Chapter 11

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Business Bankruptcy Issues Recent Developments

What Happened At The Supreme Court Oral Argument In The Section 1146(a) Bankruptcy Transfer Tax Exemption Case?

On Wednesday, March 26, 2008, the United States Supreme Court heard oral argument in the case of Florida Dept. of Revenue v. Piccadilly Cafeterias, Inc. A link to the transcript of the oral argument can be found below. The case presents the following question:

Whether section 1146(a) of the Bankruptcy Code, which exempts from stamp or similar taxes any asset transfer “under a plan confirmed under section 1129 of the Code,” applies to transfers of assets occurring prior to the actual confirmation of such a plan?

With so many asset transfers in Chapter 11 cases taking place through Section 363 asset sales before plan confirmation, rather than when plans are consummated after confirmation, how the Supreme Court answers the question presented will have a significant impact on the extent to which debtors end up paying stamp and other transfer taxes as a practical matter.

The Eleventh Circuit’s Decision And Aftermath. The Supreme Court case results from a decision by the U.S. Court of Appeals for the Eleventh Circuit holding that pre-confirmation sales can be subject to the exemption under Section 1146(a) if followed by plan confirmation later in the case. Use the link in this sentence to read the Eleventh Circuit’s decision in Piccadilly.

The Language of Section 1146(a). The one-sentence section, Section 1146(a), was previously numbered Section 1146(c) but its language has not changed. (Many court orders and opinions still use the old designation.) The statute provides as follows:

The issuance, transfer, or exchange of a security, or the making or delivery of an instrument of transfer under a plan confirmed under section 1129 of this title, may not be taxed under any law imposing a stamp tax or similar tax.

As discussed below, much of the dispute over the scope of this exemption is based on interpretation of the phrase "under a plan confirmed."

Section 363 Sales And Transfer Taxes. As bankruptcy professionals know, Section 363 asset sales often precede confirmation of a plan by months. When confirmed, the plan may simply distribute the cash generated from prior sales of the debtor’s assets or may enable a reorganized but smaller debtor to emerge from bankruptcy. Courts around the country have taken very different views on whether Section 1146(a)’s exemption should apply to these pre-confirmation transfers.

Some courts will include findings in Section 363 sale orders that the sale, even though prior to plan confirmation, is exempt from stamp and similar taxes. This sale order from the Southern District of New York illustrates that approach:

The sale of the Purchased Assets . . . is a prerequisite to the Debtors’ ability to confirm and consummate a plan or plans. The Sale Transaction is therefore an integral part of a plan or plans to be confirmed in the Debtors’ cases and, thereby, constitutes a transfer pursuant to section 1146(c) of the Bankruptcy Code, which shall not be taxed under any law imposing a transfer tax, a stamp tax or any similar tax.

Cases filed in Delaware will likely receive a very different response. In 2003, the Third Circuit in In re Hechinger Inv. Co. of Del., Inc., 335 F.3d 243 (3d Cir. 2003) — unlike the Eleventh Circuit in Piccadilly — held that the Section 1146(a) exemption does not apply to pre-confirmation transfers. (The Third Circuit’s opinion was authored by then Circuit Judge, and now Associate Justice, Samuel Alito.) Delaware’s new local rule governing Section 363 sales requires sale motions to make express disclosure of an effort to obtain such a provision in a sale order:

Tax Exemption. The Sale Motion must highlight any provision seeking to have the sale declared exempt from taxes under section 1146(a) of the Bankruptcy Code, the type of tax (e.g., recording tax, stamp tax, use tax, capital gains tax) for which the exemption is sought. It is not sufficient to refer simply to "transfer" taxes and the state or states in which the affected property is located.

Other courts have taken a similar view. The Section 363 sale guidelines adopted by the Bankruptcy Court for the Northern District of California call out various provisions that the Bankruptcy Court generally will not approve in a sale order, including the following:

Any provision that purports to exempt the transaction from transfer taxes under section 1146(c). By its own terms, that section applies only to a sale pursuant to a plan of reorganization, not a sale outside of a plan under section 363(b).

