The University of Chicago Law School Faculty Blog

Primary and Secondary Liability Under Securities Law: The Stoneridge Investment Saga

By  Richard A. Epstein

(Professor Epstein spoke at the Manhattan Institute  on this case last Thursday, October 4th; listen to his discussion with Jim Copland here).

Tomorrow, October 9th, the United States Supreme Court is hearing oral argument in one of the most important securities law cases in decades, Stoneridge Investment Partners, Inc. v. Scientific-Atlanta.  This highly contentious dispute illustrates a proposition long familiar to lawyers: the choice of remedy—administrative enforcement versus private class actions—for admitted violations of the law may prove more momentous than the antecedent legal question of whether a targeted defendant has engaged in any wrongful conduct.

Exhibit A is this litigation aftermath of a securities fraud initiated by key insiders of Charter Communications Company.  Between November 1999 and August 2002, these officers had allegedly inflated Charter’s quarterly earnings by using faulty accounting business practices to capitalize deductible labor expenses, to postpone cutting off nonpaying customers, and to enter into sham transactions with Scientific-Atlanta and Motorola.

Starting in August, 2000, Charter deliberately overpaid the two defendants to purchase set-top boxes for cable TVs, on condition that they funnel the extra cash to buy unwanted TV advertisements from Charter.  Charter booked the revenues as income, but capitalized its outlays to boost stock price, which dropped substantially when the entire scheme was unmasked two years later.
The plaintiff class, which consisted of all investors who sold during the scheme period, settled with other defendants for $146.5 million.  Left open is whether they may also sue the two remaining defendants for damages for what plaintiffs describe as their “direct” participation in a “scheme” to manipulate the stock price and defraud the investing public.

Everyone agrees that the defendants could have been liable in damages to the investors if they had a duty to disclose, or if they had voluntarily made any public disclosures about the sham transactions.  But absent either, the Court of Appeals for the Eighth Circuit held that the defendants were subject only to direct administrative sanctions from the SEC.

Stoneridge raises hard questions on what the law is and what it should be.  On the former, the defendants are on strong ground in arguing that the key 1994 Supreme Court 5-to-4 decision in Central Bank, N.A. v. First Interstate Bank, N.A. lays down a categorical rule that no private party can bring a damage action under the securities laws against wrongdoers who only “aid and abet” the securities breaches by parties directly subject to disclosure obligations.

Accordingly, Central Bank refused to allow mortgage lenders to sue an indenture trustee, which failed to reassess the value of properties in its portfolio when they had received strong indications that they were no longer worth 160 percent of the unpaid mortgage balance, as the loan covenants required. The Central Bank’s dissenters thought the regulatory prohibition that makes it unlawful “directly or indirectly . . . to employ” any scheme to defraud reached aiders and abettors, including Central Bank. 

That case determines this one.  If the knowing disregard of the single bond trustee charged with a duty to protect investors does not trigger liability for damages under the securities law, then the same should be true of the numerous equipment vendors with no fiduciary duties at all.  After Central Bank, Congress specifically authorized the SEC to bring enforcement actions against aiders and abettors, but it did not change the Central Bank result barring private actions.  Clever pleading about “scheme liability” should not, and will not, upend the prohibition on private suits against aiders and abettors given that Congress has refused to overturn the result in Central Bank. 

Yet, normatively speaking, why should secondary violators be escape private damage suits brought like those brought against primary wrongdoers?  One way to end the discrepancy is to deny all private damage actions against primary offenders, which is not as farfetched as it sounds.

The key vice of these private suits is to overdeter wrongful conduct. For example, the class that sued Charter let all unfortunate buyers at inflated prices recover for their market losses.  But it does not require the lucky sellers of overpriced stock to disgorge the fortuitous profits from selling overpriced stock.  The net damage recovery from this temporary imbalance in the markets far exceeds the social losses from the underlying chicanery.  Across the board, harsh penalties for nondisclosure now induce firms to remain silent lest they incurring huge liabilities for modest misstatements. Administrative remedies can be better calibrated to the severity of the underlying wrong.

