In the News The National Law Journal

Crisis Takes Big Toll on Bankruptcy Financing

The credit market crunch triggered by the upheavals on Wall Street could radically change the face of corporate bankruptcy, attorneys across the nation say.

Multimillion-dollar companies seeking bankruptcy protection can't secure funding, or are losing pledged money, to save their operations, raising the specter of sudden liquidations, thousands of job losses -- and long workdays for armies of lawyers.

"It is not just the consumer that is running low on cash, but major financial institutions are running short on cash and are having trouble borrowing to cover their loan commitments," said Peter J. Gurfein, a restructuring specialist in Akin Gump Strauss Hauer & Feld's Los Angeles office.

Companies coming out of bankruptcy will face challenges retaining top executives and middle managers to keep firms running during restructuring or mergers, predicted June Anne Burke, a global compensation plans attorney at Baker & McKenzie's New York office. She said her office has begun working on retention terms that will keep executives without running afoul of Congress' anger over corporate bonus pay.

The heart of the problem for companies trying to emerge from bankruptcy is lack of funding to pay for it, or withdrawal of previously committed funds, according to Gurfein.

Delphi Corp., the auto parts supplier, is the most famous case of a company that has struggled to get out of bankruptcy and, so far, has failed, according to Bill Lafferty, a senior director in the bankruptcy group at San Francisco-based Howard Rice Nemerovski Canady Falk & Rabkin.

The current tight credit market only intensifies the pressures on Delphi to get enough funding to exit bankruptcy.

In 2005, Delphi, then a $29 billion company with 185,000 employees worldwide, filed for Chapter 11 bankruptcy and, with the third anniversary of its filing coming this week, the company remains under the control of the bankruptcy court.

Last week, General Motors Corp. assumed $3.4 billion of Delphi's pension liabilities to keep the reorganization on track.

"Delphi started developing problems a year ago. Lenders were more nervous and credit was not available," Lafferty said.

An additional problem for companies that thought they had funding safely locked up is finding that cash-strapped banks have pulled out of funding deals or tried to withdraw.

Lawyers closely monitored just such a legal battle between chemical company Solutia Corp. and three banks that yanked $2 billion in funding for Solutia's exit from bankruptcy.

Ultimately, Solutia received the money and exited bankruptcy in February, but many lawyers see it as a harbinger of legal battles to come.

Jonathan Henes, lead lawyer for Solutia and a restructuring specialist in the New York office of Chicago-based Kirkland & Ellis, said the economics are significantly worse now than what Solutia faced. "Companies are really struggling to figure out how they will get into reorganizations to survive," he said.

As more companies face loss of exit funding, legal battles like Solutia's will intensify, particularly around contract language that allows banks an out for "material adverse changes" in the market, said Jack Williams, a professor at Georgia State University College of Law in Atlanta and resident scholar for the American Bankruptcy Institute. He predicted more litigation in bankruptcies over lost financing due to these changed-circumstance claims.


At last month's National Conference of Bankruptcy Judges in Scottsdale, Ariz., Gurfein said he repeatedly heard worried hallway conversations among lawyers that funding for bankruptcy exit plans had "dried up" or "that funding has failed" at the 11th hour.

Banks that made major commitments to finance millions of dollars for corporate exits from bankruptcy had their own liquidity issues or had been taken over by regulators, he said.

In the short term, it means the public may see sudden closures and liquidation of companies that could not get funding or pressure on creditors to put more money into the troubled business to keep it afloat long enough to get loans.

Down the road, if tight credit continues, it will intensify liquidation of companies or consolidation within industry groups. And that will mean in-house counsel are thrown out of jobs the same as the factory worker, predicted Victor G. Milione, head of the restructuring practice in the Boston office of Nixon Peabody.

A lack of funding to assist troubled businesses through a tough economy is widespread. "We're seeing it across all segments of the revenue stream for our clients as well as companies not our clients, from midcap to large-capital companies and those publicly traded," said Milione.

Nervous lenders and less liquidity intensified the credit crunch beginning 12 months ago, so that it is now more difficult to reorganize, unless companies have a buyer or merger partner in their hip pocket, Milione said.

Filing a Chapter 11 bankruptcy allows a company to put off existing debts while it attempts to raise capital and reorganize the business to stay afloat.

Failure to keep up payments in bankruptcy, or find money to exit as a viable business, may prompt what's called a Section 363 liquidation sale, or even a conversion to a Chapter 7 liquidation for the sale of assets.

