Since the economic impact of COVID-19 started in March of 2020, the total number of bankruptcy filings in the US has increased. From April through August 2020 the number of companies that filed bankruptcy was 3,071 compared to 2,228 for the same period last year, which is a 38% increase.
The monthly year over year filings, according to the AACER website, shows 4,780 companies filed for bankruptcy from January through August, which is a 28.2% increase over the 3,728 that filed during the same period in 2019.
Financial professionals are expecting this increase in filings to continue.
Lenders are working to identify companies with a heightened risk of filing, and trying to be prepared for any possibility.
When a borrower works with its lender to develop a bankruptcy plan, including a budget and cash management plan, the lender is aware of the filing and is able to work with the borrower to improve the outcome for all parties. Not all borrowers work with their lenders prior to a filing. As a result, lenders are forced to try to anticipate riskier periods during which a troubled company may file for bankruptcy protection.
To assess the level of risk of filing, in addition to financial results, there are other considerations lenders should evaluate:
Cash cycles,
Anticipation of large and unusual receipts and payments, and
Expiration of 90 day preference periods surrounding payments or granting of rights, including additional liens or collateral rights, to creditors.
Cash Cycles
Each company has weekly and monthly cash cycles, and typically also has seasonal cash cycles. Because of this, there may be better and worse times to file for bankruptcy protection from the perspective of a borrower or a lender. The timing optimization may be different for each party depending on whose perspective is being considered.
In a situation when a company is hoping to use cash collateral rather than DIP financing, a company may elect to file for bankruptcy depending on the timing of the collection of cash or the likelihood of collecting the accounts receivable.
To consider timing implications, the lender will need to clearly understand the movement of cash through depository and loan accounts for the borrower. Depending on the use of a lock box, deposit control agreements, or other aspects of the specific cash management processes of a borrower, the timing decision for filing would be impacted.
For example, if a company experiences higher weekly collections on Thursday and Friday and has use of its cash immediately, it may elect to file for bankruptcy on Wednesday. This would allow the company to accumulate cash in the operating accounts on Thursday and Friday while waiting for an initial court hearing to request use of cash collateral.
If a company normally collects the majority of its monthly cash receipts in the second week of the month and has the use of its cash or the ability to borrow funds and hold the funds in an operating account, the company may elect to file for bankruptcy protection the last part of the first week of the month. This could allow the company to have access to the highest amount of cash possible during the initial days of the bankruptcy.
When a company requests use of cash collateral, the filing timing decision may have a material impact on whether or not cash collections are sufficient to finance post filing administrative and operating costs.
When a company has seasonal cycles, a company may employ a strategy to file at a time when accounts receivable balances are at the highest point. This could be coupled with stretching payables to ensure accounts payable balances are at their highest level also. This approach would mean the most cash is coming in and the least amount of operating costs are occurring during the bankruptcy case.
This discussion is from the perspective of a borrower looking to use cash collateral, and maximize the availability of cash to operate.
The secured creditors obviously have rights to protection of their collateral position, and may have arguments against the use of cash collateral. Vendors could also have rights tied to the status and timing of their deliveries and receipt of payments. This cash cycle and timing of filing discussion is not intended to minimize the lenders’ and vendors’ rights, but rather to identify an approach certain borrowers may employ in an attempt to maximize their chances to survive.
As a lender, the important factor to consider is that companies may use their normal cash flow cycles to their best advantage. If a lender considers this perspective and the cash management processes of the company, the lender may be better able to anticipate riskier periods for a bankruptcy filing, and to best protect its interests.
Large and Unusual Receipts and Payments
A lender should also be aware of a company’s expectation for unusual receipts and disbursements. This information is most likely available to a lender who requires a weekly cash flow forecast or a lender who is in regular contact with the borrower regarding accounts receivable and accounts payable balances.
If a large cash collection is expected, possibly for a one time sale to a customer, a company may elect to file for bankruptcy based on the timing of the anticipated receipt of those funds. One example of this situation could be a large payment for the sale of special products, such as, in today’s environment, personal protective equipment.