Even, if a damage suit against primary wrongdoers makes sense, the second round of suits is overkill.  Allow this suit against Scientific-Atlanta and Motorola, then no iron barrier protects any vendors from charges of “knowingly” engaging in fraudulent transactions with hundreds of potential buyers who thereafter mischaracterize these deals in their own financial accounting.  Just what fraction of the total loss is attributable to their actions as opposed to other financial gimmicks?  And should secondary actors be held liable for all losses if it is hard to isolate a distinct fraction for which they are responsible?  The current law of joint and several liability suggests that no apportionment will be made unless it can be made.

Imposing crushing litigation burdens on second-tier defendants who receive no direct benefit from the public fraud is a heavy-handed way to improve transparency of securities markets.  The expanded liability has two vices.  First, it chews up huge social losses in litigation costs that detract key executives from their major jobs.  Second, it leads to erroneous findings on liability rates of error whereby some innocent defendants pay  large sums while some guilty parties go free.  No system that costly and erratic supplies effective deterrence against fraud.

Empirical judgments about optimal deterrence are always subject to spirited dispute.  Owing to the underlying disagreements on policy, what matters is the Court’s current attitude toward securities cases.  Here its basic approach rests on two premises.  First, don’t rely heavily on the expansive tort analogies, but concentrate on a close reading of the statutory language.  Second, don’t initiate major changes in the status quo, but leave that job to Congress.  Both these guidelines point to keeping secondary liability under tight rein. My prediction is that the Court will follow its own precedents, and leave it to Congress to decide whether it wants to undo the current uneasy status quo.

A Review of Jack Goldsmith's "The Terror Presidency"

Jack Goldsmith's "The Terror Presidency" is one of the most interesting and most insightful books yet to come out of the Bush White House.

In October 2003, President Bush appointed Goldsmith, a self-described conservative who proudly proclaims that he is not a civil libertarian, head of the Justice Department's Office of Legal Counsel, thus making him chief adviser to the president about the legality of presidential actions. Ten months later, Goldsmith resigned because he could not endorse the unlawful policies the administration had implemented in the war on terror.

Shortly after taking office, Goldsmith reviewed a series of highly confidential opinions written by his predecessors in the Bush administration that defended the legality of "some of the most sensitive counterterrorism operations in the government." To Goldsmith's shock and dismay, he found that some of these opinions "were deeply flawed: sloppily reasoned, overbroad, and incautious in asserting extraordinary constitutional authorities on behalf of the President." What was going on?

Epstein Answers E-mails About Microsoft Ruling

On September 20, Richard Epstein and NYU's Harry First participated in an email forum sponsored by Financial Times. The pair answered questions about the European Union's Court of First Instance ruling against Microsoft a few days prior (Randy Picker also wrote about the case on these pages).

The questions and answers are available here.

H2H: LoPucki Strikes Back

Joe and I don't propose "a dramatic change in §363 practice." We think sale under §363 should continue to be an option under the current legal standard — "sound business reasons [for not going though the Chapter 11 process of disclosure and plan confirmation]."

What we do propose is to end the disastrous competition among the bankruptcy courts for large, public company bankruptcies. Because the judges are competing for cases, they can't also perform their function as regulators of the sales. They can't ask the hard questions—such as whether the proponents of the sale own a beneficial interest in the buyer. They can't control professional fees. They can't appoint trustees when the managers of the companies have been engaged in fraud. (Two good examples are Enron and Refco. The system failed to replace either management with a trustee despite a clear Congressional mandate.)

Our §363 sale study is one of several, by a variety of researchers, that show serious problems in the bankruptcy courts' handling of large public company bankruptcies since the competition began: high refiling rates by companies reorganized in the competing courts, rents extracted by managers, suspicious patterns of decision making by the competing courts, and higher professional fees in forum shopped cases.

