Business Failure Rates Edge Higher

Bankruptcy courts are seeing more action as the credit crunch reduces distressed companies' room to maneuver. And there may be worse to come.

Business bankruptcies rose 7 percent in the second quarter from the previous quarter, according to the latest data from the administrative office of the U.S. Courts. A total of 6,705 companies filed in the second quarter, a 38 percent year-over-year increase from the same period in 2006.

The figures extend a steadily rising trend in the number of insolvencies since a dramatic spike at the end of 2005, when distressed companies scrambled to file before the Bankruptcy Abuse Prevention and Consumer Protection Act ushered in what they perceived as a more creditor-friendly environment. "That surge borrowed, effectively, from bankruptcies that might have happened in 2006," says Daniel C. North, chief economist with global credit provider Euler Hermes ACI. "If we get back to normal levels of bankruptcy -- levels we saw before the change in the laws -- it would be something like a 50 percent increase [over 2006]. That's what we have forecasted, and it's not only for the technical reason of the change in the law. We also see a significant slowdown in the economy and continuing weakness coming over the next several quarters into 2008."

Three major forces are driving the slowdown, according to North: the increased costs of energy, raw materials, and labor; the lingering effects of the Federal Reserve's tightening of monetary policy over the past couple of years; and the Fed's action in "effectively popping an asset bubble -- the overinflated housing market."

Richard Epling has already noticed the effects of the credit crisis in his practice. "Where you've seen problems in the past two or three years before the recent credit crunch, they've all been industry-specific," says Epling, New York City--based partner with Pillsbury Winthrop Shaw Pittman LLP and co-leader of the firm's insolvency and restructuring practice. "Essentially, companies such as airlines and certain other organizations with big legacy liabilities from pensions or environmental claims -- or companies with mass tort problems from silicon, asbestos, or tobacco -- would use the bankruptcy courts to try to shed those liabilities. Now what you've got is companies that are essentially unable to pay long-term debt or current portions of long-term debt because it has become too expensive for them. It's a different set of problems now."

High levels of liquidity have enabled companies to paper over some problems in recent years. Most organizations that needed some type of funding could easily find it in the markets, says Fruman Jacobson, chairman of the restructuring and bankruptcy section nationwide at Sonnenschein Nath & Rosenthal LLP in Chicago. "Banks, in particular, that got fatigued in dealing with a particular borrower -- maybe there were some delinquencies, maybe some additional needs that the borrower had that the bank did not want to fund or overfund or continue funding -- could put [the debt] out in the market, and typically it would be snapped up by a hedge fund and sometimes by a private equity fund," he points out.

But with investors' appetite for corporate debt rapidly diminishing, troubled companies have fewer options. "Even the best credits we see for commercial paper are having increased rates and difficulty in some cases actually placing the paper," says North. "Of course, if they're having trouble, the smaller companies will have difficulty as well."

Euler Hermes is forecasting a total of 30,000 bankruptcies for the year. In addition to difficulties in the housing sector and industries close to it such as building material manufacturing, North expects to see "pressure in companies that are energy-related, because oil costs remain highly elevated, historically speaking. The chemical industry we also see as facing difficulties because typically these companies are making commodity goods with thin margins, and if you have an increase in raw material costs, principally petroleum, this drives your margins even thinner."