The Supreme Court Oral Argument And Transcript. Against this background, the Supreme Court heard oral argument in the Piccadilly case on March 26, 2008. A copy of the transcript of the oral argument is available by clicking on the link in this sentence.

It’s difficult to tell how the decision will come out based on the questions asked by the various Justices, but the questions are themselves quite interesting. Some focused on why Congress would want to exempt post-confirmation but not pre-confirmation transfers. Others implied that the plain language of the statute limited the reach of the exemption only to transfers made, literally, "under" a confirmed Chapter 11 plan of reorganization. Still others inquired about the administrative impact on states if pre-confirmation transfers were initially exempt but subsequently could be taxed in the event that no plan was ever confirmed. An additional topic raised was whether, if the statute were held to exempt pre-confirmation transfers, the exemption should cover only those transfers "necessary" for a later plan confirmation or also transfers merely "instrumental" to a later plan confirmation. 

The State’s Arguments. During the argument, the State of Florida contended that the statute was unambiguous and that the word "under" meant a transfer made at or following confirmation of plan. Arguing for this bright-line rule, the State asserted that if pre-confirmation transfers could also be exempt taxing authorities would not know, at the time a transfer was recorded, whether a Chapter 11 plan would in fact later be confirmed to validate the exemption. From a policy perspective, the State argued that tax exemptions should be narrowly construed, that stamp and other transfer taxes generate millions of dollars in revenues, and that it would be an administrative burden to require states to monitor Chapter 11 cases to see if plans were later confirmed to validate exemptions claimed on earlier asset transfers.

The Debtor’s Arguments. The debtor made both policy and statutory interpretation arguments. On the policy side, Piccadilly argued that a debtor cannot get a Chapter 11 plan confirmed without cash, debtors often make Section 363 asset sales to preserve value and raise funds needed to confirm a Chapter 11 plan later in the case, the exemption was designed to save cash for the benefit of creditors, and these pre-confirmation sales should receive the same benefit from the exemption. The debtor also asserted that the key phrase in Section 1146(a), "under a plan confirmed" appears in Section 365(g)(1). Section 365 was interpreted by the Supreme Court in N.L.R.B. v. Bildisco &. Bildisco, 465 U.S. 513 (1984), to require pre-confirmation, not post-confirmation, decisions on executory contracts. The debtor contended that because the phrase "under a plan confirmed" means before confirmation when used in Section 365(g)(1), it must mean before confirmation in Section 1146(a) as well. In contrast, the debtor argued, Congress used the different phrase "confirmed plan" in Sections 1142(b) or 511(b) when it intended to refer to a point after plan confirmation.

Conclusion. Whether Section 1146(a)’s exemption from transfer taxes applies to pre-confirmation transfers has split circuit and bankruptcy courts alike over the years. The questions asked during the Supreme Court’s oral argument in the Piccadilly case suggest a similar split among the Justices over how the statute should be interpreted. With the Supreme Court’s term ending in the next few months, however, debtors, creditors, and taxing authorities should not have to wait much longer for a definitive answer to this open issue.  

Business Bankruptcy Issues Recent Developments

Southern District Of New York Bankruptcy Court Proposes Amendments To Local Rules

The United States Bankruptcy Court for the Southern District of New York has announced proposed changes to its Local Bankruptcy Rules in light of the recent amendments to the Federal Rules of Bankruptcy Procedure that took effect on December 1, 2007. Many of the largest business bankruptcy cases are filed in the Southern District of New York, which includes Manhattan, making these proposed amendments to the Local Bankruptcy Rules of particular interest.

