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.

Comments

[RPD]

One issue regarding Prof. Lo Pucki's earlier post is that the post suggests that EBITDA is being used as a proxy for earnings. I would think this is incorrect, at least from a CorpFin perspective. EBITDA is a proxy for cashlow--not earnings--since EBITDA is, by definition, available to both debt and equity.

[George Marcus]

I am a U of C law grauduate (1973) practicing corporate reorganization law in Portland, Maine, concededly far from the epicenter of Chapter 11 cases for publicly held companies. Nevertheless, from my experience and observation, it seems that Prof. Baird is clearly correct in observing that the companies that seek Chapter 11 relief in order to accomplish a 363 sale are, relatively speaking, the "dogs". Prof. LoPucki apparently did not pick this observation up because I believe that his data is insufficiently refined to have permitted this conclusion. Nevertheless, the 363 sale route is generally chosen by the "dogs" because these Chapter 11 debtors do not have the financing to remain in business, or it does not make economic sense for them to remain in business, and/or the acquirors do not want to incur the transaction costs associated with going through a conventional Chapter 11 plan confirmation process,e.g disclosure statement, voting, etc. After all, why should they, as it is hard to articulate any value to an acquiror in doing so when the faster and cheaper 363 route is readily available--as Prof. LoPucki points out. Moreover, the faster a sale happens, the less likely it is that the debtor will find other suitors. In this regard, I find implausible the notion that the use of Sec. 363 is founded to any significant degree on the improper influence of "case placers". Section 363 is used because acquirors--and their targets--consider it vastly more efficient and risk free--which raises a number of other interesting issues concerning the Chapter 11 process, such as this: if the 363 process is so efficient for the dogs, why wouldn't it work with other debtors, and if it does, what is the utlilty of the rest of Chapter 11's provisions regarding plans, etc. I am very interested in following the discussion between Professors Baird and LoPucki and would be interested in a discussion of this particular issue.

[George Marcus]

I already found one error in my post. I am a 1976, not 1973, U of C law graduate. I apolgize to members of the class of 1973.

[Lynn M. LoPucki]

George Marcus refers to the 363 route as “faster and cheaper” than reorganization. But in our studies of professional fees, using several different definitions of sale, Joe Doherty and I repeatedly found no statistically significant difference between professional fees and expenses in sale and reorganization cases.

Section 363 sales are faster if you compare the time from filing to sale in sale cases with the time from filing to confirmation in reorganization cases. But if you compare time from filing to confirmation in both kinds of cases, the sales we studied took considerably longer than the reorganizations. Secured creditors were often paid from the sale proceeds at the closings. But the estates usually kept the unsecured creditors’ money – and even some of the secured creditors’ money – until months after confirmation. The professionals kept billing against it. (We don’t know what the fees were for.) So I would not agree that the 363 sale of large public companies is faster and cheaper than their reorganization.

That the sold companies are “dogs” is certainly the conventional wisdom. But what is about them that makes them dogs? We controlled for earnings (EBITDA, EBIT, and Net Income) and industry. The sales still brought lower recoveries than the reorganizations. Can anyone suggest some other, measurable variable (other than sale price of course) that would provide an objective basis for saying that the sold companies were worse than the reorganizations?

Lastly, if sales are more efficient than reorganizations and sales don’t bring lower prices for the same companies, why is it that most companies filing Chapter 11 continue to reorganize rather than sell?

[Dan McGuire]

It is difficult to think of a measurable variable. Adding to the list of difficult to measure variables, many cases end up as 363 sales after about a year in chapter 11 because a the constituents cannot agree on terms of a stand alone plan. Thus many companies that are not deemed worth reorganizing end up going the 363 route. Subjective and hard to measure, but true.

[Dan Feldman]

Doug:

Tell me why Bangor Punta shouldn't limit the rights of buyes of distressed bonds, just as it does the rights of buyers of distressed stock. Vultures like the Tribune Co bond holders make their living stressing the lives of lawyers (who advised on solvency) just for the fun of showing how tough they are; Fun is not bankruptcy's purpose