Rising food, commodity and fuel costs as 2008 wears on has not only led to more bankruptcy filings, but more Chapter 11 and Chapter 7 petitions induced by a corporate inability to make debt payments.
And it could get even worse.
Moody's Investors Service, for example, predicts that the default rate on corporate debt, which currently rests at 2.5%, could nearly triple, to 7.1%, by 2009.
Less known is what could happen with companies with "covenant-lite" loans: loans that banks and other financial institutions provided that were devoid of many crisis triggers, such as cash flow and other measures, which, when tripped, would put a borrower in default.
Those tripwires afford distressed companies, and their creditors, an early warning sign for getting help and possibly avoiding bankruptcy. Without them, however, a company's condition can deteriorate so fast and so profoundly that no one will know -- until the company makes a bankruptcy filing.
"Sophisticated parties will always attempt to work out the distress prior to a Chapter 11 filing," says Michael Sirota of Cole, Schotz, Meisel, Forman & Leonard PA, which had 41 active cases in The Deal's bankruptcy league tables for the second quarter ended June 30 and witnessed a 100% increase over its first-quarter load. "Some of these filers had covenant-lite loan deals, with no early triggers set off on their distress."
Expect even more of these silent explosions, says John Jerome of Saul Ewing LLP, which actually saw its active case count drop 38 cases, or 26.7%, to 104 in the second quarter.
Jerome doesn't think more covenant-lite blowups will necessarily add to what's becoming a burgeoning bankruptcy cycle. "Because the covenants are lite, some companies may not face some of the same problems that we've seen," he says.
The flip side of this is that lenders often aren't brought in when a situation is salvageable. "If you're not in default but have a liquidity problem, your lender comes in and you try to straighten it out," he says. "In covenant-lite agreements, these kind of dialogues don't happen as much, and companies do not face up to the hard reality."
That reality, by the way, is only getter harsher. A bankruptcy up cycle first rooted in the housing slump and credit crisis has gained momentum because of softer consumer spending and the aforementioned surge in raw material and operating costs. Homebuilders and real estate companies continue filing for bankruptcies, but petitions are proliferating across more and more industries, from restaurant chains to trucking companies, from retailers to energy providers. According to BankruptcyInsider.com, 1,722 corporate bankruptcy filings were made (including several non-U.S. ones) in the first six months of 2008, a 21% increase over the 1,424 for the same period last year.
"The storm is here," says Sirota.
William Lenhart, national director of business restructuring services for BDO Consulting Corporate Advisors LLC, a BDO Consulting subdivision affiliated with BDO Seidman LLP (429 active cases, earning it second place among noninvestment banks), says his unit was formed with the idea that companies may opt to come to the bargaining table with their lenders and avert bankruptcy. "Many companies may want to ride out the current economic environment to try and renegotiate terms with their lenders," he says.
Hedge funds and private equity firms are already taking that route, says Jerome and his Saul Ewing colleague Mark Minuti (71 active assignments).
A number of PE-backed companies have already gone bankrupt this year, but there likely would have been many more had financial buyers not huddled with their lenders. Hedge funds and PE firms are "able to work things out more efficiently with banks," Jerome says. Adds Minuti: "[Hedge funds and PE firms] can get a little more creative outside of bankruptcy."
Attempts by lenders to shop a company's assets before a filing are often unsuccessful, since most buyers typically hesitate to purchase financially unsound companies. Yet if a company does file, those lenders often have to settle for a debt-for-equity swap to get some type of recovery. Or they can use what they're owed -- known as a credit bid -- to purchase the assets themselves.
"There are many cases where the lenders are forced to credit bid their debt in order to effectively buy the assets back and manage the business for their own benefit," Sirota says.
Cole Schotz, based in Hackensack, N.J., added about 12 lawyers in its Baltimore and Delaware offices to its 25-member insolvency team during the second quarter. The effort has paid off. "The increase [in bankruptcy cases] has finally translated into substantially more business for us," Sirota says.
Ditto for San Antonio law firm Cox Smith Matthews Inc., (19 active cases), which had the highest rise (216%) in its caseload from the first quarter to the second among all the firms in the league tables. It was tapped to be debtor counsel for healthcare facility Lubbock, Texas-Highland Medical Center LP, oil and gas producer Northstar Energy Inc. and oil and gas exploration company Dorado Beckville Partners LP.
Two of the firm's attorneys, Carol E. Jendrzey (7 active assignments, up from 2) and Mark E. Andrews (8 active assignments, up from 3), also saw their workloads increase significantly.
"We decided about three years ago that we would make bankruptcy a major focus of our practice," says Cox Smith attorney Deborah D. Williamson. "When there wasn't as much competition for personnel, we were staffing up. Now that we are staffed up to the level of business that we want, the support that we need will come from within the firm."
Within the U.S., BDO's Lenhart predicted that both automotive suppliers and retailers could lead the next wave of bankruptcies. Already in the third quarter, Boscov's Inc., Steve & Barry's LLC and Mervyn's Holdings LLC -- all department store chains -- have filed for Chapter 11 protection.
To be sure, this is already becoming a bumper year for retailer bankruptcies, meaning a boon for landlord attorneys. Look at Ballard Spahr Andrews & Ingersoll LLP's David L. Pollack (312 active assignments, an 81-assignment gain); Katten Muchin Rosenman LLP's Thomas J. Leanse (477 active assignments, first among lawyers, and a 47-assignment gain) and Brian D. Huben (308 active assignments, gain of 20); and Kelley Drye & Warren LLP's James S. Carr (166 active assignments, gain of 26). These landlord lawyers have thrived because many of the retailers in the soup occupy malls, and those mall owners need representation in every case.
Stuck in the middle in nearly every industry are suppliers whose costs have risen but who can't pass them on to their customers. Auto parts suppliers still are the most obvious examples. They were having trouble even during the bankruptcy lull, but higher fuel prices and mellow consumer spending are extending their misery.
Consider Intermet Corp., which filed for bankruptcy in 2004 because it couldn't pass on the higher costs of the scrap metal it needed to make parts to its automaking customers. Intermet is back in bankruptcy again, filing on Aug. 12, this time because 60% of its business is geared toward the withering truck and sports-utility vehicle market.
Small wonder that Gregory Barrow (12 active assignments, tied for first among investment bankers with Navigant Capital Advisors LLC's Edward Casas), founder and managing director of General Capital Partners LLC, says his firm has begun to shift staff toward advising manufacturing and operating companies.
GCP actually saw its case count drop by four, with Barrow attributing the decline to the firm's turnover of several cases in the first quarter. "We're being very selective with the real estate cases we take in," he says. "We want to make sure that the ability to reorganize is there."