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October 04, 2007

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Matthew Dundon

I'm unsure the failure to appoint Chapter 11 Trustees is meaningful. When pre-petition management was incompetent or corrupt, Boards of Directors have done a perfectly fine job of cleaning house and substituting appropriate clean management -- not just Enron, but also Adelphia, Worldcom, etc.

At all times, stakeholders have been free to demand the appointment of a Trustee and almost never do, except as a late-in-the-game strategy to grind some other ax altogether.

The same dog-who-hasn't-barked objection needs to be raised regarding forum selection. Ad hoc committees and other stakeholders whose expenses aren't being covered by the estate are very motivated to minimize expense and avoid bias in favor of incumbent management, DIP lenders, or 363 stalking horses -- yet SDNY and Delaware forum almost never draws objection.

In the rare case where bona fide objection is raised, it seems to find a sympathetic hearing -- Winn-Dixie's relocation of its Chapter 11 case down to Jacksonville, FL to accommodate its large body of local trade claimants comes to mind.

And when we see mega-cases initially filed outside of SDNY or Delaware, desire for parochial advantage or mere convenience (United Airlines in Illinois, certain energy cases in Texas) is at least as likely to figure in as any desire to create a more even or less expensive playing field. (It's hard to imagine that United could have been more expensive in SDNY, although nothing's impossible.)

Lynn M. LoPucki

The reason I chose Enron and Refco as my examples is that in both those cases major players asked for the appointment of a trustee. In Enron the request was made while Ken Lay remained in charge and by creditors owed hundreds of millions of dollars. What is extraordinary is not the small numbers of motions made, but that any are made at all. The requests embarrass the competing courts and those courts never grant them.

The same is true with respect to venue objections. Why would a party with substantial money at risk want to irritate judges that are attempting to attract cases by asking those judges to transfer them away? Even though half to two thirds of large, public company bankruptcies are filed away from the company's headquarters, no motion to transfer a case larger than $800 million in assets has ever been granted, except at the request of the debtor.

Winn-Dixie filed in New York to escape, not accomodate, its local creditors. After a creditor revolt and an avalance of bad publicity, the company itself joined the creditors trying to move the case. Even after the debtor switched sides, the New York creditors' committee fought Winn Dixie and its creditors to keep the case in New York.

For a brief period, big cases shopped to Chicago for the same reason they shop to Delaware and New York: the professionals believed they and their clients would get a better deal there. When the Chicago court didn't come through for them, they stopped going.

Our data on professional fees shows that virtually every court that gets big cases pays New York rates. The big difference in fees is that they are 20% higher in shopped cases than in non-shopped cases. Since 1998, bankruptcy professional fees in large public company cases have been rising at the rate of 12% per year. The rise continued even while the demand for bankruptcy professionals fell in recent years. Can anyone come up with a benign explanation for that?

AKeller

LoPucki claims not to advocate a radical change to 363 practice, only to "end the disastrous competition among the bankruptcy courts for large, public company bankruptcies." But this perscription is only warranted if the competition is disasterous. And it is only disasterous if 363 sales are systematically underpricing the value of firms. As Prof. Baird notes, the low recovery values for firms sold under 363 has many possible explanations, of which disasterous competition is but one. If firms sold under 363 are simply "dogs," the problem isn't competition between forums; indeed, there may not be a problem at all.

I wonder if there might be a better means of answering the empirical question Baird poses. Rather than comparing recovery values, why not look at the market value of the unsecured debt immediately post petition and compare it to the market value after the firm has decided which route (363 sale or reorg) to pursue? If 363 sales are, on average, truly underpricing asset value, we'd expect a measurable depreciation in the unsecured debt after the decision to pursue such a sale is made and vice versa for the decision to reorganize.

Investors know ex ante whether the firm is a dog or a jewel, so this methodology would help control for that crucial variable.

