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With the failure of Silicon Valley Bank (SVB) and Signature Bank, many in the bankruptcy community ask what – if any – impact there will be on bankruptcy filings and the bankruptcy system. Following is a snapshot of some of the issues and impacts being discussed:

If bank regulations tighten, will filings go up or down?

That may depend on the extent of any regulatory crackdown. Right now, with the federal government back-stopping any losses to depositors, it would appear that the crisis is contained. But if the regulatory reaction leads banks to reduce lending, businesses could be on a rough ride, and chapter 11 filings may rise. In turn, that could lead to job losses and other adverse economic effects that may also push some consumer debtors over the edge into bankruptcy. 

According to a story in the Wall Street Journal, "Main Street businesses and American families are likely to find it harder to get a loan because of turmoil in the banking industry, denting economic growth and raising the risk of recession.”  The paper goes on to cite data showing that smaller and medium-sized banks, which are facing the greatest scrutiny right now, are more likely to retrench. Banks smaller than the top 25 banks make about 38 percent of all outstanding loans and a whopping 67 percent of commercial real estate loans. As smaller and medium-sized banks are most vulnerable to a regulatory crackdown, the current bank climate may lead to accelerated bankruptcy filings over time. 

What happens to bankruptcy filing rates if the Federal Reserve stops raising interest rates?

If the Fed responds to the current banking problems with a pause or reversal of interest rate hikes, then the rate of increase in the number of bankruptcy filings may move lower. If the federal government also permanently expands the $250,000 deposit insurance limits and takes steps to encourage banks to make business and consumer loans, then the rapid pace of bankruptcy filings may further slow in the near-term.

It is still hard to see how the overall number of filings could dramatically reverse the current upward trend. In fact, it seems that only a reversal in the Fed’s interest rate policy can prevent an even bigger increase in bankruptcy filings than we have been seeing. I guess we should wait for a few more Fed meetings and commentaries by economic experts before changing expectations for many more bankruptcies in 2023.        

Are bankruptcy estate funds protected?

Short answer – the law unambiguously requires it. The longer answer – it’s more complicated than that.

Payments to creditors depend upon the safety of cash deposits and investments from bankruptcy estates. Each year, up to $10 billion are disbursed by chapter 7 and 13 trustees. Chapter 11 estates disburse additional huge sums in conducting business while in bankruptcy and paying creditors under confirmed reorganization plans. That is why Congress enacted section 345 of the Bankruptcy Code, which provides that bankruptcy estates must make deposits and investments that "will yield the maximum reasonable net return on such money, taking into account the safety of such deposit or investment.” The law requires that financial institutions holding estate funds protect all amounts that exceed federal insurance limits by posting collateral or bonds.

The Justice Department’s United States Trustee Program (USTP) polices compliance with section 345 by limiting bankruptcy estates to authorized depositories that agree to USTP monitoring for compliance. This works very well in cases controlled by USTP-appointed private trustees. However, things get a bit dicier in chapter 11 cases in which management stays in control of the debtor company. Although the USTP is strict in its application of section 345, the law allows courts to make exceptions. This came to a head in the BlockFi crypto-currency case, which had not protected its money as directed by the USTP. Fortunately, no money was lost in BlockFi or other cases.

The current banking problems should serve as a significant caution to businesses, and their lawyers, that failure to adhere to section 345 protections may carry huge consequences.   

Why haven’t Silicon Valley Bank and Signature Bank filed for bankruptcy?

Banks are not eligible to file for bankruptcy. When banks become insolvent, they are liquidated through bridge banks and overseen by a banking regulator to protect depositors instead of creditors. Banks are often owned by holding companies, however, that do file for bankruptcy. The holding company for Silicon Valley Bank recently filed a chapter 11 bankruptcy petition.     

It will be interesting to see if an independent bankruptcy examiner will be appointed to investigate SVB – apart from other reported criminal and civil investigations. The purpose of the bankruptcy investigation would be to issue a public report into the causes of the collapse and possible stakeholder causes of action. During the Great Recession, Washington Mutual (the largest bank collapse in American history) and other lenders were subject to such independent bankruptcy examinations. Given the deference paid by bankruptcy judges to management and law firms representing large chapter 11 debtors, however, I would not hold my breath.

