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Why This Economic Downturn is Different From Others in Terms of Bankruptcy Filings

While most experienced bankruptcy practitioners have dealt with the effects of an economic downturn before, what we are seeing this time around looks different--and more disconcerting than usual. The financial condition of major companies that end up in chapter 11 seems to be deteriorating at a faster pace before they arrive at the doors of the bankruptcy court; and, at least in the case of large retailers, liquidations too often seem to follow shortly after the chapter 11 filing. These differences, in turn, help to underscore the severity of the current economic downturn.

The rapidity with which the financial condition of some major corporations has declined in the months proceeding the chapter 11 filing is striking. The journey from being a robust business to being a chapter 11 debtor seems to have gotten much shorter. Two recently-filed chapter 11 cases, each involving billions of dollars in debt-Lyondell Chemical and Aleris International -illustrate this point.

Lyondell Chemical ("Lyondell") and its affiliates (collectively "Lyondell/Bissell") collectively comprise one of the world's largest producers of chemicals and polymers. Lyondell and its U.S. affiliates filed for relief under chapter 11 of the Bankruptcy Code on January 6, 2009. Reading between the lines, it appears that as little as three months earlier, Lyondell did not expect to find itself in bankruptcy court-at least not this quickly. According to the "first day affidavit" filed in connection with the Lyondell chapter 11 filing:

As recently as the third quarter of 2008, LyondellBissell had a robust business. For the nine months ended September 30, 2008 its revenues were $42.5 billion and adjusted EBITDA-FIFO was $3.0 billion.

As the result of a "tightening" in liquidity which first became "noticeable" in November, however Lyondell ended up in bankruptcy court in January.

In particular, the debtor suffered a noticeable tightening in liquidity beginning in November 2008, which became clearly evident by December. The immediate cause of the lack of liquidity was a marked reduction in the price of oil as well as sale and production, which sharply reduced the borrowing base and, therefore, the amounts available under the debtor's Working Capital Facilities.

By any standard, this was a rapid and, apparently, unexpected fall.

The Aleris case indicates that this relatively rapid fall was not an isolated occurrence in the current economic environment. Aleris International ("Aleris") and its affiliates collectively comprise a major producer and seller of aluminum products. Reported assets and liabilities are each approximately $4 billion. Aleris and its U.S. affiliates filed their chapter 11 petitions on February 12, 2009. In explaining the reasons for the chapter 11 filing, the debtors noted that in the past six months, the borrowing base under their secured, asset-based revolving credit facility of up to $809 million (subject to borrowing based limitations) had declined by over fifty percent. This is an unusually rapid decline in liquidity and borrowing base. Such rapid declines in liquidity as occurred in Lyondell and Aleris are unusual in cases not involving accounting irregularities (and I am unaware of any allegations or evidence of such in either case), and evidence a particularly sharp economic downturn, along with an element of unpredictability.

A second difference from chapter 11 experience in prior economic downturns-and one that also highlights the severity of the current economic downturn--is the pace at which major retailers are filing chapter 11 cases, and then liquidating. Chapter 11 filings by retailers typically accompany economic downturns and sharp drops in consumer spending, and this downturn is no exception. But the volume and scope of the recent spate of retail chapter 11 filings, and the number of locations and employers affected, is still startling. I asked someone in my office to assemble a list of larger retail chapter 11 filings over the last twelve months (20 or more locations and at least 200 employees), and the result was a list of 26 retail chains which, in the aggregate, had over 5,000 locations and over 150,000 employees when they filed their respective chapter 11 cases. Three restaurant chains added about 970 locations and another 50,000 employees to that list.

More alarming, however, is the fact that, in the case of many large retailers that are "household names" (or close to it), the chapter 11 filing was followed in short order by a liquidation, as opposed to a reorganization or a sale of the business as a going concern. The magnitude of the retailer liquidations stands out.

The model for a retailer chapter 11 case is that, at the end of the day, operating improvements are implemented, poorly-performing stores are closed (and the related leases rejected), the pre-chapter 11 debt is restructured, and the retailer reorganizes around a smaller core of "better" locations, either by way of an internal reorganization, a capital infusion, or the sale of the business as a going concern to a third party. In the recent wave of chapter 11 filings by large retailers, however, this relatively happy ending is not what happened to Mervyn's (over 170 locations and approximately 13,000 employees), Linen's 'n Things (over 550 locations and approximately 17,500 employees), Circuit City (over 700 locations and over 35,000 employees) or KB Toys (over 450 locations and approximately 10,500 employees), to name a few. Within a few months after each of those chapter 11 filings, a liquidation was announced-in the case of Mervyn's, within 1 month after the chapter 11 filing; in the case of Linen's 'n Things, within 3 weeks after the chapter 11 filing; in the case of Circuit City, within 2 months after the chapter 11 filing; and in the case of KB Toys, within 1 week after the chapter 11 filing. In short, the economic landscape has became littered with the liquidation of larger retailers.

These features of the current wave of large chapter 11 filings, while admittedly anecdotal, certainly corroborate the unusual severity of the current economic downturn.

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