It’s always gratifying to learn that bankruptcy legends read this blog. Lynn LoPucki is one of those people.
Last night I opened an email I received from Professor LoPucki letting me know that he and my (not-so-old) old law school professor, Doug Baird, would be duking it out at the University of Chicago Faculty Law Blog over issues raised in Professor LoPucki’s recent paper (written with empiricist Joseph W. Doherty) entitled Bankruptcy Fire Sales, 106 Mich. L.R. 1 (2007). The article was posted on SSRN last April, accompanied by the following abstract:
For more than two decades, scholars working from an economic perspective have criticized the bankruptcy reorganization process and sought to replace it with market mechanisms. In 2002, Professors Douglas G. Baird and Robert K. Rasmussen asserted in The End of Bankruptcy (pdf), an article published in the Stanford Law Review, that improvements in the market for large, public companies had rendered reorganization obsolete. Going concern value could be captured through sale.
This article reports the results of an empirical study comparing the recoveries in bankruptcy sales of large public companies in the period 2000-2004 with the recoveries in bankruptcy reorganizations during the same period. We find that, controlling for company values reported at case commencement, pre-filing operating profits, and post-filing operating profits, the recoveries in reorganization cases are more than double the recoveries from going concern sales. We attribute the low recoveries in sale cases to continuing market illiquidity and the corruption of the bankruptcy process by competition among bankruptcy courts for large, public company cases.
We also find that bankruptcy recoveries are higher in years when merger and acquisition activity is higher for reasons other than high stock prices. Lastly, we find that bankruptcy recoveries are higher when debt capacity in the debtor’s industry is lower – the opposite effect predicted by Professors Andrei Shleifer & Robert W. Vishny in their landmark article in 1992 [entitled Liquidation Values and Debt Capacity: A Market Equilibrium Approach, 47 J. Fin. 1343 (1992)].
This "H2H"–as the U of C Law Blog calls the "head to head" grudge match–is sure to be a classic, as Professors LoPucki and Baird have been sparring over bankruptcy’s most fundamental questions since 1990, when Professor LoPucki first challenged Professor Baird’s "faith" in the free market’s ability to properly value a company’s worth in chapter 11. See LoPucki, Bargaining Over Equity’s Share in the Bankruptcy Reorganization of Large, Publicly Held Companies, 139 U. Penn. L. Rev. 125 (1990). Their ongoing debate remains central to bankruptcy jurisprudence, as noted in this last post, with recent opinions by the Seventh Circuit’s Judge Cudahy (while sitting by designation as a Third Circuit judge in VFB LLC v. Campbell Soup Co.) and Judge James M. Peck (in the Iridium bankruptcy) suggesting that judges, by placing a heavy burden of proving market folly on the party challenging the market’s indication of value, are beginning to share Professor Baird’s faith in free market valuations.
Professor LoPucki also took issue early on with the idea that chapter 11 should be eliminated and companies forced instead to liquidate expeditiously in chapter 7, an idea he attributes first to a 1986 article by Professor Baird (and Professor Baird’s former writing partner, Thomas H. Jackson). See LoPucki, Strange Visions in a Strange World: A Reply to Professor Bradley and Rosenzweig, 91 Mich L. Rev. 79 n.2 (1992); and LoPucki & Whitford, Corporate Governance in the Bankruptcy Reorganization of Large, Publicly Held Companies, 141 Univ. Pa. L. Rev. 669 (1993).
Professor LoPucki stepped up the rhetoric in the debate in 1994, paying Professor Baird this back-handed compliment at an interdisciplinary conference at Wash. U. Law School: "Without the unrealistic work done by Baird and Jackson during the 1980s, bankruptcy scholarship might not have gone beyond the relatively shallow analysis produced by doctrinalism in the 1970s." See LoPucki, Reorganization Realities, Methodological Realities, and the Paradigm Dominance Game, 72 Wash. U. L. Q. 1307, 1312 (1994).
Professor Baird (with my former classmate, USC Law School Dean Bob Rasmussen) in The End of Bankruptcy, 55 Stan. L. Rev. 751 (2002), extended his critique of chapter 11 by concluding that "[c]orporate reorganizations have all but disappeared" and that chapter 11 has been transformed of late into a "convenient auction block" or a site that "merely put[s] in place preexisting deals." Professor LoPucki challenged this conclusion, citing to his 20 years of empirical data in an article the next year entitled The Nature of the Bankruptcy Firm: A Response to Baird and Rasmussen’s "The End of Bankruptcy," 56 Stan. L. Rev. 645 (2003). Professors Baird and Rasmussen were unmoved, though agreed that while "the end" may not yet be here, the "twilight" sure is, for creditors–not managers–control the process. See Baird & Rasmussen, Chapter 11 at Twilight, 56 Stan. L. Rev. 673, 675 (2003) ("Corporate reorganizations today are the legal vehicles by which creditors in control decide which course of action–sale, prearranged deal, or a conversion of debt to a controlling equity stake–will maximize their return.").
Professors Baird, Rasmussen, and LoPucki have continued to debate the utility or futility of chapter 11 as a reorganization process, and who does (or should) control that process: the "residual owners" (i.e., the creditors) or "the judges and fiduciaries." Compare LoPucki, The Myth of the Residual Owner: An Empirical Study, 82 Wash U. L. Q. 1341 (2004), with Rasmussen, Search for Hercules: Residual Owners, Directors and Corporate Governance in Chapter 11, 82 Wash. U. L. Q. 1445 (2004); see also, Baird & Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. Penn. L. Rev. 1209 (2006) ("Today’s creditors craft elaborate covenants that give them a large role in the affairs of the corporation…. When a business stumbles, creditors typically enjoy powers that public shareholders never have, such as the ability to replace the managers and install those more to their liking. The powers that modern lenders wield rival in importance the hostile takeover in disciplining poor or underperforming managers. This essay explores these powers and begins the task of integrating this lever of corporate governance into the modern account of corporate law.").
