Spencer Fane Provides Valuable Insights on Rising Bankruptcy Activity

Chapter 11 filings have been on the rise to the tune of a 106% increase year-over-year in October. Eric Johnson, Elizabeth Lally and Jason Medley of Spencer Fane, taps into state-by-state analysis on this subject, giving insight on steps for a factor to take if a client files for bankruptcy and more.

Chapter 11 bankruptcy filings increased 106% year over year in October, continuing a trend of increasing activity. Can you put such a rise in perspective? Is it common for there to be such a rise later in the year or is this a sign of something larger?

Eric Johnson: A larger rise in Chapter 11 bankruptcy filings during a particular time of year can be attributable to numerous factors.

For example, one extremely large business might file for bankruptcy protection along with upwards of 50 related entities or subsidiaries also filing for bankruptcy at the same time. In that case, there will be more than 50 bankruptcies being registered as filed in one day, one month, etc. If you have a few of those mega cases in one quarter, the year-to-year quarterly percentage of filings might be somewhat artificially increased.

There is also, generally, an expected seasonality to certain filings. Retailers, for example, would usually try to get through the holiday season prior to filing for bankruptcy, if they can, and file in the first or second quarters of the new year. Other businesses have similar seasonal cycles that might affect when or if to file for bankruptcy. But a rise at the end of the year is not, per se, unusual.

As to the year-to-year increase in Chapter 11 filings, we are seeing numerous factors as having resulted in this, but there are a few that stand out as more “universal” in 2023.

First, many businesses are just, finally, dealing with the long-term financial impact of COVID-19. This spans all industries, from real estate, retail, hospitality, entertainment and healthcare. As part of these long-term impacts, debt may have been restructured during COVID-19, and if those debts are becoming due, business owners may be finding their prior lender is unwilling to renegotiate and want the debt paid. These same owners are then going into the marketplace and finding that they can’t find a new loan or pay off the old one because credit standards have tightened, lenders are lending less, and, even if they can get a loan to “take out” the prior lender, interest rates are very high compared to recent years.

In terms of commercial real estate, perhaps the collateral is not worth what it was prior to COVID-19 due to lost tenants or tenants taking much less space on new leases, and the occupancy rate is not as high as it needs to be. The same factors affect hospitality where occupancy rates at hotels and conference centers are facing the issues of few business travelers and lower occupancy due to more people conducting business meetings remotely. 

In addition to rising interest rates, many businesses are being impacted by inflation and rising costs, such as higher wages. Finally, while certain COVID-19 relief repayments may have been forgiven, COVID-19 Economic Injury Disaster Loan (EIDL) loans are proving exceptionally challenging for smaller business owners to repay.

Spencer Fane conducted a state-by-state analysis on this subject. What were some of the most pertinent findings you uncovered?

Johnson: The recently created Subchapter V bankruptcies designed for small businesses continue to gain traction. These are small businesses where the total non-contingent debt is less than $7.5 million. Through the end of October, the Subchapter V cases are up 41.3% over the same period of time in 2022.

The Southern District of Texas continues to be the leading jurisdiction for traditional commercial Chapter 11 filings. Through end of October 2023, almost 25% of commercial Chapter 11 cases were filed in the Southern District of Texas. While some of this percentage can be attributed to multiple filings connected with the same enterprise, many of the largest bankruptcy cases in the country are filing in the Southern District of Texas, followed by Delaware, the Eastern District of New York and New Jersey. Indeed, 54.6% of the traditional commercial Chapter 11 cases have been filed in these four jurisdictions.  However, Subchapter V filings are much more diffused across the nation, with the heaviest concentration in the Central District of California (6.5%) and the Middle District of Florida (6.4%). Given the many open issues that remain with Subchapter V, this will potentially lead to more diverse and differing viewpoints as to how these open issues will ultimately be resolved.

While nationwide Chapter 11 bankruptcy filings were up, approximately 11 states saw a decrease in traditional commercial Chapter 11 filings. However, with respect to consumer-based filings (Chapter 7 and 13), all but one state saw an increase over the past year.

Why can factoring often be a lifeline for companies that file bankruptcy?

Jason Medley: Many traditional banks have tightened their underwriting requirements for ABL deals or have declined to make loan policy exceptions, so commercial factors are stepping in and filling that void.  Most factors will simply underwrite the account debtor more so than the debtor-in-possession borrower. I have seen an increase in factors (as opposed to traditional lenders) as the DIP financier this past year for that very reason. 

