VIEW FROM THE BENCH
BANKRUPTCY COURT JUDGE KAPLAN WEIGHS IN ON RESTRUCTURING TRENDS
BY THE HONORABLE MICHAEL B. KAPLAN
MICHAEL B. KAPLAN
U.S. Bankruptcy Court Judge for the District of New Jersey
Once again, the 2018 Chapter 11 landscape was dominated by the “retail apocalypse” with Toys ‘R’ Us and Sears grabbing headlines on a daily basis. U.S. Bankruptcy Court Judge Michael B. Kaplan discusses the events that shaped the restructuring industry in 2018 and the potential impact of the Fed’s decision to ease regulations on highly leveraged loans.
Q: Looking back on the turnaround and restructuring landscape of 2018, which events stand out and why?
A: In my view, there is one single event — the Toys ‘R’ Us bankruptcy filing. It has impacted the bankruptcy landscape in numerous ways. First, the choice of filing in Virginia reignited (or rather flamed) a roaring fire as to the existing bankruptcy venue law and its manipulation by parties in efforts to forum shop. As many of you know, in January of this year, Senators Cornyn and Warren introduced S. 2282 which would modify our current statutory venue scheme to address perceived abuses. I am not going to use this platform to voice my views; however, I will note that the NCBJ is finalizing a one hundred plus page white paper in which all arguments regarding change in the laws, both pro and con, are analyzed in depth and exhaustively. I will note that in Toys ‘R’ Us, of the 19 debtor entities which filed in the Eastern District of Virginia, Richmond Division, only one is a Virginia entity. The company was headquartered in New Jersey. Just saying. The true lasting impact of the Toys ‘R’ Us case is the lack of trust engendered in the Chapter 11 process, which in this case saw 30,000 employees lose their jobs and hundreds of millions of dollars in accumulated, unsatisfied trade debt. Going forward, suppliers, unions, employees, landlords and judges will have long memories as to how a debtor in possession aggressively accelerated new orders and built up inventory, on extended credit terms, at a time when covenant defaults under its DIP loan were on the horizon. It will not surprise me at all if in future Chapter 11 proceedings, as a result of what transpired in Toys ‘R’ Us, suppliers will be more aggressive and less flexible in dealings with distressed companies — both pre-petition and certainly post-petition.
Q: The Fed recently eased up on regulations on highly leveraged loans, leading to a sudden surge in such loans in 2018, despite warnings from regulators that a frothy credit market could mean a much higher rate of default. Considering that these loans are often given to companies already in some financial trouble, this could mean trouble down the road. What are your thoughts on this trend?
A: The growing percentage of leveraged loans must be alarming to all and comes at a time when governments, corporations and consumers have accumulated significant debt which cannot be serviced. I understand that in the past six years in the U.S., the value of highly leveraged loans (5 x EBITDA) has ballooned to over $1 trillion dollars and comprises roughly half of all corporate issuances. In Europe, the situation is even more dire. Making matters worse, many of these leveraged loans are being packaged into collateralized loan obligations (CLOs) to be bought and sold by investors. Sound familiar to anyone? Multiple oversight agencies, such as the Fed, the Bank of England and the IMF have raised alarms and cited parallels with the sub-prime mortgage crisis we saw in 2008. The timing of this trend is equally disturbing since we also see retail sales declining, housing flattening and auto loans failing. With rising interest rates, I see limited refinancing opportunities and available exit strategies, apart from Chapter 11 restructuring efforts. So, it may be good news for our bankruptcy bar and related professionals. However, not everyone sees the situation with such gloom; JPMorgan recently predicted 2019 to be a great year for leveraged loans, with continued interest from retail and institutional investors. Good, I am glad someone will buy what I sell, because as soon as I finish typing this answer, I am going to reach out for my broker to discuss shifting weights in my retirement portfolio. As you know, judges do not get paid by the case.
Q: The “retail apocalypse” showed no signs of abating in 2018. Mattress Firm, David’s Bridal and Sears are all major retailers that have declared bankruptcy this past year. While Mattress Firm has exited Chapter 11, Sears and David’s Bridal are still stuck in bankruptcy, with the former in danger of liquidation. What is your outlook for this ongoing trend and what are the key takeaways for retailers?
A: This is a good question to follow the previous one regarding the continuing trend of highly leveraged loans. Surprisingly, they are related. One would think that historically low unemployment and a growing economy would signal a retail boom. Yet, this is not the case, as we have seen so far this year more than double the amount of store closings as compared to new store openings. In 2018, we have seen such mainstay retailers file for Chapter 11 as Sears, Toys ‘R’ Us, David’s Bridals, Nine West, Rockport, Mattress Firm, Brookstone and Claire’s. These filings have also had a downstream effect on mall and shopping centers which have increased delinquencies. I see this trend continuing in 2019 and beyond because the root of the problem remains — highly leveraged loans. These and other retailers are not struggling because of a dip in sales or revenues due to online sales to Amazon; rather, these companies do not have the cashflow to service the debt from these leveraged loans. Toys ‘R’ Us, for instance, which is the third largest retail bankruptcy ever, generated $11.5 billion in yearly sales and was the leading seller of infant products. Yet, it succumbed to its $5 billion in debt and $400 million annual interest obligations, all the residual from a prior leveraged buyout. Much of the accumulated debt for these companies did not go into supporting technological advances or expansion; but rather, to simply buy back shares. I have seen some statistics which suggest that between 2019 and 2025, roughly $5 billion annually in high-yield retail borrowings will come due. So, the trend will continue, and I am afraid that fixing the problem may be well above my pay grade.
