One year after Congressional legislation made it more difficult for consumers to discharge their debts through bankruptcy, the impact has spread to the business sector, with fewer Los Angeles County companies filing for bankruptcy.
Thanks to little-publicized provisions in the landmark bankruptcy law reforms that went into effect last Oct. 17, businesses that file for bankruptcy face tighter timelines and greater costs. Along with relatively easy access to billions of dollars in private equity capital, that has dissuaded some businesses from seeking protection.
"There is now more incentive than ever before to cut a deal and stay out of bankruptcy court, because the costs and time constraints of the Chapter 11 route are so onerous," said Keith Owens, partner in the business reorganization group in the Los Angeles office of Foley & Lardner LLP.
Business reorganization filings for the first nine months of 2006 in Los Angeles County under Chapter 11 of the Bankruptcy Code are off 18 percent from the same period last year and more than 56 percent from 2004 levels, according to figures compiled by LexisNexis Court Link for the Business Journal.
But that's not all that's down. Business liquidations under Chapter 7 for the first nine months of the year are running 50 percent below the same period for both 2004 and 2005. Overall Chapter 7 filings, including those by individual consumers, are off 82 percent from 2005 and 68 percent from 2004.
For years, banks and credit card companies had lobbied hard to reduce what they claimed was an epidemic of consumers using the bankruptcy laws to walk away from their debts. In response, Congress last year passed the Bankruptcy Abuse Prevention and Consumer Protection Act. Among other things, it requires individuals and sole proprietors seeking to liquidate their debts under Chapter 7 to pass a "means test" to determine whether they can pay back some of their debt. All individual filers must also undergo credit counseling from a certified provider.
As a result of the changes, sole proprietorships which were heavy users of bankruptcy court are much less likely now to find bankruptcy attractive.
Another factor in the drops: Many individuals and business owners facing financial difficulties heard about these pending changes and rushed to file before the new law took effect. That caused a spike in Chapter 7 filings in September and October of 2005. Then, for the next several months, there was little activity as virtually everyone who could have filed had already done so or was too scared to proceed.
With each passing month, however, these effects have worn off, causing the number of filings in all categories to creep back up again. Still, on the corporate side, lesser-known changes sought by creditor parties have made Chapter 11 filings less attractive. Chief among these: a requirement that within 90 days of filing, a company must tell all landlords whether it intends to keep or dispose of leases.
Landlords welcomed this provision because it allows them to sign up replacement tenants more quickly. But it also forces the company to come up with at least the outlines of a reorganization plan very quickly after filing. For a company with dozens or hundreds of branch locations or stores, this can be a daunting process.
Another provision allows creditors to file their own reorganization plan for the bankrupt company within 18 months if the company itself hasn't come up with its own plan and had it approved by the bankruptcy court.
"Both of these provisions have shifted more bargaining power to creditors," said Howard Weg, partner in the Los Angeles bankruptcy law firm Peitzman Weg & Kampinsky LLP.
From the creditors' perspective, this avoids long, drawn-out multiyear bankruptcies, such as the notorious Manville Corp. case in the 1980s that took more than six years to resolve. Creditors have more certainty as to when they will get paid.
From the debtor company's perspective, it means a lot more work must be done up front at greater expense before filing for bankruptcy.
"The new law has put the kibosh on businesses that were seeking a few months breathing room by filing Chapter 11, especially smaller businesses," said Paul Shankman, a bankruptcy attorney with the Torrance law office of James Andrew Hinds.
For example, Weg said a client who owned a residential tower had to have a reorganization plan ready at the time it filed and that "was unheard of before the changes in the law."
Trouble is, often there isn't time to do all the work, especially if a sudden major disruption to the business is the cause for the bankruptcy filing.
That leaves a limited set of choices for the business: agreeing to pay more back to creditors than initially intended or rushing to find a buyer for the assets through an expedited bankruptcy code process known as a "363 asset sale."
"We're seeing more and more 363 sales, especially with companies with under $30 million in revenues," said Robbin Itkin, a partner with the restructuring practice in the Los Angeles office of Kirkland & Ellis LLP.
In effect, these 363 asset sales are liquidations; the only difference is that the management and ownership of the company retains control over the business while the liquidation is going on. Faced with these choices, some companies are opting instead to cut out-of-court deals with their creditors to avoid filing for bankruptcy in the first place.
There's also the effect of the private equity boom. With so much capital floating around, businesses that might have considered bankruptcy are able to obtain new loans to pay off the old ones.
"It's like continually refinancing your house," Owens said.
This has served to blunt the impact of the bankruptcy law changes during the first year. But, like home refinancing, it only works as long as the underlying value of the business can be sustained.
Of course, if private equity were to dry up or the economy to slow substantially, bankruptcy experts say a wave of filings could hit.
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