5 posts categorized "H2H: LoPucki v. Baird"

October 04, 2007

H2H: LoPucki Strikes Back

Joe and I don't propose "a dramatic change in §363 practice." We think sale under §363 should continue to be an option under the current legal standard — "sound business reasons [for not going though the Chapter 11 process of disclosure and plan confirmation]."

What we do propose is to end the disastrous competition among the bankruptcy courts for large, public company bankruptcies. Because the judges are competing for cases, they can't also perform their function as regulators of the sales. They can't ask the hard questions—such as whether the proponents of the sale own a beneficial interest in the buyer. They can't control professional fees. They can't appoint trustees when the managers of the companies have been engaged in fraud. (Two good examples are Enron and Refco. The system failed to replace either management with a trustee despite a clear Congressional mandate.)

Our §363 sale study is one of several, by a variety of researchers, that show serious problems in the bankruptcy courts' handling of large public company bankruptcies since the competition began: high refiling rates by companies reorganized in the competing courts, rents extracted by managers, suspicious patterns of decision making by the competing courts, and higher professional fees in forum shopped cases.

The competition arose by historical accident. The two major organizations representing unsecured creditor interests—the National Association of Credit Managers and the Commercial Law League—along with the National Bankruptcy Conference and the National Bankruptcy Review Commission have all endorsed legislation to end the competition.

Court competition—a form of regulatory competition—doesn't work in situations where one side picks the court and the other can do nothing about it. When that kind of competition has arisen in other contexts—tort and class action forum shopping for example—Congress has acted to eliminate it. The bankruptcy court competition is permitted to continue only because Senator Joseph Biden (D-Del.) wields tremendous power in the Senate.

In 2005, Congress rewarded the Delaware bankruptcy court by raising the number of Delaware bankruptcy judges from two to six. So far this year, six of the seven large public companies that filed bankruptcy anywhere in the United States (86%) filed in Delaware. The New York court—triumphant as recently as 2005—must now respond or risk fading into obscurity. One who seeks to do no harm should insist on studies showing court competition to produce no harm before permitting clever strategists to make such a dramatic change in large, public company bankruptcy. That showing hasn't been made.

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.

October 02, 2007

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.

October 01, 2007

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

September 28, 2007

October H2H: LoPucki v. Baird

Thanks to Glenn Reynolds and Cass Sunstein for their contributions to our September edition of the Head to Head debate -- we hope discussion on the very interesting issues they raised will continue on these pages.

On Monday, we'll begin the October H2H.  Lynn LoPucki, the Security Pacific Bank Professor of Law at UCLA Law School and  current visitor at  Washington University Law, will discuss his recent paper Bankruptcy  Fire Sales with our Douglas Baird. This promises to be a lively  consideration of key fundamental questions in bankruptcy. In this paper  co-authored with Joseph Doherty of UCLA Law, Lynn challenges some recent  influential work on bankruptcy (in particular, Douglas’s 2002 paper with 1985  Chicago Law grad and now-University of Southern California Dean Bob Rasmussen). Read  the paper over the weekend and show up Monday ready to talk.