Swamped bankruptcy courts threaten US recovery
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In early March, just as Covid-19 was spreading alarm in the west, the US sporting goods retailer Modell’s filed for bankruptcy. The company has long been blighted with excess debt and poor sales, and was overdue for a shakeout.
What happened next was odd — and symbolic. In the last two months, courts have repeatedly frozen Modell’s bankruptcy process, citing the pandemic. The company is now a zombie, neither dead nor alive. Its status could soon proliferate across corporate America, further confusing the economic outlook.
So far, bankruptcy filings have been strikingly low for a recession. In April, 560 companies filed for a Chapter 11 bankruptcy, which allows them to keep operating while slashing debt. That is less than in 2017. Include the Chapter 7 liquidation process, and there were 2,278 corporate filings in April, down 35 per cent from last year.
This is merely a lull before the storm. Thus far filings have almost certainly been staved off because of government aid, creditor forbearance and wishful thinking about a V-shaped economic rebound. But now the economic outlook is worsening and it is unclear how long the aid from the Coronavirus Aid, Relief, and Economic Security Act will last.
Rating agencies project that default rates among companies whose debt they consider risky will hit or exceed the 15 per cent level seen after the 2008 crisis. Law professors Benjamin Iverson and Mark Roe predict “the biggest surge in bankruptcies” that the US court system has ever seen.
What is even more alarming is that America’s legal and financial infrastructure seems ill-prepared. Historically, the US bankruptcy system has been considered among the most effective and efficient in the world, while its deep capital markets create an effective framework for out-of-court restructuring and rescue deals.
However, this system is currently beset by five problems. One is that the Chapter 11 process is too costly and cumbersome for most small companies, notwithstanding recent reforms. Another is that Chapter 11 bankruptcies can only proceed smoothly if debtors can obtain financing through the process; this has dried up, says David Skeel, another law professor.
Third, a vast chunk of risky corporate debt has been packaged into collateralised loan obligation structures, vastly complicating creditor negotiations. Fourth, extreme economic uncertainty around Covid-19 will complicate negotiations around asset valuations without court intervention; this was the key reason for the Modell’s freeze.
The fifth — and biggest — problem is a shortage of judges. Profs Iverson and Roe calculate that if bankruptcies surge to 2008 levels, “a US bankruptcy judge would have to work close to 50 hours per week to keep up with the increased caseload”. However they fear that bankruptcy rates could actually be double the 2008 level. “No one can expect bankruptcy judges to work 100 hours per week,” they lament. Not even, presumably, with Zoom.
In theory, this can be fixed. In March high profile bankruptcy lawyers asked Congress to help create “breathing space” via debt forbearance. That has happened, albeit in a piecemeal fashion.
The Cares Act has also bought time. The White House likes to say it is a “rescue” programme that prevents collapses. In truth it is better viewed as a tool to “flatten the curve” of bankruptcies, says Jeremy Stein, a finance professor. Cares recipients will still go bust — but at a staggered rate.
The onus is now on Donald Trump’s administration to use this “breathing space” wisely. It could take steps to improve the bankruptcy system. Profs Iverson and Roe think Congress should immediately double the 350-strong ranks of bankruptcy judges. Prof Skeel wants the Treasury to offer debtors financing, and to create a “pre-packaged” filing process that would speed it up.
But the White House seems to be sitting on its hands, even as Mr Trump insists to his supporters that the economy will rebound swiftly, allowing most companies to recover.
That is a big mistake. Whether or not Mr Trump wants to admit it, a wave of bankruptcies is coming. The US economy will rebound much faster if it has an effective system to handle this, in line with its capitalist ideals. The alternative is a plague of zombies, sitting in legal limbo, that saps economic growth, erodes enterprise values and creates more investor uncertainty.
Put another way, investors need to worry not just about which companies go bust, but how. Remember that the next time a company follows Neiman Marcus or J Crew into bankruptcy, and pray the White House acts.
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