LoPucki may well be right that 363 sales (and forum competition) pose significant problems. But we should make sure this is so before fiddling with the bankruptcy process.

mt

The data and analyses in Bankruptcy Fire Sales are worthless - actually less than worthless. The article is a negative contribution to policy analysis because it is so blatantly wrong. The data points - e.g., valuations in petitions - are totally unreliable. Petition date valuations are typically inserted by counsel after a 3-5 minute discussion with the company executive responsible for assisting counsel with preparing the petition. There is no analysis or effort that goes into that valuation. Typically, in fact, it is the client who asks the lawyer what to put in and the lawyer will often advise, if it is a public company, "use the numbers in your last SEC filing so no one can accuse you of any inconsistency between the two fora". That is the sum of the valuation work that typically goes into Exhibit A. Any correspondence between an Exhibit A valuation and reality would be an accident.

Similarly, the ratios examined in the study - e.g, ebitda to assets - are completely irrelevant, as is any operation performed using those ratios. In 25 years in the field, I have never heard anyone use the EBITDA to assets ratio to assess a company's ability to reorganize.

The real facts and the relevant ratio for analysis are (1) the ability of the company to cover operating expenses, professional fees and to service its prepetition secured debt either from postpetition cash flow or from a DIP, and (2) the recovery for secured creditors. In many of the 363 cases in Exhibit C to the article, there was negative cash flow to begin with (particularly the telecom cases, which also are cases of gross prepetition overvaluations) or else the secured lenders had determined that they were at risk of having their recovery impaired from prolonged operations, advised the company that they would not support the company continuing to pay unsecured creditors, stated that they only provide further funds in the form of a DIP to fund a sale process, and stated they would oppose any priming DIP and any reorg plan that did not provide for a sale. Thus the company had no or a very weak ability to reorganize and opted for a 363 sale as the only certain way to remain a going concern. This is by far the dominant fact pattern behind 363 sales - not managers duping unsuspecting creditors and courts but secured creditors exercising their contractual and statutory rights to limit their risk under alternative scenarios. In many if not all of the 363 cases, senior creditors secured by all the assets of the company took losses in 363 sales.

I see no evidence that you pursued any interviews of professionals in the cases, even professionals who represented creditors. Had you done so you probably would never have written the article you did. The ANC Rental case is a good example of the flaws of your analysis. In that case, the debtor had a prepetition offer to be acquired by a strategic partner for an amount equal to its entire debt plus $1 per share to stockholders. Instead, it opted to file and try to reorganize under a new manager, who made a mess of the operations and had to be replaced after more than a year of failing to hit his own projections. All the creditors joined together and demanded that the company be sold. By that time, however, the strategic partner had moved on with another company and the process resulted in a sale to Cerberus for less than the secured debt. Unsecureds were left with little if anything. Cerberus replaced almost all the management team and the company became quite successful post sale. That case was a 363 driven not by management sneakiness, but by creditor exasperation at management failure.

Because your study (1) uses data and ratios that are unreliable and unused by anyone in the restructuring business, (2) failed to consider the data and ratios that are actually used by creditors and professionals to determine whether to pursue a 363 or fullblown 11, and (3) failed to make inquiries of the case participants why they opted to support a 363 sale, the study is completely unreliable and has no explanatory power, and the speculative, ad hominem theories the study and your post above offer to explain the results your bad data yield are unsurprisingly wildly incorrect.

Lynn M. LoPucki

AKeller’s suggestion to value companies at filing on the basis of the market value of the unsecured debt is a good one. We investigated the availability of bond price data and found that it was published for only two or three of the 30 sale cases. AKeller advised me by email that unpublished trading values may be available through investment banks. I prefer to conduct studies based on published values, because publication assures greater accuracy and integrity. But I would be very interested in seeing the results of a study based on proprietary values.

