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.