Covid-19 and Bankruptcy: A Case For “Light-Touch” Reorganizations

Different countries have adopted various strategies to prevent or delay initiation of insolvency proceedings and protect businesses in the wake of the Covid-19 crisis. Global response has broadly been along the lines of providing direct financial aid (by way of loans or grants) or taking steps by way of emergency legislation to delay insolvency proceedings. Whether it is the United States or Europe, the overall aim of these strategies is to keep businesses afloat and provide them with protection, albeit temporary, from creditor action. The protection is based on the premise that, in a post-lockdown period, businesses will be able to become fully operational and profitable again and will then be able to repay loans or absorb debts accrued as a result of the lockdown.

However, the premise is a topic of contention. It is clear that Covid-19 has caused a very real economic slowdown, and consequently it is impossible to predict with certainty that businesses will be able to survive or grow at a pre-Covid-19 rate or repay loans in the near future. Secondly, second-wave risks and gradual easing of lockdowns all over the world suggest that there is likely to be a period of slow growth before commercial activities could even consider returning to the same level of growth pre-Covid-19, and as a result businesses are likely to face long-term cash flow issues potentially lasting  so long that  insolvency proceedings can no longer shield them from creditors.

Against this backdrop of global economic and public health uncertainty, viable businesses that anticipate returning to profitability in the future face a very real dilemma. Businesses face the threat of bankruptcy, the government’s  heavy financial aid to businesses across the spectrum seems to be the best solution. However, although an injection of funds from the government or otherwise might assist businesses in surviving in the short-term, the long-term consequences are that, failing repayment, it does not actually rescue them from creditors in the long run. To put it simply, should businesses, after the lockdown, be unable to absorb this new debt (on top of other accumulated debt) or repay loans, they are likely to find themselves closer to bankruptcy later.

Therefore, additional funding, either by way of government loans or private aid, is only buying businesses time to delay creditor action and survive in the short-term. Therefore, the question that remains is: What should companies that have viable business and anticipate returning to profitability when the lockdown ends do to protect their business?

In the United Kingdom, insolvency practitioners have adopted a “light-touch” or “soft-touch” variant of the administration process ((hence light-touch administration or LTA) that is used frequently in corporate insolvency law. As per this process, (as with any other administration process) when the business enters into administration, a moratorium is imposed on the business preventing all creditors from initiating recovery of debt. Secondly, the process requires appointment of administrators or insolvency professionals to plan and negotiate a rescue strategy with creditors for all the debt that has been (or is being) accumulated and is due now or in the future. The light touch comes from the fact that the business continues to trade, the management of the business retains day-to-day control, debt is being restructured in negotiations with creditors, and trading is not handed over to the administrators or trustees or insolvency professionals. This allows for a restructuring of all debt by analyzing cash flow projections and renegotiating with creditors. Allowing debtors to stay in possession is an extraordinary response to extraordinary circumstances since English Insolvency Law is largely based on a creditor-in-control approach. The Covid-19 crisis has led practitioners to understand and appreciate the systemic risk that could materialize should creditors start initiating debt recovery that could potentially leave thousands of companies in default with potentially no one left financially sound enough to  pick up these companies.

In the US, Chapter 11 of the Bankruptcy Code permits reorganization and provides a mature and effective mechanism modeled on the debtor-in-possession approach. Chapter 11 is the bedrock of this newly recognized LTA mechanism in English Law. Such a reorganization strategy requires, in some circumstances, the appointment of a trustee or administrator or insolvency professional to oversee the affairs of the business and to ensure that a business has a well-planned exit strategy.  In these extreme times however, considerations might be different.

To weather the Covid-19 storm, businesses should strongly consider reorganization, given the numerous benefits of these reorganization strategies. Further, the issue of perception is paramount. Businesses and lawmakers need to change the way bankruptcy laws and Chapter 11 proceedings are perceived generally. Chapter 11/LTA mechanisms that have historically been linked to business or management failure need to be seen in new light as rescue tools.

On the face of it, bankruptcy or insolvency proceedings were predicated on the assumption that management failed at some level and the last people who should be left in control are those who were responsible for the company’s plight. However, in the present crisis, barring cases where businesses were in poor financial health before Covid-19, the main financial issues most businesses face are not due to management failure. As a result, if a business opts for reorganization today, this should not necessarily prompt stakeholder or regulator concern with management performance.

It is possible that Congress recognized the multiple benefits of Chapter 11 reorganization and, consequently, through the CARES Act, amended the Small Business Reorganization Act of 2019 (SBRA) by increasing the eligibility threshold from $2.7 million to $7.5 million of debt for businesses filing for Chapter 11 relief. This amendment would allow small businesses to elect for treatment under the new Subchapter V of Chapter 11 of the Bankruptcy Code. This increased threshold will potentially allow more businesses with greater access to SBRA to survive.

The increasing popularity of LTA or Chapter 11 reorganizations in the last few months (both in the UK and the U.S.), particularly in jurisdictions that do not conventionally advocate a debtor-in-possession approach, suggests that these mechanisms might just be the difference between systemic risk and survival and should be strongly considered by every business and insolvency practitioner.

This post comes to us from Kumar Kartikeya Sharma, a dual-qualified barrister at the Bar of England & Wales and India.