Cash Collateral And DIP Financing Disclosures. The most significant proposed changes for Chapter 11 bankruptcy cases address cash collateral and DIP financing motions and, if adopted, the local rule amendments would supplement the disclosures required by amended Federal Rule of Bankruptcy Procedure 4001. Proposed Local Bankruptcy Rule 4001-2 would require at least fifteen material provisions to be disclosed in cash collateral and DIP financing motions. These include the following:

  • the amount of cash to be used or borrowed, including any borrowing base formula and availability;
  • material conditions to closing, including budget provisions;
  • pricing and economic terms, including various fees;
  • any effect on existing liens;
  • any carve-outs from liens or superpriorities;
  • any cross-collateralization;
  • any roll-up provisions;
  • any provisions that would materially limit the Court’s power or discretion or the fiduciary duties of a trustee, debtor in possession, or committee;
  • any limitation on the lender’s obligation to fund activities of a trustee, debtor in possession, or committee;
  • termination or default provisions;
  • any change of control provisions;
  • any deadline for sale of property;
  • any prepayment penalty or other restriction on repayment;
  • terms governing joint liability of debtors; and
  • any funding of non-debtor affiliates.

Additional Proposed Financing Changes. Other provisions would require (1) disclosure regarding efforts to obtain financing, (2) adequate notice after an event of default and before a lender could exercise remedies, (3) disclosure regarding carve-outs and allocations of carve-outs, (4) investigation periods for committees, and (5) appearances at preliminary and final hearings. In addition, the proposed local rule would mandate certain provisions in proposed orders, including a reservation of the Court’s right to unwind roll-ups if a successful challenge is later made. 

Other Proposed Amendments. The remaining proposed amendments are mainly technical. They would repeal local rules that have become unnecessary, drop the requirement that attorneys use an identifier that includes the last four digits of their social security number, conform attorney signature rules to current practice, and dispense with the need for a separate memorandum of law if a discussion of the law is included in the motion itself.

Opportunity For Comments. The Bankruptcy Court has not yet promulgated these local rule amendments and it is accepting comments on the proposed changes until April 23, 2008. Information on how to submit comments is available on the Court’s website at the Local Rule page.

Business Bankruptcy Issues

North Of The Border: Reorganization Under Canada’s Companies’ Creditors Arrangement Act

With the enormous amount of business between the United States and Canada these days, it’s little wonder that from time to time U.S. companies find themselves affected by a Canadian insolvency proceeding. A better understanding of Canada’s approach to bankruptcy and insolvency law can be helpful when sizing up how such a filing might affect your rights.

The Lay Of The Land. Canada has two primary federal insolvency acts, the Bankruptcy and Insolvency Act, known as the BIA, and the Companies’ Creditors Arrangement Act, known as the CCAA. (A third statute, the Winding-up and Restructuring Act, is less frequently invoked.) You can access the text of each of three acts by clicking on the preceding links. These national statutes also operate in conjunction with applicable provincial law.

Canada’s Reorganization Law. When larger Canadian companies need protection from creditors they often seek relief under Canada’s CCAA. The CCAA is the Canadian insolvency law most analogous to Chapter 11 of the U.S. Bankruptcy Code. Company management generally remains in charge as a debtor in possession, although a monitor is appointed and has certain oversight authority. Unlike the much longer U.S. Bankruptcy Code, the CCAA currently has only 22 sections, leaving it to the courts to fill in the gaps. Courts generally do so, including issuance of an early "initial order" that commonly implements a stay similar to the automatic stay of U.S. bankruptcy  law. (Click on the link for an example of an initial order.) Other court orders permit contracts and leases to be disclaimed (rejected), assets to be sold, and a restructuring to be implemented through a plan of arrangement after voting by creditors.

Cross-Border Issues. Canada has not yet adopted the Model Law on Cross-Border Insolvency, which the U.S. did in 2005 as Chapter 15 of the U.S. Bankruptcy Code. At least for now, Canada continues to use its own cross-border procedures under Section 18.6 of the CCAA and cross-border protocols used to coordinate proceedings in different countries. (For more on Chapter 15, you may find this prior post entitled "Chapter 15: The Bankruptcy Code’s New Cross-Border Insolvency Rules," of interest.)

