Catch-11

The government's plan for saving small and medium-sized businesses from liquidation puts them in a bind that brings to mind the one Yossarian had to contend with. The problem, in a nutshell, is this: Chapter 11 bankruptcy may be many firms' best hope for surviving the present crisis. But to take advantage of it, they need credit—the cheaper the better. Firms can get cheap credit through either the Small Business Administration's (SBA's) Paycheck Protection Plan or the Fed's Main Street Lending Programs. But there's a catch: to qualify for these loans, they mustn't file for Chapter 11.

That's Catch-11, and it, too, is some catch.

In this post, I'll quickly explain how Chapter 11 bankruptcy can help firms survive the crisis, and why many firms may need financial assistance to take advantage of it. Next I'll explain why they can't get such assistance from either the SBA or the Fed. Finally, I'll consider some options for getting around Catch-11.

Chapter 11

Although the government can't undo the damage caused by the coronavirus epidemic or steps taken to contain it, there are things it can do to help sound firms survive, so as to avoid unnecessary waste and an unnecessarily slow return to full employment.

"Helping" a business means helping it to pay its bills. The government can do this by giving or lending a firm money. It can also allow the firm to put-off payments as it reorganizes its debts. In the U.S., Chapter 11 bankruptcy is one way firms can get the second sort of help.

Unlike Chapter 7 bankruptcy, which leads to liquidation, Chapter 11 leaves a firm's management in place, while charging it with working out a plan for discharging its debts. If it comes up with one agreeable to its creditors, and the court accepts it, a new firm emerges that preserves much if not all of its predecessor's goodwill. That's the long-run advantage of Chapter 11. Its chief, immediate advantage consists of the "automatic stay" that takes effect as soon as a firm files for it, which temporarily protects it from creditors who might otherwise force it into liquidation by insisting on the immediate settlement of their debts.

Because firms face only modest odds of emerging from Chapter 11 intact, and the process tends to be both time-consuming and expensive, until recently it was seldom practical for small or medium-sized businesses. But this changed in February—just in the nick of time for the present crisis—when the Small Business Reorganization Act (SBRA) took effect. That act added a new subchapter (Subchapter V) to Chapter 11, allowing smaller firms to resort to a streamlined and less costly version of the usual procedure. Among other things, that procedure allows small-business owner-managers to continue to own and run their firms, provided they give their disposable income to creditors for several years. Although Subchapter V was originally available only to firms with less than $2.7 million in debt, in response to the crisis that limit has been raised to $7.5 million.

At that higher limit, not quite 60 percent of all Chapter 11 cases will qualify for Subchapter V. That's a substantial number of firms. And according to David Skeel, even without Subchapter V, the present crisis, combined with the extraordinary amount of debt many firms have taken on in recent years, would have resulted in "a much greater surge in business bankruptcy filings than either of the two most recent recessions." Although no one wants to see many firms filing for Chapter 11, that may prove in the months to come to be their only alternative to shutting down for good.

DIP Financing

Though some may think of bankruptcy and emergency financing as alternative ways to rescue struggling firms, they can be complements rather than substitutes. In particular, firms that file Chapter 11 will still have expenses to pay while their cases proceed. To meet those expenses, they may need financing. Because a firm that files for Chapter 11 bankruptcy is known as a "debtor-in-possession," this financing is called debtor-in-possession (or "DIP") financing. Without it, many firms can't survive long enough to successfully reorganize; and unless they expect to survive, most won't bother to file.

The need for DIP financing is likely to be acute today. As Stanford University professors Peter DeMarzo, Arvind Krishnamurthy, and Joshua Rauh explain,

While in a typical recession, cash flows may experience a decline of, say, 10%, in the current COVID recession, cash flows for some firms will temporarily fall by 100%. Importantly, the current situation should be viewed as a pause: cash flows of many of the affected firms will bounce back once the COVID recession is past. However, before the pause is over, firms may face situations where they are unable to service their debts and other fixed financial commitments. These sudden but temporary cash flow stoppages may force many corporations to file for Chapter 11 bankruptcy.

Firms that have had little or no income for weeks aren't likely to have the cash it takes to finance themselves in bankruptcy.

Normally private lenders can be expected to offer DIP funding, at a price: a December 2019 study of DIP lending to large firms found that, even though DIP lending is generally safe, "the average [DIP] loan spread is a whopping 600 basis points, which is 70% higher than the average spread on high-risk leveraged loans obtained by the same terms three years prior to Chapter 11 filing." But private DIP funding overwhelmingly favors very large firms; and the same events that have left firms of all kinds short of cash could also cause even that limited funding to dry up. According to an April 8 Wall Street Journal report, the crisis has turned normally low-risk DIP loans into "problem investments," and that could make DIP loans "both harder to find and more expensive just when American corporations need them most."

Without proper funding, companies can't keep themselves afloat in bankruptcy and reorganize successfully, raising the likelihood they will end up dismantled through liquidation.

In short, unless the government supplies them with DIP financing at a reasonable price, many businesses that might otherwise be saved could end up failing, making for that much more unemployment, and a correspondingly slow recovery.