"We're in a brave new illiquid world," said Peter Kaufman, managing director of the Gordian Group, a New York investment bank and head of its restructuring operation.

The cost of exit financing -- the money to pay to operate a company as it leaves bankruptcy and restructures -- is so high that it is a better play to sell the assets rather than reorganize, said Williams. "What you're seeing right now is nothing; nothing is moving. You're not seeing much exiting from bankruptcy at all," he said.

These massive corporate cases require battalions of lawyers.

Howard Rice's Lafferty described using 50 lawyers from his firm alone to manage the 2001 bankruptcy of California utility giant Pacific Gas & Electric Co. The company, worth $29 billion, was solvent but got caught in a cash flow squeeze due to electricity market manipulation and the ensuing California energy crisis.

The lawyers had to resolve 20,000 creditor claims for payment, and Lafferty oversaw the hiring of 82 law firms just to handle the continuing operations for Pacific Gas' regular business until it exited bankruptcy in 2004.

"It was extraordinarily complex," Lafferty said. "But today the whole thing is different. Today lenders are more nervous and credit is not available," he said.

To complicate the tricky financing situation further, the 2005 bankruptcy law reforms shortened the time for some reorganizations and for the approval of reorganization.

The credit pressures are likely to produce more bankruptcies that have been pre-negotiated and turned around quickly to avoid being caught without financing, Milione said.

"The effect on practices will be to look at quick turnarounds, prenegotiated deals and out-of-court restructuring," he said.

A faster process is generally cheaper. He pointed to cookie-maker Mrs. Fields Famous Brands LLC, which filed a pre-packaged reorganization plan in mid-August and is expected to emerge from bankruptcy this week, he said.

Lehman Brothers Holdings Inc. was also cited as a case in point. It went into bankruptcy and nearly overnight assets were sold off, something that might have taken 18 months or two years in the past, according to Williams.

The ramifications of failed reorganizations will reach well beyond bankruptcy practices.

Expect to see a slowdown in initial public stock offerings for companies and a decline in securities class actions because those go with boom times, according to Milione.

There will be an increase in white-collar defense demands as trillions of dollars in these collateralized debt obligations come due and the asset values to back them up don't exist. People will chase down officers and principals in hedge funds claiming fraud and misrepresentation, he said.

The U.S. Securities and Exchange Commission has disclosed a probe of Fannie Mae and Freddie Mac, the nation's two largest mortgage lenders, as part of a wider inquiry into the roots of the mortgage crisis. Two dozen hedge funds have been ordered to turn over trading records, according to a Wall Street Journal account. And the FBI has 26 companies under investigation.


He predicted that law firms dependent on servicing industries now facing financial trouble will get less work and have to downsize themselves. He pointed to Heller Ehrman, a 118-year-old West Coast firm with 650 lawyers that announced its dissolution in September after merger efforts failed.

And the turmoil is spilling into arenas of employment law.

Burke of Baker & McKenzie spelled out the executive-retention concerns. Corporate bankruptcies almost always include retention bonuses or pay packages to ensure that executives who know the company remain.

"We are looking at incentive programs with one eye on design and the other on the legislation," she said. "We are going to see restraints on executive pay resurface. We are beginning to talk to clients about incentive plans and what we will be allowed to do," Burke said.

And it is all moving very fast, with the potential for company liquidations, closures or mergers, she said. But no one knows how long agencies will take to provide regulations or guidance to flesh out the details of the bailout legislation.

"I foresee severance packages at [executive] levels, but subject to constraints. There will be a lot of employee dislocation lower down," she said.

"What may not be appreciated yet by companies with overseas operations: Layoffs can be very expensive outside the U.S.," Burke said. Other countries require severance pay based on years of service.

There are post-integration issues in merged companies, from corporate culture issues to hierarchy battles and marrying of different stock-options purchase plans, she said.

Not all the work relates to failed restructuring.

"One thing we're spending a lot of time on these days is acquisitions of distressed companies by strategic buyers," said Larry Engel, a bankruptcy and restructuring partner in the San Francisco office of Morrison & Foerster.

With the financial turmoil, private equity firms and hedge funds that had been buying distressed companies at a premium have stepped back, he said. Now strategic buyers have the stage again and can buy at attractive prices.

But Engel expressed concern that the down cycle is by far the worst he's seen in 30 years. "The bailout legislation will help stabilize some of the market, but it will not help lending get back to normal," he said.