Coming Through in a Crisis: How Chapter 11 and the Debt Restructuring Industry Are Helping to Revive the U.S. Economy

During the recent financial crisis, U.S. bankruptcy courts and debt restructuring practitioners were faced with the largest wave of corporate defaults and bankruptcies in history. In 2008 and 2009, $1.8 trillion worth of public company assets entered Chapter 11 bankruptcy protection—almost 20 times the amount during the prior two years. And the portfolio companies of U.S. private equity firms faced a towering wall of debt that, many observers predicted, was about to wipe out most of the industry. But far from the death of private equity or a severe contraction of corporate America, the past three years have seen an astonishingly rapid working off of U.S. corporate debt overhang, allowing corporate profits and values to rebound with remarkable speed and vigor. And as the author of this article argues, corporate America's recovery from the recent financial crisis provides a clear demonstration of the importance of U.S. bankruptcy laws and restructuring practices in maintaining the competitiveness of U.S. companies and the long‐run growth of the U.S. economy.     

Post-Chapter 11 Bankruptcy Performance: Avoiding Chapter 22

Despite the long experience in the U.S. with restructuring companies in bankruptcy, there remains a persistent tendency for companies to emerge from Chapter 11 with too much debt and too little profitability. In this article, the author uses a variant of his well-known "Z-Score" bankruptcy prediction model to assess the future viability of companies when emerging from bankruptcy, including the likelihood that they will file again—a surprisingly common phenomenon that is now referred to as "Chapter 22."
The author reports that those companies that filed second bankruptcy petitions were both significantly less profitable and more highly leveraged than those that emerged and continued as going concerns. Indeed, the average financial profile and bond rating equivalent for the "Chapter 22" companies on emerging from their first bankruptcies were not much better than those of companies in default.
The authors findings also suggest that a credible corporate distress prediction model could be used as an independent, unbiased method for assessing the future viability of proposed reorganization plans. Another potential application of the model is by the creditors of the "old" company when assessing the investment value of the new package of securities, including new equity, offered in the plan.     

Bankruptcy as an Auction Process: Lessons from Sweden

The traditional U.S. Chapter 11 bankruptcy process in which financial claims are renegotiated under court protection and the firm continues to operate under existing management has long been criticized by economists as an inefficient way of dealing with financially distressed companies. In this paper, the authors make the case for a mandatory auction bankruptcy system of the kind now used in Sweden—one that requires all companies filing for Chapter 11 to be sold in open auctions soon after the filing. After discussing the notable features of and differences between the U.S. and Swedish bankruptcy systems, the authors summarize recent research (much of it their own) on the benefits and possible drawbacks of the Swedish system. Among the most notable findings of this research, there is no evidence that mandatory bankruptcy auctions in Sweden lead to “fire‐sale” discounts in auction premiums. Moreover, the fact that three‐quarters of the Swedish companies that filed for bankruptcy survived as going concerns should allay concerns that an auction system will produce excessive liquidations. At the same time, the post‐bankruptcy operating profitability of the companies that emerge from Swedish auctions as going concerns tends to be on a par with that of their (non‐bankrupt) industry peers. Such post‐operating performance, when combined with a 75% rate of reorganization (versus liquidation), suggests that allowing auction investors—instead of the bankruptcy court—decide which companies survive and how they get capitalized and restructured has been quite effective in accomplishing the two aims of a bankruptcy system: (1) preserving intact all economically viable enterprises while (2) eliminating the excess capacity that results from prolonging the existence of companies that are never expected to earn high enough returns on capital to attract private investment. Consistent with these findings, the U.S. in recent years has seen a sharp increase in the use of auctions in Chapter 11 bankruptcies, though on a voluntary rather than a mandatory basis. Such a change reflects the growing recognition of the role of auction processes in reducing bankruptcy costs and preserving going‐concern values as U.S. capital market participants push harder for private workouts, “prepackaged” Chapter 11 filings, and auction sales in Chapter 11.     

