There Is a Tsunami Coming

“Everyone, it seems, is preparing for a coming wave of new bankruptcy filings,” noted a recent article in The New York Times.  

According to Robert Sheehan, the managing partner of the law firm of Skadden, Arps, Slate, Meagher & Flom, there is a tsunami coming in the bankruptcy arena. Mr. Sheehan made his comment before the recent stock market gyrations of the past couple of weeks, but he was merely looking ahead to what he apparently views, in his legal opinion, as the inevitable outcome of what has been going on in the U.S. economy these past several years.

The New York Times article to which I am referring profiled an attorney named Richard Levin, who practices primarily in the field of bankruptcy law. Among his other accomplishments, Mr. Levin served from 1975-1978 as counsel to the U.S. House Judiciary Committee, where he helped to draft much of the present U.S. Bankruptcy Code. Mr. Levin has had a distinguished career in the bankruptcy field and was recently hired away from his previous law firm, Skadden Arps, where he had been a partner for a decade, to join the old-line New York firm of Cravath, Swaine & Moore. This is symbolic, if not significant, for reasons we will discuss below.

The Ultimate Go-to Firm

In a profile published on July 25, 2007, the authoritative Dow Jones’ Daily Bankruptcy Review described Cravath as “the ultimate go-to firm,” and further noted that Cravath “has perhaps the most demanding hiring standards” of any New York law firm. So it says something loud and clear that Cravath is hiring the guy who literally “wrote the book” for modern bankruptcy practice in the U.S., to include drafting the 1978 amendments to the U.S. Bankruptcy Code. Combine this with the fact that Cravath previously had no significant bankruptcy practice in recent decades (actually, Cravath reorganized Westinghouse after the Panic of 1907 and assisted with many railway reorganizations over the past century), although many of its fine attorneys have appeared often in the bankruptcy courts of many federal and foreign venues and jurisdictions. But it is fair to say that Cravath was not known lately as a “bankruptcy firm” in any respect. Rather, Cravath focused much of its large-caliber legal effort on what is called “transactional” work, such as putting together large merger and acquisition deals, or dealing with matters before the U.S. Securities and Exchange Commission (SEC) and similar foreign entities. The blue chip client list of the white-shoe Cravath law firm includes such powerhouse organizations as IBM, Xerox, Merck, Novartis, the board of directors of TXU, Credit Suisse and the Carlyle Group.

A Continental Shift

The New York Times article noted that “Cravath’s move, in the words of one bankruptcy lawyer in New York, was ‘a continental shift,’ a recognition by an old-line firm, however belatedly, that bankruptcy had moved beyond the days when it was the purview of collection lawyers chasing debtors to the courthouse.” Having practiced a good deal of bankruptcy law in my misspent youth, I take exception to that last characterization. Bankruptcy law is far more complex than just “chasing debtors to the courthouse.” Still, the point is that within the past decade, many law firms like Cravath did not offer bankruptcy services to their clients. (There are lots of client-conflict issues, among other reasons.) Top-line firms likely would have referred the bankruptcy work out to other firms.

But things change. Bankruptcy has become a serious, and certainly respectable, form of law practice now, and can be a large moneymaking part of a major law firm. For large-scope bankruptcy cases, billing rates at some law firms are in the realm of $750 (and more) per hour of attorney time.  In fact, a few lawyers recently cracked the psychologically important mark of charging over $1,000 per hour.  Yes, that is quite pricey. And the bankruptcy judges seem to approve the fees, too. So let’s put 2 and 2 together. Large mainline, white-shoe law firms are building up their bankruptcy practices because they expect a lot of that kind of “debtor-chasing” business to come through the doors in the near future and pay out big fees. And what else does the future hold?

Loaded up with Debt

First, let’s catch up to the present. During the past few years, there has been a major change in corporate reorganizations. Prompted by the availability of easy — if not cheap — credit, many companies have loaded themselves up with debt. The debt was used for everything from making acquisitions and alliances to paying bonuses to managers to buying back stock options and outstanding shares. (On rare occasions, U.S. firms even use the borrowed money to build a new plant or factory, or to buy new equipment. Really, it has been known to happen.) At many business schools, they refer to this process of financial decapitalization as “the discipline of debt.” (And no, we won’t go there just now.)

