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.     

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.     

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.     

Postbankruptcy Performance and Management Turnover

This article examines the performance of 197 public companies that emerged from Chapter 11. Over 40 percent of the sample firms continue to experience operating losses in the three years following bankruptcy; 32 percent reenter bankruptcy or privately restructure their debt. The continued involvement of prebankruptcy management in the restructuring process is strongly associated with poor post-bankruptcy performance. The substantial number of firms emerging from Chapter 11 that are not viable or need further restructuring provides little evidence that the process effectively rehabilitates distressed firms and is consistent with the view that there are economically important biases toward continuation of unprofitable firms.     

Corporate Restructuring and Corporate Dissolution of Companies in Financial Distress: Ensuring Creditor Protection. A Comparison of the US,UK and Dutch Models

Where a company is in financial distress, there are two options: rescue of the (viable) company by restructuring or liquidation of the (unviable) company by dissolution. In practice, the most important restructuring procedure is the US Chapter 11. Many European jurisdictions have used Chapter 11 as a source of inspiration for the enactment of their restructuring proceedings. However, in Europe, national restructuring rules vary greatly in respect of the range of procedures available to companies in financial distress aiming at restructuring. Some European jurisdictions do not provide for formal restructuring procedures at all. Unviable companies in financial distress are too broke to restructure. In most European jurisdictions, unviable companies can be dissolved very quickly and cheaply. However, these procedures also differ from each other. Copyright © 2017 INSOL International and John Wiley & Sons, Ltd.     

REORGANIZATION AND FINANCIAL DISTRESS: AN EMPIRICAL INVESTIGATION

Prior studies on financial distress focus on the restructuring of one aspect of the firm. By examining various forms of restructuring, we provide empirical evidence that asset restructuring and governance restructuring play significant roles before bankruptcy filing. Our analysis shows that financial restructuring before bankruptcy is influenced by the holdout problem among creditor groups. Evidence suggests that the fraudulent conveyance provision does not pose a serious impediment to divestitures during the two years before bankruptcy. The evidence also indicates that Chapter 11 reorganization is lenient toward management. Although Chapter 11 allows the firm to breach burdensome executory contracts with employees, our findings suggest that union busting is not an important part of the reorganization process. Finally, we identify various financial characteristics to predict the different types of restructuring a firm may undertake.     

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.     

Private Equity,Buy‐outs and Insolvency Risk

Private equity restructuring using debt has been criticized for increasing financial distress and bankruptcy especially following the financial crisis. We build a unique dataset comprising the population of over 9 million firm‐year observations and 153,000 insolvencies during the period 1995–2010. We compare the insolvency hazard of the spectrum of buy‐out types within the corporate population over time and investigate the risk profile of the companies pre‐buy‐out. Controlling for size, age, sector and macro‐economic conditions, private‐equity backed buy‐outs are no more prone to insolvency than non‐buy‐outs or other types of management buy‐ins. Moreover, leverage is not the characteristic that distinguishes failed buy‐outs from those surviving.     

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.     

Post‐IRCJ challenges: changing Japanese culture to enable early revitalization of troubled corporations

The Industrial Revitalization Corporation of Japan (IRCJ) was created in 2003 to restructure distressed debtor corporations with excessive debts before their bankruptcy with a view to deterring ever‐increasing non‐ and poor‐performing loans. The IRCJ successfully reorganized target debtor companies through the out‐of‐court workout with multiple financial institutions where unanimous consent of financial creditors is required. Since the lifetime of the IRCJ is limited, the IRCJ cannot rescue troubled corporations after the end of March 2005. From then onward, the out‐of‐court workout should be utilized more widely in Japan in order to revitalize distressed businesses at an early stage without impairing the rights of trade creditors and deteriorating the value of the businesses. To make the workout most effective, it is important to ensure that the statutory reorganization procedures, including the majority rule, are applied more flexibly and reliably. Copyright © 2005 John Wiley & Sons, Ltd.     

The Bankruptcy System's Chapter 22 Recidivism Problem: How Serious is It?

