Corporate Insolvency & Restructuring Report 2020: Covid-19 Special Focus: United States
Robert Trust, Christopher Hunker and Maximilian Ferullo, Linklaters
Like many jurisdictions, the US has seen a surge in bankruptcy filings amid the Covid-19 pandemic. Retailers – already burdened by unfavourable lease obligations and a general shift in consumer preference to e-commerce – have borne the brunt of the crisis. In the first two quarters of 2020, nearly 20 major retailers sought Chapter 11 protection in the US, including high-profile brands such as JC Penney, Neiman Marcus, J Crew, Pier 1 Imports, John Varvatos, True Religion, Modell's Sporting Goods and GNC.
The energy sector has also seen a dramatic increase in Chapter 11 filings. During the first half of 2020, 40 energy companies filed for Chapter 11 – the most since 2016. While these two sectors made up the largest share of filings in the first half of the year, Chapter 11 filings were up for nearly every industry, which highlights the unprecedented impact of the Covid-19 pandemic.
Companies in trouble, including those adversely impacted by the pandemic, will find that the US environment for corporate restructuring cases is very accommodating. The US enjoys the advantage of an experienced judiciary comprised primarily of former restructuring lawyers. The US also has a well-established statute – the US Bankruptcy Code – and a sophisticated advisory community that is accustomed to using the US Bankruptcy Code's tools to resolve complex domestic and cross- border corporate restructuring cases.
Even still, significant emergency relief measures have been proposed or implemented in response to the current economic crisis. With passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020, Congress sought to offer relief to troubled companies dealing with the impact of Covid-19. The CARES Act made important revisions to the US Bankruptcy Code for small businesses. By temporarily increasing the debt threshold for businesses eligible to participate in the streamlined Chapter 11 procedures established under the Small Business Reorganization Act of 2019 (SBRA), Congress sought to enable small businesses to reorganize in a more efficient and cost-effective manner.
US bankruptcy courts, operating as courts of equity, have also taken the practical impact of the crisis into account. In several recently filed retail cases, including Pier 1 Imports¸ Modell's, and J. Crew, bankruptcy courts took the highly unusual step – over the objections of their landlords – of allowing the debtors to defer payment of post-petition rent during the period when operations at its stores were limited by state mandated "stay-at-home" orders.
The US Bankruptcy Code provides two primary types of insolvency cases for financially distressed corporate debtors: Chapter 7 and Chapter 11. A debtor does not need to be insolvent to commence a Chapter 7 or Chapter 11 case. Chapter 11 is a reorganisation regime used frequently by corporate debtors because it provides an opportunity to reorganise as a going concern. Typically, in a Chapter 11 case, the debtor's management and board of directors remain in place, and the debtor attempts to confirm a Chapter 11 plan of reorganisation.
Chapter 7 bankruptcies are liquidation proceedings in which a court-appointed trustee shuts down the business, liquidates the assets, and then distributes the proceeds to creditors. It is less common for a large company to file a Chapter 7 case because the company will likely not remain as a going concern.
In general, directors and officers owe fiduciary duties of loyalty, care and good faith to the company and shareholders for which they serve. As a company begins to experience financial distress, it is important that the board of directors hire legal and financial advisors to assist them in discharging their duties. Although those duties do not shift to a particular group of stakeholders when a company is in financial distress, the board's actions will often be scrutinised by creditors particularly if the company subsequently files for bankruptcy protection.
The duties owed by directors and officers have not changed as a result of the pandemic. However, a company's officers and directors would be prudent to consider how the unique challenges presented by the crisis affects their existing duties. Companies that have been performing well previously but are now experiencing financial distress primarily because of the pandemic would benefit from legal counsel and financial advice about their fiduciary duties and how best to discharge them in these uncertain times.
The filing of a bankruptcy petition has an immediate impact on the rights of creditors and affords debtors certain protections during the pendency of the case. Upon becoming a debtor under Chapter 7 or Chapter 11, the debtor enjoys the statutory protections of an automatic stay. The automatic stay is a pervasive worldwide injunction that protects a debtor and its assets wherever located from litigation, lien enforcement, declaration of acceleration and other actions (judicial or otherwise) that attempt to enforce or collect a prepetition claim or otherwise affect the debtor's property.
