WRITING THE FINAL CHAPTER
Bankruptcies Are Increasing in More Sectors, and They’re Spawning More Litigation.
SPECIAL REPORT
By CHRIS CZIBORR
The wave of bankruptcies that began among the county’s technology companies last year is spreading to other sectors. And more bankrupt companies are liquidating rather than trying to reorganize in an increasingly sour economy.
“Over the past nine months, I’m seeing an increase in bankruptcies in the manufacturing sector and the service industry,advertising, marketing and healthcare,” said Michael Reynolds, a bankruptcy and commercial litigator with the Irvine office of Phoenix-based Snell & Wilmer LLP. “Ventures that dot the landscape here in OC are facing tremendous financial pressure and many of them are considering Chapter 11, and some of those in Chapter 11 are considering liquidation.”
The increasing number of business failures is spawning litigation by creditors and investors seeking to recover some of their losses, local attorneys said.
“You have creditors looking for assets someplace,” said Craig Millet, bankruptcies partner with the Irvine office of Los Angeles-based Gibson Dunn & Crutcher LLP. “So you have a lot of lawsuits coming up.”
“We are expecting an increase in the number of bankruptcy filings,” said Marc Winthrop, partner and shareholder with Winthrop Couchot, a Newport Beach “boutique” law firm specializing in bankruptcy. “And we’re seeing a little bit of that now,we’re very early on for this but I expect our workload to increase over the next few months.”
“Healthcare,hospitals and practice groups,is certainly a troubled industry,” Winthrop said. “And a lot of people expect problems in retail.”
Winthrop said he is starting to see more companies whose sales have been hurt by recession and “meanwhile, debt load is up there and they can’t adjust fast enough.”
Millet agreed, saying, “We saw a lot of people bulking up (with debt) pre-recession and now they can’t handle it.”
And besides falling revenues, these companies face a much tighter credit environment, making it doubly difficult to finance a turnaround.
“We’re seeing an increase in the level of pessimism in the business community,” Reynolds said. “That’s accompanied by a decrease in the willingness of lending institutions and other creditors to extend the credit necessary to support a business’ rehabilitation.”
Snell & Wilmer reported that for the Central District,comprising the counties of Los Angeles, Orange, Ventura, San Bernar-dino and Riverside,Chapter 7s accounted for 65% to 70% of bankruptcies in 2000. But during the first three quarters of 2001, the number had jumped to 76%.
“We’re certainly seeing more bankruptcies overall, and as a percentage the Chapter 7 filings are growing,” Reynolds said.
He said he is seeing more companies interested in reorganizing now forced to liquidate because current economic conditions don’t support a rehabilitation of the business.
“As economic conditions continue to worsen or are at least perceived to be worsening in the state, the percentage of business filings that start out as Chapter 11 reorganizations but got converted to Chapter 7 liquidations has gone up,” Reynolds said.
Also, when there is nothing to reorganize and there are no real assets of substantial and tangible value, a trustee may pursue claims through litigation, according to Gibson Dunn’s Millet.
“It becomes an issue of what does the trustee want to pursue or what do the former investors want to pursue,” he said.
“Or third parties who believe they have been wronged, such as investors and banks, try to pursue those claims,” he said. “They can’t sue the estate, but they go looking for third parties like the former accounting firm, saying, ‘Mr. Accountant, you misled me because you should’ve told me of the financial condition of the company and the deepening insolvency that was occurring, but you didn’t,so I’m suing you now.'”
Third parties that feel wronged also can go after an investment banker, according to Millet.
“In such a case they would say, ‘In raising money for my investment you failed to tell me what I needed to know, so you engaged in securities fraud,'” he said. “So we’re seeing creditors in essence try to pursue private remedies against others, other than the debtor itself, to try and recover money.”
Millet said his department at Gibson currently splits work evenly between reorganizations and genuine bankruptcies.
“In 1991, it was more like 90% reorganizations and 10% bankruptcies,” he said. “Much more so than in the early 1990s, we’re now seeing professionals at risk,former accountants and lawyers of the now-debtors,whereas before those folks didn’t get sued so much. Accounting firms have become ripe targets.”
Millet said the same now holds true of company officials.
“People are saying the operators of the company should’ve informed them the company was doing badly and so they’re suing various officers and directors personally,” he said. “They’re going after officers’ and directors’ liability policies, so insurance is always a big issue,they’re looking for any deep pocket.”
Reynolds said such cases could go to litigation if it holds hope of uncovering assets.
“There will be litigation if there’s reason to suspect that corporate insiders have absconded with corporate funds or assets have been transferred without receipt of equivalent consideration,” he said.
Reynolds said this is more likely to occur in situations where, before declaring bankruptcy, a company pays off key officers and directors with huge bonuses, leaving only an empty husk for the creditors to share in the bankruptcy.
“We’re seeing more of that or at least more willingness by creditors to investigate the assets and financial status of a company prior to entering bankruptcy than in previous periods,” Reynolds said. “I think that’s because when there’s less of a chance of obtaining a substantial recovery through the bankruptcy process, creditors will look to more traditional means of litigating to obtain a meaningful recovery.”
However, Reynolds said he isn’t seeing much of this by creditors of failed dot-coms.
“There’s not much use in it from a creditor’s perspective,” he said. “The old adage, ‘you can’t squeeze blood out of a turnip,’ holds true there.”
Meanwhile, Millet said OC is escaping the brunt of the bankruptcy wave afflicting other parts of the nation.
“We’re not seeing as much in Orange County proper as we’re seeing nationwide,” he said.
“OC thus far is weathering the storm much better than most places,we’re better than the rest of the country right now,” Millet said. “With interest rates so far down, real estate development here is still continuing.”
Millet also said many landlords who leased to high-tech companies in recent years took as security letters of credit or fairly large deposits.
“So when their tenants failed, they weren’t hurt as badly,” Millet said.
In another trend, OC bankruptcy lawyers are seeing more bankruptcies resulting from cash flow problems, rather than insolvencies.
“In the cases that have a chance of truly reorganizing, turning assets into cash, halting business and distributing assets pursuant to a plan of reorganization is much more of a trend now than it was in the 1990s,” Millet said.
Millet said he expects to see more cross-border bankruptcies, too.
“A lot of our work is not local,Japan will take off again in bankruptcy work for us,” he said. “Keep in mind Enron has filed bankruptcies in multiple countries. ”
County lawyers say they don’t think much of the increase in bankruptcies has resulted from the terrorist attacks of Sept. 11.
“I have not seen a change in the trends since then. It was enough to push companies already on the brink over the edge,” Reynolds said. “But in the grand scheme of things, I would say the trends that existed before Sept. 11 have continued since then.”
Millet said that, apart from the travel and airline sectors, many companies already were on edge before Sept. 11.
“Most of those companies,especially high-tech firms,would’ve needed help post-Sept. 11 anyway,” he said.