Commentary provided by Clifford J. White, Managing Director – Bankruptcy Compliance for AIS.

  

February 2023 bankruptcy filings rose by a hefty 18.2 percent compared to the same month last year. This uptick matched the January percentage increase. After falling during the first part of 2022, filings began to climb, slowing beginning last summer. The rapid acceleration experienced over the previous two months is the greatest since the Great Recession in 2009. If this trend continues, about 70,000 more cases will be filed this year than in 2022.  

Filings Rose Across the Board

With total February filings of 32,032, all major chapters of the Bankruptcy Code saw a significant rise compared to last February. As has been the case for the past year, chapter 13s led the way with a huge increase of 29.3 percent. Chapter 7s, which have consistently lagged behind other chapters since the pandemic, are also in an upward tilt mode with a strong rise of 10 percent. Chapter 11 cases skyrocketed by 77.2 percent last month as they stay on a steep upward path. Small business subchapter V cases registered a solid gain of 23.9 percent.

Of course, there may be many blips ahead. But the strong filing rates in February continue a strong upward trajectory that may not stop very soon. 

Possible Reasons for the Rapid Increases

The current rocketing numbers may be fueled by the same economic conditions described in previous AIS reports, except now the fuller effects of adverse economic conditions are being felt in fuller force. The economic picture is mixed, but the positive data, such as lower unemployment rates, have not offset the hardships caused by the negative economic factors.

Historically, bankruptcy filings are influenced by macroeconomic conditions and more specific factors so that, during some periods, increased numbers of consumer and business debtors have needed bankruptcy relief during prosperous times. That makes sense because good times usually involve relaxed credit and more opportunities to make risky bets or take on too much debt.

In February, the Federal Reserve published data showing that revolving debt reached nearly $1.2 trillion in 2022, surpassing pre-pandemic debt levels. That is often a sure sign of economic travails to come for those in shakier economic circumstances.

A prominent chapter 13 trustee recently suggested that wage-earner repayment plans may continue to rise because of high home mortgage interest rates. In the past, some consumers who owned homes would walk away from their mortgages with confidence that they could buy another home in a couple of years when they could better afford it. Today, overburdened homeowners know they are likely to confront higher mortgage interests rates in the future and choose instead to make chapter 13 plan payments and keep the current family home.

The evidence continues to mount that consumers have lost their cash cushion from pandemic-era government assistance. The Wall Street Journal recently reported an estimate by Goldman Sachs that, by the end of the year, consumers will have spent down 65 percent of the cash they had built up during the pandemic. Other cited data showed that the problem is even more acute for lower-income Americans. As we know, those are the debtors who may be the first to be pushed over the bankruptcy cliff.  

The prime rate now stands at 7.75 percent, which reflects an almost 140 percent rise from a year ago. That affects consumers and businesses across the board.

Perhaps the best summation of the national economic news was provided by the Director of Congressional Budget Office (CBO), who said: 

"For 2023, we project stagnant output, rising unemployment, gradually slowing inflation, and interest rates that remain at or above their current levels at the beginning of the year – before the economy subsequently rebounds.” 

The impact on consumers is detailed in a report by Ares, an alternative credit manager and lender (source: the Creditor Rights Coalition’s weekly Creditor Corner), which summarized the situation this way: "[S]avings are depleted and households increasingly turn to debt to finance their continue spending . . . . [W]e are seeing a rapid transition from increasing savings to increasing indebtedness at the microeconomic, household level.”  Ares goes on to describe increased withdrawals in pension funds and "massive losses with residential mortgages” suffered by banks.

CBO also paints a gloomy picture on government debt levels, but we will leave the implications to economists, rather than bankruptcy watchers.

Conclusion

For now, all we can do is monitor next month’s bankruptcy filing numbers and see how lenders begin to cope with bankruptcy filing increases not seen in recent memory.   

Commentary provided by Clifford J. White, Managing Director – Bankruptcy Compliance for AIS.