Small Business Financing
As Bankruptcies Surge, Fewer Emerge
As the effects of the recession continue, the high number of
—7,514 in May, up 40% from the prior year—shows few signs of abating. That's because the factors pushing companies into bankruptcy, including depressed sales and tighter credit, may linger even when the economy starts growing again, especially if the recovery is less than robust.
More than 100,000 companies—about one in every 270 American businesses—have landed in bankruptcy court since the downturn began 18 months ago, according to data compiled by Oklahoma City-based Jupiter eSources, which tracks bankruptcy filings through its AACER database. The rate of commercial bankruptcies has more than doubled in two years, and economists expect the level to remain high for a year or longer once the recession ends. In addition, creditors are less willing to work with business owners to find ways for an insolvent firm to recover.
That's because in a sluggish recovery, banks with already fragile balance sheets are unlikely to be sympathetic to debtors' turnaround plans. Often creditors recover more of their debts faster by closing bankrupt businesses and selling off the assets. "Today lenders—meaning banks—have much less patience for a traditional reorganization, no matter what size the case," says attorney Kenneth Rosen, head of the bankruptcy group at in Roseland, N.J.
A Surge Still to Come? Statistics measuring business bankruptcies are notoriously difficult. U.S. Courts records show business bankruptcies make up between 3% to 5% of all filings. But research by bankruptcy scholars Robert Lawless and Elizabeth Warren (the latter is now head of the TARP oversight panel) suggests that filings related to a business failure make up closer to 15%. Jupiter eSources' database, AACER, which stands for Automated Access to Electronic Court Records, counts an individual filing with a "doing business as" name or a taxpayer ID number as a commercial bankruptcy. Those filings include business owners whom U.S. Courts records might count as consumers.
Regardless of the discrepancies, both AACER and U.S. Courts data show increasing business filings. , which provides insurance against defaults by trading partners, expects business bankruptcies to rise by 45% this year over 2008, and decline only slightly in 2010. The firm estimates that on average, "it takes GDP growth of 2% to 3% to stem the rise in insolvencies." A slow, "L-shaped" recovery could extend the high rate of business filings, says Harlan Platt, a finance professor at Northeastern University who has studied bankruptcies. "I think the surge in commercial bankruptcies is probably not yet here," he says.
The business cycle is only one factor that affects bankruptcy rates. Lawless, a professor at the University of Illinois College of Law, says the availability of credit is more important than GDP growth. "I don't expect that to really ease," he says. In the short term, Lawless says bankruptcies are usually triggered by some interruption in income. While that might mean a layoff for a wage earner, declining sales for a business owner could make them insolvent.
Vast Majority Go Chapter 7 Bankruptcies also don't measure the broader rate of business failures. "The bulk of closures, believe it or not, do not leave debt behind in a way that leads business owners to seek bankruptcy protection," says Brian Headd, an economist with the 's Office of Advocacy. For example, about 1.15 million businesses closed their doors in the first three quarters of 2008, according to the latest data from the Bureau of Labor Statistics. (That figure includes companies that closed without being in distress—if the owner retires, for example.) Only a small fraction filed for bankruptcy protection.
That may be in part because bankruptcy proceedings are expensive and, in most cases, unlikely to position the company for a turnaround, says Lowenstein Sandler's Rosen. The retainer for a Chapter 11 case for a company with less than $10 million in annual sales ranges from $25,000 to $50,000. In addition, the bankrupt business typically pays the legal and accounting fees of creditors. Increasingly, Rosen says, both debtors and creditors benefit from out-of-court settlements that avoid the expense and time of a bankruptcy case.
Indeed, the vast majority of business bankruptcies are Chapter 7 liquidations, in which the company ceases operations and its assets are sold to pay off lenders. So far in 2009, just 18% of business filings have been Chapter 11, according to AACER. Creditors are also unlikely to agree to dubious turnaround plans. "They say if I force you to liquidate, I'm going to recover maybe 80% of my money right away, instead of waiting two years and maybe recovering less," says Northeastern's Platt.