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July 11, 2006


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Kimball Corson

Perhaps a desire for continued salary and benefits, plus the hope of a miracle cause management to keep a company out of the tank too long, but it is not clear that, as Saul explains, that jumping in or staying and working out is going to fundamentally affect the allocation of resources or assets in the relevant markets in the medium or longer term, at least in a material way.

If that is the case, thoughts should turn to having a system that minimizes the adjustment or disequilibrium time because for that period at least the relevant markets are not properly allocating resources. The key problem here is that it takes time for people to learn and understand what is happening and emotionally adjust to that reality. Stockholders can and do go to their graves years later, still mumbling about their losses. Setting pecking order priorities among the descending vultures seems reasonable enough, but the real conclusion from Saul’s Coasian analysis is we need to accelerate the process, whichever it is to be.

Eric Rasmusen

From http://finance.yahoo.com/q?s=GM it seems that GM is still paying a dividend of a dollar per share, a 3.4% yield. That seems peculiar for a company in distress. If I were a new lender, I would not want to see that cash leave the company.

A new lender could get a commitment from GM not to issue dividends in one of two ways. The direct way is by contract, a bond covenant. The indirect way would be by having GM go into Chapter 11.

For dividends, contract would seem to work well because the problem is so simple--cash exits the company. For other asset-reducing measures, though, contracts wouldn't work so well. Can a bond covenant be written that will prevent GM from selling a physical asset at a low cash price so as to raise the money for immediate interest payments in the hopes of a surprise increase in revenue, thus preserving the shareholder's call option value? Hving some court supervision might work better (or might not-- I am pretty ignorant about how Chapter 11 works).

Kimball Corson

But what would happen to the price of its stock or market value if GM stopped paying a dividend, given its other problems? If its market value falls too far below its net asset value, controlling interest in the Company can be acquired and the assets sold off in profitable liquidation of the company without the help of the bankruptcy court.

Barry Adler

In response to my posting on General Motors, Dean Levmore writes:

"[W]e might just as well deny bankruptcy and force things to be decided by contract ... ." He then adds: "I hope this is a fair review."

Certainly he will get no argument from me. The idea that bankruptcy and auction both could be replaced by contractual arrangement, with specified events triggering a change in ownership, has been a core of my scholarship for years. See, e.g., A Theory of Corporate Insolvency, 72 NYU L. Rev. 343 (1997); "Financial and Political Theories of American Corporate Bankruptcy, 45 Stan. L. Rev. 311 (1993).

A purely contractarian approach, though, proposed in different forms by others as well (Bob Rasmussen, Alan Schwartz, e.g.) does not theoretically dominate alternatives such as bankruptcy reorganization, and as a political matter a purely contractarian approach is not likely in the cards. Thus, I have also written on ways to reform the existing system. See, e.g., my article with Ian Ayres, A Dilution Mechanism for Valuing Corporations in Bankruptcy, 111 Yale L.J. 83 (2001), which proposes an auction variant (the case for auctions in one form or another having been made previously by Douglas Baird and separately by Mark Roe, and by Lucian Bebchuk). My GM posting and the theoretical article on which it was based, Accelerated Resolution of Financial Distress, 76 Wash. U. L.Q. 1169 (1998), is in the genre of proposals for the reform, rather than replacement, of the existing system. (And so long as I am touting my own work, the empirical paper mentioned in my original posting, is: Adler, Barry E., Capkun, Vedran and Weiss, Lawrence A., "Bankruptcy Initiation in the New Era of Chapter 11" (June 19, 2006). Available at SSRN: http://ssrn.com/abstract=795987 ).)

In sum, then, I agree with Saul's characteristically bold tack and am happy to say that at least on this topic I share it, though I also write less provocatively for those who might wish to consider smaller steps.

Regarding the posts on dividends, starting, I think, with Eric's, internal corporate rules may impose (weak) constraints on their payment and yes creditors can do more by contract, but apparently in the case of GM they haven't (a reason Bob Rasmussen, in an early comment, suggests shedding no tears for them.) Keep in mind, though, that other than payment default, events of financial distress are difficult to verify, which may explain why creditors don't protect themselves more fully through covenant.

saul levmore

I appreciate the comments. I remain optimistic about alternatives to tinkering with timing of Chapter 11 filings, and even about the possibility that we imagine a world in which some version of GM remains forever, like a state in the Union, and contracts adjust accordingly. So a few things to bear in mind. I do not think we need to worry much about Eric's asset-recucing" sales. After all, the managers will have an incentive to get as much as possible in these sales. More difficult, I think, is to know what to make of GM's or other struggling firms' dividend payouts. These can be irrelevant; bad signs about the firm but good signs about the managers (who are giving out money because they recognize that the recipients can do better with the money on their own than inside the firm); good signs about both (following the cash-flow view of dividends, the firm may go back to the market for capital and allow it to help monitor its new projects); bad regarding managers but hardly unexpected (if they perceive that a dividend slash will bring about their removal because various players "expect" dividends). The list goes on.