The Economic Impact of Chapter 11 Bankruptcy versus Out‐of‐Court Restructuring

Companies in financial distress have usually been able to choose between working out an agreement with their creditors (“private restructuring”) or entering into more expensive and lengthier formal Chapter 11 bankruptcy proceedings. But 2015 rulings in two cases by the U.S. District Court for the Southern District of New York may force distressed firms to enter Chapter 11 rather than seek negotiated out‐of‐court settlements. Using a large sample of U.S. companies that experienced financial difficulty during the period 2006–2014, the authors found that the companies that filed for bankruptcy and went through Chapter 11 proceedings experienced significantly more job losses and reductions of economic output than companies achieving out‐of‐court restructurings, both overall and on a per‐case basis. The authors' estimates of the overall losses in output associated with Chapter 11 bankruptcy cases ranged as high as 2.3% of 2014 GDP, as compared to at most 0.3% of GDP in the case of out‐of‐court negotiations. At the same time, the authors estimate that as many as 2.2 million job losses were attributable to cases involving bankruptcies while the out‐of‐court cases were associated with the loss of at most about 300,000 jobs. But, as the authors concede, these findings are exaggerated by a clear self‐selection bias—one that stems from the well‐documented tendency of more fundamentally profitable, and hence more solvent, companies to choose private restructuring over bankruptcy. Despite this limitation, the study provides a useful point of departure for future studies that aim to quantify the costs to the U.S. economy of limiting or removing the option of companies with valuable operations but the “wrong” capital structures to work out their financial difficulties outside of the bankruptcy court.     

ROUNDTABLE ON PRESERVING VALUE IN CHAPTER 11

In an article published in this journal in 1991, Michael Jensen describedthe U.S. bankruptcy system as "fundamentally flawed." As Jensen went on to say, "It is expensive, it exacerbates conflicts among different classes of creditors, and it often takes years to resolve individual cases. As a result of such delays, much of the operating value of viable businesses is destroyed and the value of creditors' claims is often dissipated in providing life support for terminal cases." Lending support for Jensen's claim, academic studies of financial reorganization in the 1980s reported that the cost of reorganizing companies in Chapter 11 tends to run as much as ten times the cost of out-of-court workouts.
In this roundtable, bankruptcy authority Thomas Jackson discusses the current state of Chapter 11 with a financial economist, a practicing bankruptcy attorney, and a corporate executive who recently helped lead his firm (Global Crossing) through a reorganization. According to Jackson, academic research has helped bring about notable improvements in the court-supervised reorganization process. The most important source of such improvements is the growing tendency to limit "exclusivity periods" and use auctions to solve information and incentive problems that plagued the traditional process. Though by no means a panacea, as the practitioners point out, the increased use of auctions is preserving value by effectively substituting the market's judgment for that of a bankruptcy court judge in both valuing the assets and determining who is most qualified to own and manage them.     

Dutch corporate insolvency law: On the brink of a revolution?

The Dutch Bankruptcy Code (DBC) has not changed fundamentally over the more than 110 years of its existence, at least as far as corporate insolvency proceedings are concerned. On 1 November 2007, however, a committee of insolvency experts presented a draft for an entirely new code to the Ministry of Justice. Whether this new code will gain the force of law and whether this will happen within the near future remains uncertain but the proposals will in any event dominate discussions on insolvency law in the Netherlands for the foreseeable future. The main goal behind many of the proposals is improving the ability to successfully restructure companies that experience financial difficulties. To this end the proposals include various measures that would weaken the position of (secured) creditors. The proposals include widening the scope of the cooling-off period during which secured creditors are unable to enforce their security by granting the administrator a right of use of assets subject to security interests. The ability to rely on early termination clauses in contracts is also reduced during the cooling-off period. The position of secured creditors is further weakened by a proposal to grant the right to sell assets that are subject to security interests to the administrator if he continues the business. Under the current bankruptcy code, secured creditors can largely ignore insolvency proceedings, there is no general stay on enforcement and, early termination clauses in contracts are generally thought to be valid and enforceable during insolvency proceedings. Although banks have already argued that weakening the position of secured creditors will limit the ability to restructure companies, it seems safe to assume that the relatively comfortable position that secured creditors currently enjoy during insolvency proceedings in the Netherlands will be under fire due to the proposals for a new bankruptcy code. Copyright © 2008 John Wiley & Sons, Ltd.     

Self‐Fulfilling Prophecies of Failure: The Endogenous Balance Sheets of Distressed Companies

This article analyses a problem at the intersection of accounting, law, and economics: the economically efficient operation of legal arrangements for company failure is undermined because valuations of assets and liabilities become unstable once a firm is distressed. The paper draws on the three disciplines to show the pivotal role of asset and liability valuations in answering the legal question, whether the firm is insolvent, and the economic question, whether the firm should fail and its assets be redeployed to an alternative use. U.S. and U.K. evidence reveals a disconcerting indeterminacy in these processes: the probability that a firm will fail affects significantly the valuations assigned to assets and liabilities; but at the same time the valuation of assets and liabilities itself determines the probability of failure. This balance sheet endogeneity is then shown to delay economically efficient management changes under debtor‐oriented U.S. Chapter 11, and to induce unnecessary costly bankruptcy with creditor‐oriented U.K. receivership/administration. Recent cases trace this endogeneity in failures involving often controversial countermanding of huge financial claims.     