Professor LoPucki shifted the debate from the empirical to the theoretical by positing his "Team Production Theory of Bankruptcy Reorganization" against Professor Baird’s "Creditors’ Bargain Theory." See LoPucki, A Team Production Theory of Bankruptcy Reorganization, 57 Vand. L. Rev. 741 (2004), in which he described the fundamental differences between the two theories as follows:
The Team Production Theory of Bankruptcy Reorganization, like the Creditors’ Bargain Theory it challenges, is contractarian. It attempts to identify economically efficient institutions by assuming they are the institutions contracting parties would choose. In contrast to the Creditors’ Bargain Theory, which is based on a hypothetical contract derived by the theorist, the Team Production Theory is based on the actual contracts entered into by team members. Researchers can test the Team Production Theory empirically by determining whether the actual contracts match those asserted by the Team Production theorist. The theory is both positive in attempting to describe the actual contracts among the team members and normative in its assertion that the actual contracts should be enforced because they are efficient. Id. at 744.
With Professor LoPucki hitting the mainstream with his book, Courting Failure: How Competition for Big Cases Is Corrupting the Bankruptcy Courts (Univ. of Michigan Press, 2006), Professors Baird and LoPucki debated the merits of Professor LoPucki’s thesis in these articles: Baird, Beyond Recidivism, 54 Buff. L. Rev. 343 (2006), and LoPucki, Where Do You Get Off? A Reply to Courting Failure’s Critics, 54 Buff. L. Rev. 511 (2006). Professor LoPucki further defended the premise of his book in an article published last year in the University of Chicago Law Review entitled Delaware Bankruptcy: Failure in the Ascendancy, 73 Univ. of Chicago L. Rev. 1387 (2006).
With his latest article, Bankruptcy Fire Sales, Professor LoPucki shifts the debate with Professor Baird back to familiar ground: the utility or futility of chapter 11 reorganizations. This is the first time, however, that they are going head-to-head in a blog forum, thus sparing both the author and the reader from having to labor through footnotes! Also, with the blog format, we get their real-time thoughts and responses, and don’t have to wait a year for the official academic response in a law review article.
Professor Baird will have his work cut out for him, though, as the LoPucki/Doherty team has packed the article densely with empirical supporting data. Still, unlike this recent crestfallen champion, I doubt Professor Baird will be rubbing any "clear" on his head or arms for extra strength and insight before responding. Regardless, LoPucki’s and Doherty’s charge that "bankruptcy courts [are not fulfilling their] obligation to ensure that debtors in possession and their professionals act in the best interests of the debtors’ estates when choosing between going-concern sale and reorganization" won’t win the authors many kudos from judges attending the National Conference of Bankruptcy Judges later this month in Orlando. They write in conclusion:
Bankruptcy going-concern sales can provide a substitute for bankruptcy reorganization only if, for a given company, the sale can realize at least as much value as a reorganization. Otherwise, reorganization should continue in order to maximize value.
We found that, on average, reorganizations yielded 80% or 91% of book value, while sales yielded only 35% of book value. Those findings warrant the conclusion that, on average, companies sell for less than would be realized in their reorganizations. To reach a contrary conclusion, one might suppose that the best and strongest companies were reorganized while the worst and weakest were sold. But if debtors could sell their companies for as much as they would bring in reorganization, the statistically significant difference in sale and reorganization recoveries would never have arisen. Sale or reorganization would have been equally likely for each company and the pattern of sale or reorganization choices random. That the difference arose demonstrates at minimum that reorganization was sufficiently preferable to sale in high-recovery cases to warrant the cost of sorting the cases. If the reorganized companies had to be sold in some new regime, whatever reorganization advantage caused them to sort themselves under the old regime would be lost.
Our finding that the choice between sale and reorganization remains highly significant, even when we control for the financial condition of the company, suggests considerably more. It is theoretically possible that large differences in value existed among the companies studied; that those differences were not reflected in either book values or EBITDA; and that, for some reason not yet explained, those differences were highly correlated with the choice between sale and reorganization, with the weaker companies choosing sale. But barring such unlikely, unidentified differences, our findings demonstrate that large public companies were sold in bankruptcy going-concern sales for less than half what they would have been worth in reorganization.
Possible explanations for this market failure are not in short supply. The managers who decided to sell these companies rather than reorganize them frequently had conflicts of interest. So did the investment bankers who advised the managers and solicited bids. The stalking-horse bidders received protections in the form of breakup fees and substantial minimum bid increments that discouraged other bidders. The costs of participating in the bidding were high because the companies’ situations were complex and changed rapidly. Bidders other than the stalking horse had little chance of winning. As a result, only a single bidder appeared at most bankruptcy auctions. The process from the hiring of the financial advisor to the court’s order approving the sale was generally leisurely, averaging just under a year. In only five of twenty-nine cases (17%) did it take less than 180 days. But once the stalking horse was selected, the cases were fast tracked. The average time from execution of the stalking horse contract to the auction was only 41 days, giving competing bidders little time to organize. Together, these findings demonstrate, and at least partially explain, the failure of going-concern sales as an alternative to reorganization.
The bankruptcy courts have an obligation to ensure that debtors in possession and their professionals act in the best interests of the debtors’ estates when choosing between going-concern sale and reorganization. Our findings show that the bankruptcy courts are not fulfilling that obligation.
Thanks for reading!
[For those keeping track, still no twins…ETA, Tuesday night.]
© Steve Jakubowski 2007