Rafael X. Zahralddin participates in the IR Global Insolvency Virtual Series – Insolvency & Restructuring: How the global pandemic changed the rules on insolvency

Rafael X. ZahralddinShareholder, Director, and Practice Chair, Elliott Greenleaf

Foreward by Andrew Chilvers

Insolvency and restructuring legislation changed radically in all jurisdictions in the wake of COVID-19. While governments have tried to delay the number of insolvencies in the short term, most experts agree that distressed businesses will start to fail significantly later this year and into 2021.

For insolvency practitioners and lawyers alike, the pandemic has posed problems that have not been seen on a global scale in more than 100 years. Many businesses have faced sudden and catastrophic closures along with the evaporation of their revenue as emergency lockdowns have been implemented across all jurisdictions in an attempt to control the virus.

And now as lockdown measures have eased around the globe, those companies still functioning may well be tipped over the edge into insolvency by the loss of trade during and post the pandemic. No surprise then that later this year, the number of company insolvencies and liquidations is predicted to soar.

This provides the challenge for insolvency professionals; how to retain value and restructure decent businesses that were robust and profitable before March, while allowing zombie businesses to naturally fail?

Are different governments introducing new legislative or country regimes that allow for restructuring over liquidation? There is no legislation that allows restructuring, so how does it preserve its economic value?

One of the biggest changes in U.S. bankruptcy law has been the small business chapter five election, and the Trump administration increased the amount necessary to be eligible for the election to $7.5 million of uncontested debt. Under sub-chapter five designation you don’t have the costs of a creditors’ committee. There’s a chapter five trustee put into place, but you retain command over your company like you do under a regular chapter eleven.

One of the significant features, aside from the speed and the cost reduction for these smaller businesses, is that you are able to retain equity as an owner, which is something you can’t do under a normal chapter eleven where equity gets wiped away without new investment. If you’re an owner of a small business you should be able to keep ownership, including what people call sweat equity, as opposed to new money coming in to retain equity.

But in this new sub-chapter five election, you are not only allowed to keep ownership in your small business, but if you have personal guarantees as an owner, you can also wipe those out. It’s a little bit different from a chapter eleven, where the debts are wiped away. Instead, you’re going in and paying the debts over three to five years. This is brand new. It was enacted to start in January.

Do “rushed through” insolvency measures address both large enterprises and small and medium-sized companies? Is there legislation pending to address this in your jurisdiction?

I’m not sure what’s going to happen in the U.S. because we have this little thing called an election coming up in November. Even with the new chapter five, I saw a headline yesterday that a bank just foreclosed on 25 hotels. There is going to be more than $7.5 million dollars in debt, in maybe just one hotel. The lenders want to take over the real estate, but all that going concern value is simply wiped away.

Whoever set the thresholds on what they consider to be small businesses didn’t actually talk to anyone, which isn’t surprising because the small business sector is often neglected. Even with the Small Business Administration in the U.S., they are often neglected and there is very little information about them. But they are the engine of the U.S. economy. They create sustainability for a majority of people who don’t want to expand. For example, an entrepreneur may have just one hotel that can hire their immediate family, their extended family, and maybe some friends.

And that’s what makes the U.S. economy strong; when that goes down you have serious problems which is why there is such a wealth gap right now in the U.S. I don’t know what you would do as a small-to-medium sized enterprise, and certainly if you are a smaller restaurant or hotel, and the victim of a riot on top of COVID – as riots are not covered by traditional insurance. I would suggest that you go away, sit back and take three months off to figure out what you are going to do next.

With the “light touch administration” processes now being implemented in different jurisdictions, does this give too much power back to directors? What are the potential risks for the office holder?

It’s OK to make mistakes here in the U.S. You just can’t do it carelessly and you can’t be dishonest. Instead, you can use the advice of counsel and other professionals to work through it and I think this offers a tremendous amount of flexibility.

That said, there isn’t enough flexibility in chapter eleven today. The lions of the restructuring and reorganization practices out there lament the fact that we haven’t had true reorganizations in the U.S. for a long time. Most of what we have here is a distressed mergers and acquisitions market. It seems that selling businesses as a going concern is the only option. The debtor isn’t really making a decision to sell because of the way that different waves of lenders have exerted control of the enterprise. You aren’t really seeing management being able to continue along to preserve the value of the business and come out on the other side. There are legions of people who can no longer even use their own given name because their company was sold out from under them, and the lenders pushed them into chapter eleven and used the mechanism this way.

The only real difference between a chapter eleven and a chapter seven in the United States is who is in charge of the company. I think that the officers and directors should be given more flexibility to reorganize, but right now, the fact that they don’t have flexibility is a product of the lending markets. At some point this will adjust itself because eventually the markets do adjust themselves the right way.