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Law360 (January 27, 2021, 3:36 PM EST )
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| Keith Aurzada |
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| Aaron Javian |
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| Michael Venditto |
As we begin 2021, the efforts taken by many businesses to survive the COVID-19 crisis thus far will manifest themselves as major challenges this year especially in the hardest hit industries, including retail, travel, oil and gas, and entertainment. In the year ahead, that stress is likely to spread to other sectors.
For many businesses, survival in 2020 focused primarily on maintaining sufficient liquidity to continue operating. Implementing that strategy depended on the availability of capital.
The initial response from the Federal Reserve was another round of quantitative easing and interest rates near zero, which encouraged investors to put money into riskier assets. That trend will undoubtedly dissipate as the pandemic stretches on.
Frequently, raising liquidity required challenged businesses to increase their leverage, encumber previously unencumbered assets and agree to tighter — albeit often springing — covenant packages. Investors willing to lend new money in 2020 were often able to improve their position in credit stacks by, for example, elevating their priority positions over collateral. The consequences of such liquidity raises in 2020 will be felt in 2021.
During 2020, major brick-and-mortar retailers, hotels and restaurants were hit hard. There were numerous Chapter 11 cases filed in the U.S. Bankruptcy Court for the Southern District of Texas in particular, including J.C. Penney Co. Inc., Neiman Marcus Group and Chuck E. Cheese to name just a few.
The same is expected in 2021 for a number of reasons. First, Paycheck Protection Program loan funds are running out for many labor-intensive businesses and the second draw of PPP funds, while helpful, is unlikely to be sufficient for a long-term recovery. There are discussions of further stimulus efforts, which may be helpful, but absent some action, most expect 2021 to be dismal for this group.
Second, many larger retailers with unencumbered assets increased liquidity by pledging assets. In 2021, this option will not be available.
Finally, if there is good news on the horizon, it is the promise of vaccine availability and the fact that the equity markets have remained remarkably robust. But when will the good news overtake the bad? Moreover, will shoppers, who have found online alternatives to help them through the last year, return in sufficient numbers?
A timely example of the continued ripple effects of 2020 is the Jan. 25 bankruptcy filing of CiCi's Holdings Inc., a chain of pizza restaurants, in the U.S. Bankruptcy Court for the Northern District of Texas. CiCi's has a nationwide reputation, but had precipitous revenue drops due to COVID-19 challenges.
The filing featured a first-day plan including a debt exchange and new liquidity in the form of a debtor-in-possession loan. This will be a radical modification to the balance sheet of the company with the real losers being the unsecured creditors. Unlike other real estate-laden retail businesses, CiCi's is primarily a franchiser. According to its disclosure statement, 96% of its 369 restaurants were franchise locations. Thus, distress is being felt beyond operators burdened with real estate obligations.
Like retailers, the airlines have generated liquidity by pledging unencumbered assets. American Airlines Group Inc. and other mainline carriers have taken previously unencumbered assets, such as their loyalty rewards programs, and pledged them to create the liquidity necessary to maintain their fleets and retain their workers and routes while demand remains low due to COVID-19.
The important pending question remains whether these liquidity measures will be sufficient to wait out the storm until travelers take back to the skies. Some non-U.S. airlines have already hit the liquidity wall and were forced to file Chapter 11 including LATAM Airlines Group SA, Avianca SA and Grupo Aeromexico SAB de CV. None of these debtors has yet emerged from their cases, and each will succeed or fail based upon its ability to muster sufficient liquidity to survive until passengers return.
Many companies have survived COVID-19 thus far by spending the flexibility afforded to them by covenant-lite debt documents, maxing out available debt baskets and pledging previously unpledged assets in exchange for additional liquidity, interest payment holidays and extending maturity dates.
The cost has included more robust financial covenants that will enable lenders to exert greater control. Loan agreements have been amended to add strict loan covenants, such as debt service coverage ratios and fixed charge covenants. Another consequence of raising liquidity and adding additional covenants has been to increase overall leverage of the balance sheets of companies in troubled industries.
On a macro level, this will undoubtedly lead to additional defaults if demand does not increase or if these same companies experience execution risk of some kind.
Despite these headwinds, there will be opportunities in 2021. Healthy strategic buyers and private equity-backed financial buyers will be able to take advantage of buying opportunities. For these buyers, we expect 2021 to provide an active Section 363 bankruptcy sale market. It is no secret that the use of commercial space has been reevaluated during the COVID-19 crisis. Many businesses burdened with long-term, expensive leases of real property could become attractive targets in Section 363 sale transactions because of the lease rejection option available in Chapter 11.
In addition, many acquisitive financial investors have already positioned themselves favorably in the debt capital structures of troubled businesses for a wave of potential recapitalizations if economic recovery lags. These lenders, however, will be challenged in 2021 to carefully consider their options.
While including tight loan covenants and default remedies provides control, many businesses remain closed due to government-imposed shutdowns.
For example, Studio Movie Grill Concepts I Ltd., a Chapter 11 debtor in the U.S. Bankruptcy Court for the District of Texas, rejected leases for locations in California because they remain closed due to state and county closure orders. The debtor continues to look for buyers and there is the possibility of a credit bid being approved in favor of the secured lender.
This illustrates the conundrum that lenders will increasingly confront this year. Do they actually want to own such distressed businesses?
Unlike prior financial crises, weaker companies will not be alone in experiencing distress. In 2021, COVID-19 will continue to ravage strong and weaker players alike in susceptible industries. For example, it does not matter how strong a movie theater operator is when shutdown orders are keeping its doors closed, or significant numbers of would-be theater goers prefer to stream new releases at home.
Nevertheless, this environment presents opportunities for well-funded investors or newcomers to markets that transition from closed to open as public health measures take effect and regulations are lifted.
One anomaly in the real estate sector continues to be the unavailability of traditional remedies of foreclosure and eviction. In many states, foreclosures are literally unavailable.
In New York, for example, the governor has issued a series of executive orders placing a moratorium on initiating or enforcing the foreclosure of any commercial mortgage due to nonpayment.
In addition, in Harris County, Texas, there has only been one month since March 2020 when the county judge allowed foreclosures to go forward. This leaves lenders unable to foreclose and take title to their collateral, but it also leaves the lender exposed in the sense of not being able to control, maintain or protect the property.
The year 2021 figures to be volatile as investors seek to predict which industries and companies will quickly return to normal when the pandemic subsides, and which will need to deal with the potentially long-term ramifications of changing behavior.
If the public health crisis persists deeper into 2021 than expected, investors holding equity or subordinated debt in distressed businesses that they believe have long term value, may need to be willing to open their checkbooks defensively to stave off defaults that could precipitate bankruptcy filings, which, in turn, could wipe out their investments.
We expect valuation issues to be highly contentious in bankruptcy cases in 2021 for businesses that default before the crisis abates.
In addition, we expect the pace of litigation relating to debt incurred during 2020 to increase in 2021, particularly with respect to transactions that were structured by one group of creditors for their benefit at the expense non-participating creditors.
Keith Aurzada, Aaron Javian and Michael Venditto are partners at Reed Smith LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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