H2H: Douglas Baird Responds
Lynn’s most recent paper with Joe requires everyone who cares about the operation of the bankruptcy system to wake up and take notice. Their evidence suggests selling a firm in a §363 sale stands to reduce creditor recoveries by 50 percent. Going-concern sales—like anything else—can be done well or badly, and Lynn and Joe’s evidence suggests they are being done very badly indeed. It should at least lead bankruptcy judges to be vigilant before approving them. (Whether they will respond in this fashion, however, is less clear. Bankruptcy judges as a group are not Lynn’s biggest fans. When you tell people they are corrupt, they tend to take it the wrong way.)
But is the evidence compelling enough to require a radical change in existing §363 practice? There are several reasons to hesitate. The first is intuitive, while others are the more concrete, omitted-variable problems that regrettably plague virtually all empirical studies.
First, an intuitive qualm. The value reported lost from fire sales seems implausibly large. These numbers, if true, suggest way too much money is being left on the table. Lynn believes the flaws in existing practice begin with case-placers who control the process (and complacent judges who appease them). But why don’t the case-placers, instead of allowing a fire sale, force through a plan that allows them to steal the firm for themselves?
One can argue (as Lynn and others have) that Chapter 11 was designed for general creditors and other constituencies and not for the benefit of those who now control the process. But making this argument is somewhat in tension with the argument that, after co-opting the process, the same people will give the firm away to someone else for a fraction of its value. Lynn suggests that managers and others who pull the levers stand to gain from sales. Perhaps so, but the right question is whether the case-placers collectively can gain more by doing something else. Again, following Lynn and imputing only bad motives to everyone, it would seem side payments could be made to the managers (and others with control who profit from fire sales) to ensure that the case-placers as a group capture the value of the business rather than give it to someone else.
Apart from the intuition that Lynn’s account fails to cohere, there are two selection-bias problems. Lynn uses firms that emerge from Chapter 11 publicly traded as a proxy for all firms that go through a reorganization instead of a §363 sale. If the reorganized firms that remain publicly traded are different from those that are not, then Lynn’s conclusions do not follow. Perhaps in the past, firms that remained publicly traded were a decent proxy for all that reorganized.
During the 1980s, more than 60 percent of large firms that entered Chapter 11 emerged as going concerns that were publicly traded. But now only about 30 percent do.
One needs to consider the possibility that, at least at the present time, the decision to remain a public entity is not that much different than the decision to do an initial public offering. Only those businesses that are the most healthy and most transparent remain public. In this case, the firms in his sample are not representative of firms that reorganize.
Moreover, we cannot assume that the choice between a §363 sale or a reorganization is random. Lynn controls for firm size and EBITDA, but there is much for which he cannot control. The low sale prices might reflect that the firms that are sold tend to be dogs. Rather than a representative sample of the firms in Chapter 11, those sold are disproportionately those that can no longer can make it as stand-alone firms. Their only value may lie in the synergy they have with someone else’s business. In addition, the firms that are sold might be the ones that run out of cash. None of the stakeholders is willing to invest the cash to keep it running. Only a third-party buyer with deep pockets will. In short, firms that are sold may be disproportionately the worst firms.
But looking at these possibilities (and they are only possibilities) should not distract from a larger point. While Lynn’s findings do require us to reassess current §363 practice, we should not forget that a “sale” of a firm properly conceived takes place whenever an outside investor acquires ownership and control of a firm. Outside of bankruptcy, it can happen through a merger, an asset purchase, or a stock acquisition. In Chapter 11, an outside investor also can take a number of different routes to acquire control and ownership. She can buy a firm in Chapter 11 by taking a controlling position in the fulcrum security, by agreeing to fund a plan of reorganization, or by a §363 sale. The crucial question in many instances is not whether the firm is to be sold in bankruptcy, but how. As Lynn’s data themselves tell us, the days in which most large publicly traded firms that entered bankruptcy emerged intact as publicly traded firms are no longer with us.
-- Douglas Baird