Current policy discussions tend to minimize the role of bankruptcy law in mitigating the financial fallout from COVID-19. Scholars too are unsure about the merits of bankruptcy, especially Chapter 11, in resolving business distress. In this paper, we argue that bankruptcy should be a central part of policies targeting large corporations, but should be used only as a backup to other policies for consumers and small businesses.
With respect to large corporations, we begin with the observation that, although the current crisis has destabilized all businesses, many were likely to suffer distress regardless of a pandemic. The past decade saw a dramatic increase in corporate debt, especially leveraged loans, that allowed financially distressed “zombie companies” to survive without filing for bankruptcy by repeatedly refinancing their debts. By some estimates, zombies account for 16 percent of publicly traded U.S. firms. By the end of 2019, a large proportion of even investment grade debt was vulnerable to a ratings downgrade. These statistics imply that a substantial proportion of stressed businesses today merit financial restructuring (or even liquidation) in bankruptcy instead of, or in addition to, financial aid from the federal government, such as the CARES Act. It would, in our view, be a mistake to extend further financing without requiring a simultaneous bankruptcy filing: The financing would allow these firms to use public funds to further delay a necessary restructuring.
The government should therefore treat Chapter 11 as a tool that works in tandem with other policies to mitigate financial stress in the corporate sector, particularly for large corporations that were approaching distress prior to COVID-19. For those businesses that need restructuring, the government can still provide liquidity, but in the context of a bankruptcy proceeding that enables financial restructuring, facilitates operational changes necessary to cope with a post-COVID-19 world, and forces investors to shoulder the costs of distress that were exacerbated by excess leverage.
Our argument here, however, is hardly novel. Chapter 11 is a time-tested tool for mitigating the stress of large corporations in crises, as we saw with Chrysler and General Motors during the 2008 financial crisis. Chapter 11 offers a flexible, speedy, and crisis-tested tool for preserving businesses and restructuring liabilities, permitting them to shed drags on their innovation, while ensuring that the costs of those improvements are borne primarily by investors, not taxpayers.
We reach very different conclusions when we turn to the distress suffered by households and small businesses. For them, the bankruptcy process can be expensive and time consuming, especially given the capacity constraints of our bankruptcy courts. More fundamentally, the ultimate goal of bankruptcy is to eliminate debt, but for many households today, that’s stronger medicine than necessary: They can pay their debts when the COVID-19 shutdown ends and they return to work; they just need financial assistance in the interim to bridge a short-term (we hope) emergency.
These key policy levers – bridge financing and forbearance – are available in theory to small businesses in Chapter 11. The practical reality, however, is that bankruptcy is unattractive to many owner-managers who are essential to the business, but may have their ownership interests wiped out in bankruptcy. Even putting that issue aside, our bankruptcy courts likely lack the capacity to serve a deluge of small business bankruptcy cases.
Although we believe that bankruptcy should serve as a backstop during the current crisis, this backstop may be used heavily in the months ahead. We therefore encourage policymakers to ensure adequate funding for our courts, which may need a greater number of judges and trustees.
This post comes to us from Edward R. Morrison, the Charles Evans Gerber Professor of Law at Columbia Law School, and Andrea C. Saavedra, the Assistant Dean of Judicial Clerkships at Columbia Law School. It is based on their recent paper, “Bankruptcy’s Role in the COVID-19 Crisis,” available here.