Учебный год 2023 / Bhandari_J__Weiss_L_Corporate_Bankruptcy_Economic_and_Legal_Perspectives_1996

The uneasy case for corporate reorganizations

for troubled enterprises. They do not exist to implement the investors' bargain (more specifically, the effective exercise of their withdrawal rights). Rather, they exist to prevent the creditors' individual (or collective) interests from destroying a firm as a going concern by forcing it to liquidate piecemeal, destroying both jobs and assets in the process.

Bankruptcy law, under this view, tries to ensure that a firm survives, quite apart from whether the owners as a group want it to or not. The filing of bankruptcy petition stays collection efforts of creditors to give a debtor an opportunity to recover from a "temporary cash-flow problem" or a cyclical downturn in the economy. This approach to bankruptcy law frequently seems to assume that we are always better off if a particular firm stays in business. It does not squarely face the possibility that all interested parties might be better off as a group if the firm's assets were put to a different use.

The common fear that investors will exercise withdrawal rights when the firm's fortunes take a turn for the worse is misplaced. Investors contribute capital in the first instance because of the higher return the investment promises relative to the next best one available. An investor will not ordinarily exercise a withdrawal right simply because the firm's fortunes have dipped temporarily. In the absence of a change in conditions, an investor who wishes to end his participation is typically better off trading his rights against the firm to someone else instead of trying to exercise a withdrawal right.

Moreover, an investor will exercise his right to withdraw his contribution only if the firm is unable to find a new investor. If a firm with an impatient investor is experiencing a reverse that is only temporary, it should be able to find another investor who is willing to buy the impatient one out. A firm's inability to replace a contribution may be good evidence that it has more than a cashflow problem.

One might argue that, under existing law, creditors, in fact, bargain for withdrawal rights even when removal of capital from the firm is not justified. But determining when withdrawal rights should be exercised is difficult. It is possible that a senior investor would bargain for expansive withdrawal rights to ensure that he would always have the power to withdraw when he found it necessary. Bargaining for the power to do something is quite different from exercising the power when one has it. Senior investors may want not merely the power to withdraw when it is necessary but also the right to determine when it is in fact necessary. However, one should not draw too many inferences from existing practices of creditors, given the impediments under both bankruptcy and nonbankruptcy law to exercising a withdrawal right once it has been triggered. If courts and others were more willing to enforce the right, firms would behave differently in granting such rights in the first instance.

The purpose of a bankruptcy proceeding is to enable the owners of the firm's assets to act collectively, but collective action may not always be in the

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interests of the creditors as a group. If the value of the assets is unlikely to be impaired by the actions of individual creditors, there is no need to incur the costs of a collective proceeding. Costs include not merely those of the procedure itself (such as attorneys' fees)4 but also those that may result when the owners can no longer exercise their rights to monitor and control the firm. A collective proceeding, for example, prevents a secured creditor from seizing his collateral in the event of default. A secured creditor's ability to seize collateral controls misbehavior, and this check redounds to the benefit of all parties. Even if the secured creditor's priority right is adequately protected, the replacement of this check with others (such as those provided by the trustee's supervision of assets of the estate) may make everyone worse off.

Ill

The simplest collective proceeding is a sale of the firm for cash and the distribution of the proceeds to all the investors. The common objection to such sales is that they cannot preserve the value of a firm as a going concern. Under this view, finding a third party who is willing to buy the firm as a single unit is so time consuming and so difficult that, without a mechanism to stay the rights of all creditors and force them to become owners of the firm, the firm would be broken into small pieces that are worth less than the firm as a single unit. Only a reorganization provides the necessary "breathing space" that gives all involved a chance to sort out their affairs.

