The Examiners: When Assigning Blame, Debtors Shouldn’t Look Far

When a company files for Chapter 11 protection a second, third or even fourth time, who’s to blame?

Although the U.S. bankruptcy system is designed ideally to “fix” struggling companies, Chapter 11 is not a panacea, nor does the process ensure prolonged health when the companies emerge. A growing number of companies have filed multiple times and commenced Chapter 22s (or even Chapter 33s or 44s). While there are numerous explanations that could shed light on why some organizations repeatedly seek bankruptcy protection, companies should consider how much of the blame lies with themselves.

Chapter 22s occur across industries, suggesting that a repeat bankruptcy is not an affliction to which only a specific type of company succumbs. The second time around, one can attempt to assign blame to secured creditors (who likely engineered the most favorable deal for themselves in round one), to judges (who are often required to assess a company’s plan for future viability with imperfect information), or to the system in general, which pits self-interested constituents against each other in an arena governed by the illusory goal of making everyone as close to whole as possible. But regardless of what external circumstances are cited as factors driving a second filing, an ailing company must assume at least partial responsibility for its own financial and often operational shortcomings.

Recidivist debtors tend to cite external or unique circumstances—often espousing the same precipitating factors each time they file—in order to explain how they ended up in Chapter 11 (again). These reasons have included recently the economic downturn (popular among many companies that filed around 2009), Hurricane Sandy (for multiple Atlantic City, N.J., casinos) and high labor-related legacy costs. While such factors undoubtedly worsen a company’s financial distress, when a company is forced to go through Chapter 11 multiple times despite its industry counterparts staying afloat, external pressures are an insufficient explanation.

Through data collected from 1984 to 2013, New York University Professor Edward Altman found two factors are most indicative of a debtor filing again: its profitability upon its first emergence and its leverage. The data reveals that for recidivist debtors, their financial profiles upon exiting their first bankruptcy tended to resemble that of other firms as they entered bankruptcy—namely too much debt and too much leverage. This data supports what restructuring professionals have experienced anecdotally. Sometimes a plan is premised on the best available recapitalization structure, which is not necessarily the right structure.

One could suggest that there should be a higher threshold for confirming the feasibility of a bankruptcy plan or that lenders (and particularly secondary lenders) wield too much power, pressuring debtors to implement plans that do not fully address the company’s financial difficulties. A debtor simply may not be able to obtain exit financing other than from existing lenders or an opportunistic plan sponsor with a high risk appetite and no competition. And equity and debt may quickly change hands upon emergence from bankruptcy, leaving the company at the mercy of credit terms negotiated by lenders that have already moved on.

However, placing blame on the system itself does not vitiate the fact that it is the responsibility of any company going through Chapter 11 to formulate a plan the first time —and hopefully only time—that will eradicate debt, right the balance sheet and position the company for long-term health.

Shaunna D. Jones is a partner at Willkie Farr & Gallagher’s business reorganization and restructuring practice. She is based in New York.