Will Lower Unemployment Drive Bankruptcies?

Watch for a flood of Chapter 11 filings later this year if interest rates are raised, a prominent bankruptcy attorney warns.
David McCannMarch 17, 2015
Will Lower Unemployment Drive Bankruptcies?

Surely everyone can agree that the falling unemployment rate is good for, well, everyone. Yes?

Maybe not.

In fact, rising employment could deal the death blow to companies teetering on the edge of bankruptcy, according to a prominent bankruptcy attorney.

More employed people puts more money into circulation, which normally would bump up the inflation rate. A key defense against rising inflation is raising interest rates, and if the Federal Reserve Bank does that, as it’s expected to this year, companies that have been able to keep their heads above water because of their access to low-cost capital may meet their doom.

Victor Sahn

Victor Sahn

“Unrealistic, unsustainable low interest rates have been the palliative for many sick companies,” says Victor Sahn, a partner with Sulmeyer Kupetz, a law firm specializing in bankruptcy. “However, we are fast approaching the unveiling of higher rates. As employment increases, it puts a lot more pressure on [Fed chair] Janet Yellen to raise rates. ”

Sahn’s view is hardly shared by everyone. Jamie Pierson, the CFO of trucking company YRC Worldwide and a former turnaround specialist with consulting firm Alvarez & Marsal, says the economic environment has exponentially greater power to drive bankruptcies than do interest rates. “A company’s interest rate as a percentage of overall expenses is only a couple of points,” Pierson notes. But, he adds, “If you’re banking on your cost of debt to keep you out of bankruptcy, you probably should already be in.”

On that point, Sahn agrees. Interest rates are so low, he says, that they allow companies that should be going through reorganization and recapitalization to avoid doing so, as there’s little reason not to stay overleveraged.

According to Sahn, who has been practicing bankruptcy law for 30 years, pushing up rates by as little as 50 basis points would throw many companies into bankruptcy. He identified two groups of companies as particularly at risk: those whose business models are predicated on their presence in malls, and real estate firms.

Wet Seal is among the largest of many mall-based companies that have filed for bankruptcy lately, also announcing plans to close two-thirds of its 500-plus stores.

“Small, boutique mall businesses, as opposed to the ‘big box’ stores, are seeing a significant decline in their business because people aren’t going to malls at the same rate as they used to because of the internet,” Sahn says. That problem will only deepen for brick-and-mortar shops: as much commercial traffic as the internet has picked up recently, there’s room for enormous growth, he notes.

For many such businesses, converting to an online-only business model makes sense in the current environment, but it’s a strategy that’s not available to some of them, Sahn adds. “Even if you have the capital to develop an effective online sales presence — and many of these companies don’t, because they’re not earning enough profits — you’re still left with all your leases.”

As for real estate companies, several have filed for bankruptcy this year, because a lot of the loans made five to eight years ago are coming due. And if interest rates go up, takeout financing to retire such debt becomes more expensive.

Assuming that rates are hiked in June, as some observers expect, “You’ll see some more real estate bankruptcy filings for big properties like office buildings and apartment complexes starting in the middle of this year, and then going on from there in greater and greater numbers,” says Sahn.

Not only banks, but also many of the hedge funds and private equity funds that have increased their lending activities in recent years, have lately been fairly tolerant of defaults by borrowers and haven’t pursued their available remedies, Sahn explains. “But you can’t kick the can down the road forever,” he says, “and I think that [leniency] is going to start coming to an end. What we’ve seen in the past five years certainly isn’t typical. Lenders usually aren’t that tolerant.”

What can financially distressed companies do to weather the coming higher interest rate environment? “I think they have to finally face their problems,” says Sahn, “whether it’s cutting costs or frankly selling to someone who can operate the business more efficiently and profitably. That will be the consequence of creditors getting more active.”