Finding buyers for firms that in fact are worth preserving as going concerns may not be more difficult, more expensive, or more error prone than the alternatives. Valuing a firm's assets is a tricky business. One must project how much income can be derived from the assets in their current use and alternative uses and discount all these to present value. The value of assets may depend on much that is uncertain. It may also depend on information that is hard to obtain. As a result, third parties may underestimate a firm's chances for success. On the other hand, they may overestimate them. The question is not how likely third parties are to offer too much or too little for a collection of assets but whether they are so apt to undervalue a firm's value or so apt to find the valuation process itself costly that they are likely to be unwilling to pay an amount that is at least equal to the value of the firm in the hands of the existing investors.

Third-party buyers may not value firms accurately, but before rejecting a sale of assets to a third party (or third parties) as the best means of ending a particular ownership arrangement, one must explain why anyone else would appraise them more accurately or more cheaply. If assembling information on

4 The cost of a straightforward chapter 11 reorganization in which a creditors' committee is appointed runs in the neighborhood of $100,000.

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the firm's value is hard for third parties, why would it be easier for anyone else? Third-party buyers have an advantage over all others in that they bear all the consequences of guessing right or wrong. If they overvalue a firm (if they, for example, erroneously think the firm has value as a going concern), they will not enjoy the same return on their investment as other buyers. If they undervalue assets, they will lose in the bidding to other, more astute buyers. Perhaps third-party purchasers are not willing to pay as much for these firms as the old shareholders and bankruptcy judges think they are worth, but how likely is it as a general matter that shareholders and bankruptcy judges rather than buyers will value the firm correctly?

Unlike competing third-party buyers, the shareholders have nothing to gain (and something to lose) from undervaluing the firm. Unlike the competing third-party buyers, a bankruptcy judge enjoys no benefits and suffers no costs if he underor overvalues a firm. A bankruptcy judge may be less able to cast a cold eye on an enterprise and make tough decisions than someone who has put his own money on the line. He may have no effective constraint analogous to the discipline a market imposes on competing buyers who make systematic errors. Like any other individual outside such constraints, he may tend to underestimate risks.5

None of this, however, is to suggest that going-concern sales of a firm are without costs. In addition to the difficulties I have mentioned, one must recognize that a sale of the firm's assets may be difficult to orchestrate. The sale should be conducted by the residual claimants to the firm's assets because they have an incentive to obtain the best price. If the firm can be sold for about $10,000 (for more than $5,000 but less than $15,000), and if secured creditors are owed $5,000, general creditors $10,000, and subordinated debenture holders $10,000, the general creditors should conduct the sale. They stand to gain or lose when they decide whether to sell the firm in pieces or as a unit. They also suffer the consequences if they devote insufficient resources to finding a buyer or buyers, or if they waste time and money trying to sell the assets for more than anyone is willing to pay.

Ensuring that residual claimants conduct the sale (or, more precisely, ensuring that those who conduct the sale are entitled to keep the excess) is not easy. For example, the identity of the residual claimants may be uncertain. If it is

5 Jackson suggests that the inability of individuals to assess risks accurately in the absence of any market constraint may justify bankruptcy's fresh start-policy for individuals. See Thomas H. Jackson, "The Fresh Start Policy in Bankruptcy Law," 98 Harvard Law Review (1985). It is commonly assumed (although empirical data is scant) that bankruptcy judges have tended to overvalue firms in bankruptcy. See Walter J. Blum, "The Law and Language of Corporate Reorganization," 17 University of Chicago Law Review 565, 577-8 and n. 18 (1950); see also Paul F. Festersen, "Equitable Powers in Bankruptcy Rehabilitation: Protection of the Debtor and the Doomsday Principle," 46 American Bankruptcy Law Journal 311, 329 (1972); J. Ronald Trost, "Corporate Bankruptcy Reorganizations: For the Benefit of Creditors or Stockholders?" 21 UCLA Law Review 540, 548-9 (1973).