I agree with AKeller and Baird that “the low recovery values for firms sold under 363 has many possible explanations, of which disastrous [court] competition is but one.” My argument that the court competition has been disastrous is based principally not on the 363 sale study, but on several studies of the refiling and refailure rates large public companies. Doherty and I found that the refiling rate for companies emerging in Delaware during its period of ascendency (1991-96) was seven times the failure rate for companies emerging from courts other than Delaware and New York. Several follow up studies by others have confirmed those results. See LoPucki & Doherty, Delaware Bankruptcy: Failure in the Ascendancy 73 University of Chicago Law Review 1387 (2006).

Lynn M. LoPucki

mt misunderstands what Doherty and I did in our study. We did not “use the EBITDA to assets ratio to assess a company’s ability to reorganize.” The variable we used to assess a company’s ability to reorganize was the explanation the company gave to the court when it applied for approval of the sale.

mt would assess ability to reorganize based on whether the company’s cash flow would cover the payments necessary to continue operations. In fact, all of the companies included in formulating our conclusions continued to operate in the period immediately after the sale. mt asserts that many of the sale companies could not reorganize because their secured creditors had cut off funds, and argues that may account for the low recoveries in sale cases. But we found no correlation between sale prices and debtors’ assertions of inability to reorganize.

Mt’s telling of the ANC Rental story exposes the weakness of his complaint. He asserts that ANC was sold because it could not be reorganized, yet he reports that it was reorganized by the buyer. That story is fully consistent with our findings that companies are sold for a fraction of their reorganization values. Had the court forced the management team out, held the lenders in, and reorganized the company, the creditors would have had a far greater recovery.

Dan McGuire

"Had the court forced the management team out, held the lenders in, and reorganized the company, the creditors would have had a far greater recovery." The court cannnot force the lenders to make new advances; few companies can survive on cash collateral; even fewer can get a non priming DIP or satisfy the requirements to prime the exising lenders. Courts do not reorganize companies- creditors and manamgement do. I suppose the court could have appointed a chapter 11 trustee sua sponte. Beyond that, this is an unrealistic view of how bankruptcy works, or could work under title 11 in its current form. Nobody was willing to put in the new capital needed to make ANC work through a stand alon plan. ONly because they could acquire the assets free and clear through a 363 sale was Cerberus willing to make the necesasry investment. Simply put, the Cerberus turnaround would not have taken place through a stand alone plan.

Lynn M. LoPucki

Dan McGuire’s post frames an interesting paradox. The “dogs” are so weak they can’t be reorganized. But when those same dogs are sold, the buyers reorganize them. Of course, the buyers must change managers and make new investments to accomplish that. But changing managers, accepting new investment, and giving the new investors ownership and control are all standard parts of the reorganization process. Why did the bankruptcy system choose fire sales over reorganizations during that brief period from 1998 through 2004? (I’ve stated what I think are the reasons, but I would be interested in hearing what those on the other side of this debate think.)

Dan McGuire

The people willing to put in the new investment prefer to do so through a 363 sale where they take the assets and divorce themselves from the prior operations and obligations. Simply put, offering them control in exchange for their investment, while shackling them with the same company with obligations reduced through a plan, is not an investment they are willing to make. I would venture to guess that many stand alone plans these days involve a significant portion of the equity being conversion of prepetition obligations. There people already have money at stake, so putting in some new equity to enhance the recovery on your existing obligations may make sense. The 363 buyers, with no existing skin in the game, are not willing to make the investment through a plan. Without new capital, many stand alone plans would struggle to satisfy 1129(a)(11). You cannot force new investment through a plan; assuming it is as easy to obtain as through a 363 sale is counterfactual. What I am trying to say is, while it may be true that plans return a greater recovery to prepetition creditors, that does not mean that plans are a viable option in cases that result in a 363 sale. Without new capital, many chapter 11 debtors cannot emerge, and it is harder to get new capital though a plan. In other words, it may be the buyers/investors who drive cases to 363 sales rather than stand alone plans, not corrupt case placers and judges. I accept the theoretical, non reality based argument that these investors should be willing to fund plans to still get a healthy and avoid the almost certain market test of a 363 sale. In reality, that dog won’t hunt with most private equity shops and other investors.

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