Conversely, if a large payment is required to a vendor or other creditor, a company may elect to file for bankruptcy protection before making the payment. This approach could preserve cash for other purposes post filing. The company may also elect to file if it cannot make the large payment and the vendor or creditor has threatened an involuntary bankruptcy filing. For example, if a company has an informal agreement with a vendor to make a large payment on a certain date, such as right after the holiday shopping season In December, the company may wait until the sales and receivables are highest and then file for bankruptcy protection before the vendor payment is due.
Payments to vendors should also be considered from the perspective of 503(b) (9) claims by vendors. Goods received and payments made to vendors in the period leading up to the filing should be considered from the perspective of the 503(b) (9) claim calculations and a vendor’s ability to argue for an administrative claim under that statute. A lender may request that its financial advisors or the company’s financial advisor provide that type of analysis.
In these situations, the vendors or other creditors may have rights and arguments against the company’s use of cash collateral, but the company’s opportunity to use the cash may be tempting for a weak performing entity.
Similar to cash cycles, large receipts and payments are situations when a company could use its specific cash flow timing to maximize its cash advantage going into a bankruptcy filing.
Expiration of 90 day Periods Surrounding Certain Agreements
A lender should be aware and monitor timelines that include 90 day preference period tracking related to critical events or substantial payments.
For example, if a company made an agreement to provide an additional security interest to a vendor to support the payable balance with the vendor, the company may want to file for bankruptcy protection prior to the expiration of 90 days to enable the company to gain leverage over the vendor by asserting that the security interest should be set aside as a preference in bankruptcy.
Another example would be if a company granted a secured lender additional collateral. The company may be tempted to file for bankruptcy before 90 days have expired and then ask the bankruptcy court to set the granting of the collateral aside.
When a lender has identified borrowers with increased performance issues, it is important to review the collateral position of the lender and identify any issues with perfection of security positions, and to consider the ability to acquire additional collateral. These are important considerations for lenders and also require monitoring of the 90 day preference period timelines.
These situations all have specific legal implications for the company and its vendors and creditors. A lender should be aware of the timelines and be attentive to the potential risk of the company using the timeline against its creditors.
Bankruptcy courts generally prefer to give a company a chance to reorganize.
There are many situations where it is clear the company is using cash collateral to its advantage during a bankruptcy case and there are very clear and rational arguments a secured lender could make to preclude the use of cash collateral by that borrower.
However, even though the situation could appear bleak with little prospect for success, the court may grant a short term use of cash collateral, and damage to the secured lender’s position may be done during that period. Or, the court may grant the use of cash collateral for an extended period and the secured lender may be forced to incur legal fees to fight the use of cash collateral. The secured lender could be forced to receive minimal or no adequate protection payments while an expensive bankruptcy takes place.
What Should the Lender Do?
Whether a lender is or is not part of the bankruptcy planning process for a company, the lender’s understanding of the timing around cash flows coupled with an understanding of the bankruptcy process, will allow a lender to work as a team with its legal and financial advisors to develop a plan to incorporate cash flows and timelines into a the development of a bankruptcy monitoring or planning strategy.
When a lender is not part of the company’s bankruptcy planning, understanding the impacts discussed in this article could help the lender anticipate trigger points.
Watching activity in and out of bank accounts is critical.
Reviewing cash flows, and monitoring budget to actual performance is key.
Knowing about contracts or agreements and how the terms, such as signed dates, due dates, and amounts involved, will be extremely important.
No borrower or its advisors will be able to guarantee a speedy process or specific results during a troubled company’s reorganization or liquidation process. Lenders and their advisors must be prepared for uncertainty, and use available information to prepare for the alternative strategies a company may employ, and the various outcomes and dynamics that may occur.
Lenders who are armed with experienced legal and financial advisors, and lenders who know the details of their borrower’s cash flows and agreements, will be the best able to maximize the possibility of achieving a desirable outcome even in the face of difficult and often unpredictable circumstances.