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not clear whether the assets are worth more than is necessary to satisfy the claims of general creditors and those senior to them, a choice must be made between allowing the general creditors (or the trustee, as their representative) to conduct the sale alone and allowing those junior to them to participate. Either decision brings difficulties. If the general creditors act alone, they may not take account of the interests of those junior to them. On the other hand, if junior owners participate, they will tend to favor any tactic that might bring a higher price - such as costly searching or endless delay - that a sole owner would reject as unjustified. These junior claimants would have the correct set of incentives only if they bore the additional costs of searching for a buyer who would pay more than the total amount of claims senior to their own. One might require the general creditors to buy out all those junior to them before they conducted the sale, but conducting such a forced sale introduces holdout problems of its own.

In addition, there may be more than one residual claimant. A firm, for example, may have dozens or thousands of general creditors. Even if they can be identified easily, it may be difficult to fashion a set of rules that enables them to work together or to appoint someone to act on their behalf. Under current law, the bankruptcy trustee is charged with acting on behalf of the general creditors, but in practice it is hard for general creditors to monitor the trustee and ensure that he heeds his obligations to them. Problems of monitoring arise whenever one person acts as the agent of others. The problem is exacerbated in bankruptcy. Unlike the directors of a corporation, a trustee's reputation is not closely tied to the fortunes of any particular firm. His concern for his reputation may be insufficient to check the temptation to place his own interests above those of the creditors he represents. Perhaps for this reason, the costs of assembling a debtor's assets and conducting the bankruptcy proceeding (many of which are incurred by the trustee) consume, in practice, a large part of the proceeds of many sales of assets. These costs need to be borne in mind in evaluating whether there should be any bankruptcy process at all (that is, whether these costs are not themselves greater than the costs of a race to the firm's assets).

One should not exaggerate, however, the difficulties inherent in deciding who among the investors should conduct the sale. In the case of a large firm, the residual claimants would likely hire someone with the appropriate expertise (such as an investment banker) to run the sale. It may not much matter whether the decision to hire Goldman Sachs rather than Shearson Lehman Brothers rests in one investor rather than another.

IV

In a reorganization, prepetition creditors give up their claims against the debtor in exchange for claims against the interests (such as stock) in a re-

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organized firm that has been stripped of all prepetition liabilities. A set of rules must ensure that the assets are used effectively while ownership interests are readjusted. In addition, steps must be taken so that no one creditor or group of creditors has the ability to exploit the reorganization process and receive more than his substantive nonbankruptcy rights entitle him to. In a liquidation, what various claimants are entitled to receive is relatively fixed. If a firm is sold outright, substantive nonbankruptcy entitlements largely determine who gets what in what order. There is often little to argue over because rights are fixed and payments are made in cash. In a reorganization, on the other hand, many more issues are open. One must value shares in the reorganized company and allocate them to the old owners. Complicated procedures are necessary to tell us who can propose a restructuring of the firm and under what conditions others have the right to approve or reject such a proposal.

A threshold question is whether the complications of reorganizations and the opportunities they provide for undercompensation and strategic game playing by creditors, shareholders, and managers are worth the benefits they bring. The justification for reorganizations usually begins with the observation that many firms are worth more if kept intact (or largely intact) than if sold piecemeal. The rationale for a reorganization, however, must be simply that some firms are worth more as "going concerns" than if liquidated. Although not common under present law, a liquidation is consistent with keeping a firm intact as a going concern. The difference between a liquidation and a reorganization is that the first involves an actual sale of all the assets of a business to a third-party buyer and the second involves a hypothetical one.

Under existing law, petitions filed under chapter 7 usually lead to a piecemeal sale of the assets, and those under chapter 11 involve attempts (many of which fail) to keep the firm intact as a going concern. Nothing in current law, however, prevents a sale of the firm as a going concern in chapter 7, and chapter 11 presently allows for a piecemeal sale of the assets of the firm. The justification for a reorganization must focus on showing the higher costs of selling the firm to a third party.

