I thank Douglas Baird and the Chicago Faculty Blog for this opportunity to debate Douglas regarding Joseph Doherty's and my paper, Bankruptcy Fire Sales. The paper, which will be published shortly at 106 Michigan Law Review 1 (2007), reports on our empirical study of the bankruptcy sales of large public companies as going concerns during the period 2000 through 2004.
Douglas and his frequent coauthor, Bob Rasmussen, inspired our study with the publication of their article, "The End of Bankruptcy," 55 Stanford Law Review 751 (2003). In that article, Douglas and Bob wrote that "the days when reorganization law promised substantial benefits are gone" and "[t]oday, creditors of insolvent businesses . . . no longer need a substitute for a market sale. Instead of providing a substitute for a market sale, chapter 11 now serves as the forum where such sales are conducted." Had those developments in fact occurred, they would have marked the end of corporate reorganization.
To determine whether they had, Joe and I compared the bankruptcy sale prices for 30 large public companies with the values of 30 large public companies reorganized in bankruptcy during the same period. We dropped five of the sales because the companies were not sold as going concerns. We calculated the sale recoveries as the ratio of the sale price to the value of the company reported on the bankruptcy petition. We calculated the reorganization recoveries as the ratio of post confirmation reorganization value to the value of the company reported on the bankruptcy petition. We computed post confirmation reorganization values two alternative ways (1) the fresh-start value placed on the company by the negotiating parties and (2) the market capitalization of the emerging company based on the reported value of its debt and trading price of its shares.
We found that the companies sold for an average of 35% of reported value, but reorganized for an average fresh-start value of 80% of reported value and an average market capitalization value of 91% of reported value. After logging these ratios (to reduce the effect of outliers) and controlling for the lower earnings (EBITDA) of the sold companies we estimated the market capitalization reorganization recoveries at 75% of reported value and sale recoveries at 29% of reported value. In essence, our data showed that the recovery from reorganizing a large, public company was, on average, more than double the recovery from selling an apparently identical company.
Of course, there might be differences between the two sets of companies not reflected in reported assets or earnings. Those differences might account for some of the difference in recoveries. But the difference in recoveries was so great that we doubt other variables could explain it away. We conclude that, during the period studied at least, the bankruptcy courts were selling large public companies at fire sale prices.
We identified essentially two market failures. The immediate failure was a lack of competition in bidding. In a majority of the auctions, no one bid against the stalking horse. Even in the eight cases where someone did bid against the stalking horse, the stalking horse still ended up the high bidder in four.
Ultimately, regulatory competition failed. By historical accident, large, public companies can choose their bankruptcy courts. Formally, the choice is made by the debtor's management, but the debtor's professionals and prospective DIP lenders also play a role (together the "case placers"). At least since the early 1990s, several bankruptcy courts have been competing for big cases. Two panels -- those in Delaware and New York (Manhattan) -- have dominated the competition, attracting most of the cases. The courts compete in part by favoring the case placers. One result is that the competing courts lack the ability to say no to case placers who propose a fire sale. If a court did say no, future cases would go to other, more compliant courts.
That explains why bankruptcy judges would approve fire sales. It does not, however, explain why the managers and the companies' high-priced professionals proposed fire sales. We think the explanation is that the case placers were pursuing their own interests rather than those of the companies. We found instances in which the managers who proposed the sales reaped substantial bonuses, substantial severance pay, or lucrative jobs with the buyers. We also noted that if the companies left money on the table, the investment bankers who arranged the sales had valuable opportunities they could steer to favored clients. Consistent with this theory, the sale efforts were leisurely until the debtor and its investment banker selected a stalking horse. Then they suddenly became urgent. Creditors' committees opposed some of the sales, but were unable to persuade the courts to stop them.
Our explanations for the low sale prices are in large part mere speculation. But regardless of what might be depressing sale prices, we think that the sale prices themselves justify the continued availability of reorganization as a bankruptcy alternative. The days when reorganization law promises substantial benefits are still with us.
-- Lynn LoPucki