Alternatively, since so many companies have been filing, it’s possible some factoring clients will file (or may have already). What are the most critical steps for a factor to take if a client files for bankruptcy?

Johnson and Elizabeth Lally: The most critical step if a client files for bankruptcy is not to delay in engaging your outside counsel to get involved in the bankruptcy case. Traditional Chapter 11 cases can move very quickly, with some of the largest Chapter 11 cases moving the fastest, especially in certain districts (Texas or Delaware, for example). You need to have someone who understands the process and the types of filings to expect that would affect you (cash collateral, debtor-in-possession financing). However, Chapter 11, Subchapter V cases are where we are seeing the largest impact on clients. Subchapter V is designed to move very, very quickly and to be a process of negotiation to try to come to an agreed plan, and there is a Subchapter V trustee assigned in every case to try to get the parties to an agreement.  There are also very tight deadlines and other factors that come into play in a traditional Chapter 11 that are not at play in Subchapter V cases. Therefore, the best advice is to engage your outside bankruptcy counsel as soon as possible to advise you as to the case.

Medley: If you are pursuing account debtors, although the factored invoices are not part of the bankruptcy estate (because you own in them, not your bankrupt customer), you should still seek clearance from the bankruptcy court that you are not violating the automatic stay in pursuing collection. 

And if your guarantor has not filed bankruptcy, sue them. 

Lastly, if an account debtor has filed bankruptcy, you are an unsecured creditor (typically), but you should still file a proof of claim in a timely manner, if applicable. However, before doing so, you should consult with your counsel to confirm that you have no potential claw-back exposure. In many instances, filing a proof of claim without taking certain precautions can have certain jurisdictional implications, including your right to have a jury or have a court other than the bankruptcy court hear the matter.

Your outside counsel can help you evaluate the above, including whether or not to object to a discharge.

How does a factoring facility fit into the financing stack for a company that has filed for bankruptcy protection?

Medley: Most of our clients are secured and have properly perfected UCC-1 financing statements on file. As such, in order of priority, they fall somewhere within the line of secured creditors. However, because of the nature of bankruptcy, any secured creditor might also be only partially secured and partially under or unsecured. Each case has its own set of facts in this regard.

Many third parties will not understand that you own the factored invoices and have a lien on the non-factored invoices (and other assets), so you may have to educate such parties. You will also want to evaluate if there are any MCAs stacked behind you. Also, with respect to factored invoices that you own, you will want to re-run your lien search to make certain you were and are in first position.

How does filing bankruptcy in different states impact the process and how can factors best navigate any potential challenges?

Johnson and Lally: One of the most important things to consider/know in any case, especially in bankruptcy cases, is “what court you are in.”

Filing for Chapter 11 in different states or a different district within a state, such as Texas, can have a significant impact on the process. For example, certain districts and courts are set up to handle more complex Chapter 11 filings with special judges assigned to large cases and with special rules that apply to larger cases under the local rules. The best way to navigate such a challenge is to have counsel who is aware of the local rules and procedures to advise you as to the same. 

Although there has been a stay in the implementation of Section 1071 temporarily, how do disclosure laws and other regulations impact how factors do business with companies in bankruptcy?

Medley: Failure to adhere to disclosure requirements can open the factor up to new defenses against payment, or an attack by the factoring customer/debtor.

Do you expect bankruptcy activity to continue to increase through the rest of the year and 2024? Why or why not?

Johnson: There will be some increase in bankruptcy filings in 2024 over 2023. How large this increase will be mostly depends on what happens with interest rates. Since last year, the benchmark interest rate set by the Federal Reserve increased at the fastest pace in more than two decades. And while inflation has cooled from 2022, it is still higher than the target 2% set by the Federal Reserve. Therefore, while interest rates were again recently increased, it is likely that at least some minor increases are still to come. This will continue to make it difficult, if not impossible, for borrowers to refinance debt at a lower rate than they currently have to get their credit extended, or to get new or “take out” loans from other lenders. Meanwhile, inflation is still an issue, and many businesses are generally facing higher COGS, some of which, but not all, can be passed on to buyers, which results in fewer profits to pay expenses, such as loan repayments. This is in addition to certain industries, like hospitality, that have not been able to recover from long-term COVID-19 effects.