Учебный год 2023 / Bhandari_J__Weiss_L_Corporate_Bankruptcy_Economic_and_Legal_Perspectives_1996

Bankruptcy and debt: A new modelfor corporate reorganization

The principal problem with such a result is that it depends on a fine-tuned judgment by the parties or the court that seems unlikely to be accurately made by all parties.

4. Resolution as to basic impediments

The post-reorganization market cannot provide a perfect valuation or perfectly fit the risk preferences of the claimants. But since the current reorganization mechanism (1) sometimes results in creditors' receiving risky securities for which they had not bargained7 and, particularly when they receive securities drawn from a complex capital structure, about which the market may have inadequate information, and (2) suffers from judicially based informational problems, the market mechanism appears to offer an accuracy no rougher than the current one.

C. The uncertain market efficiency during reorganization

Although the post-reorganization market seems, in principle, an accurate evaluator of enterprise value, serious problems would arise if the plausibly efficient market were thrust into the midst of reorganization. Use of a slice-of- common-stock sale and extrapolation of value could lead to significant distortions if there would be a residual block sufficiently large to control the enterprise, if the buyers in the valuation sale were those in the market who valued the bankrupt firm the highest, if parties to the reorganization attempted to manipulate the timing and terms of the valuation sale, or if parties to the reorganization strategically bid at the valuation sale to raise or lower the auction price to their own advantage. I examine each of these potential distortions in the following discussion.

1. Control blocks

Creditors with large debts could obtain a block of stock sufficient to control the reorganized firm. This could skew the price offered by bidders in the valuation sale, who would anticipate the blocks. As such, the sale price and hence the compensation given creditors could be distorted, over-compensating large senior creditors because the bidders expected to be minority shareholders in the reorganized enterprise.

Contrary distortions could arise because the large block might not be marketable immediately as a block. Creditors with special liquidity needs will therefore be undercompensated. Or creditors might end up with a risky security they cannot manage well or simply do not want.

7 Bankruptcy Code section 1129(b) (cram-down provisions).

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However, there is some partly theoretical, partly empirical basis to suggest that the marketability problem of large blocks may not be as severe for recent bankrupts as first thought. Although the marketing of large blocks of stock is often accompanied by a decline in price, some evidence indicates that the decline is not so much the result of the additional supply of the stock thrown onto the market as it is the result of the informational content of the sale.8 The holder of a large block is often an insider. The market assesses the sale as an indication that one with access to superior information, or one in a superior position to evaluate the information, has concluded that the market currently overestimates the firm's value. But in the case of postreorganization sales, this "insider" informational inference is less warranted. Presumably the post-reorganization desire of the former creditor to sell the block of common stock arises because of legal impediments or an aversion to holding any risky security, and is not the result of a specific aversion to the particular bankrupt's security. To the extent the market understands the reasons for the sale, this critical insider informational inference leading to a price decline in normal large-block sales would not be made in the post-reorganization sale.

This difference in market reaction to sales of control blocks after reorganization provides the possibility that the bankruptcy court could at the time of the valuation sale require marketing of sufficient shares from the control block such that the valuation sale bidders could expect dissipation of control in the near future. Or the valuation sale could be large enough that its proceeds could be used to compensate in cash those who would otherwise obtain control if compensated in stock.

2. Disparate enterprise valuation

Because "only," say, 10 percent of the firm is to be sold, it could be argued that the valuation slice will not represent an equilibrium of full-market trading for the entire firm, but rather will represent the demand from the highest tenth of the market. Those who overvalue the firm the most will drive out the remaining 90 percent.

First, however, the availability of rough substitutes reduces this overvaluation. As long as shares of, say, John Deere were a reasonably good substitute for those of what was International Harvester, the demand curve for Harvester stock should have been reasonably flat. In other words, as long as the disparate assessments of Harvester were principally a function of disparate assessments of the farm machinery market, high valuers would not pay a premium, because they had an adequate substitute.

8 M. Scholes, "The Market for Securities: Substitution versus Price Pressure and the Effects of Information on Share Prices," 45 Journal of Business 179 (1972).

