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Friday, August 1, 2008

Law Firms Gear Up -- and Wait --For Anticipated Bankruptcies

For months, bankruptcy lawyers in the U.S. have sounded a little like Marvin the Martian, the manic Looney Tunes character who ran around with his ray gun asking, "Where's the kaboom?"

While 2008 has seen its fair share of bankruptcy filings, including Linens 'n Things Inc., Aloha Airgroup Inc., Sharper Image Corp. and, just last week, retailer Steve & Barry's LLC, the trend hasn't been earth-shattering. That is bad news for law firms that boosted employment in anticipation of lots of bad news for everyone else.

"We're just not seeing the flood that everyone's been expecting," said Stephen Selbst, a bankruptcy lawyer at Herrick, Feinstein LLP.

Law firms' bankruptcy departments are busier than they have been in several years. Last month, 4,992 businesses entered bankruptcy-court protection, up from 3,408 in June 2007, according to Automated Access to Court Electronic Records, or AACER, a bankruptcy-data and management company.

Still, the increase isn't of the type that many anticipated -- a rush of Chapter 11 filings, one or two of which can keep a department humming for months, if not years. Lynn LoPucki, a bankruptcy-law expert at the University of California, Los Angeles, said the AACER statistics don't account for size. According to his own Bankruptcy Research Database, 2008 is on pace to finish with about 26 Chapter 11 filings by companies valued at $250 million or more, twice the 13 filed in 2007 but fewer than a third of the 97 filed in 2001, during the last economic slump. "This is not a boom," he said.

The missing spike is no small matter for big law firms that feed off of corporate bankruptcies during down markets. Bankruptcy practices are typically regarded as countercyclical, meaning they are hot when other practices are cool. So, in recent months, many firms have added lawyers to their U.S. bankruptcy practices, hoping they would serve as a hedge against practices, such as mergers and acquisitions and structured finance, that have slowed in the wake of the subprime-mortgage crisis and ensuing credit crunch.

"It's a bet, whether or not to gear up," said Dan DiPietro, the client head of the law-firm group at Citi Private Bank. "For a lot of firms, it's not paying off at the moment. But most are still hopeful that it will."

Over the past year or so, Quarles & Brady LLP, which is based in the Midwest, has added several experienced restructuring lawyers to its offices in anticipation of increased work. "The worst-case scenario is to have to say to a client, 'We don't have the capacity to take this on,' " said John Dawson, a Phoenix-based restructuring lawyer at the firm. "So we'll err on the side of having a little excess capacity, even if that may not fit the Harvard B-school model." But excess capacity comes at a cost, which often is pulled straight from the partnership's pockets.

Will the market ultimately prove the Dawsons of the world to be prescient? Some think so, predicting that the Chapter 11 floodgates will open any second. Up until about this time last year, these folks said, the major investment banks were practically handing out money on request. Many companies secured "covenant-lite" financing -- loans with fewer or less-stringent financial benchmarks that had to be met over the course of the loan. As a result, "troubled companies were able to finance their way out of trouble," said Herrick, Feinstein's Mr. Selbst.

But for many companies, these loans will soon start to expire. And when they do, new lenders may be hard to come by. "Instead of loans getting rolled over at slightly higher interest rates, lenders are just saying, 'No, we're not going to do this,' " said Greg Milmoe, co-head of the restructuring practice at Skadden, Arps, Slate, Meagher & Flom LLP. "That's what's going to trip up a lot of [companies] into full-fledged restructurings."

Even so, a boom could be tempered by several factors, including a 2005 change to the bankruptcy laws. According to Marshall Huebner, co-head of the restructuring practice at Davis Polk & Wardwell, in 2005, "Congress made Chapter 11 a much less hospitable place" for corporations when it passed the Bankruptcy Abuse Prevention and Consumer Protection Act. The law added new financial burdens on corporate debtors and restricted their ability to get rid of unwanted leases and retain and compensate some personnel. As a result, adds Mr. Huebner, "Chapter 11 has gotten harder, uglier and more expensive."

And Chapter 11 typically requires big injections of cash both at the outset, called debtor-in-possession financing, and at the end, called exit financing. Lawyers said the tightening in the credit markets has left such packages hard to come by. "The usual sources just aren't lending," said Richard Cieri of Kirkland & Ellis LLP. Steve & Barry's -- the cheap but chic retailer -- failed to get debtor-in-possession financing and is aiming to either sell itself or to liquidate.

A relative dearth of Chapter 11 filings won't necessarily leave bankruptcy lawyers without anything to do. But it will likely change the nature of their work. Expect to see troubled companies -- and their lawyers -- working harder to reach out-of-court agreements with their existing creditors. And watch for shorter Chapter 11 cases as existing lenders push for Steve & Barry's-type liquidations and fire sales, rather than lengthy restructurings.

What does it all mean for the lawyers? "It depends on the firm's business plan," said Jack Williams, who teaches bankruptcy law at Georgia State University College of Law in Atlanta. Mr. Williams predicts that firms that can juggle a lot of short-term engagements are going to do well. "But those who stick with a more traditional approach," like relying on one or two cases that drag on for years, might struggle. "That business plan just isn't going to square with what's going on."

By: Ashby Jones
July 16, 2008; Page B5