UNIVERSITY OF ROCHESTER ROUNDTABLE ON Bankruptcy vs. Bailouts: The Case of General Motors and the U.S. Auto Industry

In an event staged at Rochester's Geva Theatre in the midst of the global financial crisis in 2009, Tom Jackson, one of the world's two most highly regarded bankruptcy scholars (the other is Doug Baird) as well as a former President of the University of Rochester, begins by explaining why the U.S. Chapter 11 reorganization process is well suited to resolving the problem of excess capacity that has long plagued the U.S. auto industry. As Jackson has noted elsewhere, thanks to both academic research and the efforts of legal and corporate practitioners to implement the findings of this research, The current Chapter 11 process is a dramatic improvement over the world of 1985. In those days, our system put the bankruptcy judges— people who generally do not have a great deal of financial sophistication—in the impossible position of deciding among the conflicting claims of parties whose incentives were to provide biased information. The great thing about the auction process that is now routinely used by the ABI—and which wasn't being used anywhere in the bankruptcy process 20 years ago—is that we're likely to get more reliable information from people who are putting up their own money…[and so] backing their projections of future performance and value with cash. This has the great benefit of taking the judges out of a role for which they have neither the proper training or experience—or the right incentives… [As a result of recent reforms,] what we have today is a much more streamlined process. Sale mechanisms are more likely to be used, exclusivity periods are less likely to be extended, and it has begun to look a lot like the auction or M&A model that some of us proposed years ago. This relatively new reliance on an M&A‐type auction process is reassuring because, as Cliff Smith points out, One of the biggest challenges in bankruptcy is determining the value of the firm, or the size of the pie that can end up being divided among the creditors. And this means that before you start divvying up the firm's assets, it's critically important to get reliable answers to questions like: How valuable is this business under the current management? And how valuable could it be if we allowed the ownership to change? Judges don't have a comparative advantage in answering these questions because they simply don't have the specific knowledge to make this kind of determination. Using the auction system in a market setting is likely to generate much more reliable answers. Besides preserving value for creditors, a better informed and more efficient reorganization process can also have the critically important effect of removing excess capacity in industries that are weighed down by it. And as Smith goes on to say, Financially troubled companies that will not be viable under any management team and are therefore worth more dead than alive are clearly candidates for Chapter 7, and the job of the bankruptcy courts is to get them there as expeditiously as possible. Liquidate the business and free those assets to move to higher‐valued uses… Take the case of the airline industry. Although keeping extra carriers in business through prolonged stays in Chapter 11 may help keep airfares down, these artificially low fares are also likely to discourage even profitable competitors from investing in the future. And this ends up working against the long‐run interest of the industry and the general public. In sum, bankruptcy has at least two potentially important roles to play in a well‐functioning economy. First is distinguishing companies that should survive and remain intact from those that should be pulled apart. In cases of chronic overcapacity in which companies are clearly worth more dead than alive, the firm's assets should be sold, either piecemeal or in their entirety, to the highest bidders. But for all economically viable businesses, there are two general outcomes: In cases where a competent management team is the victim of external circumstance—and perhaps the wrong capital structure—the likely outcome is an LBO‐type transaction in which outsiders provide new funding for the current team. But in those cases where the current management is viewed as part of the problem, the system is designed to shift control to new owners and management—and as quickly as possible. Such a process can be expected to contribute to long‐run economic growth by helping ensure that industries end up with the right amount of capacity, neither too much nor too little.     

Bankruptcy law and corporate investment decisions

Major European countries have recently adopted bankruptcy codes that strengthen entrepreneurs’ power to renegotiate outstanding liabilities. Renegotiation in bankruptcy allows lenders to increase recovery rates, however it also weakens the contract’s ability to solve the moral hazard problem embedded in the production project. Hinging on this trade-off, I show in which circumstances a soft bankruptcy law that resembles Chapter 11 in the balance of lenders’ and entrepreneur’s rights encourages the choice of investments that privilege the achievement of long-term results. However, I also show that, in contrast to the common wisdom, soft bankruptcy can lead to the choice of investments that are biased towards the achievement of short-term outcomes.     