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Second, and perhaps more decisively, bidders for the 10 percent slice of capital stock would be aware that some or all of the remaining 90 percent of the firm would be available after the valuation sale. They would not bid the full value they assigned the stock if they knew that others would sell at a lower price shortly thereafter. If information as to how the old creditors will value the firm is uncertain, the high valuers must guess, perhaps inaccurately, as to what the subsequent equilibrium will be. Although the "shadow" equilibrium would thus be a wobbly one, it ought not to be persistently too high.

3. Strategic delay and manipulation of the terms of the valuation sale

Costly delay is one of the nasty side effects of reorganization by bargain or litigation. Uncertainty as to valuation seems to be a focal point for some or much of that delay. We have thus far examined market-based valuation as a potential objective source for quick valuation in an effort to limit the strategic, costly delay in the bargain or litigation processes. However, some may still favor delay. Elimination of valuation disputes may only shift one of the focal points for disputes and delay not the result.

A serious obstacle to the speed of open-market valuation of the firm would come from those claimants likely to be hurt by a market valuation. They will seek to delay the time of a valuation sale if they see reasonable prospects for a market rise.

Still more significant problems arise when determining the size of the valuation offering and its price. In a typical firm-commitment underwriting, the company negotiates a fixed price with the underwriters. If company management is controlled by common shareholders, conflicts could emerge as the shareholders, through management, attempt to maximize sale price, and thereby gain a large portion of the reorganized firm, perhaps by an attempt to market a very small number of shares at a high price. For example, the firm might overcompensate the investment banks with an abnormally high selling concession in order to induce placement of a few overpriced shares to unsophisticated investors.

The underwriting problem could be managed successfully. If the court is reasonably certain that the common stock is not under water, but uncertain as to how far above water it is, then it can tell the common shareholder (through management) that they must sell a specified minimum number of shares by a certain time at a "normal" selling concession.

The difficulty here is again that the court might have to make preliminary determinations of value. These determinations are subject to strategic manipulation and require the court to make determinations that I have suggested it is unlikely to make particularly well.

Similar difficulties would arise from litigation about priority and liens. That is, the juniors might not concede the validity of (or extent of) their subordina-

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tion agreement or might seek the equitable subordination of the seniors. But this need not stymie the valuation sale in its entirety. The sale could take place and shares reserved to be distributed after the subsequent determination of the subordination arrangements.

4. Strategic bidding

The old common stockholders and juniors might want to bid high for the offered slice of the enterprise and thereby skew the valuation to their advantage. For example, if the firm has a true market value of $90 million, the old common shareholder might bid $22 million or more, instead of the true value of $10 million, for the 100,000 shares. When bidding above true value, the old common shareholders would be willing to purchase shares at $22 million although the new shares would (really) be worth only $11 million. Since the remaining 900,000 shares would be (incorrectly) valued at approximately $200 million, the old common shareholders would receive 450,000 shares, worth in real terms about $45 million. This would be obtained by offering only an $11 million premium above market for the 100,000 shares sold in the valuation auction. Similarly, seniors would want to depress firm valuation by selling short.

While this problem would also need careful attention, it can also in principle be solved. First, the securities law faces the problem of manipulative bidding in a variety of guises and resolves it with prohibitions, restrictions, and criminal penalties. This problem becomes most significant when the juniors are sufficiently cohesive to make such manipulative bidding individually worthwhile. A holder of only 100 shares for the widely held firm will only bid his own, actual expected value, since the value of a manipulatively high bid would disproportionately go to the others that hold the firm's stock. If all the shares were held in small lots, the chance of a manipulative bid would seem low. And a holder of a large block would be the easiest to monitor, discover, and punish for manipulation.

5. Summary

Thus, there is a substantial basis to believe that although the post-reorganiza- tion market might be better than a court, and quicker than the bargaining parties, in valuing the firm, bringing the market into an ongoing reorganization could introduce several distortions. As such, the simplicity of the marketbased solution must be treated with skepticism. An administrative apparatus to control or assess the significance of the distortions would be necessary; the relevant choice is not simply among market, bargain, and judicial administration, but also among judicial administration of different matters. Since no one has tested either the severity of the market distortions or the capacity of legal institutions to control them during a reorganization, the question of the supe-

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riority of a market-based reorganization on this score is one of judgment, not economic deduction or statistical observation.

