U.S. Bankruptcy filings are on a decline. Sounds like good news, though it may signal troubles ahead
Here is why
Total bankruptcy filings decreased sharply according to data provided Epiq Systems, Inc and the American Bankruptcy Institute (ABI). Total registered fillings* for October 2020 dropped by more than 27,000 or about 31% in comparison to October 2019.
Fewer bankruptcy filings, better-than-expected economic activity, and skyrocketing stock markets can be interpreted as positive stories and the indication of a strong post COVID recovery. Nonetheless, there is much more to the story than what meets the eye, as these number can masquerade important warning signs, especially for small and medium sized firms.
Rather than a signal of decreasing stress on businesses, the reduction in fillings for the year are likely to suggest a large rebound in bankruptcies for year 2021. On the same report, the ABI indicated a rise in Chapter 11 petitions for 2020. Moreover, the number of Chapter 11 fillings by the end of October 2020 are the largest cumulative 10-month sum since 2013, and already surpassed the total number of fillings in 2019.
The rise of Chapter 11 filings is a signal of business distress, but mostly centered on larger firms. As evidenced by the recent proliferation of high-profile bankruptcy filings, such as Hertz, Brooks Brothers, and JC Penney. Moreover, a recent publication by the Brookings shows that about 80% of firms with liabilities above $500 million end up reorganizing rather some form of liquidation. On the other hand, while more than 90% of bankruptcies with liabilities under $1 million end up in liquidation. According to the U.S. Federal Reserve, businesses small and medium sized businesses (SME’s) are particularly vulnerable to social distancing for two main reasons:
First, these businesses are widespread in sectors that have seen large decline in revenues (such as beauty salons, restaurants, and stores found on shopping malls)
Second, smaller firms tend to be more financially constrained than large firms. They usually count on less cash to operated and are more dependent on bank loans, credit cards and personal resources of owners.
These findings suggest that firms with larger resources and better access to credit are the ones making proactive use of legal and financial means to negotiate with creditors, protect their capital, and eventually be in better shape to navigate the economic mayhem caused by the pandemic. On the flip side, small and medium operators are probably holding up with the help of government aid and forbearances from banks and other creditors.
Breathing room can last as long as government aid and moratoriums
Business managers and policy makers should be on the look for the effects on business activity in the face of dwindling help provided by government aid programs and collective payment accommodations by banks, landlords and other creditors. The extension of cash infusion by the government and payment leniency by creditors have the potential to delay -or even avoid - default situations for many businesses as it proved to be highly effective during 2020. The problem lies when fixed operating costs for businesses are much larger than the benefit of government aid and moratoriums; or when support halts before sales come back. Either situation elevate the risk for cashflow shortage in businesses and eventual default in their payment obligations.
Talk to your creditors before trouble deep trouble sets in
One powerful and scarcely used tools by business managers is to close the communication gap between with their creditors. In this context creditors are usually commercial banks, but may also include credit unions bondholders, and even suppliers of business-critical inventory.
Good communication with such stakeholders can help businesses avoid unnecessarily contentious situations, extend payment forbearances, and even attain financing terms more suitable to the new reality.
Jesús Daniel Mattei, CFA
M: +1 787 310 0297
[a] Commercial and non-commercial filings
https://www.brookings.edu/wp-content/uploads/2020/09/Greenwood-et-al-conference-draft.pdf  https://www.federalreserve.gov/monetarypolicy/2020-06-mpr-part1.htm - xbox3-smallbusinessesduringthecovid--106f51bf