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Advantage of Corporate Bankruptcy Is Dwindling

November 19, 2008

Originally published in the New York Times

Edited for clarity and content

Harsh as it is, a bankruptcy filing has always offered a glimmer of hope for a business hobbled by debt or a downturn. A company could slim down, negotiate manageable payments to workers and suppliers and keep going, preserving jobs.

But the credit crisis has trampled on that dream. More companies that file for bankruptcy protection are shutting down because they cannot obtain enough financing to operate while they reorganize.

Linens ’n Things, in bankruptcy since May, is liquidating now that creditors have refused to extend more credit. Another retailer, Mervyn’s, announced it would also liquidate, and several analysts expect the same at Circuit City. On Wall Street, Lehman Brothers is being dismantled in the biggest bankruptcy ever.

So companies battling for survival have lost another lifeline. While they might have once gotten together with their creditors and worked out a plan in the common interest, they are avoiding bankruptcy court if at all possible because they know that without ready access to credit, the odds of emerging from legal proceedings are slim.

Is it any wonder that companies confronting serious problems — General Motors, for example — are reluctant to gamble?

And if a corporate bankruptcy does not offer a path to reorganization, many of the jobs at struggling companies may vanish for good. That suggests a long and painful economic downturn.

Bankruptcy protection is supposed to give a company a breather, blocking creditors while workout specialists, lawyers and managers try to figure out how to return it to profitability. In court, the bankrupt company can renegotiate loan payments and modify contracts.

Lenders to a company trying to reorganize under Chapter 11 of the Bankruptcy Code decide whether they want to bet on the company’s success once it emerges from court oversight, by offering new loans or converting their existing loans into equity. If the company emerges, there is a chance it will repay investors.

Deterred by lack of credit and wagering on the possibility of a government bailout, corporate executives have chosen to avoid bankruptcy and delay changes that might keep businesses going, which can block a successful reorganization.

Part of the problem is that in recent years, large lenders to corporations have been hedge funds, private equity investors or other institutions. Even if these lenders wanted to extend a loan to a struggling company, they might not be able to do so because they need cash quickly, from the sale of whatever assets a bankrupt company has, to satisfy their own nervous shareholders.

The prospect of liquidation of enormous companies, like Detroit’s Big Three, is frightening; the collapse of one would wipe out tens of thousands of jobs. But the absence of credit poses a practical obstacle to their reorganization through bankruptcy proceedings: Who wants to extend a loan to companies with such shaky prospects?