Much of this new debt was then repackaged by the loan underwriters into other forms of financial instruments and flipped, sold and resold down the line to a myriad of buyers who may or may not have understood the nature of the risks they were assuming. There are few ironclad guarantees in this world, but I can almost surely guarantee you that when the loans go bad and the time comes to litigate over who is not getting repaid, the jilted creditors will deny up and down at depositions that they understood the nature of the risks. The creditors will claim, with straight faces, that they were lied to, misled, defrauded. Don’t believe me? Want to bet?

Enter the God of Insolvency

As with many things in life, it is nice when all goes well. But then again, things do not always go well. So when the god of insolvency enters upon the stage and drops his thunderbolts upon these deeply indebted firms and they “breach a material covenant,” as the saying goes, they often wind up attempting a financial workout or visiting the clerk’s office of a U.S. bankruptcy court to file their petition and the utterly critical first day motions. And just so you know, filing for bankruptcy is not something that you do when you have “no money.” It actually requires quite a bit of money for a business corporation to operate successfully in bankruptcy. Thus, strange as it seems, it helps to file for bankruptcy with money in the bank and receivables coming in (called “cash collateral”), or at least some sort of backup lender who is bold enough and willing to fund your operations after the bankruptcy petition is filed.

Welcome to the Future

So welcome to the future, where the smartest of the smart law firm money is betting that many more business firms will be visiting the bankruptcy courts of the land. This is why the big law firms are beefing up their bankruptcy rosters. This is part of the takeaway point for this week’s update. But how do these law firms think that they will get paid?

In many ways, hedge funds and private equity firms have turned the corporate bankruptcy process into another form of return-driven market. Among other things, these cash-rich entities have come to view the bankruptcy process as a marketplace for assets they can purchase at distressed prices, although many of the higher-quality assets have tended to command premium prices in bankruptcy sales of recent vintage. For this reason alone (and there are others), the presence of hedge funds and private equity firms has significantly transformed the process of bankruptcy. They have brought new money to the table, and deep pockets.

But in a world where you have debtors in possession of bankrupt corporations, and creditors getting stiffed up and down the line, and lawyers and related professionals charging large fees, and deep-pocketed buyers waiting at the fringes to buy assets or participate in recovery plans, you will have many new and previously unexplored legal issues. Professor Douglas Baird of the University of Chicago Law School recently noted that “We are about to go into a period of bankruptcy history where there are going to be lots and lots and lots of really unclear issues.”

Lots and Lots and Lots

Note that Chicago’s professor Baird said there will be “lots and lots and lots” of those “really unclear issues.” That sounds to me like a lot of unclear issues, and a lot of headaches for people who are standing too close to the coming bankruptcy tsunami. And that is why you, dear readers, as investors should stay away from indebted companies with poor cash flow. That is why we have companies in our Outstanding Investments portfolio like Goldcorp (GG: NYSE), with no debt. Or Valero (VLO: NYSE), with immense cash flow and a price-to-earnings ratio of 6.9. At Outstanding Investments, we like well-managed companies with real assets in hand, such as ore in the ground or oil and gas reserves, or companies that make real things in real plants and factories. And we like to see little or no debt, certainly in this economic environment.

Finally on this topic, I hope that none of you ever has to see the inside of a bankruptcy court. The big bankruptcies are raw and brutal, and proceed in a meat-grinding sort of way. It reminds me of the case of Jarndyce v. Jarndyce, if you have ever read Charles Dickens’ great book Bleak House. Don’t go there if you don’t have to. We congratulate Mr. Levin on the flattering report about him in The New York Times and wish him well at his new job with Cravath. But we would prefer to read about Mr. Levin’s exploits in the pages of the newspaper and not own shares in companies on whose behalf, or against whom, he is litigating in bankruptcy court.

Until we meet again…
Byron W. King

September 10, 2007

The Daily Reckoning