Corporate Governance and the Investment Efficiency of Diversified Corporate Asset Buyers

Many corporate assets are bought and sold each year in the U.S. and most scholars believe these transactions improve economic efficiency. But given the reality that the interests of corporate managers may diverge from those of their shareholders and reflect empire‐building or other managerial entrenchment strategies—and that such agency problems tend to be worse in highly diversified, multi‐divisional companies—the authors tested the proposition that diversified corporate asset buyers with more effective governance structures can be expected to allocate capital more efficiently, as reflected in higher rates of return on operating capital and more favorable market reactions to the announcements of their purchases. Using a sample of diversified U.S. companies that announced large asset purchases between 1988 and 2006, the authors report finding that the investment allocation process following such asset purchases was more consistent with value creation in the case of diversified buyers with more effective governance structures, which were identified by their greater board independence, higher‐quality audit committees, and higher levels of stock ownership by institutional ownership, directors, and CEOs.     

Bankruptcy outcomes: Does the board matter?

We examine the association between board composition and bankruptcy outcomes. Preliminary analyses provide no evidence that the proportion of outside directors is significantly associated with the likelihood that a Chapter 11 firm liquidates. Further analyses indicate, however, that the relation between the proportion of outside directors and bankruptcy outcomes is a function of the outside directors' ownership. More specifically, we find that the association is positive when outside director ownership is low and negative when it is high. The overall evidence supports the notion that a one-size-fits-all approach to corporate governance is likely to result in suboptimal board structures and hinder firms' strategies for dealing with poor performance.     

The Structure of Corporate Ownership in Japan

I examine the structure of corporate ownership in a sample of Japanese firms in the mid 1980s. Ownership is highly concentrated in Japan, with financial institutions by far the most important large shareholders. Ownership concentration in independent Japanese firms is positively related to the returns from exerting greater control over management. This is not the case in firms that are members of corporate groups (keiretsu). Ownership concentration and the accounting profit rate in both independent and keiretsu firms are unrelated. The results are consistent with the notion that there exist two distinct corporate governance systems in Japan —one among independent firms and the other among firms that are members of keiretsu.     

Financial structure change and banking income: A Canada–U.S. comparison

Data suggest that the Canadian financial structure, and particularly indirect finance (e.g., banking), have become more market-oriented. We associate this financial trend in part with the regulatory changes that have occurred in Canada since the 1980s. Financial intermediaries are increasingly involved with financial market activities—e.g. off-balance sheet (OBS) activities such as underwriting securities. In this article we analyze the noninterest income attributable to these financial market activities. We find that the variance of Canadian banks’ aggregate operating-income growth is rising because of the increased contribution of noninterest income. Overall, our analysis corroborates the U.S. findings of Stiroh and Rumble (Stiroh, K., 2006. A portfolio view of banking with interest and noninterest assets. Jounal of Money, Credit, and Banking 38, 1351–1361; Stiroh, K., Rumble, A., 2006. The darkside of diversification: the case of U.S. financial holding companies. Journal of Banking and Finance 30, 2131–2161): by contributing to banking income volatility, market-oriented activities do not necessarily yield straightforward diversification benefits to Canadian banks.     

A Brief Review of Catastrophe Theory and a Test in a Corporate Failure Context

Catastrophe theory (CT) is a mathematical theory that attempts to describe a system exhibiting discontinuous behavior under continuous stimuli. Although CT has been used to describe corporate bankruptcy, this is an application that has not been tested. This paper reviews CT and provides such a test. We construct a time series of stock returns on companies that have filed for Chapter 11. Under certain, frequently occurring conditions, CT would predict a structural shift in firm stock returns as the data of filing is approached. Results confirm that such a shift does occur and in a way consistent with the CT prediction. Our findings both support the use of CT to describe corporate bankruptcy and raise questions about some techniques frequently used to study bankruptcies.     

The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in theUnited States and model bankruptcy as a strategic decision.We analyze a firm's choice between liquidation under Chapter7, renegotiation of the debt contract in a workout, and reorganizationunder Chapter 11 of the bankruptcy code. Our premise is thata financially distressed firm chooses its action in order tominimize the loss in value caused by the well-known over- andunder-investment problems. We show that the firm initiates aworkout when it faces under-investment, and commences Chapter11 when it faces over-investment. Some of the results are: (i)in default, total firm value and equity value increase uponthe announcement of a workout and decrease upon the announcementof Chapter 11; (ii) firms with shorter maturity of debt aremore likely to reorganize in a workout; (iii) among the firmsthat renegotiate their debt contract, the proportion of firmsentering Chapter 11 is higher for firms in mature industriesthan for firms in growth industries.     

