borrowers more time before declaring them in default. While lenders won’t be “irrational,” and will continue to rework credit terms for most commercial customers, says Carson, the time horizon for working out new payoff schedules has shrunk from about a year down to three months. That’s because banks and other lenders know they may be able to quickly recoup some of their investment through an accelerated bankruptcy process or liquidation.

While 363 sales rise, Carson points to another trend that might change the landscape of Chapter 11 reorganizations: “hybrid bankruptcies.” That’s how he describes the Chrysler and GM restructurings that were done with the help of government bailout money. “Companies that were once deemed ‘too big to fail’ now have a roadmap that is steeped in precedent for how to navigate a restructuring with heightened levels of government involvement,” he says.

Section 363 sales are also popular because the expedited process keeps bankruptcy costs at bay, and lenders are keen on that feature. Paying fees to creditor committees, lawyers, advisers, and consultants for their work to strip out debt from the balance sheet is a relatively expensive proposition. And it can be hard to convince lenders that a company needs to spend time and money to work out operational issues while still in Chapter 11.

“I think the accelerated path is great if the facts justify it. But if you have an operationally troubled business, you may have to make sure you don’t rush through Chapter 11,” opines Carson. For instance, a retailer bogged down by expensive real estate leases may need to shed the contracts before emerging from the process, otherwise the debtor risks collapsing again under the weight of unproductive leases.

Also, complex capital structures are forcing companies to spend more time — and money — in Chapter 11 limbo, and a 363 sale helps avoid that financial purgatory. Twenty years ago, companies raised debt through fairly straightforward bank borrowing, bond issues, and trade credit. Today, bank debt is often structured with first and second liens; companies then add mezzanine debt, and bonds are often issued in first-tier and subordinated tranches. Carson contends that the layering of debt leads to prolonged infighting among creditors, as they jockey for position in the bankruptcy pecking order to determine which creditor gets paid off first.

The creditor sparring matches usually are sparked by competing asset valuations, with creditors that are lower in the pecking order often claiming asset values that are much higher than the calculations of senior lenders. To be sure, the higher the asset valuation, the more likely there will be more money to go around once a 363 sale or liquidation is completed.

Despite the doom and gloom about the rising number of Chapter 11 filings, companies with good business models and supportive stakeholders will “survive bankruptcy and flourish upon emergence,” contends Carson — regardless of what exit strategy they use. Bankruptcy is “becoming more difficult in certain situations,” he says, “but Chapter 11 is as vibrant now as it has been, and I think it will be a very prominent part of our economic culture for the next couple of years.”