This paper is adapted from the keynote address from the Eastern Finance Association's 2014 meeting in Pittsburg, Pennsylvania. We highlight a recidivism problem: about 15% of debtors who emerge as continuing entities under Chapter 11, or are acquired as part of the bankruptcy process, ultimately file for bankruptcy protection again (18.25% when considering only those firms which emerge as a continuing, independent entity). We argue that the “Chapter 22” issue should not be dismissed by the bankruptcy community just because no interested party objects during the confirmation hearing. Applying the Z”‐Score model to a large sample of Chapter 11 cases reveals highly different and significant expected survival profiles at emergence. Credible distress prediction techniques can effectively predict the future success of firms emerging from bankruptcy and be used by the bankruptcy court to assess the feasibility of the reorganization plan, a requirement mandated by the Bankruptcy Code. Branch reviews, discusses, and critiques in this follow‐up article to Altman's original thesis.     

The Canadian Keiretsu

This article describes the Canadian keiretsu , in which a main Chartered Bank dominates an interlocking group of corporate clients, investment dealers, trust companies, and professional advisors. Such a network facilitates information-sharing and monitoring among group members, while also reducing the agency costs of banker misbehavior. Most major Canadian firms are members of a keiretsu , and stock ownership of Canadian corporations is far more concentrated than ownership of U.S. companies.
Given their many similarities of history, law, and geography, Canada and the United States should have ended up with similar corporate ownership and governance structures. But they did not, and the difference was Canada's less restrictive banking and bankruptcy laws, which in turn can be traced to Canada's distinctly non-populist historical experience.
The Canadian keiretsu arose primarily for two reasons: (1) the larger concentration of commercial banking (the six largest Canadian banks today account for 98% of the industry's assets) allowed by Canadian law; and (2) the greater powers of Canadian secured lenders in the event of default. Unlike a U.S. Chapter 11 filing, in a Canadian bankruptcy the lender's right to assume control of the assets was not stayed until quite recently. And, even with the recent change in Canadian bankruptcy law, Canadian secured lenders have much stronger protection of their claims in bankruptcy than their U.S. counterparts in Chapter 11.     

Bad news does not always travel fast: evidence from Chapter 11 bankruptcy filings

This paper examines the stock price performances of 275 non‐financial, non‐utility U.S. industrial firms that continue trading on the main exchanges after filing for Chapter 11 bankruptcy between 1 October 1979 and 17 October 2005. This paper identifies a negative and statistically significant post‐bankruptcy drift that lasts for at least 6 months. This finding adds to the literature showing that the market is unable to process bad public news events in a timely manner. Further analysis suggests that the theoretical model proposed by Hong and Stein (1999) can be used to help explain this market‐pricing anomaly.     

CEO turnover and bankrupt firms’ emergence

This paper examines whether CEO turnover within a bankrupt firm predicts the firm's likelihood to reemerge from bankruptcy proceedings as a reorganized entity. Using 836 bankruptcy cases filed under Chapter 11 of the United States Bankruptcy Code from 1989 through 2016, we show that firms that undergo CEO turnover are significantly more likely to emerge from Chapter 11 proceedings. We conduct further analyses to examine the potential mechanisms through which CEO turnover is linked to a firm's chance of emergence. Consistent with the perspective that CEO turnover constitutes an observable event that can signal creditor support, we find that CEO turnover in bankrupt firms is positively associated with debtor-in-possession financing. Additionally, there is a significant increase in managerial quality post-turnover. Further, we document that the predictive power of CEO turnover is stronger in bankruptcy cases with greater uncertainty, such as in free-fall bankruptcies, where there is less preexisting agreement between the firm and its creditors. Overall, our findings provide valuable insight into external investors and stakeholder groups, whose interests are significantly impacted by corporate bankruptcies.     

The Use of Noncourt‐Based Corporate Rescue: Does the Australian Voluntary Administration Procedure Provide a Model for China?

In the recent international history of insolvency law reform, the reform of corporate rescue and restructuring has been an ongoing project. In China, the enactment of the Enterprise Bankruptcy Law 2006 saw the introduction of a bankruptcy reorganisation procedure that incorporates the debtor‐in‐possession model found in Chapter 11 of the US Bankruptcy Code. However, the Chinese corporate rescue procedure has been significantly underused due in part to various drawbacks associated with this court‐based and highly politicalised process. This paper explores the possibility of reforming China's current corporate rescue regime by drawing upon the Australian voluntary administration procedure. Found in Part 5.3A of the Corporations Act 2001 (Cth), this procedure was designed to provide a relatively swift, inexpensive and flexible corporate rescue mechanism for companies in financial distress. It comprises a noncourt based mechanism under the control of one or more professionally qualified private administrators. It is interesting to note that the UK also moved away from exclusive reliance upon court‐based administration procedures following the passage of the Enterprise Act 2002. This moved the UK closer to the Australian practitioner‐dominated approach to corporate rescue. This paper argues that the addition of a voluntary administration‐style procedure to China's current corporate rescue regime may be needed as China develops its market economy based on the rule of law. Copyright © 2017 INSOL International and John Wiley & Sons, Ltd     

