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

Comments

[Dan McGuire]

Interesting stuff. Here are a few quick observations:

Your point about committees not having the resources to fight the debtor over an inadequate sale price is not well supported by your arguments. You state that they do not have the resources because debtors spend 4 times as much as committees. Both sets of counsel get paid from the same source, the estate, and the fees of both are subject to the same standard of review. That committees in fact spend less does not mean they cannot spend more if they deem it necessary. The larger the case, the less likely the cost will be viewed as a barrier to objection by the committee.

You suggest that break up fees "likely attracted some stalking horses who would not otherwise have bid." That is rarely, if ever, the case. Buyers of large public companies are not in the business of making money off break up fees. They are in the business of buying and running companies. The break up fee is a nice balm to heal the wound of being outbid, but it does not bring bidders to the table who would not otherwise be there. As you indicate, most stalking horse bidders win, so they would in fact have no expectation of getting paid the break up fee. I am also curious about how you determined the number of bidders. The number who actually appeared at the auction is not the real test. There is often a mini auction conducted by the debtors prior to entering into a stalking horse agreement. Rather than being a give away to lure a bidder, break up fees are often the incentive to get bids higher during the informal auction for position as the stalking horse.

Let me suggest one possible theory for why you see sales over reorganizations: it is easier. A properly conducted 363 sale will meet with little objection, as there are not many grounds for objection for courts that follow more of a debtor’s business judgment standard rather than a Lionel Train type of standard. Thus, you conduct what you believe is a market test of the value of the company, and you are left with a pot of cash to divvy up. The liquidating plan is not too difficult to put together and confirm. Confirming a reorganization plan is much harder. The negotiation with various constituencies is a much more arduous process than a 363 sale. In addition, the valuation issues that can derail a plan or lead to a difficult confirmation battle are much more difficult to overcome than any objection to a 363 sale.

[Lynn M. LoPucki]

Dan McGuire raises several interesting points. First, he points out that debtors and creditors committee professionals “are paid from the same source, the estate, and the fees of both are subject to the same standard of review,” and then notes that the creditors’ committees could spend more if they deem it necessary. I agree. That doesn’t, however, prove parity. Managers still are in control of the company and the case, and have far better information. If a fight develops, some combination of creditors will probably be paying the professional fees for both sides, while the managers pay nothing.

Second, McGuire expresses skepticism that break up fees attract stalking horses. But if they don’t, why should the courts permit break up fees at all?

Third, McGuire asks how we determined the number of bidders in our study. The answer is that we counted only those who qualified and bid at the formal auction. We caught glimpses of the phenomenon McGuire mentions – mini-auctions of the stalking horse position. Those mini-auctions, however, take place in secret, unregulated, and no systematic data are available. The existence of secret unregulated auctions in a system where the auctions are supposed to be public and regulated is hardly reassuring.

[Dan McGuire]

You make a fair point about unequal information, although that is always the case where one litigant is objecting to the behavior of another. The party whose behavior is being questioned will have more information. The opponent needs to rely on discovery to catch up. So, too, with committees objecting to 363 sales. In large cases, committees will always have a financial advisor who will have taken the time to become rather familiar with the debtor's fincial condition, so it is not like the committee is starting from scratch.

I should have been clearer in my point about stalking horses. It is the "who would not otherwise have bid" part I think is contrary to how these sales occur. I do not deny that break up fees help lock in interested bidders to set a floor price in exchange for bid protections, I just do not see the bid protections as luring bidders to the table who would not otherwise be there. In my experience bid protections serve as an incentive to lock in potential bidders, but do not bring bidders to the table in the first place.

I readily concede that the mini auctions for stalking horse position are contrary to the purpose and intent of section 363. That does not make it any less true that the number of qualified bidders at the 363 sale itself is not a good proxy for the number of bidders. In addition, most reorganization plans evolve from a behind the scenes negotiation over what creditors will get what interest in the reorganized debtor. True, the result of those negotiations still must pass through section 1129, but so, too, must the stalking horse satisfy 363.

[Lynn M. LoPucki]

With those clarifications, I don't disagree with Dan McGuire on the points addressed in his first two paragraphs. I also agree that the number of qualified bidders at the 363 sale may not be a good proxy for the number of bidders in touch with the debtor. But there is still an important difference between the functioning of the 363 sale and reorganization processes. In reorganization, each constituency has a legal right to its distribution. If deprived of that, they can raise it with the court. But a bidder, even one willing to pay more than the stalking horse selected, has no legal right to become the stalking horse. Thus failure in the negotiations to select a stalking horse is of more consequence than failure in the negotiations for a plan.

[FernandezAlexia]

Great Job! It looks top notch and very professional. It is just the kind of message I want to send to my patients. Keep up the great work. I wish i was a student at Chicago Law school.