The automatic stay remains in effect while a bankruptcy case is pending unless one of the narrow exceptions applies or the court terminates or modifies the stay upon a party's request. The US Bankruptcy Code contains an exception for certain protected financial contracts. A provision in a contract that provides for its termination upon insolvency or bankruptcy is generally unenforceable.
Priority, dissenters and asset sales
The US Bankruptcy Code contains a detailed priority scheme. Certain prepetition claims are designated as priority claims, including employee wages earned within 180 days of the bankruptcy case (subject to a statutory cap), contributions to an employee benefit plan and taxes owed to governmental authorities. Priority claims are senior in right of payment to general unsecured claims. A Chapter 11 plan cannot be confirmed unless it provides for the payment of priority claims in full in cash.
The US Bankruptcy Code provides inducements to lenders to provide post-petition financing to a financially distressed company. The debtor can grant a priming lien on its assets that ranks senior to certain pre-bankruptcy liens and a superpriority administrative claim that ranks senior in right of payment to all other administrative and priority claims. A debtor's ability to obtain debtor-in-possession (DIP) financing is a major advantage of the US Bankruptcy Code because it usually facilitates a debtor's reorganisation.
The US Bankruptcy Code permits a debtor to bind dissenting creditors and shareholders to a confirmed Chapter 11 plan and cram down a class of creditors or shareholders that does not vote to accept a Chapter 11 plan.
There is tremendous uncertainty going into the next 12 months. The ultimate toll the virus will take on US businesses remains unclear
A dissenting creditor or shareholder will be bound by a confirmed Chapter 11 plan if the class in which the dissenting creditor or shareholder sits votes to accept the plan. Often times, shareholders' existing interests are extinguished under a Chapter 11 plan and the class of existing equity holders is conclusively presumed to reject the Chapter 11 plan without an opportunity to vote. Whether or not a class of shareholders has an opportunity to vote on a Chapter 11 plan depends largely on whether there are sufficient assets to pay creditors in full.
A Chapter 11 plan of reorganisation can be crammed down on a class of creditors or shareholders that does not vote to accept a plan, if a debtor can show, among other things, that: (i) at least one impaired class of creditors has voted to accept the plan; (ii) the plan does not discriminate unfairly against the dissenting class; and (iii) the plan is fair and equitable with respect to each impaired dissenting class (meaning that the proposed Chapter 11 plan complies with the absolute priority rule).
The US Bankruptcy Code provides a debtor with the authority to sell its assets outside the ordinary course of business. Any asset sale outside the ordinary course of business must be approved by the US Bankruptcy Court after notice and a hearing. A debtor's decision to sell assets outside the ordinary course of business is reviewed by the US Bankruptcy Court under the deferential business judgment standard. The US Bankruptcy Code induces potential buyers to acquire an asset from a debtor by permitting the assets to be sold free and clear of liens, claims and interests if certain statutory requirements are met. If a debtor decides to sell its assets, it often seeks a stalking horse purchaser whose bid will usually be subject to an auction process.
Various other key stakeholders, such as the Pension Benefit Guaranty Corporation (PBGC) and other governmental or regulatory agencies (including state and federal taxing authorities), could all have an impact on the outcome of a restructuring depending on the circumstances of each case. For example, a debtor's failure to satisfy minimum funding requirements or attempts to terminate pension plans may result in significant claims by a plan trustee or the PBGC, a governmental agency that regulates pension plans and guarantees certain pension benefits.
Certain sectors and industries have their own or modified insolvency regimes. Different insolvency regimes exist under federal and state law to resolve national and state-chartered banks and other financial institutions, such as insurance companies, securities brokers and commodities broker. Insolvency regimes applicable to financial institutions generally require that a governmental regulator or trustee assume management of the business to wind down the business and satisfy claims in accordance with statutory priorities. In addition, the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in the aftermath of the financial crisis introduced another insolvency regime, known as the Orderly Liquidation Authority, which is applicable to financial institutions identified as systemically important.