Q: In a press release announcing the 75% increase in commercial Chapter 11 filings, ABI Executive Director Samuel J. Gerdano said, “Bankruptcy provides a shield for distressed consumers and businesses confronted with rising interest rates and global economic challenges.” The Fed has increased rates three times this year. How have these rate hikes affected bankruptcy filings?
A: For most of us, if we bet and lose $5,000 on black at a roulette table, we feel the immediate pain in our wallet and on our general finances. If, however, we buy $100 worth of losing lottery tickets (for some reason they don’t sell me winning tickets) every week, the result is the same, but we do not see it immediately. This is similar to rising interest rates. About 100 million consumers who have taken out loans with variable rates, such as credit cards and residential mortgages, face higher monthly debt service payments as a result of every Fed increase of .25%. A significant portion of these consumers will be pushed into default and eventual bankruptcy. Even with consumers having fixed-rate loans, such as most car loans, defaults are rising with higher interest rates because consumers are struggling to meet other obligations. Independent studies show that more Americans are falling behind on car loan payments. I have read that subprime borrowers are falling behind on their car loan payments at the highest rate in more than six years, and some bonds backed by these loans are vulnerable to getting downgraded. Increased Chapter 13 consumer filings are likely to happen, and as discussed previously, lower consumer confidence leads to business bankruptcies, as we have seen in our spate of retail filings. Needless to say, increased interest rates will go hand in hand with restructuring activity in retail, healthcare and energy industries, where refinance opportunities will be more limited.
Q: How does the perception of bankruptcy in the media line up with the reality seen from the bench? Does public opinion ever change the course of a bankruptcy proceeding?
A: The perception of Chapter 11 bankruptcy in both the media and public is often negative, and I think, in some cases, for valid reasons. One need only look to the furor raised in the media and on Capitol Hill regarding the fight for severance payments for laid-off Toys ‘R’ Us and Sears workers, as juxtaposed against awarded management and professional fees. However, rarely does the public get to see or hear about effective restructurings in Chapter 11 which have saved family businesses, supported environmental cleanups, preserved worker jobs or recaptured equity investments. Indeed, in New Jersey and other areas throughout the country, numerous hospitals continue to serve communities thanks to Chapter 11 reorganizations and restructurings. Many of these hospitals faced flat or declining patient admissions due to shifting demographics, as well as serious financial losses and vulnerabilities due to Medicare and Medicaid restrictive policies. Opportunities available in Chapter 11 allowed these hospitals to retrench footprints, eliminate old debt and revamp services for the communities. There is no doubt that public relations play a significant role in bankruptcy proceedings, where the value of brand names and intellectual property can be negatively impacted. Just ask any retailer in Chapter 11 how it’s doing with sale of gift cards. But bankruptcy professionals can reduce the public’s negative perception by being prepared with a plan prior to filing and being cognizant of the costs and risks of a lengthy process that lacks direction. More importantly, the bankruptcy courts and bankruptcy professionals need to direct these cases towards fair outcomes for customers, suppliers, landlords, and employees — all who too often take the hardest hits in a Chapter 11 proceeding.
Q: Canada and the U.S. recently renegotiated NAFTA. The new agreement, the U.S.-Mexico-Canada Trade Agreement (USMCA) changed the legal framework that has been in place for the last 20 years. How will the USMCA affect bankruptcy proceedings?
A: Well, that’s a challenging question for a bankruptcy judge sitting in Trenton, NJ. But here’s my best effort: The most significant impact that the USMCA will have on the bankruptcy practice is to reduce the mounting pressures on farming in our Midwest regions (dairy, corn, soybean and wheat producing areas). Chapter 12 family farm bankruptcies have been on the rise since 2012, and 2017 saw the highest number of filings since then. The filings in 2018 have continued this negative trend, traceable to the falling grain prices and the ongoing trade war with China which has reduced soybean imports. The USMCA has left intact most of the favorable NAFTA provisions for grain and pork producers, as well as providing for some relief for dairy farmers. Absent USMCA, pork producers, who rely significantly upon trade with Mexico, and farmers would be facing a severe cashflow crunch at a time of rising interest rates on farm loans. Over the past five years, farmers have been relying upon cheap money for survival; however, in this era of slowly rising interest rates, farmers cannot survive additional body blows from trade wars.