Important Changes May Be Coming. Canada is currently working on adoption of significant revisions to its bankruptcy and insolvency laws. The legislation was originally proposed in 2005 as Bill C-55, and more recently was approved in legislation known as Bill C-12.  If it comes into force, this law would make a number of changes, including one of interest to licensees of intellectual property. The legislation would add to the CCAA a formal provision akin to Section 365(n) of the U.S. Bankruptcy Code, protecting the rights of licensees to continue to use licensed intellectual property if the underlying license agreement is disclaimed (rejected) in the CCAA proceeding.

Conclusion. Navigating Canadian insolvency law can be complex, especially when proceedings are pending in both the U.S. and Canada. Getting advice from U.S. and Canadian bankruptcy counsel can prove invaluable if your business becomes involved in an insolvency proceeding north of the border.   

Business Bankruptcy Issues Recent Developments

Bankruptcy Rule Amendments: New Article Reviews The Important Changes

An article my partner Adam Rogoff, associate Seth Van Aalten, and I wrote was recently published in the January 2008 issue of Pratt’s Journal of Bankruptcy Law. The article discusses the significant amendments to the Federal Rules of Bankruptcy Procedure that took effect on December 1, 2007. Those amendments covered a range of procedures from omnibus claims objections to motions to assume executory contracts and real property leases to "first day" motions in Chapter 11 cases. 

If you don’t have a copy of the Journal, you can read the article, entitled "Important Changes To Bankruptcy Rules Take Effect," by clicking on its title in this sentence. For more details on the rule changes, use the links that follow for a copy of the full, "clean" set of rule amendments as well as the redline set showing changes made by the amendments to the existing rules, together with the Advisory Committee’s comments.

Business Bankruptcy Issues Recent Developments

Delaware Bankruptcy Court Adopts New Local Rule For Section 363 Sales

The Delaware Bankruptcy Court has recently adopted amended Local Rules, which became effective on February 1, 2008, and they include meaningful changes to the procedures governing Section 363 sales of assets. New Local Rule 6004-1, entitled "Sale and Sale Procedures Motions," requires additional disclosure and the highlighting of certain key provisions often seen in sale motions.

By following the links in this sentence you can find the redline version and clean version of the new Delaware Bankruptcy Court Local Rules.

The Section 363 Sale. As a reminder, a bankruptcy asset sale often happens in the first few weeks or months of a Chapter 11 case, rather than as part of a plan of reorganization. Frequently this will involve a sale of all or substantially all of a debtor’s business as a going concern. The sale is generally referred to as a "Section 363 sale" because Section 363 is the key Bankruptcy Code section that governs a debtor’s sale of assets in bankruptcy. The debtor must seek bankruptcy court approval of a sale that is not in the ordinary course of business and of any effort to transfer executory contracts, intellectual property licenses, or commercial real estate leases to the buyer.

Sale Motion Requirements. The new local rule first addresses motions to sell property of the estate. A copy of the proposed or near-final purchase agreement must be attached to the motion, as well as a proposed sale order, and any request for a consumer privacy ombudsman under Section 332 of the Bankruptcy Code must be included. The most interesting changes, however, are in the list of provisions which, if included in the motion or sale order, must be highlighted together with a justification for each such provision. These include the following:

  • Sale to insiders
  • Agreements with management
  • Releases
  • Private sale or no competitive bidding
  • Closing and other deadlines
  • Good faith deposit
  • Interim agreements with proposed buyer
  • Use of sale proceeds
  • Section 1146 tax exemption
  • Retention of records
  • Sale of avoidance actions
  • Successor liability findings requested
  • Sale free and clear of leases or licenses
  • Credit bid
  • Waiver of 10-day stay under Rule 6004(h)

A Few Specifics. To get a sense of the changes made, here’s what the amended rule now requires for disclosure of agreements with management included as part of a sale motion:

Agreements with Management. If a proposed buyer has discussed or entered into any agreements with management or key employees regarding compensation or future employment, the Sale Motion must disclose (a) the material terms of any such agreements, and (b) what measures have been taken to ensure the fairness of the sale and the proposed transaction in the light of any such agreements.