A Self-Selection Advantage

Fortunately there are good reasons why DIP funding is an option any government seeking to aid struggling businesses should consider. Providing such aid efficiently means trying to steer clear of three sorts of errors: (1) failing to support otherwise viable firms that won't survive without help; (2) supporting firms that are bound to fail because they're fundamentally unprofitable; and (3) supporting viable firms that could survive without help. Running that gamut is difficult even under the best of circumstances. Doing it during a crisis, when there's no time for the usual due diligence, is well-nigh impossible.

But compared to other sorts of aid, low-cost DIP financing is a good bet. That's because it takes advantage of a self-selection process that can partially compensate for inadequate due diligence: firms that don't need help don't file for bankruptcy, while many with low prospects for survival would rather go bust than put themselves through the ordeal of Chapter 11. Finally, assuming they're treated like other DIP lenders, government-sponsored DIP lenders may enjoy special protection from loss, which—provided their clients' existing creditors are found to be "adequately protected"—can include priority over those other creditors (a so-called "priming lien").  For all these reasons cheap DIP financing is likely to be less wasteful, dollar for dollar, than other forms of relief.

The SBA

Of course the government is supplying companies with cheap, if not free, funds, through both the SBA and the Fed. The rub is that firms that have filed for Chapter 11 can't have them.

When the SBA's Paycheck Protection Program (PPP) first got going in early April, firms that had filed for bankruptcy were surprised to find themselves excluded from it. Although the CARES Act itself contains no hint that they would be, the PPP application form asks applicants whether they are "involved in bankruptcy proceedings"; and the SBA has denied funds to any that are. At last, on April 15th, the SBA posted an interim rule making its policy explicit: firms in bankruptcy were ineligible for PPP loans, while those that had filed for bankruptcy after having been offered PPP loans had either to cancel the loans or risk being charged with the "use of PPP funds for unauthorized purposes."

The SBA's arguments in defense of its stance are puzzling, to say the least. It says,  first of all, that giving PPP funds to firms in bankruptcy "would present an unacceptably high risk of an unauthorized use of funds or non-repayment of unforgiven loans." In fact, lending to DIPs is a lot less risky than lending to firms that may very well end up filing for bankruptcy after they get a loan, because (as we've seen) DIP lenders get priority over others in bankruptcy. Instead of protecting the SBA from losses, the SBA's policy could actually make it worse off, by encouraging firms to wait until they have their PPP funds on hand to file for bankruptcy, leaving the SBA to press its claims at court!

The SBA's second argument, that "the Bankruptcy Code does not require any person to make a loan or a financial accommodation to a debtor in bankruptcy," hardly deserves a response. But for the record: as the same Code also does not prohibit any person from making a loan to a debtor in bankruptcy, it supplies the SBA with no reason at all for having taken the position it took.

Unsurprisingly, the SBA's decision has already yielded a crop of lawsuits by firms seeking permission to use PPP funds to restructure in bankruptcy. One plaintiff, a Texas ambulance company, has already scored a victory. In a judgement passed down on April 25th, Chief Judge David R. Jones of the Bankruptcy Court for the Southern District of Texas declared the SBA's reasons for denying PPP funds to bankrupt firms "frivolous" and lacking in "good faith." "This can't be what Congress intended," he said. "The people that need the most help and who have sought protection under our laws are the people who are the targets of discrimination in a government support program; can't possibly be." Jones went on to enjoin the SBA from considering the ambulance company's bankruptcy.

A week later, in In re Roman Catholic Church of the Archdiocese of Santa Fe, Judge David Thuma of the New Mexico Bankruptcy Court called the SBA's decision to deny the archdiocese a PPP loan on the grounds that it was in bankruptcy "arbitrary and capricious." Having found that the SBA had no authority to "engraft a creditworthiness test where none belonged," Thuma held that the archdiocese might be entitled to compensatory damages, if not to punitive ones, were the SBA to persist in denying it funding.

The "Main Street" Alternative

Despite these recent rulings, the SBA still considers firms in bankruptcy ineligible for PPP funding. So far as its administrators are concerned, firms needing DIP funding need to look elsewhere. Might the Fed help? Its soon to be launched Main Street Lending facilities are, after all, the only other important source of government-sponsored emergency business credit.

Alas, any bankrupt firm that's sent packing by the SBA is bound to be turned away by the Fed as well. For one thing, the Fed's Main Street facilities are meant for firms with 500 to 15,000 workers. That alone rules out most firms that might try for PPP loans. The only exceptions are chain restaurants and franchises, which can apply for PPP loans so long as each of their outlets has fewer than 500 employees.

But even firms with 500 to 15,000 employees can forget about getting DIP funding from the Fed. And in this case it's not just because of some arbitrary Fed decision that a judge might countermand. It's because of language in the Federal Reserve Act itself. According to Section 13(3), subparagraph B, part i of that act,

The Board shall establish procedures to prohibit borrowing from programs and facilities by borrowers that are insolvent. Such procedures may include a certification from the chief executive officer (or other authorized officer) of the borrower, at the time the borrower initially borrows under the program or facility (with a duty by the borrower to update the certification if the information in the certification materially changes), that the borrower is not insolvent. A borrower shall be considered insolvent for purposes of this subparagraph, if the borrower is in bankruptcy, resolution under title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act, or any other Federal or State insolvency proceeding.