A common justification for corporate reorganization of closely held corporations is that the firm's survival as a going concern depends crucially on continued participation of the existing managers, who are also present shareholders. A sale of the firm to a third party, however, should not prevent the firm from surviving intact. Because the creditors have no claim to the managers' expertise, they are entitled only to the value of the firm without it. Even if the managers are under contract to the firm, the remedy for a breach of such a contract is only damages, not specific performance. The third party acquiring the assets can bargain with the managers and obtain their services by striking separate deals with each of them.

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While a sale to a third party is being negotiated, it may be necessary to persuade the old managers to continue temporarily. The shareholder-managers of a closely held firm who might well be replaced if a third-party buyer acquired the firm may not be willing to continue to manage the firm during the search for a new buyer. Without their help during the interregnum, the firm might shut down, and its value as a going concern might be lost.

Yet obtaining the cooperation of the existing managers during the bankruptcy process should not depend on whether the firm is sold to third parties. When the process is over, the investors who have the power to hire and fire the managers will probably no longer be the managers themselves. Regardless of whether there is a liquidation or a reorganization, these other investors will have the power to replace the existing managers. There is no reason to think that either the existing owners or a third-party buyer will choose to retain existing managers when others can do the job better. The willingness of managers to keep working temporarily should not turn on who ends up with the corporation. The same fate should await them when the bankruptcy proceeding is over regardless of who owns the assets. The perception that presently exists that managers will only cooperate in reorganizations, not in liquidations, may be due to the imperfections in existing law that may make continuation of the business and retention of managers in liquidations difficult.6 In both liquidations and reorganizations, the owners must bargain with the existing managers, and in both cases the owners must strike a deal or do without them. In principle, there is no reason why the bargaining should be easier in one place rather than another.

The owners of a firm might prefer a forced sale of assets to themselves (which a reorganization is, in effect) to an actual sale to one or more third parties if it were cheaper. In that event, the owners would spare themselves the expense of searching for an actual buyer. But these savings may not be substantial. The ability investment bankers have shown to take large firms public (such as the Ford Motor Co. or Apple Computer) and the willingness of others to acquire firms for huge sums (such as General Motors' multibillion dollar purchase of Hughes Aircraft) suggest that it is possible to sell the assets of even giant corporations to third-party buyers. Moreover, the savings from eliminating an actual sale may be more than offset by the costs of conducting a hypothetical sale in which the assets must be appraised and procedures must

The difficulties of continuing to run the firm in a chapter 7 liquidation stem largely from the presumptions built into current law. Thus a trustee is appointed in liquidation cases under chapter 7, while in chapter 11 reorganizations the managers of the firm continue to operate as the debtor in position unless replaced. (A trustee is appointed only for cause, such as fraud, dishonesty, incompetence, or gross mismanagement, or when such an appointment is in the interests of creditors and equity holders. Section 1104(a).) Under existing law, the trustee in a liquidation my continue to run the business ad continue to employ the old managers "if the operation is in the best interest of the estate and consistent with the orderly liquidation of the estate." Section 721.

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be created to prevent one set of owners from taking advantage of the absence of the discipline of an actual sale.

Owners might prefer a forced sale to themselves for one other reason. The assets might in fact be worth more in their hands than in anyone else's. In such a case, it would be in their interest to have a hypothetical sale even if it cost as much as an actual one. One can imagine cases in which one of the present owners would put a higher value on the assets than an outsider. The founder of a firm, for example, might have a large interest in the firm, and his energy and expertise may be hard to replace. Similarly, a large firm (such as IBM) might buy a minority interest in another firm (such as MCI). In neither case is the investor passive. Each exercises control over the direction and management of the firm. Nevertheless, it is rare to find many such investors in a publicly held firm. The large majority of stock-, bond-, and debenture holders probably have no special expertise or knowledge with respect to the firm that would give them an advantage over others. They are typically indifferent whether they hold an interest in one firm or in another offering similar risks and returns.