III. Valuation and the Nonvaluation Problems

in Reorganization

A. Other valuation problems

First, we have ignored secured creditors. Their special background might make a court reluctant to give them stock for their note and security. In a reorganization where the value of the property to which the security interest attaches is uncertain, the assets would have to be valued: litigation, bargaining and delay would to that extent become unavoidable. For similar reasons, the reorganization of complex holding company structures might require the valuation that the slice-of-capital sale would avoid. Creditors of a solvent constituent company would argue that they should be paid in full. Creditors of underwater constituencies would argue for a different valuation or assert that the substantive consolidation of the holding company, making creditors all claimants on a consolidated entity, is in order.

However, not all companies have a significant amount of secured debt or use complex holding companies. Of those that do, the secured party may be sufficiently secured such that there is no serious question that the value of the security covers the claim. Furthermore, some of these questions could be resolved after the valuation sale, with shares reserved to cover the contested amounts.

B. Bankruptcy as other than a bargain among financial creditors

Reorganization is not always just a question of readjusting the financial capital structure. Executory contracts such as labor agreements may give rise to critical reorganization negotiations. Suppliers may have made informal investments in the firm that do not appear on the firm's balance sheet and that would not formally constitute a claim in bankruptcy. These suppliers may be the real subject of some reorganizations, but would be untouched in a com- mon-stock sale arid recapitalization.

That is, financial creditors may stand-off against such claimants, offering to give up a few points in interest (or exchange debt into stock) in return for a reduction of the managerial workforce or a cut in wage rates. The slice-of-stock sale would leave these nonfinancial claimants untouched, reducing their incentive to participate in the reorganization give-ups, effectively make them superior in right of payment to the financial claimants. Multiparty, deadlocking negotiations might have some use if they were more likely to produce an ethic under which everyone (creditors, suppliers, labor, and management) "chips in" something.

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IV. Related Issues

A. Could the market produce a bankruptcy-avoiding security?

A question that recurs to academic observers of corporate bankruptcy is related to the efficacy of market-based bankruptcies of public firms: why is there little effort to precook a recapitalization? If the prospect of a decline in the firm will create deadlocks, could the recapitalization be preplanned to avoid the costs of deadlock? If there are bankruptcy costs, as the financial models posit and practical observation confirms, why don't firms - in the manner prescribed in a different context by Ronald Coase9 - precook a recapitalization to avoid these costs?

A simple numerical example will illustrate. The firm contracts with a creditor for a loan of $50. To avoid the costly haggle if the firm declines, the two agree that in the event that the firm's stock price falls to $2 per share, the debt will be exchanged into 25 shares of stock. No bankruptcy, no recapitalization, no deadlock.

We are now beginning to see securities that have similar features that automatically allow the firm to alleviate some financial stress.

A full inquiry requires an extended treatment elsewhere. But we have covered enough similar terrain in this chapter that a useful summary answer can be given.

1. Rejection in bankruptcy

A security that would accomplish an "automatic" recapitalization would be rejectable in bankruptcy. Abankrupt firm may reject executory contracts - contracts whose performance is incomplete.10 Contracts to deliver stock in exchange for debt would be likely candidates to be classified as executory contracts in bankruptcy. Although rejection gives rise to a claim for damages an exchangeable bond once rejected is useless as a means of avoiding financial stress.

How would the exchange feature be rejected? Shareholder/managers, fearful of losing control of the firm, might launch a preemptive strike by filing for bankruptcy and seeking to reject the exchange feature. Even though the firm would decline in value because of the enhanced stress, the managers or shareholders might think that they would get a bigger slice of the diminished firm, thereby making the bankruptcy worthwhile for them.11

9 R. Coase, "The Problem of Social Cost," 3 Journal of Law & Economics 1 (1960): J. Bulow and J. Shoven, "The Bankruptcy Decision," 9 Bell Journal of Economics 431, 438 (1978) (bankruptcy costs raise "primary question [of] why bankruptcy should ever occur").

