Bankruptcy has always been a process in which creditor constituencies had a common interest—to be repaid the amount of their indebtedness. The ultimate fate of the company, whether reorganization or liquidation, was seldom of concern to any creditors, save for those who wanted (or needed) a continuing customer relationship.

A change in this process began during the last downturn with the emergence of the debt-trading community. These traders provided liquidity and a new exit strategy for many traditional bank lenders and bond investors. Since then, the market in nonpublic debt trading has soared. The reasons have been examined, explained and debated for several years, but it is a fact that investors now use various vehicles to move up in the capital structure from equity-holders to debt-holders. Whether it is a risk mitigation strategy or a desire for a fixed rate of return really doesn't matter to the end result—the creditors in the next wave of restructuring will be different people, with different motives.

New Debt-holders and Capital Structures

These new debt-holders are not merely seeking the return of their principal plus interest, but are also buying the debt at a discount to increase their rate of return. If they can meet the expected rate of return by selling the debt, they will do so quickly, which results in new "creditors" constantly entering and exiting the restructuring process. There are a significant number of participants who are buying this debt for the specific purpose of acquiring the equity in the reorganized company in exchange for all, or a portion, of the debt they hold. These factors are going to have a direct impact on the professionals in the restructuring field.

Often in the past, large bankruptcies were controlled by groups of senior lenders, secured or not. Many were banks, with organized departments charged with the responsibility of collecting defaulted loans. There was often a junior group of bond creditors, subordinated to the senior lenders, and a collection of trade creditors. The junior bond group seldom possessed the sophisticated "work-out" personnel of the larger banks and relied heavily on professional advisors for both business and legal advice. Meanwhile, the trade creditors watched from the sidelines, having little cohesion and individual economic exposure to justify the expense of restructuring professionals.

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The involvement of nonbankruptcy professionals will increase dramatically as we deal with so many new evolving structures. It will be an exciting time to be a bankruptcy professional.

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The sea change in capital structures has upset the traditional triumvirate of negotiators in a restructuring—the borrower, senior lenders and junior lenders. Now, with multiple tranches of debt—the revolver, term a, b, c, etc., junior debt-holders, convertible debt-holders and various derivatives of all of the above—what was once a three-way discussion has the potential to turn into a Tower of Babel and a fight for control among people with vastly different motives and levels of experience in the restructuring process. Combine this with the number of structures (such as second-lien financing) that have never really been tested in a restructuring, and documents that are far from standard, and the challenges faced by restructuring professionals are going to be huge.

Skill Set for the New Advisor

No longer will anyone be able to quote from memory the standard subordination language from a public debt issuance and be able to know not only that the language is in the document, but probably in which paragraph number it falls. Advisors are going to have to truly know the terms of each and every deal they touch. It will be necessary for the financial advisor to know the legal documents and their effect on the analysis of the performance of the company. The lawyers will no longer be able to point to a document and quote it; they are going to have to explain the impact of these agreements on the performance and value of the company.

Further, all of the advisors are going to have to fully understand the nature of the business being restructured, no matter which constituency they may represent. The industry expertise formerly provided by the clients will now have to come from the professionals. Many a lawyer can quote sections of the Bankruptcy Code and explain the law's impact. But when asked whether or not it would be a good idea to exercise those legal rights from a business standpoint and explain the business consequences of taking those actions, very few lawyers are comfortable responding.

Are there super-advisors lurking out there to whom clients can turn? Are there enough of them around to represent the interests of all the constituencies? Any advisor can tell you how quickly a negotiation will become fruitless if the person you are talking to doesn't understand the issues and is operating off of a one-page list of "how we do things at our business." Examined realistically, there is not a group of super-advisors out there prepared or capable of being all things to all parties in any given deal. And unfortunately, the concept of multi-disciplinary practices has never caught on. To understand the scope of the issue, consider a typical debt structure: Company A has a senior secured loan, a second-lien loan, an intercreditor agreement between the senior secured loan-holder and the second lienholder, a senior subordinated debt issuance, a junior subordinated debt issuance and a convertible subordinated debt issuance. There are tens of thousands of pages of documents to be read and understood.