Challenging a debtor's transactions
The US Bankruptcy Code permits a debtor to challenge certain pre-bankruptcy transactions after it commences a case. The US Bankruptcy Code provides a two-year look-back period from the petition date to challenge any transactions in which the debtor transferred assets (i) with an intent to hinder, delay, or defraud creditors (known as actual fraudulent transfer) or (ii) for less than reasonably equivalent value at a time when it was insolvent (known as constructive fraudulent transfer).
The US Bankruptcy Code provides a 90-day look-back period to challenge any alleged preferential transfers made by a debtor. The look-back period is one year if such transfers are made to a debtor's insider. A preference occurs when a debtor makes a transfer on account of antecedent debt at a time when it is insolvent that permits the creditor to recover more than it would have recovered in a hypothetical Chapter 7 case.
Non-US companies can commence a bankruptcy case because the threshold for establishing debtor eligibility under the US Bankruptcy Code is low. A foreign company is eligible to be a debtor under the US Bankruptcy Code if it has a place of business or property in the US. US Bankruptcy Courts have interpreted the property requirement broadly, holding that maintaining a bank account in the US or establishing a retainer with US counsel is sufficient.
Chapter 15 of the US Bankruptcy Code incorporates the Model Law on Cross-Border Insolvency to facilitate cooperation between US and foreign courts in cross-border insolvency cases. Recognition will be granted if certain statutory conditions are met and affording comity would not be manifestly contrary to US public policy. If the statutory requirements for recognition are satisfied, a foreign debtor can obtain the protection of the automatic stay in respect of its property located within the territorial jurisdiction of the US. US Bankruptcy Courts also have discretion to provide additional assistance, including recognising and enforcing approved schemes of arrangement or sauvegarde plans and related third party releases.
Covid-19 and beyond
Passage of the CARES Act as well as certain actions taken by the Federal Reserve have likely tempered the full impact of the Covid-19 pandemic on companies of all sizes and across all industries. The Paycheck Protection Program (PPP), a $669 billion business loan program established under the CARES Act, allowed certain businesses to apply for low-interest loans to retain workers and continue to operate. Unemployment benefits offered to qualifying individuals have likely bolstered sluggish consumer demand.
Much of the relief provided in the CARES Act has either expired or is set to expire in the coming months. It is unclear whether and to what extent these governmental initiatives will be extended to further mitigate the impact of the Covid-19 pandemic. To date, Congress has been unable to agree on a further stimulus package to extend the protections afforded to businesses under the act, including the PPP loan program, or the unemployment benefits offered to qualifying individuals under the Act.
As such, heading into a presidential election year, there is tremendous uncertainty going into the next 12 months. The ultimate toll the virus will take on US businesses remains unknown.
Many have compared the current downturn to the economic crisis of 2008 due to the massive unemployment, government stimulus and historically low interest rates. While lessons learned from 2008 will be instructive, there is significantly more liquidity available to businesses today. The Federal Reserve has implemented an aggressive direct lending program, and banks are well-capitalized and ready to expand lending. Many businesses will have access to cash while dealing with the impacts of the pandemic.
Under any scenario, we believe it is likely that US bankruptcy filings will continue to occur at a significant level over the next 6 to 12 months. Retail and energy sectors are likely to continue to face challenges and – absent further government intervention – filings are likely to increase dramatically in industries such as transportation, hospitality, and healthcare. Questions also remain as to the ultimate impact the pandemic will have on municipal governments. Rising deficits at the state and local government level will be something to watch as the federal government has so far balked at any form of relief for state and local governments whose revenues have been hard hit by the effects of the virus.
New York, US
T: +1 212 903 9217
Robert Trust regularly advises clients in connection with Chapter 11 restructurings, out-of-court workouts, acquisitions of troubled companies and the structuring of corporate and credit transactions.
New York, US
T: +1 212 903 9267
Christopher Hunker has significant experience advising key constituents in corporate reorganizations, restructurings and liquidations.
New York, US
T: +1 212 903 9356
Maximilian A Ferullo is involved in all facets of corporate reorganisations and out-of-court restructurings.