Similarly, if a finding is requested regarding a tax exemption under Section 1146(a) of the Bankruptcy Code, the motion must now detail the following:

Tax Exemption. The Sale Motion must highlight any provision seeking to have the sale declared exempt from taxes under section 1146(a) of the Bankruptcy Code, the type of tax (e.g., recording tax, stamp tax, use tax, capital gains tax) for which the exemption is sought. It is not sufficient to refer simply to "transfer" taxes and the state or states in which the affected property is located.

Another part of the new rule requires more disclosure of efforts to sell free and clear of leases and licenses:

Sale Free and Clear of Unexpired Leases. The Sale Motion must highlight any provision by which the debtor seeks to sell property free and clear of a possessory leasehold interest, license or other right.

Sale Procedures Motions. In addition to an actual sale motion, the new local rule includes new provisions addressing motions for approval of sale and auction procedures. Although these provisions are already typically set forth in motions, the rule makes mandatory the highlighting of certain ones, including the following:

  • Financial qualification procedures
  • Deadlines for submitting bids
  • Format of overbids
  • Good faith deposit
  • No-shop or no-solicitation rules
  • Break-up/topping fee and expense reimbursement
  • Bidding increments and use of break-up fees
  • Details of auction procedures

Other Important Local Rule Changes. In addition to a number of minor changes, the amended Local Rules include three significant additions governing (1) discovery motions, (2) service of discovery materials, and perhaps most importantly, (3) electronic or e-discovery. These new rules are found at Local Rules 7026-1, 7026-2, and 7026-3, respectively. Local Rule 3007-1 on omnibus claim objections, discussed in a prior post, has been revised to reflect Delaware’s continued adherence to its local practice notwithstanding the recent national rule changes. (Click on the links in this sentence for more on the national rule amendments and Delaware’s decision to retain its own omnibus claim objection procedures.) Also of note, amended Local Rule 9010-1 now makes explicit the requirement that associated Delaware counsel file all papers and attend proceedings before the Court.

Conclusion. While many of the amended sale motion rules are not new to Delaware practice, Local Rule 6004-1 will change the way sale and sale procedures motions are prepared going forward. Chapter 11 debtors must comply with the new rule and that should give creditors and potential overbidders an easier time spotting the material provisions in these motions.

Business Bankruptcy Issues Recent Developments

First Appellate Court Decision Addresses Question Left Open In The Supreme Court’s Travelers Opinion: Can Unsecured Creditors Recover Post-Petition Attorney’s Fees?

Happy New Year to everyone. I’m back from a holiday blogging break with a report on the first appellate decision to address the question left open in last year’s U.S. Supreme Court decision in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. — whether post-petition attorney’s fees can be added to unsecured claims. Although unrelated, this new decision also tackles the interesting question of whether a guarantor of a debt can become liable if the payment of the debt by the primary obligor later is returned in a preference settlement.

The Travelers Case. As a brief refresher, the U.S. Supreme Court overruled the Ninth Circuit’s so-called Fobian rule in the Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. decision (available here) in March 2007. However, it did not decide whether unsecured creditors could recover, as part of their unsecured claims, post-petition attorney’s fees incurred during the course of the bankruptcy case. For more on the Travelers decision, you may find this earlier post of interest.

A Developing Split. Since the Travelers decision, two bankruptcy courts issued decisions on the open issue, coming to different conclusions. 