Barry Adler

Another response to Saul's posting, one I neglected initially. He asks:

"Won't comparable principal-agent problems reassert themselves whatever the legal rules?"

The answer to this is a resounding "yes." But the answer cuts to a degree against Saul's notion that we should move beyond tinkering.

As a thought experiment, replace bankruptcy with a system of contracts that shift ownership upon specified events, as my work has proposed: no bankruptcy, no auctions (unless the owners in control at any time choose to have one). The firm would then exist like a state of the union, as Saul suggests, with any crisis-driven changes (to add a metaphor) occurring under the hood.

So far, so good, but moving from the abstract to the concrete, one might ask what those shifting contracts and triggering events might look like. A premise of the need for bankruptcy, or some alternative, is that there can be a financial crisis. A firm could set itself up so that none were posssible. Some do; they are all equity firms. There is an economic role for fixed obligations, however, a disciplinary role. That is, fixed obligations tell managers to pay, or else. The "or else" needn't be the sheriff confiscating assets or a bankruptcy process; it could be the shifting ownership under the hood instead.

Still, for this system to work, the failure to pay must trigger the transformation at an appropriate time; if a firm can get new capital to delay the trigger indefinitely, then the fixed obligations are not doing their work.

Thus, limiting the availability of new capital, the proposal in my initial posting, is important whether bankruptcy or a contractual alternative is the financial distress regime in place.


One thing that we need to pay attention to here is the distinction between control rights and cash flow rights. Dividends, loan repayments, wages and such only go to how the pie is sliced. While, for reasons we all know, the allocation of cash flow rights can affect the exercise of control rights, in the modern financial environment we can see more direct contracting over control rights. Indeed, one can view many of the benefits of private equity as the ability to exercise control rights more effectively.

GM may be a unique corporation for historical reasons. However, in the main, we would expect creditors to ensure that they exercise control in bad states of the world. The control that they exercise is selecting the managers. The premise that managers can engage in value-reducing tactics assumes that creditors cannot guard against this beforehand. When we add the ability of creditors (or better, just say "investors") to contract over control rights as well as cash flow rights, Saul°s point has even more bite. The combination of GM°s new credit facility and the activity of a prominent shareholder has the current CEO on a very short leash.

Dan McGuire

Barry, Saul or Robert:
Would one of you be so kind as to direct me to some empirical data for the widely accepted view among academia that the degree of creditor control in bankruptcy has increased dramatically in the past several years? I cannot locate such evidence. As a practitioner I find that creditor influence has risen since the mid 90s, mostly since 203 N. LaSalle, but that creditors still rarely exercise control rights, even if permitted to do so by their loan documents. I don't pretend that my experience is a substitute for research, so I'm looking for an article by someone whose proven the point. Thank you.
On a somewhat related note, I wonder what the practical impact would be of encouraging managers to file for relief earlier. Rarely is a company a viable candidate for bankruptcy in order to preserve value for equity interests, such interests being last in line. Mostly it is about seeing if value exists beyond the secured debt and, if so, how much. Given that the secured creditors are largely the ones influencing the outcome of a chapter 11 case, is the idea to allow the managers to preserve value for unsecured creditors in order to prevent the secured creditors from driving down value and taking the equity upon on exit from chapter 11 (for example, through a cram down on secureds that gives a fair portion of the value in the reorganized enterprise to the trade)? I'm curious as to the parties you see benefiting from earlier, manager driven filings.



In terms of the claim that creditors (especially senior ones) exercise control in today's reorganization cases, Douglas Baird and I examined all of the cases of large, publicly held companies that completed the bankruptcy process in 2002 and found a high level of creditor control. See Baird & Rasmussen, Chapter 11 at Twilight, 56 Stan L Rev 673 (2003). The dynamic we discuss there is different from that we saw in bankruptcy practice in the late 1980s and early 1990s, a time during which it was thought by many that managers could use the Code to hold creditors at bay. We do not, however, make a claim as to the exact on which things changed; rather, we view the process of creditors exercising more control as an evolutionary one to which many factors contributed over the space of a few years. In addition to 203 North LaSalle, we can point to increasing liquidity (which has facilited takeover activity such as the acquisition of Kmart), changes in Artilce 9 (which allowed lenders basically lock up all of a debtor's cash), and general learning by creditors as explanations for why creditors have greater influence today than they did a decade ago. While creditors may, for fear of equitable subordination, the tort of deepening insolvency and lender liability, not exercise control directly, they often make their wishes known and boards understand the signals that are being sent.

Barry Adler

Been away from the site for a while and not sure anyone is still watching this string, but I want to reiterate that I agree emphatically with the idea that dynamic creditor control rights can in principle solve the sort of problems noted in my original post on GM (problems that may well still exist despite GM's apparently postive earnings news today). This has been the central position in years of my scholarship and I never intended to suggest otherwise, as I mention above. Bob Rasmussen at least must recognize the irony of my position, responding to a criticism from Saul that I don't appreciate the value of control that can shift with financial misfortune.

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