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.
Prof Baird's analysis is exactly right. The data used by Prof. LoPucki and the analyses performed on the data have the illusion of reliability but in the real world they are completely off base. First, book value is meaningless as an indicator of value for any company, solvent or not. Seoond, a debtor's petition date valuations are completely unreliable. The debtor might spend 3 - 5 minutes discussing with counsel what to say about value in the petition and for public companies, the answer will normally be "use the numbers in your last public filing, none of the creditors really pays attention to that field anyway." Third, firm size is only weakly correlated with ability to reorganize. Fourth, and most important, as Prof Baird's example of ABC-Naco illustrates, the study misses completely the key drivers of why a 363 sale is selected to resolve a distressed situation: it is not absolute EBITDA or absolute value that matters. What matters is the ability of a debtor to generate sufficient positive cash flow in chapter 11 or obtain DIP financing to pay admin expenses and service the secured debt. Many 363's involve companies that have (1) negative cash flow to begin with - for example, many tech companies that went public in the 90s and then went bust had negative cash flow, (2) insufficient cash flow to cover post petition operating expenses, professional fees and secured debt service, (the ABC-Naco example) or (3) a need for a priming dip to stay alive, but cannot obtain one because there is insufficient equity cushion and all the assets are pledged. Most 363 cases occur not because a faithless management has duped the creditors (that is absurd if you actually work in big chapter 11s) but because the secured lenders have lost patience with the company and have told the management they will not support the company's reorganization, but will only allow them enough funds to stay alive for a short while if the company is put up for sale. 363 sales are simply dignified and more efficient chapter 7's, and are not comparable to 11's. The data and analysis behind Bankruptcy Fire Sales are totally unreliable, and a comparison between successful 11's and 363 sales is like comparing groceries to garbage.
Posted by: MT57 | October 08, 2007 at 02:05 PM