Because the Fed's Main Street facilities operate under its Section 13(3) authority, this rule absolutely prevents them from lending to DIPs. What's more, the Fed plans to ask applicants for Main Street facility loans to certify that they do not expect to file for bankruptcy for at least 90 days after they receive funding. As in the SBA case, it will still be possible for firms to file for Chapter 11 once they have funds in hand. But that possibility will only make the Fed and its partner banks all the more reluctant to lend to those firms that are least likely to survive without its help. That's Catch-11.

A DIP Financing Facility?

Catch-11 has already inspired some calls for action, including a proposal, by Peter DeMarzo, Arvind Krishnamurthy, and Joshua Rauh, for a new Fed "Debtor In Possession Financing Facility" or DIPFF:

The Federal Reserve will finance X% of a special purpose vehicle (SPV) that will own the DIP financing loans, across all corporations in default and applying to the facility. The Treasury will make an equity investment of 1-X% in the SPV.  The underlying firm collateral together with the first-loss piece provided by Treasury will ensure that the Fed's investment is risk-free.

"X," the authors explain, "will depend on the risk of the underlying DIP loan." As DIPFF loans would be either fully collateralized or protected by priming liens, X would presumably be a modest number, perhaps not much different from the 12.5% backing of the Fed's Main Street facilities.

Unfortunately, that's not all that the DIPFF proposal would have in common with the Fed's Main Street facilities: like them, and the Fed's other SPVs, it could only be established under the Fed's 13(3) authority, which alone allows the Fed to lend to ordinary businesses (and on non-discount window collateral). But as we've seen, that same authority prohibits lending to firms in bankruptcy. The DIPFF plan is therefore self-defeating. Catch-11 again.

Fixing the Catch

If the Fed can't offer emergency DIP financing, and the SBA won't do it, what options does that leave? Unfortunately, so far as the CARES Act is concerned, the answer is: hardly any. That law uses those two agencies as conduits for almost all of the emergency lending it provides for, including $454 billion dedicated to backstopping Fed programs, roughly half of which have been spoken for thus far.

It follows that, if there's to be emergency DIP lending, Congress still has to provide for it. It might do so by authorizing new funding for the purpose, to be administered by agencies other than the Fed and the SBA. Alternatively, it can change the rules for SBA and Fed lending, by instructing the SBA to abandon its prohibition against lending to bankrupt firms, or by amending section 13(3) of the Federal Reserve Act so as to allow the Fed to lend, at least temporarily, to bankrupt firms. The last two options have the distinct advantage of allowing already-appropriated funds to support emergency DIP lending.

Any plan for emergency DIP lending poses some risk of having the government either waste resources by propping-up mortally ill "zombie" firms or competing unfairly with private DIP lenders. The risk can be mitigated, however, by permitting official funding of DIP loans only under extraordinary circumstances, and according to clearly and carefully defined rules. (Regarding some of those rules, see this excellent 2016 article by Marc Heimowitz.) Sticking to the current practice of channeling emergency DIP funding through private-market lenders that are required to keep some skin in the game can also help.

The last approach has been recommended by David Skeel, who also recommends having private lenders keep a 20-25 percent share of Fed-supported DIP loans they originate, as opposed to the 5 percent share of ordinary Main Street loans they must keep. The rationale for directing public DIP support through private lenders is well-stated by Jared Ellias, a law professor at U.C. Hastings, in a recent interview with Kate Judge. It's that private-market DIP lenders

provide more than money. They also supply expertise and often go so far as to dictate the outcome of the bankruptcy case by attaching restrictions to the DIP loan. …The government could step in to supply capital, but Treasury or the Fed don't have a large number of experts in distressed investing that can step in to play that leadership role in the bankruptcy process. When the government played that role with GM and Chrysler, it also brought in a team of proven experts from the world of distressed investing.

Although Skeel's idea may be the best solution to the immediate problem of DIP financing, there are good reasons for wanting to keep the Fed out of the DIP lending business in the future, and for leaving it either to private-market DIP lenders alone or, when that won't do, to some other government agency working in conjunction with such lenders.

For example, Congress could establish a temporary, independent agency resembling DeMarzo et al.'s DIPFF, but fully-funded by the government (that is, with X = 0), with commercial lenders originating and holding a substantial portion of DIPFF-funded loans. As I've explained elsewhere (see the first subsection here), although it would increase the official deficit, dispensing with Fed "leveraging" doesn't actually reduce the tax burden, and might even save the government money. Besides making new DIP loans, an independent DIPFF could also take responsibility for any outstanding Fed DIP loans, supposing it ever makes any. Instead of having to take on an ever-escalating number of risky missions, the Fed could then focus on its fundamental duties.

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