Lynn is quick to ride an old hobby-horse. No one doubts that corruption brings with it massive inefficiency, but Lynn’s leap from his data to corruption is far from compelled. It is one inference from the data, but not the only or even the most plausible one. Lynn assumes that there is a treatment effect—putting a company up for §363 sale will lead to lower returns than if the company is reorganized. But the results could equally well be the result of a selection effect—the bad firms are the ones that get sold. Lynn’s data do not reject this story, and he offers no method for choosing between competing interpretations. And it matters. A dramatic change in §363 practice along the lines he suggests, far from improving Chapter 11 practice, may make it worse—exactly along the dimensions Lynn cares about.
The idea I suggested in my first post that case-placers could gain capture the value of the firm by reorganizing it instead of selling it is far from academic fantasy. It’s a well-known dynamic in modern reorganizations. A senior creditor who controls the process may be able to advance a plan of reorganization that both low balls the value of the firm and reserves to itself the lion’s share of the reorganized company’s equity. And existing managers are only too happy to see their options reset at an artificially low valuation. One of the benefits of promoting a robust market for going-concern sales is that it curbs exactly this sort of abuse. In Adelphia, for example, the junior parties pressed for a sale, precisely because it was a way of keeping the case-placers in line. The possibility of selling in the market (whether the sale actually happens or not) puts discipline on the reorganization process.
Extra vigilance with respect to some types of sales (such as when the dip lender is also the buyer) is important, of course. Bob and I wrote at length about why having the dip lender as a buyer is especially troublesome several years ago, and we were hardly the first. But we should be aware of what we lose by condemning a practice merely because one interpretation of the data suggests it is bad. If a firm is up for sale while in Chapter 11, the ability to game the reorganization process is reduced. Dramatically curtailing §363 sales removes this check and may aggravate the ills that Lynn worries about most.
The larger point is a methodological one. Lynn tells us that firms that were sold still do poorly even after controlling for EBITDA and eliminating the telecoms. Moreover, other controls are not available. Fair enough. But the possibility remains that firms that are sold are weaker in ways that he can’t control for and this is what is driving the results. It is not the fault of the regression analysis or the people doing it, but it points to the limits of what it can tell us.
We need to look more closely at the thirty sales that Lynn and Joe identify, get under the hood, and see exactly what was going on. If they are right that value was lost on anything like the scale they claim, it should become manifest in on on-the-ground inspection. But this is a big job, and I have not done it beyond looking at one case and then only briefly.
There was no magic to the case I picked (abc-naco), other than that it seemed a promising candidate for lost value of the sort Lynn worries about. Not only was very little realized on sale (a paltry 17% of book value), but the sale took place less than two months after the filing of the petition. Moreover, the creditors’ committee vigorously opposed the sale and indeed characterized it as a “fire sale.” But a closer look suggests it is unlikely that the firm was sold for too little.
ABC and NACO merged in 1998 and became one of the dominant firms in the design, engineering and manufacture of components for railcars. With the merger, however, came a large debt burden. Moreover, the market for railcars dropped precipitously. A number of divisions were sold off and the debt was restructured multiple times. By the time of the petition, a single group of secured lenders were owed more than $170 million. A member of this group also provided dip financing, and this group was the one pressing for the sale. The business could have been worth a $100 million more than the $67 million for which it was sold and this group would have received every penny. Those pushing for the sale had every reason to find a better offer if one was to be had.
While the unsecured creditors objected, they were so much out of the money that their voices should not count for much. More to the point, they objected to the dip financing too. It turns out the general creditors did not want a traditional reorganization any more than they wanted a sale. However efficient and however many jobs a sale or a reorganization might have saved, Chapter 11 would consume the few remaining unencumbered assets and leave the unsecured creditors with nothing. By contrast, those in control in abc-naco had every incentive to maximize value. After all, all the value would end up in their pockets.
One can argue that the secured creditors in abc-naco should not have been able to use Chapter 11 as a way to realize on their collateral, but this is another debate. The fact remains that abc-naco was not a fire sale. Of course, this is merely one case, a single data point. What about the other cases? We don’t know. We can’t reject Lynn’s theory that value is being squandered in §363 sales without learning more.
Where does this leave us? While we need to take Lynn’s data seriously, we should not accept his interpretation uncritically, nor are we somehow obliged to accept his interpretation unless we are able to disprove it. There is more than one plausible interpretation of the data, and there is no reason to privilege Lynn’s, especially as the competing and equally plausible interpretations suggest that Lynn’s reforms push in exactly the wrong direction. It is too soon to reject the hypothesis that there is a selection effect at work (bad firms get sold), and we should not forget that sales may provide a powerful check on bankruptcy abuse.
Hippocrates had it right and not just about medicine: First do no harm.