How do banks resolve firms’ financial distress? Evidence from Japan

The main purpose of this paper is to investigate how banks resolve firms?? financial distress in Japan. Our results show that distressed firms that have more unsecured bank debt are more likely to restructure debt successfully out of court. Second, private debt restructuring is conducted during the year in which a financially distressed firm would be compelled to report negative net worth because of substantial accounting losses if no debt restructuring plans were implemented. Third, firms that are already in a negative net worth situation are more likely to receive debt forgiveness and/or debt-for-equity swaps. Finally, both the 1-year-lagged total liabilities-to-assets ratio and accounting losses are positively related to the private workout level. These results suggest that banks resolve firms?? financial distress in shareholders?? and creditors?? interests. We argue that, along with bankruptcy laws, the stock exchange rules and the fact that banks are allowed to hold shares in these firms affect the resolution of firms?? financial distress.     

The Impact of Receiving Debtor-in-Possession Financing on the Probability of Successful Emergence and Time Spent Under Chapter 11 Bankruptcy

The ability to obtain financing is a critical element in attempting to successfully reorganise a firm which has declared Chapter 11 bankruptcy. Debtor-in-possession (DIP) financing has become an increasingly popular method in recent years. This paper examines whether receiving DIP financing is related to successful reorganisations and a shortened duration under Chapter 11 bankruptcy proceedings. This study finds that there is an increase in realised returns to equity at the announcement of DIP loan agreements which is positive and statistically significant. It is also found that DIP-financed firms have a reduced probability of liquidation, and shorter time spent under bankruptcy proceedings.     

Surviving Chapter 11 Bankruptcies: Duration and Payoff?

Three of the authors previously developed a model to predict the duration of Chapter 11 bankruptcy and the payoff to shareholders ( Partington et al ., 2001 ). This work augments that study using a much larger sample to re-estimate the model and assess its stability. It also provides an opportunity for out-of-sample testing of predictive accuracy. The resulting models are based on Cox's proportional hazards model and the current article points to the need to test two important assumptions underlying the model. First, that the hazards are proportional and, second, that censoring is independent of the event studied. Using the extended data set, all the previously significant accounting variables drop out of the model and only two covariates of the original model remain significant. These are the market wide credit spread and the market capitalization of the firm, both measured immediately prior to the firm's entry to Chapter 11. Receiver operating characteristic curves are then used to assess the predictive accuracy of the original and extended models. The results show that Lachenbruch tests can provide a misleading indication of predictive ability out of sample. Using the Lachenbruch method of in-sample testing, both models show predictive power, but in a true out-of-sample test they fail dismally. The lessons of this work are relevant to better predicting the gains and losses likely to accrue to shareholders of companies in Chapter 11 bankruptcy and in similar administrative arrangements in other jurisdictions.     

Private Equity and Portfolio Companies: Lessons from the Global Financial Crisis

Critics of private equity have warned that the high leverage often used in PE‐backed companies could contribute to the fragility of the financial system during economic crises. The proliferation of poorly structured transactions during booms could increase the vulnerability of the economy to downturns. The alternative hypothesis is that PE, with its operating capabilities, expertise in financial restructuring, and massive capital raised but not invested (“dry powder”), could increase the resilience of PE‐backed companies. In their study of PE‐backed buyouts in the U.K.—which requires and thereby makes accessible more information about private companies than, say, in the U.S.—the authors report finding that, during the 2008 global financial crisis, PE‐backed companies decreased their overall investments significantly less than comparable, non‐PE firms. Moreover, such PE‐backed firms also experienced greater equity and debt inflows, higher asset growth, and increased market share. These effects were especially notable among smaller, riskier PE‐backed firms with less access to capital, and also for those firms backed by PE firms with more dry powder at the crisis onset. In a survey of the partners and staff of some 750 PE firms, the authors also present compelling evidence that PEs firms play active financial and operating roles in preserving or restoring the profitability and value of their portfolio companies.