10 Bankruptcy Code section 365.

1' However, this possibility could be reduced. The exchange feature could be structured so that bankruptcy could not easily be obtained before the exchange was complete. By having the exchange occur when the firm was still solvent, the potential to use bankruptcy in a preemptive strike would be doubtful. While insolvency is no longer a formal prerequisite to a voluntary bank-

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2. Discharge-of-indebtedness income

The firm's tax liability might be increased.12 General standards of forgiveness of indebtedness create income to the extent debt is forgiven. Even if an exception could be fashioned under today's Internal Revenue Code, as I think drafters of such a security could fashion (income does not arise in such an exchange if the face value of debt equals the market value of common stock received in return), the drafters would have to contemplate the instability of these forgiveness sections. Three structural changes have occurred in these sections in the past half-dozen years; and recent changes have grandfathered completed recapitalizations but not future recapitalizations involving securities outstanding.

3. Historical nonnegotiability

As an historical matter, negotiability frictions could well have impeded their use until recent years. When the negotiability friction was lifted in the 1960s, the potential bankruptcy of the public firm just was not an especially pressing problem.

4. First-mover disadvantages

In today's world the first mover to use an exchangeable bond would incur costs. Lawyers' fees would be higher than normal. Securities' analysts might have some difficulty following the firm's securities, due to the unusual feature. Special tax rulings might have to be sought and paid for. Furthermore, and this may be significant, the first mover might seem to be a bit odd. While the typical bond indenture is full of clauses that help the creditor in the event of an issuer default, the atypical clause - such as the exchange feature would surely at first attract special attention. Potential buyers would wonder whether there is some special reason to expect an issuer decline into financial stress or to expect especially costly stress if it occurs. This adverse signal, even if a false one, might be costly for the potential first issuer. In that case, it may decline to use the feature and take the chance of potentially costly financial stress.

5. Benefits to nonbargain creditors

The precooked recapitalization would work only if all creditors participated or compensated other creditors for their nonparticipation (i.e., nonparticipants

ruptcy, Bankruptcy Code section 301, good faith is. Bankruptcy Code section 1129(a)(3). (To be precise, the good faith requirement attaches to the plan confirmation prerequisites, not the petition prerequisites. Courts and commentators have viewed a bad faith petition as justifying dismissal of a voluntary proceeding, since a plan arising from such a tainted petition usually could not be confirmed. In re Johns-Manville Corp., 36 Bankr. 727, 737 (Bankr. S.D.N.Y. 1984); Gaffney, "Bankruptcy Petitions Filed in Bad Faith: What Actions Can Creditor's Counsel Take?," 12 U.C.C. Law Journal 205, 210-11 (1980).) If the exchange were to occur before the stress of insolvency or nearinsolvency was manifest, good faith would be in doubt. Indeed even if the firm were insolvent, if the exchange feature would eliminate the financial stress, the good faith of the bankruptcy petition would be in doubt.

12 See I.R.C. section 108(e).

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would benefit because they would be better assured of being paid off in full after the participating financial creditors took stock. To make such a security work, nonparticipants would have to compensate participants ex ante). But such compensation is sometimes difficult. Not all potential creditors readily bargain over such matters.

6. Securities regulation

The 1930s regulators wanted a regulatory structure that would reduce the prospect of contractual reorganization. They instituted regulatory structure that would thwart out-of-court workouts. Some of those structures are still in place. For example, in the 1930s the SEC proposed and successfully shepherded through Congress a requirement that no bondholder could be bound to a recapitalization outside of bankruptcy without that bondholder's individual consent.13 That is, votes among bondholders that would bind all, are prohibited. Whether bondholders would want such a reorganizable security is one question; now they are simply prohibited from having one.

Conclusion

There seems little to undermine the view that were a bankruptcy court most interested in maximizing the post-reorganization viability of the bankrupt, it would seek all-common-stock recapitalizations. The most significant viability problems arise not from the post-reorganization capital structure, but from the reorganization process itself. Bankruptcy courts oversee a rambling bargain that implicitly assigns a value to bankrupt public firms and then provides a capital structure that often is high in debt. If the bargain fails, litigation results. Both these processes are lengthy, costly, and, if a rapid, objective basis to value the firm is available, unnecessary.