  • In May 2007, in the In re Qmect, Inc. decision (available here), the U.S. Bankruptcy Court for the Northern District of California held that unsecured creditors could recover post-petition attorney’s fees. For more on that decision, see this earlier post on the case and its analysis. 
  • In July 2007, in the In re Electric Machinery Enterprises, Inc. case (available here), the U.S. Bankruptcy Court for the Middle District of Florida came to the opposite conclusion, following a majority of courts that had addressed this issue unrestrained by the Ninth Circuit’s Fobian decision. See this previous post for more on the Florida decision.
  • Commentators, including with the recent article written by the American Bankruptcy Institute‘s Scholar in Residence Professor Mark Scarberry, have joined the fray as well.

The SNTL Corp. Ruling. On December 19, 2007, the Ninth Circuit Bankruptcy Appellate Panel ("BAP") issued its decision in the In re SNTL Corp. case (available here). After carefully reviewing both the Qmect and Electric Machinery decisions, as well as pre-Travelers case law, the BAP chose to follow Qmect, holding that "claims for postpetition attorneys’ fees cannot be disallowed simply because the claim of the creditor is unsecured." Judge Dennis Montali, writing for the unanimous BAP panel, first explained its analysis of the interplay between Sections 502 and 506(b):

We are not persuaded by the approach of the Electric Machinery court and, like Qmect, we reject the argument that section 506(b) preempts postpetition attorneys’ fees for all except oversecured creditors. While we cannot predict how the Ninth Circuit will decide this issue in Travelers, we do find a clue in Joseph F. Sanson Inv. Co. v. 268 Ltd. (In re 268 Ltd.), 789 F.2d 674, 678 (9th Cir. 1986), where the Ninth Circuit observed that section 506(b) defines secured claims and does not limit unsecured claims:

When read literally, subsection (b) arguably limits the fees available to the oversecured creditor. When read in conjunction with § 506(a), however, it may be understood to define the portion of the fees which shall be afforded secured status. We adopt the latter reading.

268 Ltd., 789 F.2d at 678.

Next, the BAP discussed Section 502(b)(1)’s requirement that the court determine the amount of an unsecured claim as of the petition date: 

The Electric Machinery court, like the bankruptcy court here and many of the pre-Travelers majority courts, disallowed the postpetition fees of an unsecured creditor because section 502(b)(1) provides that a bankruptcy court  “shall determine the amount of such claim . . . as of the date of the filing of the petition” and the postpetition fees did not exist as of that date. Elec. Mach., 371 B.R. at 551; Pride Cos., 285 B.R. at 373. Because the amount of fees incurred postpetition cannot be determined or calculated as of the petition date, section 502(b) purportedly precludes their allowance. Id. We disagree with this approach, as it is inconsistent with the Bankruptcy Code’s broad definition of “claim,” which — as discussed previously — includes any right to payment, whether or not that right is contingent and unliquidated. See 11 U.S.C. § 101(5)(A); Qmect, 368 B.R. at 884.

The BAP then held that the Supreme Court’s 1988 Timbers decision did not apply:

We believe that Electric Machinery’s reliance on Timbers is misplaced. Timbers provided that an undersecured creditor could not receive postpetition interest on the unsecured portion of its debt. Timbers, 484 U.S. at 380. This holding is consistent with section 502(b)(2), which specifically disallows claims for unmatured interest. Inasmuch  as section 502(b) does not contain a similar prohibition against attorneys’ fees, the comparison between the current issue and that presented in Timbers is not persuasive.

Finally, the BAP held that it was unnecessary to reconcile the competing public policy considerations advanced by the Electric Machinery and Qmect decisions:

Because we find that the Bankruptcy Code itself provides the answer to this issue (by not specifically disallowing postpetition fees), we do not attempt to reconcile these policy concerns. In the end, it is the province of Congress to correct statutory dysfunctions and to resolve difficult policy questions embedded in the statute.