A TEST OF THE TWO-TIER CORPORATE GOVERNANCE STRUCTURE: THE CASE OF JAPANESE KEIRETSU

We examine the effect of corporate governance structure on the relation between ownership structure and financial leverage among Japanese firms. Under normal conditions, we find no significant relation between ownership variables and financial leverage. When firms signal financial difficulties, however, keiretsu financial institution equity owners intervene to moderate the use of debt. This evidence reveals the existence of a keiretsu two-tier corporate governance system. In the first stage, the unique corporate cross-shareholding allows mutual monitoring under normal circumstances. In the second stage, when firms get into financial trouble, keiretsu financial institutions assume control by reducing debt levels. The results highlight differences between keiretsu and independent corporate governance structures.     

INTERNATIONAL CORPORATE DIFFERENCES: MARKETS OR LAW?

Current differences in international corporate ownership and governance systems reflect primarily differences in the efficiency of capital markets, not differences in corporate law. Law is an output of this process, not an input. In countries where financial markets are more efficient, there is both less law and greater investor protection. Unlike nations in Asia and most of Europe, the U.S. and the U.K. have large and efficient capital markets, with no restrictions on cross-border capital flows. It is thus notsurprising that when American and English banks, mutual funds, and insurers are allowed by law to increase the concentration of their holdings, they don't do so. With efficient markets, there is no money to be made by holding undiversified blocks in public corporations. If public markets were inefficient, entrepreneurs would arrange for large blocks of stock (or take companies private), just as they grant powers of control to venture capitalists. The effect of law on corporate governance and ownership is far less pronounced in America than in Europe and Japan. Restrictions on U.S. banks aside, corporate law in the United States is “enabling”–that is, it lets people do largely what they want in organizing, managing, and financing the firm. Corporate law in Europe and Japan is much more “directory.” And there is a straightforward explanation for this difference: When capital markets are efficient, the valuation process works better, which in turn provides investors with stronger assurances of fairness. When markets are less efficient, some substitute must be found–law, perhaps, or the valuation procedures of banks. Thus, banks play larger corporate governance roles in nations with less extensive capital markets–and corporate law, as the European Union's company directives show, is more restrictive. European corporate law is today about as meddlesome and directory as U.S. law in the late 19th century, before U.S. capital markets became efficient.     

U.S. banking regulations and foreign banks' entry into the United States

This study provides a review of foreign banking activities in the U.S. over the past decade. Foreign banking entry into the United States has occurred through representative offices, branches, agencies, subsidiary banks, Edge Act offices, and investment companies. The total assets of foreign offices, branches, and subsidiaries in the U.S. increased 310 percent, while total assets of domestically owned commercial banks increased 99 percent. Foreign interests are not currently dominating U.S. banking activities. The shares of balance sheet accounts for foreign entrants are growing more rapidly than domestic institutions in six states, but not in New York and California. To eliminate any disadvantages U.S. institutions may face in competing with foreign banks, American state and federal banking laws need to be liberalized.     

Asset Efficiency and Reallocation Decisions of Bankrupt Firms

This paper investigates whether Chapter 11 bankruptcy provides a mechanism by which insolvent firms are efficiently reorganized and the assets of unproductive firms are effectively redeployed. We argue that incentives to reorganize depend on the level of demand and industry conditions. Using plant-level data, we find that Chapter 11 status is much less important than industry conditions in explaining the productivity, asset sales, and closure conditions of Chapter 11 bankrupt firms. This suggests that firms that elect to enter into Chapter 11 incur few real economic costs.     

The corporate reorganization regime under China's new enterprise bankruptcy law

This paper reviews the background of embarking on the bankruptcy law reform of China, and examines the newly introduced corporate reorganization regime under China's new Enterprise Bankruptcy Law 2006. As a patchwork of the US Chapter 11 and English Administration, China's new regime is a good law on paper with sound intention and perfect logic. But there are still many legal and institutional impediments to the new regime's utilization. For example there is a serious institutional incapacity among the judiciary, as the necessary training and organization of thousands of professionals has not started. Also of concern is the still‐unfinished process of updating and modification of related laws and accounting standards as well as their application and enforcement. Enacting a new bankruptcy law is only the first step. Copyright © 2008 John Wiley & Sons, Ltd.