Going Out of Business

Business bankruptcy filings hit 7,874 in June, or 358 per filing day. That's a 48% jump from a year ago, and the worst could be yet to come. "I think the surge in commercial bankruptcies is probably not yet here," says Harlan Platt, a finance professor at Northeastern University who studies bankruptcies. That's partly because bankruptcies are typically a lagging indicator of the economy's health. Two important factors that contribute to business failures—depressed sales and tight credit—may linger even once the economy starts growing again. And creditors, frustrated with turnaround plans that rarely succeed, are increasingly unlikely to work with business owners to help insolvent firms recover.

More than 100,000 companies—about one in every 270 American businesses—have landed in bankruptcy court in the past 18 months, and the rate of commercial bankruptcies has more than doubled in the past two years, according to data compiled by Oklahoma City-based Jupiter eSources, which tracks filings through its Automated Access to Court Electronic Records database. Euler Hermes, a unit of German insurer Allianz that provides insurance against defaults by trading partners, expects business bankruptcies to rise 45% this year, and to decline only slightly in 2010. In its 2009 "Insolvency Outlook" report, the firm estimates that, on average, "It takes GDP growth of 2% to 3% to stem the rise in insolvencies."

Robert Lawless, a professor at the University of Illinois College of Law, says availability of credit is more important than gross domestic product growth. "I don't expect that to really ease," he says. In the short term, Lawless says, bankruptcies are usually triggered by an interruption in income. While that might mean a layoff for a wage earner, declining sales for a business can lead to bankruptcy.

Making matters worse, banks with fragile balance sheets are largely unsympathetic to debtors' turnaround plans. Often creditors can recover more of their debts, faster, by closing insolvent businesses and selling off the assets. "Today lenders—meaning banks—have much less patience for a traditional Chapter 11 reorganization, no matter what size the case," says attorney Kenneth Rosen, head of the bankruptcy group at law firm Lowenstein Sandler in Roseland, N.J.

That's raising pressure on businesses to settle debts out of court or liquidate through Chapter 7, in which a 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. "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.

But all bankruptcy proceedings are expensive and, in most cases, unlikely to position the company for a turnaround, says 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 time and expense of a bankruptcy case.

Return to the BWSmallBiz August/September 2009 Table of Contents

    Before it's here, it's on the Bloomberg Terminal.