A Ninth Circuit Decision To Come? In the first quote above, you may have picked up the BAP’s reference to the Ninth Circuit having this issue before it in the Travelers case. That case, on remand from the Supreme Court, appears to have been fully briefed. Any decision from the Ninth Circuit itself on the issue would, of course, supersede this BAP decision and be controlling authority in the circuit, but it may be months before such a ruling comes down.

A Bonus Issue: Guarantor’s Liability Revived After A Preference Settlement. The facts of the SNTL Corp. case are complex, but the key facts are fairly straightforward. In short, one of the debtor’s insurance company subsidiaries owed money to the creditor and the debtor guaranteed the debt. Although the subsidiary paid the creditor, the subsidiary was later placed into state insolvency proceedings. The state insurance commissioner sued the creditor for return of the payment on preference grounds. The creditor settled the preference case and returned most of the payment ($110 million of a $163.4 million original payment). The creditor thereafter amended its proof of claim in the debtor’s Chapter 11 case, seeking recovery under the guaranty of the returned preference.

  • After first determining that the guaranty’s language permitted the creditor to assert a claim to the extent provided by law, the BAP next held, "[w]hile we located no Ninth Circuit or California case precisely on point, we agree that the return of a preferential payment by a creditor generally revives the liability of a guarantor."
  • The BAP cited to various case and restatement authority for the proposition that although a guarantor is discharged on payment of a debt, a preferential payment is deemed to be no payment at all.
  • The BAP also held that repayment of a preference in a settlement, following a preference lawsuit, is not a voluntary payment that would avoid the guarantor’s liability.
  • Given the risk of a preference recovery, the creditor’s revival claim under the guaranty was a contingent claim as of the petition date and became allowable once the contingency occurred following the petition. As a result, the creditor’s claim for the full $110 million of the preference settlement was an allowed claim.

An Important Decision. BAP decisions are not binding precedent in the Ninth Circuit, but this first appellate decision on the open, post-Travelers question may encourage unsecured creditors to include post-petition attorney’s fees as part of their allowed unsecured claims when their contracts or a statute provides for them outside of bankruptcy.  We may see creditors begin to include such amounts in unsecured claims at an increasing pace, while we wait for the Ninth Circuit’s decision on this issue in the remanded Travelers case. The added bonus of the SNTL Corp. court’s guaranty analysis and holding makes this decision an even more interesting, and important, read.

Recent Developments

Morgan Stanley Now Predicts A Recession For U.S. Economy

Morgan Stanley has became the first major Wall Street firm to predict that the U.S. economy will fall into recession. In an article entitled "Recession Coming," Morgan Stanley economists Richard Berner and David Greenlaw forecast that the U.S. economy will suffer a mild recession in 2008:

We’re changing our calls for US growth and monetary policy.  Since the shock of tighter financial conditions surfaced in August, we’ve incrementally reduced our outlook for future growth.  But the time for incremental changes is over.  A mild recession is now likely: We expect domestic demand to contract by an average 1% annualized in each of the next three quarters, no growth in overall GDP for the year ending in the third quarter of 2008 and corporate earnings to contract by 5-10% over that longer period.  Three factors have tipped the balance to the downside: Financial conditions continue to tighten, domestic economic weakness is broadening into capital spending, and global growth — for us, long the key bulwark against a downturn — is slowing. 

Berner and Greenlaw likewise see the potential for a "perfect storm" for consumers brought on by the continuing housing downturn (they predict a 10% decline in home prices next year), a weakening job market, and higher energy and food costs. To avoid an even sharper downturn, they expect the Federal Reserve to cut interest rates by 100 basis points over the next seven to nine months, moves they believe will help keep the recession short and mild.

To date, most Wall Street economists have stopped short of predicting a recession. If the Morgan Stanley forecast comes true, it would almost certainly accelerate the predicted rise in corporate debt defaults, especially on high-yield debt. That would very likely bring about an even bigger increase in Chapter 11 bankruptcy filings than has already been predicted.