When was the last time a client read and understood all those documents? To a large degree, banks used standard forms, which the bankers were familiar with, and sub-debt was issued on standard forms, which the buyers were familiar with. Term sheets were all anyone needed to review, because any major negotiation point on the standard document would be reflected there. Those days are largely gone. They may return one day, as investors prize predictability in legal documentation, but there are many new asset classes out there today that have not matured into standardized instruments. In our business, assumption is the main reason that errors and omissions insurance is so expensive.

Considering the issues set forth above and the tremendous expense of a team of professionals learning enough to be able to advise a client of the options, what is the client likely to do? With the fundamental change of non-public debt essentially being publicly traded, it is perhaps more economical for a client prospect to sell the debt and take a known loss rather than incur the expenses, not just of the professionals but of its own people, to deal with the issue. If one assumes (there is that word again) that the market is rational, and that adequate information is available, the price being offered for the debt will reflect the anticipated costs of collecting it, as well as any expected recovery plus, one also assumes, a healthy rate of return. So down the food chain the debt goes, until it becomes valueless or ends up in the hands of a holder who has faith in the ultimate recovery.

Central to where the debt finally resides is the enterprise value of the business, or its hard-asset value. Valuation of either is far from an exact science, but it is one in which advisors will play a key role. Again, however, it is that combined business/financial/legal skill set that the client will need.

The issues for the advisors, though, are more complex. The last place any advisor wants to be in a restructuring is representing a client who is one step below the recovery zone. So before even accepting a representation, the advisors have to make an initial decision as to who they want as a client. There are several ways to do that. One can do the business/financial/legal analysis up front and identify the client possibilities in that fashion, or one can pursue clients who regularly land in the recovery zone in distressed situations. Without many of the asset classes in today's market having been tested in a distressed time, the effectiveness of either of those choices is not very clear, at least in the short term.

A second issue for the advisors is their very structure. Few, if any, advisors possess personnel in business (operational), financial (analytical) and legal under one roof. Doing "what ifs" on the white board is all well and good, but one-legged stools, or even two-legged stools, tend to be very unsteady platforms.

A third issue is the cost of advisory services. Depending on where a company is in the recovery zone, a third party (i.e., the borrower) may be picking up the tab. Cost becomes much less of a concern to the client at that point. Below that, where the client is building the cost of your services into its valuation of the transaction, costs become more important because they directly impact the client's recovery. Simply put, the more you get, the less he gets—not a good situation to be in with a client. While there are alternative payment methodologies that ameliorate that tension somewhat, few advisory firms, other than investment bankers, are willing to take those risks.

To make matters more complex, the timing and selection of advisors is seldom, if ever, done on a coordinated basis. A client will often start out with financial advisors to analyze the company and its financial performance. If that turns out to be less than rosy, the next step is often an operational analysis of how the issues can be fixed. Then the legal advisor is brought in on the legal issues. Needless to say, the legal options change the operational analysis and the financial analysis. Not only is this inefficient, depending on how well the various advisors know each other and are willing to rely on each other, it can also be incredibly duplicative—which equals more cost.

Impact of the New Law

Adding to the timing pressures, the recent amendments to the Bankruptcy Code have compressed time frames and enlarged constituencies. We will have a larger group of constituents trying to negotiate a more complex structure in less time. For instance, if a case involves a number of leases, the restructuring may need to be completely negotiated within the new 210-day requirement of §365 for assuming or rejecting leases of real property. Although 18 months of exclusivity seems like a long time, with the increased number of parties and the disparity of their interests, time will fly. The lack of exclusivity often changes the dynamics of a case, not only for the debtors but for all constituencies.

Conclusion and Predictions

We will likely see more pre-bankruptcy planning. The ways in which we market to this new breed of client will change. More professionals will be co-marketing. The traditional fee structure of the restructuring professional will change. The professionals will have to become more savvy in the workings of financial markets to even be able to identify the clients. The involvement of nonbankruptcy professionals will increase dramatically as we deal with so many new evolving structures. It will be an exciting time to be a bankruptcy professional.