The competition arose by historical accident. The two major organizations representing unsecured creditor interests—the National Association of Credit Managers and the Commercial Law League—along with the National Bankruptcy Conference and the National Bankruptcy Review Commission have all endorsed legislation to end the competition.

Court competition—a form of regulatory competition—doesn't work in situations where one side picks the court and the other can do nothing about it. When that kind of competition has arisen in other contexts—tort and class action forum shopping for example—Congress has acted to eliminate it. The bankruptcy court competition is permitted to continue only because Senator Joseph Biden (D-Del.) wields tremendous power in the Senate.

In 2005, Congress rewarded the Delaware bankruptcy court by raising the number of Delaware bankruptcy judges from two to six. So far this year, six of the seven large public companies that filed bankruptcy anywhere in the United States (86%) filed in Delaware. The New York court—triumphant as recently as 2005—must now respond or risk fading into obscurity. One who seeks to do no harm should insist on studies showing court competition to produce no harm before permitting clever strategists to make such a dramatic change in large, public company bankruptcy. That showing hasn't been made.

H2H: Baird's Second Post

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.

Baird & Henderson on "Other People's Money"

In corporate law classes at Chicago and other law schools this fall, students are studying the rules that govern the conduct of corporate directors and officers. Collectively known as "fiduciary duties", these include the "duty of care" and the "duty of loyalty". Nearly the entirety of corporate law is premised on these duties being owed to shareholders. In a new paper (see the abstract below), Professors Baird & Henderson argue that fiduciary duties as currently conceived are more harmful than helpful, and that they should be replaced with a new, contract-based approach. The full paper is available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1017615.

"Other People's Money"

Abstract:    

There is no more sacred tenet of corporate law than the one stating that corporate directors owe a fiduciary duty to shareholders. We argue that while this rule has not yet generated seriously wrongheaded outcomes, it is an “almost right” principle that should be abandoned before it does. As a threshold matter, we show the notion of special duties owed to shareholders is plainly inconsistent with everyday business decisions and corporate law. Firms can take and do take actions that are inconsistent with those of a fiduciary and that favor creditors at the expense of shareholders, despite supposedly trumping fiduciary duties owed to the latter. A bankruptcy filing is the most obvious of these. 

The recent cases in Delaware over fiduciary duties in the “zone of insolvency” demonstrate how the attempt to delineate clearly what duties are owed to different investors in a firm is doomed to fail. Using Credit Lyonnais and its predecessor Central Ice Cream, we show how courts are attuned to the problem of conflicting interests among different investors, but are not likely to create efficient rules by using labels like “fiduciary duties” and applying them to shareholders sometimes and creditors other times.

We offer two potential replacements for the shareholder fiduciary duty doctrine. The most familiar for corporate scholars and practitioners is the idea of fiduciary duties being owed to the firm as a whole, coupled with a strong business judgment rule. Although we think this is superior to the existing rule, we show how this principle itself may be wanting in some important cases. In venture capital transactions, for one, the ex ante bargain appears to give certain investors the right to take actions in bad states of the world that may destroy firm value in order to create incentives for managers to avoid those bad states. Courts disrupting these deals in the name of fiduciary duties may be upsetting well struck bargains.

We therefore set out an alternative paradigm, one in which no fiduciary duties exist at all, and directors face liability for their decisions (other than for neglect or surreptitious self-dealing) only if they violate a contractual obligation owed a shareholder, creditor, or other investor. We conclude by showing how separating corporate law from conceptions of duty brings needed clarity to the often-litigated issue of disclosure duties. The problem, we suggest, is largely contractual, and in setting the default rules the focus should be on the ability of parties to opt out—or opt in.

H2H: LoPucki's Second Post

Douglas raises essentially three points:

1. The intuitive qualm: If these deals are so good, why aren't the case placers taking the deals for themselves?

First, we don't know that the case placers aren't.  To confirm a plan of reorganization, a debtor must file a disclosure statement  -- typically 200-300 pages in length -- that explains, among other things, who will own and control the reorganized company.  To sell in a section 363 sale, requires almost no disclosure at all.  The debtor presents a witness or two who say they have investigated the alternatives and the proposed sale is best.  In the sale transcripts I read, the sale proponents neither identified the ultimate parties in interest nor negated the possibility that it might have been themselves.

