Bankruptcy and Distressed Debt Exchanges: 2008 Financial Crisis to COVID-19

Posted on Oct 19, 2020

Maya Kapelnikova

 

On June 8, 2020, the National Bureau of Economic Research announced that the United States economy officially entered a recession in February 2020.[1] This is the first recession the United States has experienced since the Great Recession of 2007-2009,[2] and it is regarded as the world’s worst economic crisis since the Great Depression of the 1930s.[3] As companies have suffered significant financial setbacks, many have turned to bankruptcy and restructuring to mitigate financial stress.[4] Some of the largest U.S. corporations filed for bankruptcy in the midst of the financial crisis of 2008,[5] and many legal experts have recommended relying on the lessons learned from the Great Recession to serve as a model for the economic crisis we are now facing.[6] A number of companies have already filed for bankruptcy, but “there is every reason to believe these are just the tip of the iceberg.”[7]

While bankruptcy litigation will be central in the coming years,[8] it is also very likely that there will be a significant rise in defaulting companies executing distressed debt exchanges,[9] out of court workouts employed as an alternative to costly and time-consuming bankruptcy proceedings. In a distressed debt exchange, a company that is unable to pay its financial obligations can renegotiate the terms of its debt obligations with its creditors. Creditors accept cash, equity, new debt, or a combination of the three,[10] taking a “haircut” on their principal amount.[11] In exchange, the debt holders move up in payment priority.[12] Companies choose to initiate distressed debt exchanges because they diminish financial obligations, defer principal and interest payments, provide extensions for payments, and allow companies to postpone or, in best cases, eliminate the risk of  future defaults and bankruptcy filings.[13] Distressed debt exchanges are also appealing to defaulting companies because they improve liquidity, produce higher recoveries for investors, are quicker and more cost-effective than bankruptcy proceedings, and are more likely than not to prevent re-default in the following three years.[14]

Distressed debt exchanges have been on the rise in the United States since around 2000.[15] The Great Recession was a turning point, as distressed debt exchanges have surged dramatically since this last financial crisis.[16] From 1990-2007, distressed exchanges accounted for approximately 10% of default events.[17] In 2008, this figure jumped to 26%, and in 2009, to 36%.[18] From 2010-2016, distressed debt exchanges, on average, have accounted for nearly 40% of default events.[19] During COVID-19, the most affected industries—entertainment, sports, and hospitality—have continued contributing to an increase in distressed debt exchanges.[20] And credit rating institutions like Moody’s Investors Services and Fitch Ratings predict that distressed debt exchanges will keep increasing in the pandemic-driven default cycle.[21] This is because the motivating forces that have led to the major increase remain in place.[22]

Moody’s Investors Service points to several attributing factors:

  1. the prevalence of private equity sponsors owning high yield companies;
  2. the increase in distressed-debt investors, who take advantage of distressed debt exchanges because by exchanging debt for equity, they hope to later take control of these distressed companies; and
  3. the weakening of debt covenants, which makes it easier for companies to restructure their balance sheets.[23]

Although distressed debt exchanges are attractive for the reasons described, the pandemic is expected to bring a lengthy default cycle, which will lead to higher default rates.[24] Higher default rates are correlated with lower recoveries.[25] As a result, Moody’s hypothesizes that many distressed debt exchanges will fail, fueling later re-defaults.[26] So, some creditors may reject distressed debt exchange proposals, as they view the transaction as merely delaying the inevitable—perhaps “it would be better for the company to file [for bankruptcy] sooner rather than drain value through an exchange that does not alter the FCF profile.”[27] The United States continues to operate in a state of economic flux and uncertainty, and it is imperative for debtors to balance preserving value and preventing additional harm when making important decisions on how to manage financial distress.[28]

 

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[1] Jeanna Smialek, The U.S. Entered a Recession in February, N.Y. Times, Jun 8. 2020, https://www.nytimes.com/2020/06/08/business/economy/us-economy-recession-2020.html.

[2] David Rodeck, Alphabet Soup: Understanding the Shape of a COVID-19 Recession, Forbes, Jul. 15 2020, https://www.forbes.com/advisor/investing/covid-19-coronavirus-recession-shape/.

[3] Coronavirus: Worst Economic Crisis Since 1930s Depression, IMF Says, BBC, Apr. 9, 2020, https://www.bbc.com/news/business-52236936.

[4] Diane L. Dick, Bankruptcy, Bailout, or Bust: Early Corporate Responses to the Business and Financial Challenges of Covid-19, 40 Bankr. L. Letter 1, 1 (2020).

[5] Edward R. Morrison & Andrea C. Saavedra, Bankruptcy’s Role in the COVID-19 Crisis, Columbia law & Economics Working Paper No. 624 (2020).

[6] Michael J. Bowe & Lauren Tabaksblat, You Can’t Sue a Germ: Comparing the 2008 Financial Crisis to the COVID-19 Economic Crisis, 36 No. 04 Westlaw J. Corp. Officers & Dirs. Liab. 06 (2020).

[7] Id.

[8] Id.

[9] Recoveries in a Pandemic-Driven Default Cycle, Moody’s Investor Services, May 20, 2020, at 1.

[10] A Closer Look at Distressed Exchanges, Moody’s Investor Services, Dec. 19, 2017, at 3.

[11] Patrick McGeever, An Introduction to Distressed Debt Exchanges, AAM, Feb. 18, 2016, http://www.aamcompany.com/insight/an-introduction-to-distressed-debt-exchanges/.

[12] Id.

[13] A Closer Look at Distressed Exchanges, Moody’s Investor Services, Dec. 19, 2017, at 3.

[14] Id. at 3-5.

[15] Id. at 5.

[16] Id. at 1.

[17] Id.

[18] Id.

[19] Id.

[20] Q&A: COVID-19 – Challenges in Distressed Debt and Liability Management, Financier Worldwide, Oct. 2020, https://www.financierworldwide.com/qa-covid-19-challenges-in-distressed-debt-and-liability-management#.X3onWZNKjQ0.

[21] Recoveries in a Pandemic-Driven Default Cycle, Moody’s Investor Services, May 20, 2020, at 1.; Distressed Debt Exchange (DDE) Usage Expected to Rise During Coronavirus Crisis, Fitch Ratings, Apr. 3, 2020, https://www.fitchratings.com/research/corporate-finance/distressed-debt-exchange-dde-usage-expected-to-rise-during-coronavirus-crisis-03-04-2020.

[22] Recoveries in a Pandemic-Driven Default Cycle, Moody’s Investor Services, May 20, 2020, at 1.

[23] A Closer Look at Distressed Exchanges, Moody’s Investor Services, Dec. 19, 2017, at 3.

[24] Recoveries in a Pandemic-Driven Default Cycle, Moody’s Investor Services, May 20, 2020, at 2.

[25] Id.

[26] Id. at 1.

[27] Unsuccessful Distressed Debt Exchanges May Lead to Bankruptcy, Fitch Ratings, Sept. 28, 2020, https://www.fitchratings.com/research/corporate-finance/unsuccessful-distressed-debt-exchanges-may-lead-to-bankruptcy-28-09-2020.

[28] Q&A: COVID-19 – Challenges in Distressed Debt and Liability Management, Financier Worldwide, Oct. 2020, https://www.financierworldwide.com/qa-covid-19-challenges-in-distressed-debt-and-liability-management#.X3onWZNKjQ0.