Because the post-reorganization market seems likely to value the firm more accurately than does the court, the reasons offered by bankruptcy institutions for rejection of the market in favor of judicial valuation (when bargaining fails) - incomplete information, stigma, and insufficient buyers - seem unpersuasive. Similarly, if the firm effectively could issue new debt into the market, there is little reason arising from a goal of firm viability for the bankruptcy court to attempt to ascertain the appropriate level and terms of debt for the bankrupt firm.

It is true that incompleteness of available information, costliness of available information, monitoring costs, and problems in the disparities between the value of a large block and the value of the few shares sold for purposes of extrapolating value all suggest that the post-reorganization market falls short

13 Trust Indenture Act of 1939, section 316(b); 15 U.S.C. section 77.

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as an ideal basis for accurate valuation. But judicial valuation faces some of these same debilities, as well as others; some of the debilities in the accuracy of market-based valuation can be eliminated or mitigated. More importantly, whatever the relative accuracy of the mechanisms, a market-based valuation and recapitalization via the slice-of-common-stock sale begins with the potential to be quicker and cheaper than the alternatives.

However, jamming the market valuation into the context of an ongoing reorganization would risk recreating the very problems that an objective market valuation might eliminate: delay and judicial inexpertise. A simple valuation sale would require determination as to size, timing, price, and other terms. Post-reorganization sales by participants - to eliminate control blocks or reduce dumping - might have to be regulated. While these problems potentially are resolvable, they could require judicial determinations similar to those made in a valuation hearing. These determinations raise anew the specter of strategic delay by participants in the reorganizations. The question thus becomes one of judgment to the relative severity of the defects in the three reorganization models, and the likely relative success of judicial control of the defects in each model. The choice cannot be made by economic deduction or statistical observation of market accuracy alone.

Because many of the problems with the slice-of-common-stock sale - such as secured credit, holding company structures, creation of other sources of delay, and uncertainty associated with anything new - are possible but not necessarily present in all reorganizations, a minimal response ought to be to add the suggested reorganization method as one of the possible means of valuation and restructuring. For example, the market-based reorganization could at least be authorized as a judicial weapon if the bargain fails to produce a result after a specified period of time. The Code could be recast to allow the bankruptcy judge to intervene and force a market-based reorganization if negotiations became too complex and slow.

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CHAPTER 24

Anew approach to corporate reorganizations*

LUCIAN ARYE BEBCHUK**

I. Introduction

The concern of this chapter is the way in which corporate reorganizations divide the reorganization pie. The chapter puts forward a new method for making the necessary division. This method can address some major efficiency and fairness problems long thought to be inherent in corporate reorganizations. Although the method is proposed as a basis for law reform, it can also be used under the existing rules.

Reorganization is one of the two routes that a corporation bankruptcy may take. When a corporation becomes insolvent and bankruptcy proceedings are commenced, the corporation is either liquidated or reorganized. In liquidation, which is governed by chapter 7 of the Bankruptcy Code,1 the assets of the corporation are sold, either piecemeal or as a going concern. The proceeds from this sale are then divided among those who have rights against the corporation, with the division made according to the ranking of these rights.

Reorganization which is governed by chapter 11 of the Bankruptcy Code,2 is an alternative to liquidation. Reorganization is essentially a sale of a company to the existing "participants" - all those who hold claims against or interests in the company. This "sale" is of course a hypothetical one. The participants pay for the company with their existing claims and interests; in exchange, they receive K "tickets" in the reorganized company - that is, claims against or interests in this new entity.

Why is the reorganization alternative necessary? The rationale commonly offered is that a reorganization may enable the participants to capture a greater value than they can obtain in a liquidation. In particular, reorganization is thought to be especially valuable when:

*This chapter is an edited version of the article that originally appeared in 101 Harvard Law Review pp. 775-804 (1988). Permission to publish excerpts in this book is gratefully acknowl-

**Professor of Law, Harvard Law School. A mathematical derivation of all the elements of this article's analysis is included in the discussion paper version of the chapter, which was issued as Discussion Paper #37, January 1988, Program in Law and Economics, Harvard Law School. [Acknowledgements omitted. Eds.]

1 11 U.S.C. sections 701-66 (1982 and Supp. IV 1986). 2 Ibid sections 1101-74.

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