The University of Chicago Law School Faculty Blog

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: 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

Coase's Journey - A Douglas Baird CBI Podcast

When Douglas Baird does a talk in a series called "Chicago's Best Ideas," he doesn't mess around. For his talk in the series on February 7, 2006, Douglas examined an idea that led to the only Nobel Prize ever awarded to a faculty member of an American law school - the one given to Ronald Coase in 1991 for his work on, among other things, the nature of the firm. Douglas's CBI (as we affectionately call the entries in this series) was a fascinating foray into Coase's research on and understanding of what a firm is and why it functions the way it does - research done when Coase was still an undergraduate.  Douglas kept the full room riveted (no pun intended) by the mystery of why 1930s automobile companies bought and integrated some of their suppliers, but not others. Curious? You should be. Listen to the talk here.

As always, instructions for listening to this podcast are here. The blurb Douglas used for the publicity for his talk is below the fold.