The managers of a publicly held firm might not be perfectly fungible. Nevertheless, few managers are irreplaceable. More important, the managers' expertise and the need to compensate them for it exists regardless of whether or not managers have ownership interests in the firm. Giving stockholders shares in the reorganized company cannot be justified on the ground that it ensures continued participation of the managers. If the owners as a group want the managers to stay with the firm, they can pay them in cash, stock, or some other way. Compensating them, however, should have nothing to do with dividing rights to the firm among the existing owners. In short, few owners of publicly held firms place a special value on the assets, and those that do can easily bid at a sale that is open to third parties as well. Alternatively, they can reacquire a fresh interest from the successful third-party purchaser.

Special expertise, however, may be spread among the owners of closely held corporations. There is often a close correspondence between the managers and the shareholders. Other owners may also have special knowledge and expertise. Just as the managers might bargain successfully for an equity interest in the reorganized firm, a finance company that has monitored the firm for years and knows its operations might be best able to buy the reorganized firm's accounts and take a floating lien on its inventory.

Bargaining between several diverse former owners and the purchaser is likely to be difficult and costly. The more diverse owners there are, the less likely it is that bargains can be reached with all of them. If enough of the owners of an insolvent enterprise have expertise or other advantages that potential third-party purchasers do not possess, the assets of the firm, in fact, may have their highest value in the hands of the existing owners, albeit with a different

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configuration of ownership interests. If these diverse owners cannot cooperate, however, a sale of the firm may separate the assets from the existing owners, making them worse off because the assets will not be put to their best use. A reorganization may be justified in these cases involving closely held corporations where there is special expertise spread among several owners if the reorganization provides a better forum for readjusting ownership interests than exists elsewhere. In other words, reorganizations may be desirable if they enable those who value the assets the most to acquire them and if the alternatives (liquidations or nonbankruptcy workouts) do not.

Reorganizations may not be a good place to rearrange ownership interests. They take time. In addition, a reorganization requires a valuation of everyone's rights. Valuing assets without the discipline of a firm offer from a third party is inherently difficult. If the firm is using the assets to market a new product, the assets may be worth considerably more if the new product becomes a huge success. But predicting the fate of a particular product is a formidable job.

There is another - and more intractable - valuation problem. If the corporate reorganization is justified because many of the owners bring significant expertise to the enterprise, part of the valuation process should, if possible, put a value on that expertise. But allocating gains from keeping the same group of owners in the picture will not be easy. By hypothesis, all (or at least many) of the parties are adding value. Thus simply knowing how much more the firm is worth in the hands of its present owners than it is in the hands of third parties is not nearly enough. Ideally, we need to know how much each of the participants is adding.

A bankruptcy reorganization proceeding often does not entail an actual appraisal of the value of the firm's rights and the rights of each individual (according to the absolute priority rule). Investors and groups of investors can waive their procedural rights. Despite their ability to waive their procedural rights, investors as a group are worse off if there are too many procedural rights. If they could have bargained together before investing in the firm, each investor would have been willing to pay for additional procedures to protect its interests only until the cost of the uncertainty eliminated by additional procedure was less than the cost of the procedures designed to eliminate it.

Procedures can be too extensive or too limited. Determining either the kind or the amount of procedure is difficult. If the shareholders have the right to insist on a valuation that would consume $10,000 of the firm's assets, it is in the interests of the other owners as a group to offer the shareholders something less than $10,000 to waive this right. But bargaining over the waiver of procedural rights is itself costly and brings with it holdout and free-rider problems. If one knew what procedural rights each of the owners would have bargained for (and been willing to pay for) before becoming an owner, one would want to provide each such owner with these rights and no more. Reorganiza-

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tions are (and were intended to be) a forum in which parties would be able to reach some kind of deal without invoking all the procedures. The whole structure of the present rules governing reorganizations is designed to ensure that parties bargain with one another and that there is not a full-blown valuation.