In Polaroid, for example, Bank One Equity formed the buyer, OEP, with investors not publicly identified.  Because OEP insiders made the unusual decision to take reorganized Polaroid public about year after their purchase, we know that Polaroid's top managers joined OEP after the sale and received millions of dollars worth of stock in OEP.  We have no way of knowing the degree to which the case placers were on both sides of the deals in the other sale cases we studied.  If I were a bankruptcy judge, I would have asked.  But if I were a judge and I had asked, that probably would have been the last big 363 sale case filed in my court.

Second, while our sample included no cases in which managers or DIP lenders openly bought their companies, such cases are frequently reported elsewhere.  Third, case placers may prefer a massively inefficient sale because the small amount they can steal from such a sale is still larger than the amount they can steal from a reorganization.  Consider, for example, the analogy of a corporate purchasing agent taken a bribe of a few thousand dollars in return for a contract worth millions.  Corruption's horrendous potential for inefficiency is one of the reasons we try to eliminate it.

2. The publicly traded reorganizing companies in our comparison group may have been stronger than non-publicly traded reorganizing companies, thus exaggerating reorganization recoveries.

Douglas may well be right about this.  No valuation data are available for the non-publicly traded reorganizing companies, so we can only guess at whether they produce more value.

Douglas' guess is that "the most heathy and most transparent remain public."  My guess is that the investors who take companies private in connection with bankruptcy take the good ones for themselves and leave the bad ones for the public investors.  The factual basis for my guess is that the five-year rate of refiling for public companies emerging from bankruptcy seems to be substantially higher than the corresponding rate for private companies emerging from bankruptcy.

3. The sold firms may have been weaker than the reorganized firms.

The sold firms were in fact weaker than the reorganized firms, as indicated by lower EBITDA.  But we controlled for that weakness.  In our regression analysis, the difference in EBITDAs explained less than half as much of the difference in recoveries as did the sale-reorganization choice.  The sold firms were also more likely to be telecoms.  But controlling for that difference B and every other difference for which we had data B the choice between sale and reorganization remained highly significant.  Of course, there can always be some other lurking variable.

Because illiquidity and supposed inability to reorganize are often cited as the reason for low sale prices, we searched the sale transcripts for evidence of those phenomena.  Much to our surprise, we found a claim of inability to reorganize in only 13 of 25 sale cases (52%).  Even more surprising, those claims were not correlated with low sale prices.  We also found no correlation between the cash-to-asset ratios and the sale price-to-assets ratios of the sold firms.  Firms in stronger cash positions prior to filing did not sell for higher prices.

The issue Douglas does not address is the disastrous competition among the bankruptcy courts for big cases.  Our 363 sale study is just one of many that suggest that the courts' unseemly competition has produced a race to the bottom.

Douglas' proposed solution is that "bankruptcy judges [should] be vigilant before approving [sales.]" But I do not see how they can be.  The case placers can choose their court.  Why should case placers subject themselves to vigilant courts when such courts might prevent the case placers from doing what they want to do?  When the regulators are in competition, vigilance on the part of a regulator can do no more than drive the cases elsewhere.

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

H2H: LoPucki v. Baird, Round 1

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

Pardon Our Dust

It's a new month, we've got a new Head to Head launching within the hour, and the Faculty Blog will shortly have a brand new look. Please bear with us for the next few minutes - as the new template is applied and the blog republished, things make look a little strange around here. Stay tuned for Lynn LoPucki's first post!

Update, 10am: Ok, the basics of the new template are in place, but we'll be doing some tweaking throughout the morning. Thanks for reading!

Update, 12:14pm: Our tweaks should be done. Please let us know in the comments if you have any problems or questions, and stay tuned for more improvements over the next couple of weeks.