A major premise of the law of corporate reorganizations is that despite its costs the bargain owners can reach in a reorganization is closer to the bargain they would reach in the absence of transaction costs than the bargain they could reach outside of bankruptcy (where creditors can invoke individual debt collection procedures) or in a liquidation (where the new owner must bargain separately for the participation of the old owners). Bargaining in a reorganization has to be compared with the bargaining that might take place elsewhere. Bargaining is always going to take place among creditors and shareholders inside of bankruptcy and out. Legal rules play a large role in determining the terms of that bargain.

When ownership interests in a firm need to be readjusted, creditors will meet, regardless of whether chapter 11 exists or not. The greatest weakness of a corporate reorganization may be what is often advanced as its greatest strength - that it promotes bargaining among creditors and other owners of an insolvent firm. We cannot say bargaining is good until we know what the bargaining is all about. We may want the existing owners to bargain over the unique contribution they make to the firm. But this happens in a going-con- cern liquidation or a nonbankruptcy workout as well as in a reorganization.

In a reorganization, the bargaining is not only over substantive nonbankruptcy entitlements but also over special bankruptcy procedural rights the participants can either waive or invoke. To the extent a reorganization promotes bargaining over rights that do not exist elsewhere, it may promote bargaining about the wrong thing. Nothing is gained from having, without more, bargaining about anything other than substantive rights, yet much of the bargaining in a reorganization is over procedural rights that exist nowhere else. Such bargaining is a cost of a reorganization, not a justification for it. One must identify benefits that offset this cost. Even if present owners value the assets the most, it does not follow that a reorganization is the best forum or even a good forum for them to rearrange ownership interests.

The thrust of the argument presented in this chapter is that the owners of a firm, especially a publicly held firm, would likely prefer a sale of the firm outright to whomever was willing to pay the most for it. A going-concern sale of assets is possible under the existing structure of chapter 7 of the Bankruptcy Code. Such sales, however, run counter to the thinking of most bankruptcy judges and practitioners. To be effective, a bankruptcy system that relied pri-

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marily (or virtually exclusively) on liquidations (sales of the firm piecemeal or as a going concern to third parties) needs a clear set of rules to handle any number of problems that are likely to arise.

A sale of assets to a third party must be free of all claims against it. Those who have claims against the firm must satisfy themselves out of the proceeds of the sale. If they are able to pursue the assets at a later time, the price that can be realized from the sale will be depressed. Similarly, there needs to be a mechanism for resolving disputes about the firm's assets. To the extent that creditors (or others) can assert that the firm does not own specific property (because it is only leased, not sold), they can depress the sale and hold up the firm for more than the value of their nonbankruptcy entitlements.

In addition, one must evaluate trade-offs between creating additional uncertainty and gaining the most for the assets. For example, a requirement that a firm be sold for cash or a cash-equivalent imposes a cost that may not be outweighed by the certainty it provides.

Even though chapter 7 permits going-concern liquidations, it was not drafted with such sales in mind. The powers of the trustee have been conceived over the years as the powers of someone who would oversee the dismantling of a firm. Were the use of chapter 7 to change, the powers of the trustee (and the ways in which his behavior would be monitored) would also change. Existing laws that give investors different rights if a firm is liquidating rather than reorganizing should be eliminated. The trustee should be able to transfer to a third-party buyer not merely all the tangible assets of the firm but also the intangible ones, including such things as the lawsuits the firm has against others, such as its creditors and managers.

This chapter has suggested that the premise underlying chapter 11 of the Bankruptcy Code may be unsound. But in making this observation, one should not overlook the virtues of the existing law. Existing rules of corporate reorganizations are a vast improvement over what preceded them. The number of cases in which the bankruptcy process has done what it is supposed to do (readjust ownership interests while at the same time respecting substantive nonbankruptcy rights without interfering with the optimum deployment of the assets) is much greater now than it was before the Bankruptcy Reform Act was passed in 1978, and courts are more sensitive to the basic principles of bankruptcy law. Despite weaknesses of the Bankruptcy Code the need to reform it may not be as pressing as the need to interpret it sensibly.

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